Chapter Five

Short-Term Investments
and Receivables
Short-Term Investments

• Short-Term Investments are investments that a

company plans to hold for 1 year or less.
• Trading Securities
• Available-for-Sale Securities
• Held-to-Maturity Securities
• Trading Securities are always a current asset
(short-term).
• Available-for-Sale and Held-to-Maturity Securities
are either a short-term or long-term asset based
on management’s intention of length of holding.
Short-Term Investments

• Trading Securities: intended to be sold

in the very near future for more than
their cost.
• Available-for-Sale Securities: all
investments not classified as Trading
Securities or Held-to-Maturity Securities.
• Held-to-Maturity Securities: the investor
intends to hold the securities until their
maturity date; these securities earn
interest revenue for the investor.
Trading Securities
NOTE: VERY IMPORTANT EXCEPTION TO PREVIOUS RULES!
The market-value method is used to account for all
trading securities. Trading securities are reported on
the balance sheet at their market value as opposed to
their book value. (i.e. the price that was paid to acquire
the asset)
• Adjusting entries are carried out at the end of the year
to bring the securities up to current market value.
• Unrealized Gains or Unrealized Losses capture the
difference between the cost of investment and current
market value.
• Gain or loss – based on whether market value is > cost of
investment
• Unrealized – because the investment is not sold.
 Trading Investments

Microsoft Corporation purchases Ford Motor

Company stock on May 18, paying $100,000, with
the intention of selling the stock within a few
months.

General Journal
Date Accounts and Explanations PR Debit Credit
May 18 Short-term investment 100,000
Cash 100,000
Purchased investment

©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

 Trading Securities

Assume that Microsoft’s fiscal year ends on

May 31, and the investment in Ford has a
current market value of $102,000 on this
date.
General Journal
Date Accounts and Explanations PR Debit Credit
May 31 Short-Term Investment 2,000
Unrealized Gain on Investments 2,000
Adjusted investment to market
value

©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

 Trading Securities

Trading Securities (Short-Term Investments)

Cost 100,000
Adjustment to
market value 2,000
Balance 102,000
 Reporting on the Balance Sheet
and the Income Statement

Balance Sheet
Current Assets: $XXX
Cash XXX
Short-term investments at market value 102,000
Accounts receivable XXX
Income Statement
Revenues $ XXX
Expenses XXX
Other revenues, gains, and (losses):
Interest revenue XXX
Unrealized gain on investment 2,000
Receivables
• Receivables represent monetary claims
against others. They are assets for a business
because they represent resources expected
to produce a future benefit.
• You may think of them as the opposite of a
loan, since receivables are when others owe
the business money.
• Accounts Receivable: an informal promise to pay;
generally arises from the sale of goods and
services.
• Notes Receivable: a formal, written contract.
 Accounts Receivable (A/R)

ACCOUNTS RECEIVABLE
GENERAL LEDGER SUBSIDIARY RECORD
Accounts Receivable Aston
Bal. 9,000 Bal. 5,000

Harris
Bal. 1,000
The total value of A/R is the
Salazar
total amount owed to the
business by its customers. Bal. 3,000
Accounting for Uncollectible
Accounts (Bad Debts)
• Why do bad debts (uncollectible
accounts) arise?
• Collections lag sales
• Some people will not pay their bills, and
the company cannot collect from all.
Two ways to account for bad debt
expense:
1. Allowance Method
2. Direct Write Off.
The Allowance Method
• Records collection losses on the basis of estimates,
not waiting to see which customers will not pay.
• Preferred method
• Using estimates ensures that receivables are reported at
their proper value
• Matches expenses (i.e., bad debt expense) with the proper
revenues (i.e., the sales or service revenue that ld to the
expense).
• The estimate of the uncollectible accounts is
recorded in the account Allowance for Uncollectible
Accounts (Allow. For U.A.) or Allowance for Doubtful
Accounts (Allow. for D/A).
• Allowance for Doubtful Accounts is a contra account
to Accounts Receivable
 The Allowance Method

Balance Sheet (partial)

Accounts receivable xxx
Less: Allowance for Uncollectible Accounts – xx
Accounts receivable, net $ xxx
Income Statement (partial)
Expenses:
Uncollectible-Account Expense* xx

* = Also known as Bad Debt Expense.

