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Financial Assets

Chapter

7

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Learning Objective

LO1

To define financial

assets and explain theirvaluation in the balance

sheet.

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How Much Cash Should a BusinessHave?

$

Every

businessneedsenough

cash to payits bills!

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How Much Cash Should a BusinessHave?

Cash

Short-term

Investments

Receivables

Financial

Assets

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How Much Cash Should a BusinessHave?

Accounts

receivable

Marketablesecurities

(short-term

investments)

Cash (and cashequivalents)

Collectionsfrom

customers Cashpayments

Excesscash is

investedtemporarily

Investmentsare sold as

cash isneeded

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The Valuation of Financial Assets

Type of Financial Assets

Basis for Valuation in

the Balance Sheet

ash (and cash equivalents) Face amount

Short-term investments(marketable securities)

urrent market value

Receivables Net realizable value

Estimated collectible amount

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Cash

Coins andpapermoney

Checks

Money orders

Travelers checks

Bank creditcard sales

Cash isdefined as

any depositbanks will

accept.

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Not availablefor paying

current

liabilities

Reporting Cash in the BalanceSheet

Not a currentasset

Listed as aninvestment

RestrictedCash

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Bank agrees inadvance to lend

money.

Reporting Cash in the BalanceSheet

Liability isincurred when lineof credit is used.

Unused line ofcredit is disclosed

in notes.

Lines ofCredit

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The Statement of Cash Flows

Summarizes cash

transactions for anaccounting period.

Includes cash and cash

equivalents.

Statement ofCash Flows

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Learning Objective

LO2

To describe theobjectives of cash

management andinternal controls over

cash.

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Cash Management

Accurately account for cash.

Prevent theft and fraud.

Assure the availability ofadequate amounts of cash.

Prevent unnecessarily largeamounts of idle cash.

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Using Excess Cash BalancesEfficiently

Cash available forlong-term investment

may be used to financegrowth and expansionof the business, or to

repay debt.

Cash not needed forbusiness purposes

may be distributed tothe companysstockholders.

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Internal Control Over Cash

Segregate authorization, custody andrecording of cash.

Prepare a cash budget (or forecast).

Prepare a control listing of cash receipts.

Require daily deposits.

Make all payments by check. Verify every expenditure before payment.

Promptly reconcile bank statements.

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Cash Over and Short

GE ERAL JOUR AL

Date Account Titles and Explanation Debit Credit

May 5 Cash 10

Cash Over and Short 10

Cash Over and Short is debited for

sho

rtages and credited fo

ro

verages.

On May 5, XBAR, Inc.s cash drawerwas counted and found to be $10 over.

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Learning Objective

LO3

To prepare a bank

reconciliation andexplain its purpose.

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Bank Statements

Shows the beginning bank balance,deposits made, checks paid, other

debits and credits in the month, andthe ending bank balance.

BankStatement

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Reconciling the Bank Statement

Explains the difference between cashreported on bank statement and cash

balance in depositors accountingrecords.

Provides information forreconciling journal entries.

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Reconciling the Bank Statement

Balance per Bank

+ Deposits in Transit

- Outstanding Checks

Bank Adjustments

= Adjusted Balance

Balance per Depositor

+ Deposits by Bank

(credit memos)

- Service Charge- NSF Checks

Book Adjustments

= Adjusted Balance

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Reconciling the Bank Statement

All reconcilingitems on the

book siderequire anadjusting

entry to thecash account.

Balance per Depositor

+ Deposits by Bank

(credit memos)

- Service Charge- NSF Checks

Book Adjustments

= Adjusted Balance

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Reconciling the Bank Statement

Prepare a July 31 bank reconciliationstatement and the resulting journal entriesfor the Simmons Company. The July 31

bank statement indicated a cash balance of$9,610, while the cash ledger account on

that date shows a balance of $7,430.

Additional information necessary for thereconciliation is shown on the next page.

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Outstanding checks totaled $2,417.

A $500 check mailed to the bank for deposit had

not reached the bank at the statement date. The bank returned a customers NSF check for

$225 received as payment of an accountreceivable.

The bank statement showed $30 interest earnedon the bank balance for the month of July.

Check 781 for supplies cleared the bank for $268

butw

as erroneously rec

orded in

our b

ooks as$240.

A $486 deposit by Acme Company waserroneously credited toour account by the bank.

