Cash & Cash Equivalents

Cash is more than just the coins and bills in your register. It encompasses all immediately available funds that a business can use without restriction.

Cash includes coins & currencies (cash on hand, petty cash), cash in bank (savings and demand deposits), and undeposited collections (money orders, remittances). Demand deposits are particularly important for businesses as they allow for both passbook access and check writing privileges.

When dealing with checks, understand the differences:

• Personal checks are most common but take time to clear
• Certified checks are verified by banks and considered secure
• Cashier's checks are issued directly by banks, making them more reliable
• Traveler's checks are prepaid instruments useful for business travel

💡 Bank drafts are helpful for large purchases, as they provide guaranteed payment like a cashier's check but for much larger amounts.

Cash equivalents are short-term, highly liquid investments that can be readily converted into cash. To qualify as a cash equivalent, investments must be debt instruments acquired three months or less before maturity. Examples include Treasury bills, short-term Treasury notes/bonds, time deposits, and money market placements.

Remember that legally restricted funds (like compensating balances for loans) aren't classified as cash equivalents. They're either classified as other current assets $short-term$ or other non-current assets $long-term$.

Bank Reconciliation

Bank reconciliation helps you match your book balance (what you've recorded) with your bank balance (what the bank shows). These two figures often differ due to timing differences.

Think of it this way: your books record cash increasing when you receive it, while the bank records increases when you deposit it. Similarly, your books show decreases when you write checks, but the bank only records them when they're presented for payment.

To reconcile your accounts, start with:

1. Your unadjusted book and bank balances
2. Add deposits in transit to your bank balance
3. Subtract outstanding checks from your bank balance
4. Add credit memos to your book balance
5. Subtract debit memos from your book balance
6. Adjust for any errors

Key terms to understand:

• Deposits in transit: Money you've recorded but the bank hasn't yet credited
• Outstanding checks: Checks you've written but recipients haven't cashed
• Credit memos: Bank collections like interest income or loan proceeds
• Debit memos: Bank charges like NSF checks or service fees

💡 Remember that bank and book entries work in opposite directions! In your books, debits increase your cash balance while credits decrease it. On your bank statement, credits increase your balance while debits decrease it.

Petty Cash Fund Management: Managing petty cash requires three key steps:

1. Establishment: Create the fund by cashing a check and giving it to the custodian
2. Disbursement: The custodian gives out money for small expenses
3. Replenishment: When the fund gets low, replenish it with a check equal to the amount spent

If you need to increase the fund later, simply issue another check for the additional amount. At year-end, adjust any remaining expenses that haven't been recorded.

Trade and Other Receivables

Receivables represent money owed to your business by others. Understanding how to classify and value them is crucial for accurate financial reporting.

Types of Receivables:

• Trade receivables arise from your ordinary business operations and are always classified as current assets
• Non-trade receivables come from transactions outside your main business activities

Within these categories, you'll find:

1. Accounts Receivable (AR): Money owed by customers
2. Notes Receivable (NR): Formal promises to pay with specific terms
3. Loan Receivables (LR): Money loaned to others, typically through banks

Other important receivables include:

• Advances to employees, officers, shareholders, or suppliers
• Supplier debit balances (overpayments to suppliers)
• Subscription receivables (money owed from share subscriptions)
• Accrued income (earned but not yet received income)
• Claims receivables (insurance or tax refunds)

💡 Customer credit balances are not receivables! They should be presented as current liabilities, not deducted from accounts receivable.

Measurement of Receivables: Initially, receivables are recorded at face value (selling price). Subsequently, they must be measured at net realizable value (NRV) – the amount you actually expect to collect.

To calculate NRV, you must deduct allowances for:

• Sales returns (merchandise expected to be returned)
• Sales discounts (discounts customers are likely to take)
• Freight charges (when applicable)
• Doubtful accounts (expected uncollectible amounts)

For example, if you offer terms of "5/10, n/30" (5% discount if paid within 10 days, net amount due within 30 days), you'll need to account for both gross and net methods of recording the transaction.

Accounting for Bad Debts

When customers fail to pay, you need a system to account for these losses. There are two main approaches: the allowance method and the direct write-off method.

