1. Chapter 7
Financial Assets
Chapter 7: Financial Assets

2. How Much Cash Should a Business Have?
How much cash should a business have? Every business needs enough cash to pay its bills. However, a business that has too much cash on hand is losing the ability to earn a return by investing their cash.
Financial assets include cash, short-term investments, and receivables. Businesses manage the amounts in each of these categories to ensure they have enough cash to pay their bills and earn a return when possible.
Cash needs can be met by collections on accounts receivable and by selling investments. Because most accounts receivable have payment due dates, businesses know when to expect payments from customers on their accounts. Businesses use this timetable for expected payments to help plan for future cash needs.
When a business has excess cash on hand, it is typically invested. If the cash will be needed in the near future, then short-term investments are made. Some businesses have enough excess cash on hand to warrant overnight investing. Investing in short-term investments helps a business use its excess cash to earn a return until the cash is needed. Then the short-term investment is sold, and the cash is available for use.

3. The Valuation of Financial Assets
On the balance sheet, cash and cash equivalents are reported at their face amount. Short-term investments are reported at their current market value. Accounts receivable are reported at their net realizable value. Net realizable value is the amount of the accounts receivable the business estimates it will actually collect.
Estimated collectible amount

4. Cash is defined as any deposit banks will accept.
Coins and paper money
Checks
Cash is defined as any deposit banks will accept.
Bank credit card sales
Money orders
Cash includes much more than what we typically think of as currency. It includes the typical items such as paper money and coins, but it also includes bank credit card sales, travelers’ checks, money orders, and checks.
Cash is defined as any deposits banks will accept.
Travelers’ checks

5. Reporting Cash in the Balance Sheet
Cash Equivalents
Restricted Cash
Lines of Credit
Cash equivalents are short-term investments, usually with a maturity date of less than three months, that have little risk of market value changes. Cash equivalents are combined with cash on the balance sheet.
Restricted cash is cash that has been set aside for a particular use and is not available for paying current liabilities. Restricted cash is not a current asset, rather it is classified as an investment on the balance sheet.
A line of credit is an agreement between a bank and a business where the bank agrees in advance to lend a specific amount of money to the business. When the business borrows from the line of credit, the business receives cash and incurs a liability. The business can continue to borrow up to the limit on the line of credit. The business can also make a payment to reduce the liability at any time. Any unused line of credit must be disclosed in the notes to the financial statements.

6. Cash Management Accurately account for cash. Prevent theft and fraud.
Assure the availability of adequate amounts of cash.
Prevent unnecessarily large amounts of idle cash.
Cash management is a comprehensive system that helps accurately account for cash, helps prevent theft of cash and fraud, helps assure the availability of adequate amounts of cash, and helps avoid having unnecessarily large amounts of idle cash on hand. Many businesses have large departments that have the responsibility of properly managing the business’s cash needs.

7. Internal Control Over Cash
Segregate authorization, custody and recording of cash.
Prepare a cash budget (or forecast).
Prepare a control listing of cash receipts.
Require daily deposits.
Make all payments by check.
Require that every expenditure be verified before payment.
Promptly reconcile bank statements.
An internal control system is a collection of policies and procedures that protect assets, ensure reliable accounting, promote efficient operations, and urge adherence to company policies.
Because Cash is easily susceptible to theft, the internal controls over Cash are extremely important. Internal controls for cash include
Segregation of duties such as authorization, custody, and recording of cash transactions.
Preparing a cash budget.
Preparing a control listing of cash receipts.
Requiring daily deposits.
Making all payments by check.
Require that every expenditure be verified before payment, and
Promptly reconciling bank statements.

8. Cash Over and Short
On May 5, XBAR, Inc.’s cash drawer was counted and found to be $15 short.
When a cash drawer is over or short, the account Cash Over and Short is used to record the difference. Management monitors the balance in the Cash Over and Short account to determine if there is a problem with cash shortages or overages. The account is debited for cash shortages and credited for cash overages.
Cash Over and Short is debited for shortages and credited for overages.