The Allowance Method
• How do we estimate a company’s
uncollectible accounts?
• Two Methods:
• Percent-of-sales
• Uncollectible-account expense =
percentage of revenue
• Aging-of-Receivables
• Analyze individual receivables from
customers based on how long they have
been outstanding
The Allowance Method – Percent of Sales
• In the Percent-of-Sales approach (the Income
Statement approach), uncollectible-account
expense is determined by multiplying the net sales
by a percentage that is based on past collection
experience.
• Steps:
1. Multiply Total Revenue by the Estimated
Uncollectible Expense % (this is always given). This
result gives you the amount to use in your journal
entry.
2. Prepare the Journal entry:
Uncollectible Account Expense Dr
Allowance for Uncollectible Accounts Cr
The Allowance Method – Percent of Sales

• Example
• Kansas City Title Company has ending
Accounts Receivable of $500,000 (debit) and
ending Allowance for Uncollectible Accounts
of $2,000 (credit) prior to year-end
adjustments.
• Total Sales Revenue for the year is
$2,000,000. Kansas City Title estimates that
3% of sales will be uncollectible.
• What is the balance of the Uncollectible-
Account Expense, Allowance for Uncollectible
Accounts, and the Net Accounts Receivable?
The Allowance Method – Percent of Sales
• Solution*
• Uncollectible Account Expense
• = ($2,000,000 Revenue *.03) = $60,000
• Allowance for Uncollectible Expense
• = ($2,000,000 Revenue *.03) = $60,000 additional
in the allowance + $2,000 beginning balance =
$62,000 ending balance
• Net Accounts Receivable
• ($500,000 ending balance - $62,000 in Allowance
for Doubtful Accounts) = $438,000 net balance
The Allowance Method – Aging-of-
Receivables
• In the Aging-of-Receivables (the Balance
Sheet approach), individual receivables from
specific customers are analyzed based on how
long they have been outstanding.
• Steps:
1. Categorize accounts receivable via an aging
schedule.
2. Apply a percentage to the total of each category,
based on past collection experience. This
represents an estimate of the A/R the company
will not collect, which is the desired balance in
the Allowance for Doubtful Accounts.
3. Uncollectible Account Expense is the difference
between the balance before adjustment and the
desired ending balance.
 The Allowance Method – Aging-of-
Receivables

Days Accounts Estimated % Allowance for

Overdue Receivable Uncollectible Uncollectible
Accounts

1-30 days $1,555 6 $93

31-60 days 750 10 75

61-90 days 311 20 62

90 + days 219 79 173

$2,835 $403

©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

 The Allowance Method – Aging-of-
Receivables

Accounts before the year-end adjustment:

December 31, 20x5
Allowance for
Accounts Receivable Uncollectible Accounts
Bal. 2,835 120
 The Allowance Method - Aging-of-
Receivables

Accounts after the year-end adjustment:

December 31, 20x5
Allowance for
Accounts Receivable Uncollectible Accounts
Bal. 2,835 120
Adj. 283
403
 Aging-of-Receivables

Adjusting Entry

General Journal
Date Accounts and Explanations PR Debit Credit
Dec 31 Uncollectible-Account Expense 283
Allowance for Uncollectible
Accounts 283
Accounts after the year-end adjustment:
Recorded expense for the year
($403-120)

