Short-Term Financial Assets Chapter 9 Short-Term Financial Assets Multimedia Slides by: Gail A. Mestas, MAcc, New Mexico State University

Learning Objectives Identify and explain the management issues related to short-term financial assets. Explain cash, cash equivalents, and the importance of electronic funds transfer. Identify types of short-term investments and explain the financial reporting implications. Copyright © Houghton Mifflin Company. All rights reserved.

Learning Objectives (cont’d) Define accounts receivable and apply the allowance method of accounting for uncollectible accounts. Define promissory note, and compute and record promissory notes receivable. Copyright © Houghton Mifflin Company. All rights reserved.

Management Issues Related to Short-Term Financial Assets Objective 1 Identify and explain the management issues related to short-term financial assets Copyright © Houghton Mifflin Company. All rights reserved.

Key Issues in Dealing with Short-Term Financial Assets Management must address three key issues regarding short-term financial assets Managing cash needs during seasonal changes Setting credit policies Financing receivables Copyright © Houghton Mifflin Company. All rights reserved.

Managing Cash Needs During Seasonal Cycles Most companies experience seasonal cycles of business activity during the year Sales may be weak or strong Expenditures may be high or low Companies must carefully plan cash inflows, outflows, borrowing, and investing Copyright © Houghton Mifflin Company. All rights reserved.

Setting Credit Policies Companies sell on credit to be competitive and increase sales To increase the likelihood of selling to customers who will pay on time, companies develop control procedures and maintain a credit department Copyright © Houghton Mifflin Company. All rights reserved.

Measuring the Effect of a Company’s Credit Policies Two common measures of the effect of a company’s credit policies are Receivable turnover Reflects the relative size of a company's accounts receivable and the success of its seasonal conditions and interest rates Average days’ sales uncollected Shows, on average, how long it takes to collect accounts receivable Copyright © Houghton Mifflin Company. All rights reserved.

Receivable Turnover … reflects the relative size of a company's accounts receivable and the success of its seasonal conditions and interest rates Compute the receivable turnover for Pioneer Corporation This means that, on average, receivables were turned into cash 5.8 times during the accounting period Copyright © Houghton Mifflin Company. All rights reserved.

Receivable Turnover for Selected Industries Copyright © Houghton Mifflin Company. All rights reserved.

Average Days’ Sales Uncollected … is a relative measure that, on average, shows how long it takes to collect accounts receivable Compute Pioneer’s average days’ sales uncollected This means that the average length of time it takes Pioneer Corp. to receive payment for credit sales is 62.9 days Copyright © Houghton Mifflin Company. All rights reserved.

Financing Receivables Companies with significant amounts tied up in accounts receivable may not be willing or able to wait until cash is collected Solutions Set up financing companies Borrow funds using receivables as collateral Factoring Securitization Discounting Copyright © Houghton Mifflin Company. All rights reserved.

Financing Companies … are companies set up by corporations to help their customers pay for the purchase of their products Examples Ford Motor Credit Company (FMCC) General Motors Acceptance Corp. (GMAC) Sears Roebuck Acceptance Corp. (SRAC) Copyright © Houghton Mifflin Company. All rights reserved.

Borrowing Some companies borrow funds using their accounts receivable as collateral If the company does not pay back its loan, the creditor takes possession of the accounts receivable and converts them to cash to satisfy the loan Copyright © Houghton Mifflin Company. All rights reserved.

… is the sale or transfer of accounts receivable Factoring … is the sale or transfer of accounts receivable With recourse The seller of the receivables is liable to the purchaser if a receivable is not collected Without recourse The factor that buys the accounts receivable bears any losses from uncollectible accounts A credit card sale is an example of factoring without recourse because the credit card issuer accepts the risk of nonpayment Copyright © Houghton Mifflin Company. All rights reserved.