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Reconciling the Bank Statement

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Reconciling the Bank Statement

GE ERAL JOUR AL

Date Account Titles and Explanation Debit Credit

Jul 31 Cash 30

Interest Revenue 30

31 Supplies Inventory 28

Accounts Receivable 225

Cash 253

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Used for minorexpenditures.

Petty Cash Funds

Has onecustodian.

Replenishedperiodically.

Petty CashFunds

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Learning Objective

LO4

To describe how short-term investments are

reported in the balancesheet and account for

transactions involvingmarketable securities.

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Short-Term Investments

BondInvestments

CapitalStock

Investments

Current Assets

Almost AsLiquid As

Cash

ReadilyMarketable

MarketableSecuritiesare . . .

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Accounting for MarketableSecurities

Most short-term investments in marketable securitiesare classified as available for sale and appear on the

balance sheet at theircurrent market value.

Classification Mana ement's ntent reatment of nreali edHoldin Gains and Losses

vailable-for-

sale securities

Held for short-term

resale often 6 to 18

months

eported in stockholders'

e uit section of the

balance sheet

radinsecurities

Held for immediateresale often ithin

hours or da s

eported in "other" revenueexpense section of the

income statement

Held-to-maturit

securities

ebt securities

intended to be held

until the mature

Not reported. ecurities are

reported on balance sheet

at amorti ed cost.

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Purchase of Marketable Securities

Foster Corporation purchases as a short-terminvestment 4,000 shares ofThe Coca-Cola

Company on December 1. Foster paid $43.98 pershare, plus a brokerage commission of $80.

GE ERAL JOUR AL

Date Account Titles and Explanation Debit Credit

Marketable Securities 176,000

Cash 176,000

Total Cost: (4,000 $43.98) + $80 = $176,000

Cost per Share: $176,000 4,000 = $44.00

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Recognition ofInvestment Revenue

On December 15, Foster Corporation receivesa $0.30 per share dividend on its 4,000

shares of Coca-Cola.

GE ERAL JOUR AL

Date Account Titles and Explanation Debit Credit

Cash 1,200

Dividend Revenue 1,200

4,000 $0.30 = $1,200

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Sales ofInvestments

On December 18, Foster Corporation sells 500shares of its Coca-Cola stock for $46.04 per

share, less a $20 brokerage commission.

GE ERAL JOUR AL

Date Account Titles and Explanation Debit Credit

Cash 23,000

Marketable Securities 22,000

Gain on Sale of Investment 1,000Sales Proceeds: (500 $46.04)- $20 =$23,000

Cost Basis: 500 $44=$22,000

Gain on Sale: $23,000 - $22,000 =$1,000

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Adjusting Marketable Securities toMarket Value

On December 31, Foster Corporations remainingshares of Coca-Cola capital stock have a current

market value of $42,000. Prior to any adjustment,the companys Marketable Securities account has a

balance of $44,000 (1,000 $44 per share).

GE E A A

A i l E l i i r ir liz H l i g I ,

M r l S ri i ,

r liz : $4 , - $44, =($2, )

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Learning Objective

LO5

To account foruncollectible

receivables using theallowance and directwrite-off methods.

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Accounts Receivable

If a company makes creditsales to customers, some

accounts inevitably willturn out to be

uncollectible. PAST DUE

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GE ERAL JOUR AL

Date Account Titles and Explanation Debit Credit

Uncollectible Accounts Expense $$$$

Allowance for Doubtful Accounts $$$$

Reflecting Uncollectible Accounts inthe Financial Statements

At the end of each period, recordan estimate of the uncollectible

accounts.

Contra-asset accountSelling expense

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The Allowance for DoubtfulAccounts

Accounts receivable

Less: Allowance for doubtful accountsNet realizable value of accounts receivable

The net realizable value is the amount ofaccounts receivable that the business

expects to collect.

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Writing Off an Uncollectible AccountReceivable

When an account is determined to beuncollectible, it no longer qualifies as an

asset and should be written off.

GE ERAL JOUR AL

Date Account Titles and Explanation Debit Credit

Allowance for Doubtful Accounts $$$$

Accounts Receivable (X Customer) $$$$

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Writing Off an Uncollectible AccountReceivable

Assume that on January 5, K-Maxdetermined that Jason Clark would not pay

the $500 he owes.

K-Max would make the following entry.

GE ERAL JOUR AL

Date Account Titles and Explanation Debit Credit

Jan. 5 Allowance for Doubtful Accounts 500

Accounts Receivable (J. Clark) 500

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Writing Off an Uncollectible AccountReceivable

Assume that before this entry, the AccountsReceivable balance was $10,000 and the

Allow

ance fo

r Do

ubtful Acco

unts balancewas $2,500.