©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

The Allowance Method - Aging-of-
Receivables
• Example:
• Kansas City Title has ending Accounts receivable of
$500,000 (debit) and an ending Allowance for
Doubtful Accounts of $2,000 (credit).
• An aging of the accounts reveals that $380,000 of
the receivables are current, $80,000 are 1-30 days
past due, and $40,000 are more than 30 days past
due. Historically, 1% of the current accounts, 5% of
the accounts 1-30 days past due, and 40% of the
accounts more than 30 days past due are
uncollectible.
• What is the balance of the Allowance for Uncollectible
Accounts, Uncollectible-Account Expense, and the Net
Accounts Receivable?
The Allowance Method – Aging-of-
Receivables
• Solution*
• Allowance for Uncollectible Expense
• = ($380,000*1%) + ($80,000* 5%) + ($40,000 *
40%)*= $23,800 (The % of receivables collectively
determine the desired balance in the allowance)
• Uncollectible Account Expense
• = ($23,800 Allow for D/A ending balance - $2,000
Allow for D/A beginning balance) = $21,800
• Net Accounts Receivable
• ($500,000 ending balance - $23,800 in Allowance
for Doubtful Accounts) = $476,200 net balance
 Comparing the Allowance Methods

Allowance Method

Percent-of-Sales Aging-of-Receivables

Adjusts Allowance for Adjusts Allowance for

Uncollectible Accounts Uncollectible Accounts
BY TO

Amount of Amount of
UNCOLLECTIBLE- UNCOLLECTIBLE
ACCOUNT EXPENSE RECEIVABLES
©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren
Writing Off Uncollectible Accounts
Suppose that early in 2006, the credit department
determines that the company cannot collect from
two customers. These accounts must be written
off.

1. The journal entry to write off the account is:

Allowance for Uncollectible Accounts Dr XX
Accounts Receivable Cr XX

2. The write-off of an account does not affect net

income or net accounts receivable. Why??
 Writing Off Uncollectible Accounts

General Journal
D ate Accounts and Explanations PR D ebit C redi
Allowance for Uncollectible
Accounts 400
Accounts Receivable – Customer # 161
Accounts Receivable – Customer # 239
Wrote off uncollectible receivables

©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

 Direct Write-Off Method (alternative to
the Allowance Method)

An account is written off only when it is

decided that a specific customer’s
receivable is uncollectible.

General Journal
Date Accounts and Explanations PR Debit Credit
Jan 2 Uncollectible-Account Expense 2,000
Accounts Receivable-Jones 2,000
Wrote off a bad account

©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

 Direct Write-Off Method

Balance Sheet (partial)

Accounts receivable $8,000
Only net receivable is shown

Income Statement (partial)

Expenses:
Uncollectible-account expense $ 2,000
Weaknesses of this Method:
1. No Allowance for Uncollectibles
2. Poor matching of Revenues and Expenses
Two Key Liquidity Ratios
• The Days’ Sales in Receivables and the Acid-
Test Ratio help investors measure liquidity
and evaluate a company’s financial position.
• Days’ Sales in Receivables (the collection
period) helps to measure the quality of
receivables by calculating how long it takes,
on average, to collect receivables.
• This indicates how many days’ sales remain in
Accounts Receivables, awaiting collection.
• This is a measure of quality because the older
a receivable gets, the less likely it is to get
paid.
Two Key Liquidity Ratios
• Days’ Sales in (Average) Accounts
Receivable
= Average net Accounts Receivable*
One day’s sales**

• *Average net Accounts Receivable is calculated by

adding the beginning and ending net Accounts
Receivable balances together and dividing by two.
• **One Day’s Sales is calculated by dividing Net Sales
Revenue by 365.

• A lower number indicates greater

liquidity.
Two Key Liquidity Ratios
• Acid Test Ratio (Quick Ratio)
=Cash + S/T Investments + Net current
receivables*
Total Current Liabilities

• The higher the acid-test ratio, the better the

business is able to pay its current liabilities.
* Inventory is excluded even though it is a current
asset, because inventory is not as liquid as the
current assets included in the quick ratio.
Questions?
• Any questions or concerns?