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ACG 2021Financial Accounting

Chapter 5 – Accounting for Short-Term Investments and Accounts Receivable

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Short-Term Investments

Next most liquid Asset after Cash Investments that a company plans to hold for

one year or less.Three Types:

– Held-to-maturity securities• Usually Cash Loans

– Trading investments• Stocks or Bonds

– Available-for-sale investments• Discussed later

(Held-to-maturity and available-for-sale securities could also be long-term.)

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Trading Investments

Use of Excess CashBuy Low, Sell HighMost often, stock or bonds of

another company

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Held-to-Maturity Investments

Typically Note Receivable– Business organization lends excess

cash, expecting interest in return

Investor expects to hold until maturity date

These Investments earn interest revenue for the investor

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Reporting Short-Term Investments

Balance Sheet– Current Assets– Trading investments reported at

current market valuecurrent market valueIncome Statement

– Interest and dividend revenue reported under Other Revenue.

– Gains and losses reported under Other Revenue.

• Including Unrealized Gains and Losses

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Accounting for Trading InvestmentsRecord PurchaseAdjust at end of period to Market Value

– Unrealized Gain• Increases Trading Investment balance (debit)

– Unrealized Loss• Decreases Trading Investment balance (credit)

Record Sale– Compare Sale price to ENDING balance

• Which includes all previous adjustments to market value

– Sale price > ENDING balance = Gain– Sale price < Ending balance = Loss

Accounting for Trading Investments

Investments that can be traded

– Stocks, Bonds

Oracle 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 100,000Cash 100,000

Purchased investment

Accounting for Unrealized Gain/(Loss)Oracle 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 2,000Adjusted investment to market value

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Short-Term Investments

Short-Term InvestmentsCost 100,000Adjustment to market value 2,000Balance 102,000

What happens if at the next reporting period, if we sellFord’s stock for $105,000? What’s the entry?What if we sell the stock for $95,000? What’s the entry?

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Realized Gain / (Loss)

When Investor Sells AssetRealized Gain

– Sales Price > Investment Balance

Realized Loss– Sales Price < Investment

Cash 105,000Short-Term Invest 102,000Gain on Sale of Invest 3,000

Sold at a gain

Cash 95,000Loss on Sale of Invest 7,000

Short-Term Invest 102,000Sold at a loss

Accounting for Dividends Rcv’d

On May 27, Oracle receives a cash dividend of $4,000 from Ford.

General Journal

Date Accounts and Explanations PR Debit Credit

May 27 Cash 4,000Dividend revenue 4,000

Received cash dividend

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Reporting on the Balance Sheetand the Income Statement

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ACG 2021Financial Accounting

Accounting for:

Accounts Receivable

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Receivables

Receivables are the 3rd most liquid Assets after:– Cash– Short-term Investments

Receivables are monetary claims against the business organization customers.– Business organization extends credit to customers to make

a sale• How many business do you know where you can only pay with

cash? Two major types:

– Accounts receivable (trade receivables) – amount to be collected from customers from the sale of goods and services

– Notes receivable – written promise to pay• Secured

– Collateralized loan• Unsecured

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Issues When Extending Credit

Benefits Increase Sales VolumeGrow market shareGrow Business

ConsequencesCustomers take a long

time to pay– Ratio: Days Sales in

Receivables

Customers don’t pay at all

Additional expense from management of collection process

Higher risk of $’s being stolen by employee

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Accounting for Accounts ReceivableMain Account Receivable Account

– Debits are for new amounts owed by ALL customers

– Credits are for payments made by ALL customers

– Account balance is total owed by ALL customers

Subsidiary Account Receivables– Separate accounts maintained for each customer

• Debits are only for new amounts owed by particular customer

• Credits are only for payments paid by particular customer

• Account balance is total owed by particular customer

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Accounts Receivable

GENERAL LEDGER

Accounts ReceivableBal. 9,000

ACCOUNTS RECEIVABLESUBSIDIARY RECORD

AstonBal. 5,000

Harris

Salazar

Bal. 1,000

Bal. 3,000

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Issues in Accounting for Receivables

Measure and report receivables at net realizable valuenet realizable value.

– The amount the business organization expects to collect

• Total Accounts receivable – Estimated Uncollectible $’s

– Estimate reduces Accounts Receivable (credit) and creates an expense (debit)

Measure and report the expense associated with failure to collect.