9. Reconciling the Bank Statement
Explains the difference between cash reported on bank statement and cash balance in depositor’s accounting records.
Companies, as well as anyone who has a personal bank account, should prepare a bank reconciliation on a regular basis. Because humans are involved in business and personal accounting, it’s likely that errors may occur, and a bank reconciliation helps identify these errors and how to correct them.
The bank reconciliation explains the difference between Cash reported on the bank statement and Cash recorded in the ledger account. Why are the balances different on the bank statement and on the Cash ledger? Because of timing differences.
Let’s look at how to prepare a bank reconciliation in more detail.
Provides information for reconciling journal entries.

10. Reconciling the Bank Statement
Balance per Bank
Balance per Depositor
+ Deposits by Bank
(credit memos)
+ Deposits in Transit
- Service Charge
- NSF Checks
- Outstanding Checks
There are two sides to a bank reconciliation. The bank side starts with the balance on the bank statement and is adjusted for deposits in transit, outstanding checks, and errors made by the bank.
The book side begins with the Cash balance in the ledger and is adjusted for collections made by the bank on the company’s behalf, interest earned, bank service charges, customer checks drawn on accounts that were insufficient, and errors made. All reconciling items on the book side require an adjusting entry to the Cash account.
Examples of collections made by the bank on a company’s behalf are when the bank acts as a collection box for customer payments or when the bank collects a note receivable from a customer.
± Bank Adjustments
± Book Adjustments
= Adjusted Balance
= Adjusted Balance

11. Reconciling the Bank Statement
The July 31 bank statement for Simmons Company indicated a cash balance of $9,610
The cash ledger account on that date shows a balance of $7,430.
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 customer’s 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.
On July 31st, Simmons Company’s bank statement listed a balance of $9,610. Their Cash account had a balance on that date of $7,430. Other information includes outstanding checks of $2,417, a $500 deposit in transit, a $225 NSF check from a customer, $30 in interest, an error in recording for check 781, and a deposit of $486 into Simmons bank account in error.

12. Reconciling the Bank Statement
First, let’s start with the bank side. Begin with the given balance on the bank statement. Add deposits in transit of $500. These are deposits that were made that do not appear on the bank statement. Next, the bank made a mistake and added Acme Company’s deposit to our account. As a result, we must subtract the erroneous $486. We also need to subtract the outstanding checks of $2,417. These are checks that have been written but that had not cleared the bank by the bank statement date. After these adjustments, the adjusted bank balance is $7,207.
Next, it’s time for the book side. Start with the given Cash balance from the ledger. Add the $30 of interest earned on the bank account. A recording error of $28 was made when check number 781 was recorded. The entry was made for $28 less than the actual amount of the check. To correct this error, subtract $28 from the book balance. Next, a check that was accepted from a customer turned out to be drawn on an account that did not have sufficient funds. When the check was received it increased our cash balance, so now $225 must be subtracted from our cash balance. After these adjustments, the adjusted book balance is $7,207.
Let’s look at the journal entries required.

13. Reconciling the Bank Statement
Entries are only made for items on the book side of the reconciliation. First, debit Cash and credit Interest Revenue for the amount of the revenue earned. Second, debit Supplies Inventory and Accounts Receivable and credit Cash. The debit to Supplies Inventory is to correct the error made earlier. The debit to Accounts Receivable creates an account for the amount of the insufficient fund check received from a customer.

14. Short-Term Investments
Bond Investments
Capital Stock Investments
Marketable Securities
are . . .
Readily Marketable
Current Assets
Short-term investments are investments in bonds or stocks that are readily marketable. They are classified as current assets on the balance sheet. Due to their liquidity, investments in marketable securities are listed immediately after Cash in the balance sheet and are most often classified as available for sale.
Almost As Liquid As Cash