Factoring (cont’d) The factor charges a fee for its service Usually about 1 percent for sales with recourse Higher fees for sales without recourse because of increased risk Selling receivables with recourse creates a contingent liability A potential liability that can develop into a real liability if a particular subsequent event occurs Copyright © Houghton Mifflin Company. All rights reserved.

Securitization … is the sale of batches of a company’s accounts receivable at a discount to companies and investors The buyer receives the full amount when the receivables are paid The revenue is the amount of the discount Copyright © Houghton Mifflin Company. All rights reserved.

… is the sale of promissory notes held as notes receivable Discounting … is the sale of promissory notes held as notes receivable The holder of the note (usually the payee) receives proceeds equal to the maturity value of the note less the interest amount The seller of the note expects to collect the maturity value of the note (principal plus interest) in the maturity date Copyright © Houghton Mifflin Company. All rights reserved.

Discussion Indicate whether each of the following is related to (a) managing cash needs during seasonal cycles (b) setting credit policies (c) financing receivables Selling accounts receivable to a factor 1. c Borrowing funds for short-term needs during slow periods 2. a Conducting thorough checks of new customers’ ability to pay 3. b Investing cash that is not currently needed for operations 4. a Copyright © Houghton Mifflin Company. All rights reserved.

Cash and Cash Equivalents Objective 2 Explain cash, cash equivalents, and the importance of electronic funds transfer Copyright © Houghton Mifflin Company. All rights reserved.

Cash The most liquid of all assets Readily available to pay debts Includes Currency and coins on hand Checks and money orders from customers Deposits in bank checking and savings accounts Compensating balances Minimum amount a bank requires to be held in an account Restrict cash, increase the interest of loans, and reduce a company’s liquidity Amounts must be reported in notes to financial statements Copyright © Houghton Mifflin Company. All rights reserved.

Cash Equivalents … are short-term, highly liquid investments that will revert to cash in 90 days or less from the time of purchase Include Money market accounts Commercial paper U.S. Treasury bills These funds revert to cash so quickly they are regarded as cash on the balance sheet Copyright © Houghton Mifflin Company. All rights reserved.

Cash on Hand Kept for cash registers and for paying expenses that are impractical to pay by check Kept in an imprest (petty cash) fund The fund is established at a fixed amount Receipts are maintained for expenditures The fund is periodically reimbursed to restore it to its fixed amount Copyright © Houghton Mifflin Company. All rights reserved.

Banking and Electronic Funds Transfer EFT (Electronic Funds Transfer) A company has cash transferred from its bank to another company’s bank instead of writing checks Wal-Mart Stores, Inc. makes 75% of its payments to suppliers this way Debit cards A customer’s retail purchase is deducted directly from his/her bank account The bank documents transactions for the retailer The retailer must develop new internal controls Copyright © Houghton Mifflin Company. All rights reserved.

Discussion What items are included in the cash account? What is a compensating balance? Cash consists of coins and currency on hand, checks and money orders received from customers, and deposits in bank checking accounts A compensating balance is the minimum amount a bank requires in a company’s bank account as part of a credit-granting arrangement Copyright © Houghton Mifflin Company. All rights reserved.

Short-Term Investments Objective 3 Identify types of short-term investments and explain the financial reporting implications Copyright © Houghton Mifflin Company. All rights reserved.

Short-Term Investments … are investments with a maturity of more than 90 days, but are intended to be held only until cash is needed for current operations Also called marketable securities Copyright © Houghton Mifflin Company. All rights reserved.

Short-Term Versus Long-Term Investments Short-Term Investments Long-Term Investments Maturity of more than 90 days and less than one year Maturity of one year or more Temporary investment of excess cash to be used in current operations Assets not used in the normal operation of a business Reported under current assets on the balance sheet Reported under investments on the balance sheet Include Held-to-maturity securities Available-for-sale securities Trading securities Include Held-to-maturity securities Available-for-sale securities Copyright © Houghton Mifflin Company. All rights reserved.

