Chapter

ACCOUNTING FOR FINANCIAL ASSETS

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How Much Cash Should a Business Have?

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Every business needs enough cash to pay its bills!

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How Much Cash Should a Business Have?

Financial Assets

Business store money in three basic forms

Cash Short-term Investments

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Receivables

(Marketable Securities)

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MONEY FLOWS AMONG FINANCIAL ASSETS

Collections from customers Accounts receivable Excess cash is invested temporarily. Marketable securities (short-term investments) Investments are sold as cash is needed.

Cash (and cash equivalents)

Cash payments

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The Valuation of Financial Assets: at Current Value

Basis for Valuation in Type of Financial Asset the Balance Sheet Cash (and cash equivalents) Face amount Short-term investments Current market value (marketable securities) Receivables Net realizable value

Estimated collectible amount

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Cash
Coins and paper money

Bank credit card sales

Cash is defined as any deposit banks will accept.

Travelers checks

Checks

Money orders

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Reporting Cash in the Balance Sheet

Combined with cash on balance sheet Liquid shortterm investments

Cash Equivalents

Matures within 90 days of acquisition

Stable market values

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Reporting Cash in the Balance Sheet

Not available for paying current liabilities

Not a current asset

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Restricted Cash

Listed as an investment
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Reporting Cash in the Balance Sheet

Bank agrees in advance to lend money.

Lines of Credit Liability is incurred when line of credit is used.

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Unused line of credit is disclosed in notes.

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The Statement of Cash Flows

Statement of Cash Flows

Summarizes cash transactions for an accounting period. Includes cash and cash equivalents.

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Cash Management
Accurately account for cash.

Prevent theft and fraud.

Assure the availability of adequate amounts of cash.

Avoid unnecessarily large amounts of idle cash.

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Using Excess Cash Balances Efficiently

Cash available for long-term investment may be used to finance growth and expansion of the business, or to repay debt. Cash not needed for business purposes should be distributed to the companys stockholders.

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Internal Control Over Cash

Segregate authorization, custody and recording of cash.

Prepare a cash budget.

Prepare a control listing of cash receipts.

Require daily deposits in bank.

Make all payments by check. Verify every expenditure before payment. Promptly reconcile bank statements.
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Cash Over and Short

On May 5, XBAR, Inc.s cash drawer was counted and found to be $10 over.
GENERAL JOURNAL
Date Account Titles and Explanation Cash Over and Short Debit 10 10 Credit

May 5 Cash

Cash Over and Short is debited for shortages and credited for overages.
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Bank Statements
Shows the beginning bank balance, deposits made, checks paid, other debits and credits in the month, and the ending bank balance.

Bank Statement
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Reconciling the Bank Statement

Explains the difference between cash reported on bank statement and cash balance in depositors accounting records. Provides information for reconciling journal entries.

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Reconciling the Bank Statement

Balance per Bank Balance per Depositor
+ Deposits by Bank (credit memos) - Service Charge - NSF Checks Book Errors = Adjusted Balance
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+ Deposits in Transit

- Outstanding Checks

Bank Errors = Adjusted Balance

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Reconciling the Bank Statement

All reconciling items on the book side require an adjusting entry to the cash account.
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Balance per Depositor

+ Deposits by Bank (credit memos) - Service Charge - NSF Checks Book Errors = Adjusted Balance
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Reconciling the Bank Statement Example

Prepare a July 31 bank reconciliation statement and the resulting journal entries for 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 the reconciliation 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 account receivable. The bank statement showed $30 interest earned on the bank balance for the month of July. Check 781 for supplies cleared the bank for $268 but was erroneously recorded in our books as $240. A $486 deposit by Acme Company was erroneously credited to our account by the bank.
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Reconciling the Bank Statement

Example
Balance per bank statement, July 31 Additions: Deposit in transit Deductions: Bank error $ 486 Outstanding checks 2,417 Adjusted cash balance Balance per depositor's records, July 31 Additions: Interest Deductions: Recording error $ 28 NSF check 225 Adjusted cash balance $ 9,610 500

2,903 $ 7,207 $ 7,430 30

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253 $ 7,207

Reconciling the Bank Statement Example

GENERAL JOURNAL
Date Account Titles and Explanation Interest Revenue 31 Supplies Inventory Accounts Receivable Cash 28 225 253 Debit 30 30 Credit

Jul 31 Cash

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Petty Cash Funds

Used for minor expenditures. Petty Cash Voucher.

Petty Cash Funds

Has one custodian.
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Replenished periodically.
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Short-Term Investments
Almost As Liquid As Cash Capital Stock Investments

Readily Marketable

Marketable Securities are . . .

