CASH, RECEIVABLE, AND PREPAID EXPENSES

Definitions of Terms

In this section, we will present and elucidate various definitions of important terms. By providing clear and concise explanations, we aim to enhance understanding and promote effective communication.

Accounts receivable refers to the current assets listed on the statement of financial position. These assets represent the short-term amounts owed by customers who have made purchases on credit.

An assignment involves using accounts receivable as collateral to create a loan. In the event that the debtor is unable to repay the loan, the creditor has the right to collect the accounts receivable and keep the proceeds. However, the borrower still retains the risk of loss on the receivables, and customers are typically not informed about the assignment.

Cash encompasses various forms of currency and financial instruments held by a company, such as petty cash, checks, certificates of deposit, traveler’s checks, money orders, letters of credit, bank drafts, cashier’s checks, and demand deposits. These assets are readily available on demand and have no restrictions.

Collateral refers to assets that have been pledged to secure repayment of a loan by the debtor. If the debtor fails to repay the loan, the creditor is entitled to sell the collateral and retain the proceeds.

Factoring involves the sale of accounts receivable to a third party, who then assumes the risk of loss if the accounts receivable cannot be collected.

Factor’s holdback represents a portion of the payment for an accounts receivable sale that is retained by the factor in anticipation of product returns or other credits granted by customers.

Net realizable value refers to the expected revenue that can be obtained from the sale of an item or service, minus the costs associated with the sale transaction.

Pledging refers to the act of assigning accounts receivable as collateral for company debt.

Recourse refers to the right of a creditor in a factoring arrangement to be reimbursed by the debtor for any uncollectible accounts receivable that were sold to the creditor.

CONCEPTS AND EXAMPLES

Cash

When there is a temporary limitation on cash, such as the requirement to hold it in a sinking fund for the payment of a corresponding debt within a year, it should still be categorized as a current asset. However, it should be listed as a separate line item. On the other hand, if there is a long-term restriction on cash, like a compensating balance agreement linked to debt that will not be paid off within the current year, the cash should be classified as a long-term asset. Alternatively, if a compensating balance agreement is associated with a loan that matures within the current period, it can be recorded separately as a current asset.

If a company issues checks without having sufficient funds, it will face a negative cash situation as indicated on its statement of financial position. Instead of displaying a negative cash balance among assets, it is more appropriate to adjust the amount of the excess checks back into the accounts payable liability account. This approach ensures that the reported cash balance remains close to zero. It is important to note that an overdraft condition exists for financial reporting purposes when there is a negative book balance for the cash account, regardless of whether the financial institution is aware of the condition or not. This discrepancy is typically due to the timing of check clearances and deposits in transit, which may not align with the financial institution’s records.

Cash held in foreign currencies should be included in the cash account on the statement of financial position, with two important conditions. First, this cash must be converted to local currency units using the prevailing exchange rate as of the date of the statement of financial position. Second, the funds must be readily convertible into local currency units. If they are not, perhaps due to currency restrictions imposed by a foreign government, the cash cannot be classified as a current asset. Instead, it must be categorized as a long-term asset. This restriction is particularly significant for organizations aiming to report the highest possible current ratio but facing foreign deposits subject to exchange restrictions.

Prepaid Expenses

Prepaid expenses are classified as current assets on the financial position statement. These should encompass advance payments for expenditures anticipated within the next 12 months. Examples include prepayments for key man life insurance, rent, or association fees. Each transaction under this account should be accompanied by a detailed schedule, outlining the items charged and their respective amortization periods over which they will be expensed (refer to the sample report in the Recordkeeping section).

It is important to note that the prepaid expense account does not cover deposits, as these are generally not converted back to cash until the associated agreements conclude, often extending beyond one year from the financial position statement date. For instance, a standard one-month rent deposit required under a building lease agreement cannot be reclaimed until the lease expires. Consequently, deposits are typically recorded in the Other Assets or Deposits accounts, listed as noncurrent assets on the financial position statement. However, if the related agreement is set to expire within one year, such deposits should be included in current assets.