Held-to-Maturity Securities … are debt securities that management intends to hold to their maturity and whose cash value is not needed until that date May be short- or long-term investments Copyright © Houghton Mifflin Company. All rights reserved.

Example of Held-to-Maturity Securities Dec. 1, 20x4: Purchased U.S. Treasury bills that will mature in 120 days at $100,000 for $97,000 Dec. 31, 20x4: Accrued interest income on U.S. Treasury bills On December 31, the U.S. Treasury bills would be shown on the balance sheet as a short-term investment at their amortized cost of $97,750 ($97,000 + $750) Copyright © Houghton Mifflin Company. All rights reserved.

Example of Held-to-Maturity Securities March 31, 20x5: U.S. Treasury bills mature Copyright © Houghton Mifflin Company. All rights reserved.

Trading Securities … are debt and equity securities that are bought and held principally for the purpose of being sold in the near term Are always short-term investments Frequently bought and sold to generate profits on short-term changes in their prices Copyright © Houghton Mifflin Company. All rights reserved.

Trading Securities (cont’d) Classified as current assets on the balance sheet Valued at fair (market) value An increase or decrease in the total trading portfolio is included in net income in the accounting period in which the increase or decrease occurs Copyright © Houghton Mifflin Company. All rights reserved.

Example of Trading Securities Oct. 25, 20x4: Purchased 10,000 shares of Exxon Mobil Corp. for $900,000 ($90 per share) and 5,000 shares of Texaco, Inc. for $300,000 (60 per share) Copyright © Houghton Mifflin Company. All rights reserved.

Example of Trading Securities Dec. 31, 20x4: Exxon Mobil’s share price has decreased to $80 per share and Texaco’s has risen to $64 per share Unrealized loss on investments will appear on the income statement as a reduction in income The loss is unrealized because the securities have not been sold Copyright © Houghton Mifflin Company. All rights reserved.

Example of Trading Securities Dec. 31, 20x4: Exxon Mobil’s share price has decreased to $80 per share and Texaco’s has risen to $64 per share The Allowance to Adjust Short-Term Investments to Market account appears on the balance sheet as a contra-asset Copyright © Houghton Mifflin Company. All rights reserved.

Example of Trading Securities Mar. 2, 20x5: Sold 5,000 shares of Texaco for $70 per share The realized gain will appear on the income statement Note that the realized gain was unaffected by the adjustment for the unrealized loss at the end of 20x4 Copyright © Houghton Mifflin Company. All rights reserved.

Example of Trading Securities 20x5: Purchased 2,000 shares of BP Corporation at $64 per share Dec 31, 20x5: The price of Exxon Mobil’s stock has risen to $95 per share and BP’s stock price has fallen to $58 per share A $118,000 debit brings the Allowance to Adjust Short-Term Investments to Market account’s $80,000 credit balance to a $38,000 debit balance Copyright © Houghton Mifflin Company. All rights reserved.

Allowance to Adjust Short-Term Investments to Market Account … is adjusted at the end of every accounting period to reflect the difference between the market value of the investment portfolio and its cost Allowance to Adjust Short-Term Investments to Market Dec 31, 20x4 bal. 80,000 Dec 31, 20x5 adj. 118,000 Dec 31, 20x5 bal. 38,000 Recall that on Dec. 31, 20x4 this account was credited $80,000 to reflect the amount by which the cost of the investment portfolio exceeded its market value On Dec. 31, 20x5, the market value of the investment portfolio exceeded its cost by $38,000. The new balance of this account is a $38,000 debit balance A debit adjustment of $118,000 must be made to the account to reflect the correct balance Copyright © Houghton Mifflin Company. All rights reserved.

Available-for-Sale Securities … are debt and equity securities that do not meet the criteria for either held-to-maturity or trading securities May be short- or long-term investments Are accounted for in the same way as trading securities except that the unrealized gain or loss is not reported on the income statement Reported as a special item in the stockholders’ equity section of the balance sheet Copyright © Houghton Mifflin Company. All rights reserved.