– Why? What accounting principle requires us to report this expense?

• Matching: Must match costs with revenues that the costs generate…

– Extending credit creates revenue, we must record the cost of extending credit

Two accounting methods for recording uncollectible accounts

receivable

– Allowance Method (based on Estimation)

• Estimation technique #1: Percent of Sales

• Estimation technique #2: Aging of Accounts Receivable

– Direct Write-off Method

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Uncollectible Receivables

Allowance method– record losses based on an estimate of uncollectible

accounts.

• Percent-of-sales method

– computes expenseexpense as a percent of revenue

– income statement approach

• Aging-of-receivables method

– Computes ending allowance account balanceending allowance account balance

– individual receivables are analyzed based on how long they

have been outstanding

– balance sheet approach

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Contra Accounts

Allowance account = Contra Accounts Receivable– Contra Account is related to a “main” account

– Contra Account has opposite normal balance from “main”

account

• Accounts Receivable = Assets = Normal Debit Balance

• Allowance for Uncollectible Accounts = Contra Asset =

Normal Credit Balance

• Accounts Receivable – Allowance for Uncollectible Accounts

= Net Realizable Value

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Estimating Uncollectible A/R We need 3 T-Accounts

– Bad Debt Expense (debit)• Cost of not collecting A/R’s

– Allowance for Uncollectible Accounts (credit)• Contra account that indicates what we expect not to collect

– Accounts Receivable (no adjustment, used to calculate NRV)• Total (Gross) amount owed by customers

Step 1: Determine Estimate– Know what that estimate is

Step 2: Record Estimate– % of Sales

• Debit Bad Debt Expense• Credit Allowance for Uncollectible Accounts

– Aging of A/R• New Ending Balance in Allowance Account• Subtract Beginning Balance from Ending Balance =

– Credit Allowance for Uncollectible Accounts– Debit Bad Debt Expense

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Percent-of-SalesTotal sales are $33,000. The credit department estimates that uncollectible-account expense is 1% of total revenues.

Dec 31 Uncollectible-Account Expense($33,000 x .01) 330

Allowance for Uncollectible Accounts330

Recorded expense for the year

Accounts Receivable3,105

Bal. 3,105

Allowance forUncollectible Accounts

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330330

Bal. 350

Net Accounts Receivable

$3,105 – 350 = $2,755

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Aging-of-Receivables

Age of Account (Dollar amounts in millions)

Customer 1-30 Days

31-60 Days

61-90 Days

Over 90 Days

Total Balance

Hertz Rent-A-Car * * * * *

* * * * * *

* * * * * *

* * * * * *

* * * * * *

* * * * * *

Totals $1,800 $ 760 $ 326 $ 219 $3,105 Estimated percent uncollectible............

X 4%

X 10%

X 18.7%

X 80%

Allowance for Uncollectible Accounts balance should be

$ 72

+ $ 76

+ $ 61

+ $ 175

= $ 384

Critical Point!!!!

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Aging-of-Receivables

Dec 31 Uncollectible-Account Expense 214

Allowance for Uncollectible Accounts214

Recorded expense for the year

Accounts Receivable3,105

Bal. 3,105

Allowance forUncollectible Accounts

170

214

Bal. 384384

Net Accounts Receivable

$3,105 – 384 = $2,721

End Bal (384) – Beg Bal (170) = Expense (214)

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Aging-of-Receivables

Current balance in allowance account is $170.

Calculate the adjustment needed to bring the balance to $384.

Expense: $384 – $170 = $214

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Financial Statements using The Allowance Method

Balance Sheet (partial)Accounts receivable $10,000Less: Allowance for uncollectible accounts – 900Accounts receivable, net $ 9,100

Income Statement (partial)Expenses:Uncollectible-account expense $ 2,000

Accounts receivable, net of allowance for doubtful accounts of $701 and $767 atDecember 31, 2005 and 2006, respectively. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26,136 52,394

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Writing off Uncollectible Accounts

Decrease the Allowance account and remove the account receivable.

Mar 31 Allowance for Uncollectible Accounts 100

Accounts Receivable 100

What is the effect on total assets?Why is there no expense recorded?