Receivables—Presentation

Accounts receivable presented in the financial position statement sometimes encompass various amounts owed to the entity that do not strictly qualify as accounts receivable. It is therefore beneficial to clearly define what should be included in this account. An account receivable represents a claim payable in cash in exchange for goods or services provided by the company. This definition excludes notes receivable, which are essentially loan repayments documented by a signed note. Notes receivable should be separately itemized in the financial statements.

Additionally, short-term loans to employees (such as advances) and employee or officer loans of any duration should be reported in an Other Receivable or Receivable from Employees account, rather than under accounts receivable.

Receivables: Collateral, Assignments, and Factoring

When a company leverages its accounts receivable as collateral for a loan, an accounting entry is not mandated. However, it is crucial to disclose this information, either directly on the statement of financial position or within the accompanying footnotes. In cases where specific receivables are assigned as collateral for a loan, thereby creating a pledge, disclosure requirements must also be met.

Customer payments are typically forwarded to the lender by the reporting entity, which requires no accounting entry. If a company sells some or all of its accounts receivable without retaining any continuing involvement in their collection and without the obligation to repay the transferee in the event of a customer default, this process is known as factoring. In such cases, a sale transaction must be recorded (refer to the Decision Tree section for more details).

The accounting entries for factoring usually include:

• A credit to the Accounts Receivable account
• A debit to the Cash account for the amount received from the buyer
• An entry for Factoring Expense to account for any additional charges imposed by the factor

The cash received from the factor is also reduced by an interest charge, which is calculated based on the amount of cash provided to the company and the period during which the factor has not yet received payment from the factored accounts receivable. This interest charge is often an estimated amount based on the due dates of the individual customer obligations. It results in:

• A debit to the Interest Expense account
• A further credit to the Accounts Receivable account

A variation of this transaction occurs when the company only draws cash from the factor as needed, instead of at the time the accounts receivable are sold. This arrangement reduces the interest charges incurred by the factor for the period while awaiting payment on the accounts receivable. Consequently, a new receivable labeled "Due from Factor" is created.

Another variation happens when the factor withholds a portion of the net cash due for the accounts receivable, usually to account for potential inventory returns from customers that may need to be charged back to the company. In this scenario, the accounts receivable being transferred to the factor should be offset with a holdback receivable account. Once all cash receipt transactions are cleared by the factor, any remaining amounts in the holdback account are eliminated with a debit to Cash (remitted by the factor) and a credit to the Holdback account.

An example journal entry encompassing these factoring issues is illustrated. Here, a company sells $100,000 of accounts receivable to a factor, including a 10% holdback provision. The factor anticipates incurring $4,800 in bad debts as a result of the transaction, leading to the factor paying the company $4,800 less than the face value of the receivables. This forces the company to recognize an additional expense of $4,800 for the transaction. Additionally, the company opts not to receive all funds allowed by the factor, drawing only $15,000 to meet its immediate cash needs to save on interest costs. The factor charges 18% annual interest for the 30-day period expected to elapse before collecting the factored receivables, resulting in an interest charge of $225 on the $15,000 of delivered funds.

Exhibit 2.1: Example of Factoring Journal Entry

Debit:

• Cash: $14,775
• Accounts Receivable—Factoring Holdback: $10,000
• Factoring Expense: $4,800
• Interest Expense: $225

Credit:

• Due from Factor: $70,200
• Accounts Receivable: $100,000

When a company factors its accounts receivable with recourse—meaning the factor can demand repayment for uncollectible amounts—the risk is not transferred, leading to a typically lower factoring fee. Additionally, if the company continues to service the receivables after the factoring arrangement, it is still considered to have retained control over the receivables. As a result, this arrangement is treated as a secured loan rather than an outright sale of receivables. Consequently, the accounts receivable remain on the company’s balance sheet, and a loan liability is also recorded. In such cases, the expected bad debts should be reallocated from the Allowance for Bad Debts account to a Recourse Obligation account, from which bad debts will be deducted as they occur.