Dividend and Interest Income … for all three categories of short-term investments is shown in the other income and expenses section of the income statement Copyright © Houghton Mifflin Company. All rights reserved.

Discussion What are unrealized gains and losses on trading securities? On what statement are they reported? Unrealized gains and losses on trading securities are changes in the fair market value of securities that have not been sold. Because the securities have not been sold, the gains or losses have not been realized. They are reported on the income statement Copyright © Houghton Mifflin Company. All rights reserved.

Accounts Receivable Objective 4 Define accounts receivable and apply the allowance method of accounting for uncollectible accounts Copyright © Houghton Mifflin Company. All rights reserved.

Accounts Receivable (A/R) … are short-term financial assets that arise from sales on credit to customers Also called trade credit Trade credit terms vary by industry Installment A/R arise from the sale of goods on terms that allow the buyer to make a series of time payments Although the payment period may be 24 months or more, are still classified as current assets if customary in the industry Copyright © Houghton Mifflin Company. All rights reserved.

Accounts Receivable (cont’d) Receivables from other than regular customers (employees, owners, officers) are shown separately with a title such as Receivables from Employees Normally, individual customer accounts receivable have debit balances If a customer has a credit balance, this is shown as a current liability on the balance sheet Copyright © Houghton Mifflin Company. All rights reserved.

Accounts Receivable as a Percentage of Total Assets for Selected Industries Copyright © Houghton Mifflin Company. All rights reserved.

Uncollectible Accounts … are accounts owed by customers who will not or cannot pay Also called bad debts Represent a loss or an expense of selling on credit Companies sell on credit to increase their volume of sales, thereby increasing their earnings Losses may be recognized using the Direct charge-off method Allowance method Copyright © Houghton Mifflin Company. All rights reserved.

The Direct Charge-Off Method … recognizes the loss at the time the A/R is determined to be uncollectible Reduces A/R and increases Uncollectible Accounts Expense Used for federal tax purposes but not GAAP, because it violates the matching principle Copyright © Houghton Mifflin Company. All rights reserved.

… matches bad debt losses against the sales they help produce The Allowance Method … matches bad debt losses against the sales they help produce At the time of sale, management cannot identify which customers will not pay To observe the matching rule, losses from uncollectible accounts must be estimated The estimate becomes an expense in the fiscal year in which the sales are made Copyright © Houghton Mifflin Company. All rights reserved.

Example of the Allowance Method Dec. 31, 20x4: Management estimated that approximately $6,000 of the $100,000 of accounts receivable was uncollectible Uncollectible Accounts Expense appears on the income statement as an operating expense Allowance for Uncollectible Accounts appears on the balance sheet as a contra-asset account that is deducted from Accounts Receivable Accounts receivable may be shown “net,” with the amount of the Allowance for Uncollectible Accounts shown in a note to the financial statements Copyright © Houghton Mifflin Company. All rights reserved.

Allowance for Uncollectible Accounts Also called Allowance for Doubtful Accounts Allowance for Bad Debts Reserve for Bad Debts An older phrase that should not be used in modern practice Uncollectible Accounts Expense Also called Bad Debts Expense Copyright © Houghton Mifflin Company. All rights reserved.

Estimating Uncollectible Accounts Expense It is necessary to estimate the expense to cover expected losses for the year Management makes the final decision Can be optimistic or pessimistic about expected losses If optimistic, expense smaller and net income higher If pessimistic, expense larger and net income smaller In either case, the estimated loss should be realistic, based on experience, the economy, etc Copyright © Houghton Mifflin Company. All rights reserved.

Estimating Uncollectible Accounts Expense (cont’d) Two common methods Percentage of net sales method Accounts receivable aging method Copyright © Houghton Mifflin Company. All rights reserved.

Percentage of Net Sales Method … is a way of estimating uncollectible accounts based on the assumption that a predictable proportion of each dollar of sales will not be collected Usually based on the company’s historical losses Copyright © Houghton Mifflin Company. All rights reserved.