15. Purchase of Marketable Securities
Foster Corporation purchases as a short-term investment 4,000 shares of The Coca-Cola Company on December 1. Foster paid $ per share, plus a brokerage commission of $80.
Foster Corporation purchases as a short-term investment 4,000 shares of The Coca-Cola Company on December 1. Foster paid $48.98 per share, plus a brokerage commission of $80. The entry to record this purchase is a debit to Marketable Securities and a credit to Cash for $176,000. The cost of the securities includes the price per share of $48.98 plus the $80 brokerage commission. Thus, the cost per share for the 4,000 securities is $49.
Total Cost: (4,000 × $48.98) + $80 = $196,000
Cost per Share: $196,000 ÷ 4,000 = $49.00

16. Recognition of Investment Revenue
On December 15, Foster Corporation receives a $0.30 per share dividend on its 4,000 shares of Coca-Cola.
On December 15, Foster Corporation receives a $0.30 per share dividend on its 4,000 shares of Coca-Cola.
The entry to record this dividend is a debit to Cash and a credit to Dividend Revenue for $1,200. The dividend amount is calculated as 4,000 shares time 30 cents per share.
4,000 × $0.30 = $1,200

17. Sales of Investments at a Gain
On December 18, Foster Corporation sells 500 shares of its Coca-Cola stock for $50.04 per share, less a $20 brokerage commission.
On December 18, Foster Corporation sells 500 shares of its Coca-Cola stock for $50.04 per share, less a $20 brokerage commission. The entry to record this sale includes a debit to Cash for $25,000 (500 shares times $50.04 minus the $20 commission) and a credit to Marketable Securities for $24,500 (500 times $49 cost basis) and a credit to Gain on Sale of Investment for $500 (the difference between the sales proceeds and the cost basis). The gain increases net income and is closed to Income Summary at the end of the period.
Sales Proceeds: (500 × $50.04) - $20 = $25,000
Cost Basis: 500 × $49 = $24,500
Gain on Sale: $25,000 - $24,500 = $500

18. Sales of Investments at a Loss
On December 27, Foster Corporation sells an additional 2,500 shares of its Coca-Cola stock for $48.01 per share, less a $25 brokerage fees.
On December 27, Foster Corporation sells an additional 2,500 shares of its Coca-Cola stock for $48.01 per share, less a $25 brokerage fees.
The entry to record this sale includes a debit to Cash for $120,000 (2,500 shares times $48.01 minus the $25 commission) and a debit to Loss on Sales of Investment for $2,500 (the difference between the sales proceeds and the cost basis) and a credit to Marketable Securities for $122,500 (2,500 times $49 cost basis). The loss decreases net income and is closed to Income Summary at the end of the period.
Sales Proceeds: (2,500 × $48.01) - $25 = $120,000
Cost Basis: 2,500 × $49 = $122,500
Loss on Sale: $120,000 - $122,500 = $2,500

19. Adjusting Marketable Securities to Market Value
On December 31, Foster Corporation’s remaining shares of Coca-Cola capital stock have a current market value of $47,000. Prior to any adjustment, the company’s Marketable Securities account has a balance of $49,000 (1,000 × $49 per share).
Securities classified as available for sale are presented in the balance sheet at their current market value as of the balance sheet date. Hence, this valuation principle is often called mark-to-market. The adjustment of marketable securities to their current market value requires the use of an account entitled Unrealized Holding Gain (or Loss) on Investments. This account appears as a special stockholders’ equity account in the balance sheet.
Recall that Foster originally purchased 4,000 shares of Coca-Cola capital stock and sold 500 shares at a gain and 2,500 shares at a loss. So Foster has 1,000 shares of Coca-Cola capital stock on December 31st. Foster Corporation’s 1000 remaining shares of Coca-Cola capital stock have a current market value of $47,000. Prior to any adjustment, the company’s Marketable Securities account has a balance of $49,000 (1,000 × $49 per share).
The entry to record the current market value includes a debit to Unrealized Holding Loss on Investments and a credit to Marketable Securities for $2,000. The unrealized loss is the difference between the current market value of $49,000 and the cost basis of the shares of $47,000.
The Unrealized Holding Loss on Investments account will appear on the balance sheet in the stockholders’ equity section as a reduction in equity. An Unrealized Holding Gain on Investment would appear in the same section but as an addition to equity.
Unrealized Loss: $47,000 - $49,000 = ($2,000)