Receivables—Sales Returns

When customers return goods, accountants should establish an offsetting sales contra account rather than reversing the original sale transaction. This process involves crediting the Accounts Receivable account and debiting the Contra-revenue account. There are two primary reasons for adopting this approach:

1. Impact on Financial Reporting: Directly reducing the original sale would affect financial reporting for a prior period if the sale occurred in a previous period.
2. Visibility in Financial Statements: Charging a large number of sales returns directly against the sales account would obscure these returns on financial statements. Management would only see a reduced sales volume, potentially misinterpreting it as a drop in sales rather than an increase in product returns after sales.

Utilizing and reporting an offsetting contra account provides management with insights into the extent of sales returns.

For companies that ship products on approval, where customers have the right to return goods, and there is a history of significant returns, it is advisable to create a reserve for sales returns based on historical return rates. The offsetting sales returns expense account should be categorized under the cost of goods sold.

Receivables—Early Payment Discounts

Offering early payment discounts typically does not have a significant effect on a company’s financial statements unless the discount rate is exceptionally high. Therefore, some flexibility in the standard treatment of these transactions is permissible. The most theoretically sound method involves initially recording the account receivable at its discounted value, assuming all customers will avail of the early payment discount. Any cash discounts not taken are then recorded as additional revenue. This approach provides a conservative estimate of the funds expected from the collection of accounts receivable.

An alternative method is to record the full, undiscounted amount of each sale as accounts receivable and subsequently record any discounts taken in a sales contra account. However, this approach has a drawback: the discount is recognized in a different accounting period than the initial sale due to the usual delay in accounts receivable payments, which is not an appropriate revenue recognition practice. A solution to this issue is to establish a reserve for cash discounts in the period when the sales occur and offset actual discounts against this reserve as they are realized.

Receivables—Long-Term

For accounts receivable due for collection beyond one year, financial reporting should discount them at an interest rate that accurately reflects what would have been charged under normal lending conditions. Alternatively, the interest rate specified in the sale agreement can be used, provided it is not lower than the prevailing market rate at the time the receivable was created. This calculation will result in a smaller receivable balance than the face amount. The difference should be gradually recognized as interest income over the life of the receivable.

Receivables—Bad Debts

An accountant must recognize a bad debt as soon as it becomes reasonably certain that a loss is probable and the amount can be estimated with a reasonable degree of accuracy. For IFRS financial reporting, the only permissible method for recognizing bad debts is to establish a bad debt reserve (allowance for doubtful accounts) as a contra account to the Accounts Receivable account.

Under this method, a long-term average ratio of bad debt to sales should be estimated. This involves debiting the Bad Debt Expense (typically reported in the selling expenses section of the income statement) for this percentage of the period-end accounts receivable balance and crediting the Bad Debt Reserve contra account. When an actual bad debt is identified, the accountant credits the Accounts Receivable account and debits the reserve. The Sales account remains unaffected. If a notably large bad debt is recognized that will more than offset the existing bad debt reserve, the reserve should be increased sufficiently to ensure that the remaining balance is not negative.

Several methods can be used to determine the long-term estimated ratio of bad debts. One approach is to calculate the historical average bad debt as a proportion of total credit sales for the past 12 months. A more accurate estimate can be achieved by calculating different historical bad debt percentages based on the relative age of the accounts receivable at the end of the reporting period. For instance, accounts aged over 90 days may have a historical bad debt experience of 50%, those over 30 days may have a loss percentage of 20%, and those below 30 days may only have a 4% loss rate. Although this type of experience percentage is more complex to calculate, it can result in a more precise bad debt allowance and more accurate periodic financial reports.

It is also feasible to estimate the bad debt level based on an analysis of customer types. For example, government entities are unlikely to go out of business, so they may have a much lower bad debt rate compared to other types of customers. Regardless of the approach used, it must be fully documented so that an auditor can trace through the calculations to ensure that a sufficient bad debt reserve has been provided.

Decision Trees: Receivables—Ownership Decision

Overview

The primary concern in using accounts receivable as collateral, assignment, or factoring is the appropriate method of reporting these transactions in the financial statements. The diagram in Exhibit A provides clarity on this matter.