Example of the Percentage of Net Sales Method Dec. 31, 20x9: Account balances: Sales, $645,000; Sales Returns and Allowances, $40,000; Sales Discounts, $5,000; Allowance for Uncollectible Accounts, $3,600. Management estimates that uncollectible accounts will average about 2 percent of net sales After the above entry is posted, Allowance for Uncollectible Accounts will have a credit balance of $15,600 Allowance for Uncollectible Accounts Dec 31, bal. 3,600 Dec 31, adj. 12,000 Dec 31, adj. bal. 15,600 Copyright © Houghton Mifflin Company. All rights reserved.

Accounts Receivable Aging Method … is a way of estimating uncollectible accounts that is based on the assumption that a predictable proportion of each dollar of accounts receivable still owed will not be collected Also called aging of accounts receivable Copyright © Houghton Mifflin Company. All rights reserved.

Aging of Accounts Receivable … is the process of listing each customer’s receivable account according to the due date of the account If the account is past due, there is a possibility it will not be paid The further the past due an account is, the greater the likelihood it will not be paid Copyright © Houghton Mifflin Company. All rights reserved.

Analysis of Accounts Receivable by Age The total past due for each category is multiplied by the estimated percentage uncollectible Copyright © Houghton Mifflin Company. All rights reserved.

Analysis of Accounts Receivable by Age = The sum of the totals for each category is the estimated balance of Allowance for Uncollectible Accounts Copyright © Houghton Mifflin Company. All rights reserved.

Analysis of Accounts Receivable by Age Notice that the estimated percentage uncollectible increases as accounts become further past due Copyright © Houghton Mifflin Company. All rights reserved.

Example of the Accounts Receivable Aging Method (Case 1) Dec. 31, 20x5: Management has estimated that $2,459 of Accounts Receivable are uncollectible. Allowance for Uncollectible Accounts has a credit balance of $800 Allowance for Uncollectible Accounts Dec 31, bal. 800 Dec 31, adj. 1,659 Dec 31, adj. bal. 2,459 The target balance for the account is a credit balance of $2,459 A credit adjustment of $1,659 will bring the account to its target balance Copyright © Houghton Mifflin Company. All rights reserved.

Example of the Accounts Receivable Aging Method (Case 2) Dec. 31, 20x2: Management has estimated that $2,459 of Accounts Receivable are uncollectible. Allowance for Uncollectible Accounts has a debit balance of $800 Allowance for Uncollectible Accounts Dec 31, bal. 800 Dec 31, adj. 3,259 Dec 31, adj. bal. 2,459 The target balance for the account is a credit balance of $2,459 A credit adjustment of $3,259 will bring the account to its target balance Copyright © Houghton Mifflin Company. All rights reserved.

Comparison of the Two Methods Copyright © Houghton Mifflin Company. All rights reserved.

Why Accounts Written Off Will Differ from Estimates The total of Accounts Receivable written off rarely equals the estimated uncollectible amount When the total of accounts written off is less than estimated uncollectible accounts The allowance account will have a credit balance at year end When the total of accounts written off is greater than estimated uncollectible accounts The allowance account will have a debit balance at year end Copyright © Houghton Mifflin Company. All rights reserved.

Writing Off an Uncollectible Account When it becomes clear an account will not be collected, the amount should be written off to Allowance for Uncollectible Accounts The uncollectible amount was already accounted for as an expense when the allowance was established Copyright © Houghton Mifflin Company. All rights reserved.

Example of Writing Off an Uncollectible Account Jan. 15, 20x6: R. Deering, who owes the company $250, is declared bankrupt by federal court Allowance for Uncollectible Accounts Accounts Receivable Dec 31, bal. 2,459 Dec 31, bal. 44,400 Jan. 15 250 Jan. 15 250 Bal. 2,209 Bal. 44,150 Net realizable value of A/R Before write-off $44,400 – $2,459 = $41,941 After write-off $44,150 – $2,209 = $41,941 The write-off does not affect the estimated net realizable value of accounts receivable Copyright © Houghton Mifflin Company. All rights reserved.