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Comparing the Methods

Allowance Method

Adjusts Allowance forUncollectible Accounts

BY

Calculating Expense

Aging-of-Receivables

Adjusts Allowance forUncollectible Accounts

TO

Calculating EndingAllowance Balance

Percent-of-Sales

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

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Direct Write-Off Method

No allowance is established and the expense is recognized when accounts are written off.

Mar 31 Uncollectible Account Expense 100 Accounts Receivable 100

Accounts Receivable – Sarasota Pipe61

Accounts Receivable – Miller Auto Sales39

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Direct Write-Off Method

Assets are overstated on the balance sheet because no allowance account is used.

Poor matching of uncollectible-account expense against revenue. Net income is overstated.

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Basic Accounting for Accounts ReceivableProvided $1,000 Goods/Services on

account Accounts Receivable 1,000

Sales Revenue 1,000

Receive $1,000 payment from customer on account Cash 1,000

Accounts Receivable 1,000

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ACG 2021Financial Accounting

Accounting for Notes Receivable and Cash Flow Issues

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Some Definitions Creditor

– Who the money is owed to Debtor

– Who owes the money Debt Instrument

– Legal Document representing debt• Represented by a payable for the debtor• Represented by a receivable for the creditor

Equity Security– Stock certificate, ownership of a corporation

Maturity– Date when debt instrument must be paid

Term– Time from inception to maturity of debt instrument

• If < 1 year, listed as Current Asset / Liability• If > 1 year

– Current Portion is Current Asset / Liability– Portion due after 1 year is Long term Asset/Liability

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Notes Receivable

Creditor has a note receivable.Debtor has a note payable.Principal is the amount borrowed.Interest is revenue to the lender/creditor

and expense to the borrower/debtor.– Accrues over the period of the note– If period straddles two accounting periods

• Adjusting Entry must be made to reflect interest earned during each period – recall accrued revenues.

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Notes ReceivableLaura Holland signs a $1,000 note dated Aug. 31, 20X5 with a maturity date of Feb. 28, 20X6. To record this on the bank’s books: (How many months is this loan for? How many accounting periods does it cover?

Notes Receivable – L. Holland 1,000

Cash 1,000

Made a loan

To record interest earned at Dec. 31, 20X5:

Interest Receivable (1,000 x .09 x 44/12) 30

Interest Revenue 30

Accrued interest revenue

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Notes ReceivableTo record collection of the note on Feb. 28, 20X6:

Cash 1,045

Interest Revenue (1,000 x .09 x 22/12)15Collected note at maturity

Interest Receivable30

Note Receivable – L. Holland1,000

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How to Speed Up Cash Flow

Credit card or bankcard salesSelling receivables (Factoring)Discounting notes receivable

General Journal

Date Accounts and Explanations PR Debit Credit

Cash 97,000

Financing Expense 3,000

Sales Revenue 100,000To record a credit card sale of$100,000 and a 3% financing fee

How to Speed Up Cash Flow

Recording a credit card or bankcard sale

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

How to Speed Up Cash Flow

Recording the sale of receivables

General Journal

Date Accounts and Explanations PR Debit Credit

Cash 95,000

Financing Expense 5,000

Trade Accounts Receivable 100,000Sold accounts receivable

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

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Reporting on theStatement of Cash FlowsReceivables bring in cash when the

business collects from customers.– Operating Activities

Investment transactions change Cash– Investing Activities

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ACG 2021Financial Accounting

Acid Test & Days Sales in Receivables Ratios

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Ratios

Acid Test Ratio = Cash + ST Investments + Net Receivables

Total Current Liabilities

Day’s Sales in Receivables =Average Net Accounts Receivable

Average Daily Sales

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A stringent test of liquidityMeasures entity’s ability to pay its current

liabilities immediately

Acid-Test Ratio

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How long does it take to collect the average receivables for an organization?

Step 1: Determine Organizations sales for a single day– One day’s sales = Net sales ÷ 365 days

Step 2: Determine Organizations Average Receivables– (Beginning Balance + Ending Balance) / 2

Step 3: Calculate Ratio

A smaller number indicates a quick conversion to cash.

Days’ Sales in Receivables

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BBBB and BBY Ratios

BlackBoard– Acid Test

• FYE 2005 1.8 FYE 2006 .58

– Day’s Sales in Receivables• FYE 2006 78

Best Buy– Acid Test

• FYE 2006 .70 FYE 2007 .69

– Day’s Sales in Receivables• FYE 2007 5.06

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End of Chapter 5