20. Presentation of Marketable Securities in the Balance Sheet
Although the $49,000 cost of Foster Corporation’s marketable securities is disclosed in the balance sheet, the $47,000 market value is used in the computation of total assets. The difference between the cost and market value also appears as an element of stockholders’ equity, entitled Unrealized Holding Loss on Investments. When the market value of investment falls below cost, as in the case just presented, this special equity account is a subtraction from equity, representing a holding loss. But if the market value is above cost, this account is an addition to equity, representing a holding gain.

21. Reflecting Uncollectible Accounts in the Financial Statements
At the end of each period, record an estimate of the uncollectible accounts.
Up to this point in the course, it’s been unrealistically assumed that all of the Accounts Receivable will be collected. In reality, payment will not be received for some Accounts Receivable.
Companies must account for the fact that some customers may not be able to pay the amounts they owe.
At the end of the period, a company estimates how much of its accounts receivable will not be collected. This estimate is based on past collection history and current economic information.
The entry requires a debit to Uncollectible Accounts Expense and a credit to Allowance for Doubtful Accounts for the estimated amount.
Uncollectible Accounts Expense is classified as a selling expense on the Income Statement. Allowance for Doubtful Accounts is a contra-asset account and has a normal credit balance. It is reported on the balance sheet as a subtraction from the Accounts Receivable balance to arrive at the amount of accounts receivable that is likely to be collected.
Selling expense
Contra-asset account

22. The Allowance for Doubtful Accounts
The net realizable value is the amount of accounts receivable that the business expects to collect.
On the balance sheet, the Allowance for Doubtful Accounts is subtracted from the Accounts Receivable balance. The reported value is called net realizable value and is the amount of Accounts Receivable that will likely be collected.

23. 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.
Now, let’s see what happens when it’s been determined that a specific customer will not be able to pay the amount owed.
When using the allowance method, write off an uncollectible account to Allowance for Doubtful Accounts.
The company debits Allowance for Doubtful Accounts and credits Accounts Receivable. Now that the specific customer involved is known, the customer is noted in the transaction so the proper entry in the Accounts Receivable ledger can be made.
Now assume that before this write-off entry the balance in Accounts Receivable was $10,000 and the balance in Allowance for Doubtful Accounts was $2,500. Let’s see what effect the write-off had on these accounts.

24. Writing Off an Uncollectible Account Receivable
After the $500 write-off, the Accounts Receivable balance is reduced to $9,500 and the Allowance for Doubtful Accounts balance is reduced to $2,000. Notice that the $500 write-off did not change the net realizable value nor did it affect any income statement accounts.
Notice that the $500 write-off did not change the net realizable value nor did it affect any income statement accounts.

25. 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.
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. There are two methods to estimate uncollectible accounts. One method is the Balance Sheet Approach and the other is the Income Statement Approach. Let’s look at the Balance Sheet Approach first.
Two Approaches to Estimating Credit Losses
Balance Sheet Approach
Income Statement Approach

26. 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.
When using the Balance Sheet Approach, first classify the Accounts Receivable by age. Second, for each age group determine the likelihood of being uncollectible. Third, for each age group calculate a separate allowance amount. Finally, add up all the allowance amounts to get the balance in the Allowance for Doubtful Accounts.
Compute a separate allowance for each age grouping.

27. Estimating Credit Losses — The Balance Sheet Approach
At December 31, the receivables for EastCo, Inc. were categorized as follows:
First, EastCo’s accounts receivable have been broken up into aged categories such as current, 1 to 30 days past due, 31 to 60 days past due, and so on.
Then, for each of these age groups, it was determined how much would be uncollectible. For the current age group, one percent is expected to be uncollectible. For the 1 to 30 days past due age group, three percent is expected to be uncollectible, and so on. Notice that the older the age group the higher the uncollectible percentage.
Next, the balance of each age group is multiplied by its uncollectible percentage. Then, all of the uncollectible amounts are added up to $1,350, and this should be the balance in the Allowance for Doubtful Accounts.

