COMM 320 Chapter 6 Notes (Part 1) PDF

COMM 320 Chapter Six Cash and Accounts Receivable (Part 1) Cash-to-Cash Cycle You will often hear management discussing ways to shorten an entity’s cash-to-cash cycle. This cycle is the time period between when a business pays cash to its suppliers for inventory and receives cash from...

COMM 320 Chapter Six Cash and Accounts Receivable (Part 1) Cash-to-Cash Cycle You will often hear management discussing ways to shorten an entity’s cash-to-cash cycle. This cycle is the time period between when a business pays cash to its suppliers for inventory and receives cash from its customers. The concept is used to determine the amount of cash needed to fund ongoing operations, and is a key factor in estimating financing requirements. Clearly the goal is to minimize this cycle. As one would expect the cash-to-cash cycles are dependent on the type of business under review. A fruit and vegetable store has a very short cash-to-cash cycle whereas a winery has a much longer cash-to-cash cycle. Internal controls Management is responsible for the preparation of timely, reliable and complete financial information. The Board of Directors is responsible for ensuring that processes are in place for maintaining the integrity of the company’s accounting system and the financial statement preparation and reporting. This is an important objective of internal controls. Other objectives include ensuring the efficient use of company assets and complying with laws and regulations. The larger the entity, the more important controls become – an owner cannot be overseeing all aspects of a large organization. © Scott M. Sinclair, FCPA, FCA 2022 1  COMM 320 Internal controls continued The main principles of effective internal control are: Ensuring adequate physical controls Assignment of Responsibilities Segregating incompatible duties Independent verification of transactions Documentation While these are relatively straight forward, it is helpful to think about the consequences of not implementing internal controls. For example, assume one person in the company has complete responsibility for the all aspects of a transaction (i.e., initiation, processing, accounting, payment, etc.). Such a situation provides that person with the opportunity to commit fraud. If a supervisor or manager never reviewed or verified the transactions, there is little likelihood of the fraud ever being discovered. While internal controls are necessary, they are not without the following limitations: they must be cost efficient they are carried out by humans and therefore subject to human error they can be overridden by management they can be circumvented by collusion – i.e., two or more employees working together they can be ineffective for transactions not contemplated when the systems were initially established – i.e., unusual or infrequent transactions and changing circumstances © Scott M. Sinclair, FCPA, FCA 2022 2  COMM 320 As we work through the remaining chapters, think about the importance of internal controls in each area of discussion. I will include further comments and examples as we work through each topic. CASH A company must generate sufficient cash to sustain itself and expend that cash to pay employees and suppliers. Ensuring that sufficient cash is on hand at all times requires careful monitoring. As cash is a valuable and liquid asset, management would be wise to ensure it is well protected. Segregation of duties is very important in the handling of, and accounting, for cash. Basic principles of internal control as applied to cash would include: daily depositing of all cash and cheques restricting access to cash approval of all invoices by management payment of all expenditures by cheque requiring two signatures on each cheque the verification of cash balances on an ongoing basis. Of particular interest is the verification of cash. An important internal control for cash is a periodic bank reconciliation. It is a comparison of the cash per the accounting records of the entity to those of the entity’s bank. Before commencing our discussion, it is important to understand that if the entity and the bank have each recorded all transactions simultaneously without error, then the two balances would always agree. Such circumstances seldom arise. Most differences arise from either timing differences or errors. Timing differences arise because there are lags between the time amounts are recorded in the accounting records and the date they are © Scott M. Sinclair, FCPA, FCA 2022 3  COMM 320 processed by the bank. For example, a cheque is prepared and recorded on December 29, 2022 and mailed to a supplier. The cheque may take 7-10 days to make its way to the bank – the bank will not process it until 2023 – the next fiscal year. Such differences are reasonable and require no adjustments. Timing differences may have to be investigated if they remain outstanding for a significant period. Errors can result from bank and/or entity mistakes such as incorrect recording of cheques and deposits, cashing or depositing of cheques that do not belong to the entity. The bank must amend its