Bond Investments

Current Assets
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Mark-to-Market: A New Principle of Asset Valuation

Short-term investments in marketable securities appear on the balance sheet at their current market value as of the balance sheet date.
Management's Intent Classification to hold the securities Available for sale Held for short-term securities resale (often 6 to 18 months) Trading securities Held for immediate resale (often within hours or days) Held to maturity Debt securities securities intended to be held until they mature
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Treatment of Unrealized Holding Gains and Losses Reported in stockholders' equity section of the balance sheet Reported in "other" revenue (expense) section of the income statement Reported in stockholders' equity section of the balance sheet
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Accounts Receivable
Accounts Receivables are relatively liquid assets (Current Assets) Converting into cash within a period of 30 to 60 days. Appear in the balance sheet immediately after cash and shortterm investments in marketable securities. Some merchandising companies have accounts receivables outstanding for 12, 24 or even 48 Months.

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Uncollectible Accounts
If a company makes credit sales to customers, some accounts inevitably will turn out to be uncollectible.

PAST DUE

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Reflecting Uncollectible Accounts in the Financial Statements

At the end of each period, record an estimate of the uncollectible accounts.

Credit losses are recognized as expense in the period in which sales occur, not in the period in which the account is determined to be uncollectible. Reasoning is Matching Principle.

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Assume that ABC Co. begins business on January 1, 2013 and makes most of its sale on account. At January 31, 2013 accounts receivable amount to PKR 50,000. On this date, the credit manager reviews the accounts receivable and estimates that approximately PKR 5,000 of these accounts will not be uncollectible. The following adjusting entry would be made for it:
GENERAL JOURNAL
Date Account Titles and Explanation Uncollectible Accounts Expense Allowance for Doubtful Accounts To record the portion of total accounts receivable estimated to be uncollectible P R Debit PKR 5,000 PKR 5,000 Credit

Selling expense
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Contra-asset account
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The Allowance for Doubtful Accounts

Accounts receivable Less: Allowance for doubtful accounts Net realizable value of accounts receivable
The net realizable value is the amount of accounts receivable that the business expects to collect.
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Writing Off an Uncollectible Account Receivable

When an account is determined to be uncollectible, it no longer qualifies as an asset and should be written off.

GENERAL JOURNAL
Date Account Titles and Explanation Allowance for Doubtful Accounts Accounts Receivable (X Customer) P R Debit PKR PKR Credit

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Writing Off an Uncollectible Account Receivable

Assume that on January 5, B-Mart determined that Ali would not pay the PKR 500 he owes. B-Mart would make the following entry.
GENERAL JOURNAL
Date Jan. Account Titles and Explanation 5 Allowance for Doubtful Accounts Accounts Receivable (Ali) P R Debit PKR 500 PKR 500 Credit

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Writing Off an Uncollectible Account Receivable

Assume that before this entry, the Accounts Receivable balance was PKR10,000 and the Allowance for Doubtful Accounts balance was PKR 2,500. Lets see what effect the write-off had on these accounts.

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Writing Off an Uncollectible Account Receivable

Before After WriteWrite-Off Off PKR 10000 PKR 9500 2,500 2,000 PKR 7,500 PKR 7,500

Accounts receivable Less: Allow. for doubtful accts. Net realizable value

Notice that the PKR 500 write-off did not change the net realizable value nor did it affect any income statement accounts.
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Recovery of an Account Receivable Previously Written Off

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

GENERAL JOURNAL
Date Account Titles and Explanation Accounts Receivable (X Customer) Allowance for Doubtful Accounts Cash Accounts Receivable (X Customer) PKR PKR P R Debit PKR PKR Credit

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Monthly Estimates of Credit Losses

At the end of each month, management should estimate the probable amount of uncollectible accounts and adjust the Allowance for Doubtful Accounts to this new estimate.

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Monthly Estimates of Credit Losses Example

At December 31, 2013, Music Lands accounting records indicate the following:
Accounts Receivable = PKR 50,000 Allowance for Doubtful Accounts = PKR 200 (credit)

Past experience suggests that 5% of receivables are uncollectible.

What is MusicLands Uncollectible Accounts Expense for 2013?

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Monthly Estimates of Credit Losses Example

Desired balance in Allowance for Doubtful Accounts.

$ = $

50,000 5.00% 2,500

Allowance for Doubtful Accounts 200 2,300 2,500

GENERAL JOURNAL
Date Account Titles and Explanation Allowance for Doubtful Accounts
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Debit 2,300

Credit 2,300

Dec. 31 Uncollectible Accounts Expense

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Lets look at another way to estimate the uncollectible accounts!

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Estimating Credit Losses The Balance Sheet Approach

Year-end Accounts Receivable is
broken down into age classifications.

Each age grouping has a

different likelihood of being uncollectible.