The allowance method $used under PFRS/GAAP$ anticipates bad debts before they occur:

1. At year-end, estimate bad debt expense and create an allowance
2. When accounts become uncollectible, write them off against the allowance
3. If previously written-off accounts are later collected, reverse the write-off and record the cash receipt

The direct write-off method (used for tax purposes) only recognizes bad debts when they're definitely uncollectible:

1. No year-end adjustment is made
2. When accounts become uncollectible, directly expense them
3. If later collected, record as income

Estimating Doubtful Accounts:

You can estimate bad debts using either:

• Percentage of sales: Based on income statement figures (focuses on matching expense to current period sales)
• Percentage of accounts receivable: Based on balance sheet values (focuses on valuing receivables properly)
• Aging of AR: Most precise method that considers how long accounts have been outstanding

💡 When calculating your bad debt expense for the year, start with your existing allowance, adjust for write-offs and recoveries, then determine how much additional expense is needed to reach your required ending balance.

Special Treatment of Receivables:

• Receivables from related parties (subsidiaries, affiliates) are usually classified as long-term investments
• Customer credit balances should be classified as liabilities
• Employee/officer receivables are typically current assets
• Subscription receivables are usually part of equity, unless due within a year
• Pledged receivables remain as assets but require disclosure
• Receivables sold without recourse are excluded from assets

Notes and Loan Receivables, Impairment

Notes receivable are more secure than accounts receivable because they're formalized with a promissory note that specifies payment terms.

Measurement of Notes Receivable:

• Short-term notes (≤1 year) are initially recorded at face value
• Long-term notes are recorded at present value (PV)
• For interest-bearing notes where the stated rate equals market rate, PV equals face value
• For non-interest bearing notes or those with unreasonably low interest, PV must be calculated by discounting future payments

For example, if you receive a 2-year, $100,000 note with 10% interest payable annually:

1. For an interest-bearing note, simply record at face value
2. For a non-interest bearing note, calculate the present value:
   • PV = $110,000/(1+10%)² = $90,860 (for final payment)
   • Plus $10,000/(1+10%)¹ = $9,090 (for interim interest)
   • Total PV = $100,000

💡 The difference between face value and present value is called "unearned interest income" and must be amortized over the life of the note.

Subsequent Measurement: After initial recognition, notes receivable are measured at amortized cost using the effective interest method. Amortized cost equals:

• Initial amount
• Minus principal repayments
• Plus/minus cumulative amortization of any difference between initial amount and maturity amount
• Minus reductions for impairment

For non-interest bearing notes, amortized cost equals the present value plus amortization of the discount (or face value minus unamortized unearned interest income).

Loans Receivable

Loans receivable are a special category of receivables found in financial institutions' books (like banks). Unlike regular notes receivable, loans receivable always include interest.

When a bank issues a loan, it records several important elements:

• Principal amount
• Interest terms
• Origination costs/fees

Origination costs include expenses like credit evaluation and appraisal fees. These can be handled in two ways:

1. Deducted from loan proceeds in advance (reducing the loan receivable)
2. Charged through higher interest rates (increasing the loan receivable)

Impairment Assessment: Under PFRS 9, lenders must assess credit risk and potential impairment using the Expected Credit Loss (ECL) model. This involves three stages:

1. Stage 1: No significant increase in credit risk
   • Customer pays on time
   • Record 12-month expected losses
2. Stage 2: Significant increase in credit risk without objective evidence
   • Customer is 1+ month past due
   • Record lifetime expected losses
3. Stage 3: Significant credit risk with objective evidence
   • Customer is bankrupt or in severe financial distress
   • Record lifetime expected losses

💡 Impairment loss is calculated as the difference between the carrying amount of the loan and the present value of expected future cash flows discounted at the original effective rate.

The journal entry for impairment typically involves:

Loan impairment loss      XX
Interest receivable       XX
Allowance for loan impairment     XX

This write-down adjusts both the interest receivable that won't be collected and creates an allowance against the loan balance.

Receivable Financing

Receivable financing helps businesses generate immediate cash from their receivables. There are four main methods, each with different accounting implications.

1. Pledging of AR When pledging receivables:

• Receivables serve as collateral for a loan
• No special journal entry is required for the pledge itself
• Receivables remain on your books normally
• You must disclose the pledge in financial statement notes

For example, if you pledge $100,000 in receivables to secure a $50,000 loan from MB Bank, your receivables stay on your books while you record the loan as normal.

2. Assignment of AR Assignment is more formal than pledging:

• Requires loan documents and promissory notes
• Necessitates reclassification of the receivables
• Can be notification-based (customer pays directly to bank) or non-notification (customer pays you)

With assignment, your financial statements must disclose:

(A) AR-assigned $100,000
(L) Note Payable ($80,000)
(E) Equity in assigned AR $20,000

💡 Unlike pledging, assignment requires you to reclassify your receivables as "AR-assigned," though they remain part of your total trade receivables.