records for identified bank errors. The entity must amend its accounting records for entity errors and items not yet recorded. Let’s review the definitions of the important terms to help you better understand the process. Items that affect the balance per the bank Outstanding deposit – a deposit recorded by the entity but not yet processed by the bank. (Timing Difference) Outstanding cheque – a cheque written and recorded by the entity but not yet processed by the bank. (Timing Difference) Bank error – a misstatement which either increases or decreases the records of the bank– e.g., a cheque of another customer of the bank is charged to the entity’s bank account or a deposit made to the entity’s bank account which belongs to another customer of the bank. (Error) Please note that none of the above items will ever result in a journal entry on the company’s books. The bank must amend its records. © Scott M. Sinclair, FCPA, FCA 2022 4  COMM 320 Items that affect the Cash per the Entity’s Accounting Records Items recorded on the bank statement that have not been recorded on the entity’s records. Examples include deposits collected by the bank or electronic payments paid by the bank or bank interest or account charges. NSF cheques – customer cheques received by the entity and deposited to the bank are subsequently determined to be worthless as the customer has insufficient funds to cover the cheque. Entity errors – items which have been incorrectly handled by the entity – e.g., cheques written but not recorded, cheques written for amounts which differ from the entries made in the entity’s records. The entity will have to prepare journal entries to ensure the transactions have been properly reflected in its accounting records. Bank Reconciliation Template A bank reconciliation is a time-consuming and picky exercise. Entity accounting records must be matched to each entry on the monthly bank statement. The reconciliation should be done frequently and ideally prepared by an individual not responsible for preparing or recording banking activates. A commonly used format for completing and organizing the reconciliation is presented on the next page: © Scott M. Sinclair, FCPA, FCA 2022 5  COMM 320 Company Name Template for a Bank Reconciliation As at Date Balance per bank statement $ Add: 1) Deposits in transit 2) Bank errors that removed funds from the bank account in error Deduct: 1) Outstanding cheques 2) Bank errors which increased bank account in error Adjusted Bank Balance $ Balance per Accounting Records $ Add: 1) Deposits found on Bank statement but not yet recorded by entity 2) Entity accounting errors that mistakenly reduced Entity’s cash accounting records Less: 1) Payments found on Bank statement which have not yet been recorded on Entity’s accounting records 2) NSF cheques 3) Entity accounting errors which have mistakenly increased Entity’s cash accounting records Adjusted Accounting Records $ *The two adjusted balances must balance © Scott M. Sinclair, FCPA, FCA 2022 6  COMM 320 Journal entries arising from a bank reconciliation As previously noted, the only journal entries to be recorded by the entity arise from items found in reconciling the Accounting Records side of the reconciliation. For example: A deposit listed on the bank statement but not in the entity’s accounting records must be recorded: Dr Cash 125 Cr Rental revenue 125 This records revenue received by the bank directly from one of the company’s tenants. Identification of an NSF cheque Dr Accounts Receivable 250 Cr Cash 250 In this example, the customer gave the company a worthless cheque. As a result, the company must reinstate the receivable and reduce the cash balance on its accounting records. It is a good idea to review your bank statements on a monthly basis to identify any errors or unusual transactions. © Scott M. Sinclair, FCPA, FCA 2022 7  COMM 320 Chapter Six Cash and Accounts Receivable (Part 2) Most companies allow customers to buy on credit - i.e., they are granted time to pay for their purchases. The hope is that sales and net income will be increased as a result of such policies. Good internal control should ensure that credit is granted wisely – checking credit histories prior to credit being granted, credit limits are evaluated for each customer and prompt follow up of any amounts unpaid after the stated payment terms. Despite good internal controls, some customers are either unable or unwilling to pay their accounts. How should a company account for accounts receivable that prove to be uncollectible? One approach is to wait until the account is known to be uncollectible and then simply write it off at that time. The journal entry would be: Dr Bad debt expense Cr Accounts (Trade) Receivables This approach, which is not widely accepted, is known as the direct write-off method. There are two drawbacks to this approach. First, it is dependent on determining when an account is deemed to be uncollectible (i.e., a management decision and therefore subject to manipulation) and secondly it often results in the write-off being recognized in a different period than when the original sale was recorded – a violation of the matching principle. © Scott M. Sinclair, FCPA, FCA 2022 1  COMM 320 The Allowance Method In order to satisfy the matching principle, most companies use the Allowance Method. Under this method, an estimate is made each period of the bad debt expense. Estimates can be made using either the Percentage of Credit Sales Method or the Aging of Accounts (Trade) Receivables Method. The first method focuses on the Income Statement while the later method focuses on the Balance Sheet. Percentage of Credit Sales Method Under the Percentage of Credit Sales method, the bad debt expense is determined by multiplying Credit Sales by an estimate of those sales which will prove to be uncollectible - often based on prior credit history (usually expressed as a %). The Journal entry is: Dr Bad debt expense Cr Allowance for Doubtful Accounts Allowance for Doubtful Accounts is a contra account that offsets Accounts (Trade) Receivables. When a specific account receivable is actually known to be uncollectible, the journal entry required under the allowance method is: Dr Allowance for Doubtful Accounts Cr Accounts (Trade) Receivable © Scott M. Sinclair, FCPA, FCA 2022 2  COMM 320 Should an account previously written off become collectible, the entry to reinstate the account is: Dr Accounts (Trade) Receivable Cr Allowance for Doubtful Accounts While the balance in Allowance for Doubtful Accounts may go into a debit balance during the year, it can never end the year in a debit balance. Aging of Accounts (Trade) Receivables Method The aging method determines the ending balance in Allowance for Doubtful Accounts based on the $ amount of Accounts (Trade) Receivables that are thought to be uncollectible. The older a receivable, the greater the likelihood that it will prove uncollectible. Under this method, you must first prove what the year-end balance in the Allowance for Doubtful Accounts should be. This amount is calculated by applying an uncollectible factor to each category (i.e., less than 30 days (current), over 30 days, over 60 days, over 90 days) of accounts receivable. The older the receivable the greater the likelihood the amount will be uncollectible. You then compare the required ending balance to the balance currently in the account (prior to your adjusting journal entry). The difference is the bad debt expense for the period. The factors applied should be based on historical experience. Under this method, the accounts used in the journal entries for setting up the bad debt expense (note the number would be different than that determined under the percentage of credit sales method), the write-off of a receivable and the reinstatement of a receivable previously written off are the same as those presented for the percentage of credit sales method. © Scott M. Sinclair, FCPA, FCA 2022 3  COMM 320 When attempting questions on this topic, don’t mix the two methods - be clear what information must be used and what information is irrelevant. There is a great deal of judgment required when establishing these estimates. Management should be monitoring write-offs carefully. Excessive write-offs may be indicative that credit is being granted to unsuitable customers (i.e., poor credit risks). In practice, management’s bias is to understate the Allowance for Doubtful Accounts therefore overstating Net Accounts (Trade) Receivables and net income for the period. Financial presentation of Accounts Receivable is: Accounts (Trade) Receivables Less: Allowance for Doubtful Accounts Net Accounts Receivable Financial Statement Analysis In order to measure the effectiveness of management’s credit-granting and collection policies you will find the Accounts Receivable Turnover ratio very useful: = Net credit Sales/Average net Accounts (Trade) Receivables If net credit sales is not available, use net revenue from the income Statement. As with all ratios, we are interested in trends within the company and with competitors in the industry. © Scott M. Sinclair, FCPA, FCA 2022 4  COMM 320 Financial Statement Analysis continued Generally, the higher the ratio the more effective the policies have been. It means Accounts Receivables are being collected more quickly. An alternative ratio, the Average collection period, is calculated as follows: = 365/ Accounts Receivable Turnover Ratio In understanding this ratio, the higher number means receivables are not being collected on a timely basis and may be indicative of uncollectible accounts and/or poor credit collection policies. Assessing Liquidity Users are interested in the liquidity of an entity – the ability to convert assets into cash in order to satisfy short-term liabilities. Current Ratio = Current assets/ Current liabilities Quick Ratio = (Current assets – Inventory – Prepaid Expenses) / Current Liabilities This is a refinement of the current ratio that includes only quick assets. Bank loans often include covenants of minimum current and/or quick ratios. Once again, we are interested in the trend of these ratios. We will return to these ratios in Chapter 12 when we conclude the course with financial analysis. © Scott M. Sinclair, FCPA, FCA 2022 5