Reporting Criteria

1. Retention of Control:

   • If receivables are pledged as collateral for a loan, assigned with recourse, or if the company retains any means to reclaim them, the company essentially maintains control over these receivables. In such cases, they should continue to be recorded on the company’s statement of financial position.

2. Transfer of Control:

   • Conversely, if the purchaser of the receivables assumes the risk of loss, has the ability to pledge or exchange the receivables with a third party, and the company or its creditors lose access to the receivables, the control over these assets is transferred to the purchaser. Under these circumstances, the selling company must record the sale of the receivables and remove them from its statement of financial position.

Disclosure

• Footnote Requirement: If the selling company retains any control over the receivables, they must continue to be reported on the statement of financial position. Additionally, there should be a footnote disclosure indicating the receivables’ status as collateral for a loan.

Policies

Cash Handling

Authorization Protocols

• Separation of Duties: Personnel responsible for accounts payable are strictly prohibited from signing checks or approving money transfers. This policy ensures the segregation of duties, preventing any individual from both creating a payable and authorizing its payment, thereby reducing the risk of fraudulent activities.

Dual Signatures for Large Transactions

• Countersignature Requirement: Any check or money transfer exceeding € must be countersigned by the position. This measure introduces a second level of review for substantial payments, enhancing the oversight and minimizing fraudulent transfers. However, it should be noted that some banks may not verify the necessity of a second signature, which can limit the effectiveness of this policy.

Bonding of Check Signers

• Bonding Requirement: All individuals authorized to sign checks must be adequately bonded. This policy mandates that the company maintains sufficient bonding for its check signers, providing financial protection against potential fraud. Bonding companies typically perform background checks on signers before issuing bonds, which can alert the company to any past fraudulent behavior. This allows the company to preemptively revoke check-signing authority from individuals with a history of fraudulent activities.

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These policies collectively aim to enhance the security and integrity of the company’s financial transactions, ensuring robust mechanisms are in place to detect and prevent fraud.

Prepaid Expenses

• Employee Advances Repayment: All advances provided to employees must be repaid within a three-month period. This policy ensures that the company does not function as a bank for its employees and minimizes the outstanding balances owed by employees. As a result, the risk of financial loss to the company is significantly reduced if an employee resigns before repaying the entire advance.

• Limitation on Employee Advances: Employee advances are capped at __% of their annual salary. This measure is put in place to limit the financial exposure a company faces from advances to its employees, thereby reducing the risk of nonpayment should an employee leave the company.

Receivables

1. Authorization for Write-Offs: The accounting team is authorized to write off accounts receivable balances under $___ without seeking management approval. While requiring management approval for all receivable write-offs can decrease the risk of unauthorized write-offs, it is not efficient for managing very small balances. Therefore, it is standard practice to permit accounting staff to write off minor balances, saving management time and resources that would otherwise be spent investigating these small amounts.
2. All prospective sales that surpass customer credit limits must receive prior approval from the credit manager. Often, the credit department is pressured to grant credit quickly when a salesperson secures a substantial sale, leading to the issuance of overly generous credit limits. To mitigate this issue, it is advisable to implement a procedure where the credit manager conducts an advance review of potential sales. This enables the credit manager to inform the sales team of the maximum credit amount the company is prepared to offer before finalizing any transactions.
3. Annual Review of Customer Credit Limits It is mandatory to conduct formal annual reviews for all customer credit limits that exceed $___. The financial circumstances of customers can fluctuate over time, potentially rendering the initially approved credit limits inaccurate. This issue becomes particularly critical when a customer faces financial decline or approaches bankruptcy, while the company continues to extend significant credit to them. By instituting annual reviews of substantial credit limits, we can address this concern proactively. Additionally, feedback from the collections team will provide early warnings about potential customer issues, often well before the scheduled annual review.
4. Prohibition on Factoring Arrangements Factoring arrangements are strictly prohibited when receivables are pledged as collateral for other debts. This policy ensures compliance with loan agreements that require the company to retain its receivables as collateral, rather than diminish them by selling to a factor. Failure to adhere to this policy could result in the company being perceived as liquidating assets to the detriment of a secured lender, who would then be entitled to demand immediate repayment of their loan.