Recovery of Accounts Receivable Written Off Occasionally a customer whose account has been written off as uncollectible will pay all or part of the amount owed Two journal entries are required One to reverse the earlier write-off Another to show the collection of the account Copyright © Houghton Mifflin Company. All rights reserved.

Example of Recovering an Account Previously Written Off Sep. 1, 20x6: R. Deering notified the company that he could pay $100 of his account and sent a check for $50 Copyright © Houghton Mifflin Company. All rights reserved.

Discussion According to generally accepted accounting principles, at what point in the cycle of selling and collecting does a loss on an uncollectible account occur? According to GAAP, a loss from an uncollectible account occurs at the time the sale on credit is made Copyright © Houghton Mifflin Company. All rights reserved.

Notes Receivable Objective 5 Define promissory note, and compute and record promissory notes receivable Copyright © Houghton Mifflin Company. All rights reserved.

Notes Receivable … is a collective term for written promissory notes due in less than one year and are held by the payee Many companies accept notes receivable in settlement of past-due accounts Notes produce interest income Notes represent a stronger claim than do accounts receivable Selling or discounting notes is a common financing method Copyright © Houghton Mifflin Company. All rights reserved.

Promissory Notes … are unconditional promises to pay a definite sum of money on demand or at a future date The signer of the note is called the maker The entity to whom payment is to be made is called the payee The payee regards all promissory notes it holds that are due in less than one year as notes receivable in the current assets section of the balance sheet The maker regards them as notes payable in the current liability section of the balance sheet Copyright © Houghton Mifflin Company. All rights reserved.

Computations for Promissory Note Several terms are important in accounting for promissory notes 1. Maturity date The date on which the note must be paid 2. Duration of note The length of time in days between a promissory note’s issue date and its maturity date 3. Interest and interest rate The cost of borrowing money or the return for lending money Usually stated on an annual basis 4. Maturity value The total proceeds of a note at the maturity date Copyright © Houghton Mifflin Company. All rights reserved.

Accounting Entries for Promissory Notes June 1: Received a 30-day, 12 percent note from J. Halsted in settlement of an existing account receivable, $4,000 July 1: Note plus interest is collected Copyright © Houghton Mifflin Company. All rights reserved.

Accounting Entries for Promissory Notes (cont’d) July 1: J. Halsted dishonors her note When the maker of a note does not pay the note, it is said to be dishonored Interest earned is recorded because the maker of the note is still obligated to pay the principal and interest Transferring the dishonored note receivable to Accounts Receivable Leaves only notes that have not matured and are presumed to be collectible in Notes Receivable Establishes a record in the borrower’s Accounts Receivable account that a note receivable has been dishonored Copyright © Houghton Mifflin Company. All rights reserved.

Accounting Entries for Promissory Notes (cont’d) Sep. 30: Record accrued interest earned on a 60-day, 8 percent, $2,000 note received August 31 Oct 30: Received payment of note plus interest Copyright © Houghton Mifflin Company. All rights reserved.

Discussion What is a promissory note? Who is the maker? Who is the payee? A promissory note is an unconditional promise to pay a definite sum of money on demand or at a future date The person who signs the note and therefore promises to pay is called the maker The person to whom payment should be made is called the payee Copyright © Houghton Mifflin Company. All rights reserved.

Time for Review Identify and explain the management issues related to short-term financial assets Explain cash, cash equivalents, and the importance of electronic funds transfer Identify types of short-term investments and explain the financial reporting implications Copyright © Houghton Mifflin Company. All rights reserved.

More Review Define accounts receivable and apply the allowance method of accounting for uncollectible accounts Define promissory note, and compute and record promissory notes receivable Copyright © Houghton Mifflin Company. All rights reserved.