3. Factoring of AR Factoring involves selling your receivables:

• Transfers ownership to the factor (finance company)
• Factor handles collection and assumes risk
• Can be with or without recourse (your liability if customers don't pay)
• Can be casual $one-time$ or under continuing agreement

When factoring receivables, you record:

Cash               70,000
Loss on factoring  30,000
   Accounts Receivable     100,000

Factoring typically involves deductions for service fees, interest charges, and possibly a factor's holdback (returned after all receivables are collected).

Discounting

Discounting is the process of selling a note receivable before its maturity date, typically to a bank at less than face value.

When you discount a note, you receive cash immediately rather than waiting for maturity. The bank deducts interest (the "discount") for the remaining time until maturity.

Types of Discounting:

1. Without recourse: You have no liability if the customer doesn't pay
2. With recourse:
   • Conditional sale: You have contingent liability (disclosed only)
   • Secured borrowing: You recognize a liability

For example, if you discount a $100,000 note to a bank for $80,000:

Under conditional sale accounting:

Cash                    70,000
Loss on discounting     30,000
   Notes receivable discounted     100,000

Under secured borrowing accounting:

Cash                    70,000
Interest expense        30,000
   Notes receivable discounted     100,000

💡 With recourse, "Notes receivable discounted" is a contra-asset account deducted from Notes Receivable on your balance sheet, reflecting your contingent liability.

Calculating Discount Proceeds:

Face value/principal         X
Interest on maturity         X
Maturity value               X
Less: Discount (MV × DR × remaining term)  (X)
Proceeds from discounting    X

The discount rate is determined by the bank, but if not specified, use the same rate as on the note. The remaining term (or "discount period") is the time from discounting until maturity.

When recording the transaction, compare the total receivable (face value plus accrued interest) with the discounting proceeds and recognize the difference as a loss.

Inventory

Inventory represents assets held for sale in the ordinary course of business. In merchandising businesses, inventory consists of goods purchased for resale.

Inclusions in Inventory: Items are included in inventory when you have both:

1. Legal title (ownership)
2. Physical possession (control)

This means inventory includes:

• Goods owned and on hand
• Goods in transit (depending on shipping terms)
• Goods on consignment (for the consignor only)

Shipping Terms Matter:

• Under FOB Shipping Point: Buyer owns goods in transit
• Under FOB Destination: Seller owns goods in transit

Inventory Systems:

1. Periodic System:

   • Used for high-volume, low-value transactions (retail stores)
   • Requires physical count to determine ending inventory
   • Cost of goods sold is calculated indirectly:

     Beginning Inventory + Purchases - Ending Inventory = COGS
     

2. Perpetual System:

   • Used for low-volume, high-value transactions (car dealerships)
   • Maintains running record of inventory and COGS
   • Requires physical count to verify accuracy

💡 Both systems require physical inventory counts, but for different purposes. Periodic systems need counts to determine ending inventory, while perpetual systems use counts to verify accuracy of records.

Purchase Discounts: When recording purchases with terms like "10k, 2/10, n/30" (2% discount if paid within 10 days), you can use either:

• Gross method: Record purchase at full amount, then record discount when taken
• Net method: Record purchase at net amount, then record lost discount if not taken

Remember: Whether using periodic or perpetual inventory, freight costs paid by the owner of the goods (according to shipping terms) should be added to the cost of inventory.

Inventory Costing Formulas

Assigning costs to inventory is a critical accounting task. Three main methods are available under PAS 2:

1. Specific Identification

• Used for low-volume, identifiable items
• Directly matches each item's cost to its selling price
• Most precise method, but not practical for high-volume businesses

2. First-In, First-Out (FIFO)

• Assumes oldest inventory items are sold first
• During inflation/rising prices:
  • Results in highest net income
  • Ending inventory reflects newest (higher) prices
  • COGS reflects oldest (lower) prices
• During deflation/falling prices:
  • Results in lowest net income

3. Weighted Average (WAVE)

• Uses average cost of all similar items available for sale
• Two variations:
  • Periodic weighted average: Calculated once per period
  • Perpetual weighted average: Recalculated after each purchase (moving average)

💡 In FIFO, inventory costs flow in the same order as physical goods, while in weighted average, all costs are blended together.

Inventory Measurement: Inventory must be measured at the Lower of Cost and Net Realizable Value (LCNRV):

• Cost: What you paid (purchase price plus other costs necessary)
• NRV: Selling price minus costs to sell

This approach is conservative, ensuring inventory isn't overstated.

Purchase Commitments: When you enter agreements to buy inventory at fixed future prices:

• If market price rises above commitment price: No adjustment needed
• If market price falls below commitment price: Record loss $mark-to-market$

Remember that purchase commitments are used to minimize risk of price increases but can result in losses if prices drop significantly.