Lets see what effect the write-off had onthese accounts.

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Writing Off an Uncollectible AccountReceivable

Before

Write-Off

After

Write-Off

Accounts receivable 10,000$ 9,500$Less: Allow. for doubtful accts. 2,500 2,000

Net realizable value 7,500$ 7,500$

Notice that the $500 write-off did not change the netrealizable value nor did it affect any income

statement accounts.

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Monthly Estimates of Credit Losses

At the end of eachmonth, management

sho

uld estimate theprobable amount ofuncollectible accounts

and adjust theAllowance for DoubtfulAccounts to this new

estimate.

Two Approaches to Estimating

Credit Losses:

1. Balance Sheet Approach

2. Income Statement Approach

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Estimating Credit Losses TheBalance Sheet Approach

Year-end Accounts Receivable isbroken down into age

classifications.

Each age grouping has a differentlikelihood of being uncollectible.

Compute a separate allowance foreach age grouping.

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Estimating Credit Losses TheBalance Sheet Approach

At December31, the receivables forEastCo, Inc.were categorized as follows:

EastCo, Inc.

ched le of Acco nts eceiva ble b AgeDecember31, 2 7

Da s ast D e

Acco nts

eceivable

alance

Estimated

ad Debts

ercent

Estimated

ncollectible

Amo nt

C rrent 4 ,$1 30 15,000

31 0 5,000

Over 0 2,000

7,000$

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EastCo, Inc.

Schedule of Accounts Receivable by AgeDecember 31, 2007

Days Past Due

Accounts

Receivable

Balance

Estimated

Bad Debts

Percent

Estimated

Uncollectible

Amount

Current 45,000$ 1%1 - 30 15,000 3%

31 - 60 5,000 5%

Over 60 2,000 10%

67,000$

Estimating Credit Losses TheBalance Sheet Approach

At December31, the receivables forEastCo, Inc.were categorized as follows:

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EastCo, Inc.

Schedule of Accounts Receivable by AgeDecember 31, 2007

Days Past Due

Accounts

Receivable

Balance

Estimated

Bad Debts

Percent

Estimated

Uncollectible

Amount

Current 45,000$ 1% 450$1 - 30 15,000 3% 450

31 - 60 5,000 5% 250

Over 60 2,000 10% 200

67,000$ 1,350$

Estimating Credit Losses TheBalance Sheet Approach

At December31, the receivables forEastCo, Inc.were categorized as follows:

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Lets look at

another wayto estimate

credit losses!

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Estimating Credit Losses TheIncome Statement Approach

Uncollectible accountspercentage is based on actual

uncollectible accounts fromprior years credit sales.

Focus is on determining the amount to

record on the income statement asUncollectible Accounts Expense.

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Estimating Credit Losses TheIncome Statement Approach

Net Credit Sales

v % Estimated UncollectibleAmount of Journal Entry

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Estimating Credit Losses TheIncome Statement Approach

In 2007, EastCo had credit sales of $60,000.

Historically, 1% of EastCos credit sales has

been uncollectible.

For 2007, the estimate of uncollectible accountsexpense is $600.

($60,000 .01 = $600)

Now, prepare the adjusting entry for December31, 2007.

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Estimating Credit Losses TheIncome Statement Approach

GE E A A

A i l E l i i r i

. 31 Uncoll cti l Accounts E nse 600Allowance or oubtful Accounts 600

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Uncollectible AccountsSummary

Aging ofReceivables

Emphasis onRealizable Value

Accts.Rec. All. for

Doubtful

Accts.

Balance SheetFocus

% ofCredit Sales

Emphasis onMatching

SalesUncoll.Accts.

Exp.

IncomeStatement

Focus

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Concentrations of Credit Risk

Concentrations of credit risk occur if a significant portionof a companys receivables are due from a few majorcustomers or from customers operating in the same

industry or geographic region.

significantconcentrations ofcredit risk in the

notes to the financialstatements.

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Recovery of an Account ReceivablePreviously Written Off

GENERAL J URNAL

D A oun T andExp anation D bit Credit

A ounts Receivable (X Custo er) $$$$

Allo ance forDoubtful Accounts $$$$

Cash $$$$

Accounts Receivable (X Custo er) $$$$

Subsequent collections require that the original write-offentry be reversed before the cash collection is recorded.

