Part A: Cash and Cash Equivalents

1. What Is Included?
   1.  Cash includes currency and coins, balances in checking accounts, and items acceptable in these accounts, such as checks and money orders.
   2. Cash equivalents include such items as money market funds, treasury bills, and commercial paper.
   3. Companies typically classify investments with maturity dates of three months or less when purchased as cash equivalents. The company's policy must be described in a disclosure note.
   
   
2.  Internal Control of Cash
   1. Internal control refers to a company's plan to (a) encourage adherence to company policies and procedures, (b) promote operational efficiency, (c) minimize errors and theft, and (d) enhance the reliability and accuracy of accounting data.
   2. Section 404 of the Sarbanes-Oxley Act requires a company to document and assess its internal controls. The company's auditors must provide an opinion on management's assessment. The Public Company Accounting Oversight Board's Auditing Standard No. 2 further requires the auditor to express its own opinion on whether the company has maintained effective internal control over financial reporting.
   3. A critical aspect of an internal control system is the separation of duties.
   4. In the  cash receipt process, the employee who opens the mail should not also deposit the checks nor be involved in recordkeeping.
   5. In the  cash disbursement process, responsibilities for check signing, check writing, check mailing, cash disbursement documentation, and recordkeeping should be separated whenever possible.
      
   
   
3.  Restricted Cash and Compensating Balances
   1. Only cash available for current operations or to pay current liabilities should be classified as a current asset.
   2. Restrictions on cash can be informal, arising from management intent or might be contractually imposed.
      1. Cash that is restricted and not available for current use usually is reported as investments and funds or other assets.
      2. An example of a contractual restriction on cash is a lender-imposed compensating balance requirement.

Part B: Current Receivables

1. Initial Valuation of Accounts Receivable
   1. Receivables resulting from the sale of goods or services on account are called accounts receivable.
   2. Accounts receivable are current assets because, by definition, they will be converted to cash within the normal operating cycle.
   3. The typical account receivable is valued at the amount expected to be received, called the net realizable value.
   4. A trade discount reduces the actual price to a customer and is recognized indirectly by recording the sale at the net of discount price.
   5.  Cash discounts reduce the amount to be paid if remittance is made within a specified short period of time.
      1. Using the  gross method, we record the receivable and sales revenue at the gross, before discount price. Discounts taken are recorded as sales discounts (reductions to gross sales revenue).
      2. Using the  net method, we record the receivable and sales revenue at the net of discount price. Discounts not taken are recorded as interest revenue.
      3. The effect on the financial statements of the difference between the two methods usually is not material.
       Illustration
   
   
2. Subsequent Valuation of Accounts Receivable
   1. Possible returns and customer nonpayment could cause subsequent accounts receivable to be less than initial valuation.
   2. If  sales returns are material, they should be estimated and recorded in the same period as the related sale.
   3. If bad debts are material, the  allowance method should be used. The method estimates future bad debts and matches that expense with the related sales revenue.
      1. There are two approaches to estimating bad debts, the income statement approach and the balance sheet approach.
         1. With the  income statement approach), bad debt expense is a percentage of the period's net credit sales. The amount recorded ignores any prior balance in the allowance account.
         2. With the  balance sheet approach, the net realizable value of receivables is determined, often using an aging schedule. Bad debt expense is equal to the required adjustment to the allowance account to bring net receivables to realizable value.
      2. With either approach, accounts receivable is reduced to net realizable value indirectly by an adjusting entry in which bad debt expense is debited and an allowance account is credited.
          Illustration
      3. Actual bad debt write-offs reduce both accounts receivable and the allowance account.
      4. When  previously written-off accounts are collected, the receivable and the allowance are reinstated and the cash collection is recorded as usual.
   4. Direct write-off method
      1. This is a method not generally permitted by GAAP.
      2. Bad debt expense is simply the actual bad debt write-offs during the period.
   
   
3. Measuring and Reporting Accounts Receivable— A Summary
   
   
4. Notes Receivable
   1. Notes receivable are formal credit arrangements between a creditor (lender) and a debtor (borrower).
   2. The typical note receivable requires the payment of a specified face amount, also called principal, at a specified maturity date, along with  interest at a specified percentage of the face amount.
       Illustration
   3. Sometimes a receivable assumes the form of a so-called noninterest-bearing note.
      1. Noninterest-bearing notes actually do bear interest, but the interest is deducted at the onset (or discounted) from the face amount to determine the cash proceeds made available to the borrower.
          Illustration
      2. When interest is discounted from the face amount of a note, the effective interest rate is higher than the stated discount rate.
   4. Similar to accounts receivable, if a company anticipates bad debts on short-term notes receivable, it uses an allowance account to reduce the receivable to net realizable value.
   
   
5. Financing with Receivables
   1. Financial institutions have developed a wide variety of methods that allow companies to use their receivables to obtain immediate cash.  How do these institutions evaluate a company's receivables?
   2. These methods can be described as either:
      1. A secured borrowing.
      2. A sale of receivables.
   3. If the transferor surrenders control over the assets transferred, the arrangement is accounted for as a sale; otherwise, it is accounted for as a borrowing.
   4. An  assignment involves the pledging of specific accounts receivable as collateral for a loan.
   5. The  pledging of accounts receivable involves the assigning of accounts receivable in general rather than specific receivables. No specific accounting treatment is needed other than the disclosure of the pledging arrangement.

6. Two popular arrangements used for the sale of accounts receivable are factoring and securitization. The sale of accounts receivable can be made without recourse or with recourse.
   1. The buyer assumes the risk of uncollectibility when accounts receivable are sold without recourse, and the transfer is accounted for as a sale. The typical  factoring arrangement is made without recourse.
   2. The seller retains the risk of uncollectibility when accounts receivable are sold with recourse. If certain criteria are met,  factoring with recourse is accounted for as a sale; otherwise, its accounted for as a borrowing.
7. The transfer of a note receivable to a financial institution is called discounting.
    Illustration
8. Financing with Receivables –  A Summary


6.  Decision Makers' Perspective
   1. A company's investment in receivables is influenced by several variables, including the level of sales, the nature of the product or service sold, and credit and collection policies.
   2. Management's choice of credit and collection policies often involves trade-offs. Management must evaluate the costs and benefits of any change in credit and collection policies.
   3. The ability to use receivables as a method of financing also offers management alternatives.
   4. Investors and creditors can gain insights by monitoring a company's investment in receivables.
      1. The receivables turnover ratio is calculated by dividing net sales by the average accounts receivable.
      2. The  average collection period is calculated by dividing 365 days by the receivables turnover ratio.

This Real-World, Real-Time Electronic Case addresses accounting for bad debts and the receivables turnover ratio and average collection period using a real world example.
5. Bad debt expense is one of a variety of discretionary accruals that provide management with the opportunity to manipulate income.

 Here is a quiz to test your understanding of this chapter.