Compute a separate allowance

for each age grouping.
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Estimating Credit Losses The Balance Sheet Approach

At December 31, 2003, the receivables for EastCo, Inc. were categorized as follows:

Animal Care Centre Buterfield Citrus Groves, Inc. Dairy Fresh Farms EastLake Stables (Other Customers) Totals
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EastCo, Inc. Analysis of Account Receivable by Age December 31, 2003 Not Yet Due PKR 9,000 3,000 1-30 Days Past Due 61-90 31-60 Days Days Past Past Due Due 2,400 1,000 600 7,000 6,000 32,000 22,000 PKR 42,000 PKR 29,000 1,000 Over 90 Days Past Due

Total PKR 9,000 2,400 4,000 1,600 13,000 70,000 PKR 91,000

9,600 2,400 4,000 PKR 12,000 PKR 3,000 PKR 5,000

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Estimating Credit Losses The Balance Sheet Approach

At December 31, 2003, the receivables for EastCo, Inc. were categorized as follows:
EastCo, Inc. Schedule of Accounts Receivable by Age December 31, 2003 Percentage Estimated Age Group Considered Uncollectible Days Past Due Total Uncollectible Accounts

Not Yet Due 1 - 30 Days Past Due 31 - 60 Days Past Due 61 - 90 Days Past Due Over 90 Days Past Due McGraw-Hill/Irwin Totals

PKR 42,000 29,000 12,000 3,000 5,000

PKR 91,000

420 870 1,200 600 2,500 The McGraw-Hill Companies, Inc., 2002 PKR 5,590

1% 3% 10% 20% 50%

Estimating Credit Losses The Balance Sheet Approach

EastCos unadjusted balance in the allowance account is PKR 2,500. Per the previous computation, the desired balance is PKR 5,590.
GENERAL JOURNAL
Date Account Titles and Explanation Allowance for Doubtful Accounts
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Allowance for Doubtful Accounts 2,500 3,090 5,590

P R

Debit

Credit PKR 3090

Dec. 31 Uncollectible Accounts Expense

PKR 3,090

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Guess What! There is another alternative to estimate the uncollectible accounts!

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Income Statement Approach to Estimating Credit Losses

Uncollectible accounts percentage is based on actual uncollectible accounts from prior years credit sales. Focus is on determining the amount to record on the income statement as Uncollectible Accounts Expense.

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Income Statement Approach to Estimating Credit Losses

Net Credit Sales % Estimated Uncollectible Amount of Journal Entry

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Income Statement Approach to Estimating Credit Losses

In 2003, EastCo had credit sales of PKR 60,000.

Historically, 1% of EastCos accounts have been uncollectible. For 2003, the estimate of uncollectible accounts expense is PKR 600.
(PKR 60,000 .01 = PKR 600) Now, prepare the adjusting entry for December 31, 2003.
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Income Statement Approach to Estimating Credit Losses

GENERAL JOURNAL
Date Account Titles and Explanation Allowance for Doubtful Accounts Debit 600 600 Credit

Dec. 31 Uncollectible Accounts Expense

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Uncollectible Accounts Summary

% of Receivables
Emphasis on Realizable Value
Accts. Rec. All. for Doubtful Accts.

Aging of Receivables Emphasis on Realizable Value

Accts. Rec. All. for Doubtful Accts.

% of Sales
Emphasis on Matching
Sales Uncoll. Accts. Exp.

Balance Sheet Focus

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Balance Sheet Focus

Income Statement Focus

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Direct Write-Off Method

This method makes no attempt to match revenue with the expense of uncollectible accounts.

GENERAL JOURNAL
Date Account Titles and Explanation Accounts Receivable (X Customer)
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Debit $$$$

Credit $$$$

June 15 Uncollectible Accounts Expense

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Income Tax Regulations and Financial Reporting

Direct write-off method required to calculate taxable income. Taxable Income

Allowance methods better match expenses with revenues. Financial Statement Income
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Internal Controls for Receivable

Separate the following duties:
Maintenance of the accounts receivable subsidiary ledger.

Custody of cash receipts.

Authorization of accounts receivable writeoffs.
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Management of Accounts Receivable

Extending credit encourages customers to buy from us . . .

Credit Terms

. . . but it ties up resources in accounts receivable.

Minimize Accounts Receivable

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Ways to Minimize Amounts in Accounts Receivable

Selling Accounts Receivable Credit Card Sales

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Evaluating the Quality of Accounts Receivable

Accounts Receivable Turnover Ratio This ratio provides useful information for evaluating how efficient management has been in granting credit to produce revenue.

Net Sales Average Accounts Receivable

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Evaluating the Quality of Accounts Receivable

Avg. Number of Days to Collect A/R This ratio helps judge the liquidity of a companys accounts receivable.

Days in Year Accounts Receivable Turnover Ratio

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End of Chapter

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