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Direct Write-Off Method

This method makes no attempt tomatch revenues with the expense of

uncollectible accounts.

GE E A J URNA

ate Account Titles and Explanation Debit redit

June 15 Uncollectible Accounts Expense

Accounts Receivable X ustomer

I T R l ti d

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Income Tax Regulations andFinancial Reporting

Direct write-off methodrequired to calculate

taxable income.

Taxable Income

FinancialStatement Income

Allowance methods

better match expenseswith revenues.

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Internal Controls forReceivables

Separate the following duties:

Maintenance of the accounts receivablesubsidiary ledger.

Custody of cash receipts.

Authorization of accounts receivable write-offs.

M t f A t

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Management of AccountsReceivable

Credit Terms

MinimizeAccounts

Receivable

Extending credit encouragescustomers to buy from us . . .

. . . but it ties up resourcesin accounts receivable.

M t f A t

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Management of AccountsReceivable

Factoring

AccountsReceivable

Credit

CardSales

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Learning Objective

LO6

To explain, compute,and account for notesreceivable and interest

revenue.

N t R i bl d I t t

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A promissory note is an unconditionalpromise in writing to pay on demand or at

a future date a definite sum of money.

Notes Receivable and InterestRevenue

Makerthe person whosigns the note and thereby

promises to pay.

Payeethe person towhompayment is to be made.

N t R i bl d I t t

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Notes Receivable and InterestRevenue

PorterCompany is replacing an existing Accounts Receivable with this

Note Receivable with Hall Company.

PROMISSORYNOTE

Location Date

after this date

promises to pay to the order of

the sum of with interest at the rate

of per annum.

signed

title

Miami, Fl Nov. 1, 200

Ninety days PorterCompany

John Caldwell

Hall Company

$10,000.00

12.0%

CFO, Porter Company

N t R i bl d I t t

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On November1, 200 , Hall Companywould make the following entry.

Notes Receivable and InterestRevenue

Date Description Debit Credit

Nov. 1 Notes Receivable 10,000

Accounts Receivable (Porter Company) 10,000

N t R i bl d I t t

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Interest is a charge made forthe use of money.

The borrower incurs interestexpense.

The lender earns interestrevenue.

Interestrates

down!

Notes Receivable and InterestRevenue

Lender

Notes Receivable and Interest

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The interest formula includes threevariables:

Interest = Principal Interest Rate TimeWhen computing interest for one year, Time

equals 1. When the computation period is lessthan one year, then Time is a fraction.

Notes Receivable and InterestRevenue

For example, if we needed to compute interest for3 months, Time would be 3/12.

Notes Receivable and Interest

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What entry would Hall Company make onDecember31, the fiscal year-end?

Date Description Debit Credit

Notes Receivable and InterestRevenue

Date Description Debit Credit

Dec. 31 Interest Receivable 200

Interest Revenue 200

$10,000 12% 60/360 = $200

Notes Receivable and Interest

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What entry would Hall Companymake on the maturity date?

Notes Receivable and InterestRevenue

Date Description Debit Credit

Jan. 30 Cash 10,300

Interest Receivable 200

Interest Revenue 100Notes Receivable 10,000

$10,000 12% 90/360 = $300

Notes Receivable and Interest

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If PorterCompany defaulted on the note,Hall Company would make the following

entry on the maturity date.

Notes Receivable and InterestRevenue

Date Description Debit Credit

Jan. 30 Accounts Receivable 10,300

Interest Receivable 200

Interest Revenue 100

Notes Receivable 10,000

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Learning Objective

LO7

To evaluate the liquidity

of a companysaccounts receivable.

Financial Analysis and Decision

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Financial Analysis and DecisionMaking

Accounts Receivable TurnoverRate

This ratio provides useful information for

evaluating how

efficient management hasbeen in granting credit to produce revenue.

Net SalesAverage Accounts Receivable

Financial Analysis and Decision

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Financial Analysis and DecisionMaking

Avg. Numberof Days to Collect A/R

This ratio helps judge the liquidity of a

companys accounts receivable.

Days inYearAccounts Receivable Turnover Ratio

Ethics Fraud and

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Ethics, Fraud, andCorporate Governance

Accounts receivable is a significant account formany companies. Accounts receivable is

particularly prone to misrepresentation becauserevenue often increases when accounts receivable

increase. Manipulating accounts receivable canresult in the overstatement of both revenue and

income, which is the objective of many fraudulentfinancial reporting schemes.

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End of Chapter 7