Receivables and Short-Term Investments

Learning Objective 1 Understand short-term investments.

Short-Term Investments Short-term investments are investments that a company plans to hold for one year or less. – Held-to-maturity securities – Trading investments – Available-for-sale investments Held-to-maturity and available-for-sale securities could also be long-term.

Short-Term Investments Held-to-maturity investments are securities that the investor expects to hold until their maturity date. They earn interest revenue for the investor. Accounting for these securities is the same as accounting for notes receivable.

Short-Term Investments Suppose that Oracle Corporation purchases Ford Motor Company stock on May 18, paying $100,000, with the intention of selling the stock within a few months.

Short-Term Investments May 18 Short-Term Investment100,000 Cash100,000 Purchased investment On May 27, Oracle receives a cash dividend of $4,000 from Ford.

Short-Term Investments May 27 Cash 4,000 Dividend Revenue 4,000 Received cash dividend Oracle fiscal year ends on May 31, and the investment in Ford has a current market value of $102,000 on this date.

Short-Term Investments May 31 Short-Term Investment2,000 Unrealized Gain on Investments 2,000 Adjusted investment to market value Short-Term Investments Cost100,000 Adjustment to market value 2,000 Balance102,000

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 Dividend revenue 4,000 Unrealized gain on investment 2,000

Accounts and Notes Receivable Receivables are the third most liquid asset – after cash and short-term investments. Receivables are monetary claims against others.

Accounts receivable Types of Receivables Notes receivable Other receivables (miscellaneous)

Accounts Receivable GENERAL LEDGER Accounts Receivable Bal. 9,000 ACCOUNTS RECEIVABLE SUBSIDIARY RECORD Aston Bal. 5,000 Harris Salazar Bal. 1,000 Bal. 3,000

Learning Objective 3 Use the allowance method for uncollectible receivables.

Accounting for Uncollectible Accounts Selling on credit creates both a benefit and a cost: The benefit: Customers who cannot pay cash immediately can buy on credit, so company profits rise as sales increase. The cost: The company will be unable to collect from some credit customers.

The Allowance Method The allowance method records collection losses on the basis of estimates, not waiting to see which customers will not pay. The Allowance for Uncollectible Accounts (Allowance for Doubtful Accounts) is a contra account to Accounts Receivable.

The Allowance Method Balance Sheet (partial) Accounts receivable$10,000 Less: Allowance for uncollectible accounts – 900 Accounts receivable, net$ 9,100 Income Statement (partial) Expenses: Uncollectible-account expense$ 900

Methods for Estimating Uncollectibles Percent-of-sales Aging-of-Receivables

Percent-of-Sales It computes uncollectible-account expense as a percentage of revenue. This method is also called the income-statement approach.

Percent-of-Sales The credit department estimates that uncollectible-account expense is 5% of total revenues, which were $11 billion for 20x1. Dec 31 (in millions) Uncollectible-Account Expense ($11,000 × 0.05)550 Allowance for Uncollectible Accounts550 Recorded expense for the year

Percent-of-Sales December 31, 20x1 (in millions) After Adjustment Accounts Receivable Bal. 11,000 Allowance for Uncollectible Accounts 550

Aging-of-Receivables This method is a balance-sheet approach because it focuses on accounts receivable. Individual receivables from specific customers are analyzed based on how long they have been outstanding.

Aging-of-Receivables December 31, 20x1 (in millions) Accounts Receivable Bal. 2,835 Allowance for Uncollectible Accounts 120 Accounts before the year-end adjustment:

Aging-of-Receivables Days Overdue 1-30 days days days 91 + days Accounts Receivable $1, $2,835 Estimated % Uncollectible Allowance for Uncollectible Accounts $ $403 Aging the Accounts Receivable

Aging-of-Receivables Accounts after the year-end adjustment: Uncollectible-Account Expense283 Allowance for Uncollectible Accounts ($403 – $120)283 Recorded expense for the year December 31, 20x1 (in millions) Accounts Receivable Bal. 2,835 Allowance for Uncollectible Accounts 120 Adj

Writing Off Uncollectible Accounts Suppose that early in 20x2, the credit department determines that the company cannot collect from two customers. These accounts must be written off.

Writing Off Uncollectible Accounts Allowance for Uncollectible Accounts100 Accounts Receivable Customer A61 Accounts Receivable Customer B39 Wrote off uncollectible receivables

Direct Write-Off Method An account is written off only when it is decided that a specific customer’s receivable is uncollectible. January 2, 20x4 Uncollectible-Account Expense2,000 Accounts Receivable – Jones2,000 Wrote off a bad account

Direct Write-Off Method This method is defective for two reasons: Since no allowance for uncollectibles is established, assets are overstated on the balance sheet. It causes a poor matching of uncollectible- account expense against revenue and overstates net income.

Learning Objective 4 Account for notes receivable.

Notes Receivable Notes receivable are more formal than accounts receivable. The creditor has a note receivable. The debtor has a note payable. Note

Notes Receivable The principal amount of the note is the amount borrowed by the debtor. The maker pays the payee the maturity value. The maturity value includes principal plus interest.

Notes Receivable PROMISSORY NOTE $1,000 August 31, 20x5 Amount For value received, I promise to pay to the order of Continental bank Chicago, Illinois One thousand and no/100……………………Dollars on February 28, 20x6 plus interest at the annual rate of 9 percent Principal Interest period starts Payee (creditor) Interest rate Interest period ends on the maturity date Maker (Debtor)

Accounting for Notes Receivable Continental Bank entry is as follows: August 31, 20x5 Note Receivable1,000 Cash1,000 Made a loan How much interest revenue is accrued at December 31?

Interest = Principal × Rate × Time Accounting for Notes Receivable December 31, 20x5 Interest Receivable30 Interest Revenue30 Accrued interest revenue $1,000 × 9% × 4 / 12 = $30

Accounting for Notes Receivable February 28, 20x6 Cash1,045 Note Receivable1,000 Interest Receivable 30 Interest Revenue ($1,000 × 9% × 2 / 12 ) 15 Collected note at maturity The bank collects the note on February 28, 20x6.

Learning Objective 5 Use the acid-test ratio and the days’ sales in receivables to evaluate financial position.

Reporting Assets in Order of Liquidity CURRENT ASSETS Cash and cash equivalents$ 4,449$ 7,429 Short-term investments 1, Trade receivables, net 2,432 2,534 Prepaid expenses Total current assets$ 8,963$10,883 Long-term investments – 110 Property, net Other assets 1,092 1,149 Total assets$11,030$13,077 CURRENT LIABILITIES Total current liabilities 3,916 5,892 Long-term debt and liabilities Stockholders’ equity 6,278 6,462 Total liabilities and stockholders’ equity$11,030$13,077

One day’s sales = Net sales ÷ 365 days = 10,860 ÷ 365 = per day Days’ sales in average accounts receivable = Average net accounts receivable ÷ One day’s sales = [(2, ,432) ÷ 2] ÷ = 83 days Days’ Sales in Receivables A smaller number indicates a quick conversion to cash.

Acid-test ratio = (Cash + Short-term investments + Net current receivables) ÷ Total current liabilities = (4, , ,432) ÷ 3,916 = 2.12 Acid-Test Ratio This is a stringent test of liquidity which measures the entity’s ability to pay its current liabilities immediately. This ratio value is extremely high and indicates great liquidity for this company.

End of Chapter 5