28. Estimating Credit Losses — The Balance Sheet Approach
EastCo’s unadjusted balance in the allowance account is $500.
Per the previous computation, the desired balance is $1,350.
Assume EastCo already had a $500 balance in Allowance for Doubtful Accounts.
Since the balance should be $1,350, the account will need to be credited for $850.
The entry would be to debit Uncollectible Accounts Expense and credit Allowance for Doubtful Accounts for $850.

29. Estimating Credit Losses — The Income Statement Approach
Uncollectible accounts’ percentage is based on actual uncollectible accounts from prior years’ credit sales.
When using the Income Statement Approach, the estimate at the end of the period is determined by taking current period sales and multiplying by an established bad debt percentage. The bad debt percentage is determined based on past history of the company and current economic trends. The sales transactions included in this computation are typically only the credit sales. There are not any collection issues to consider for cash sales transactions. The credit loss estimate is calculated as net credit sales times the estimated uncollectible percentage.

30. Estimating Credit Losses — The Income Statement Approach
In the current year, EastCo had credit sales of $60,000. Historically, 1% of EastCo’s credit sales has been uncollectible. For the current year, the estimate of uncollectible accounts expense is $ ($60,000 × .01 = $600)
EastCo has credit sales of $60,000 in the current year. Management estimates that one percent of credit sales will eventually prove to be uncollectible. What is East Company’s adjusting entry for uncollectible accounts in the current year?
EastCo would debit Uncollectible Accounts Expense and credit Allowance for Doubtful Accounts for $600, which is one percent of $60,000 in credit sales.

31. 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.
Sometimes after an account receivable has been written off, a customer will send in a payment. If this happens, should the customer’s payment be returned since the account has been written off? Of course not.
When this happens, two entries are necessary. The first entry is required to reverse the write-off and re-establish the account receivable. It includes a debit to Accounts Receivable an a credit to Allowance for Doubtful Accounts.
The second entry records the receipt of cash with a debit to Cash and a credit to Accounts Receivable.

32. Example

34. Direct Write-Off Method
This method makes no attempt to match revenues with the expense of uncollectible accounts.
When using the direct write-off method, customers’ accounts receivable are written off to Uncollectible Accounts Expense at the time the company becomes aware that the customer will not be able to pay the amounts owed.
Under this method, no attempt is made to match revenues with the uncollectible accounts expense. Allowance methods provide a much better matching of expenses in the period in which they help generate revenues. For this reason Generally Accepted Accounting Principles, or GAAP, require the use of allowance methods to estimate uncollectible accounts unless the amounts are immaterial. However, the direct write-off method is required when preparing tax returns.

35. Management of Accounts Receivable
Extending credit encourages customers to buy from us but it ties up resources in accounts receivable.
Factoring Accounts Receivable
Credit Card Sales
When managing accounts receivable, keep in mind that while extending credit encourages purchases, it also ties up resources in accounts receivable. Managers need to balance the leniency of their credit terms with the need to minimize accounts receivable.
Two ways to get cash more quickly from credit sales is to factor accounts receivable and to accept credit cards.
Factoring is actually selling accounts receivable to another company. The other company charges a fee for this service, and the customer pays the other company when the account receivable is due.
Credit card sales help increase the speed and certainty of payment from credit sales. Within days of the sale, the credit card company pays the company the amount of the sale less a fee for their services. The customer then pays the credit card company on their next payment cycle. The business making the sale gets their money more quickly and does not have to deal with possible uncollectible accounts.

36. Financial Statement Analysis

39. Notes Receivable and Interest Revenue
A promissory note is an unconditional promise in writing to pay on demand or at a future date a definite sum of money.
Maker—the person who signs the note and thereby promises to pay.
Payee—the person to whom payment is to be made.
A note is a written promise to pay a specific amount at a specific future date. The maker of the note is the person who is in debt, and the payee is the person to whom payment will be made in the future. The following information is included in a note: term of the note, the payee, and the maker. The payee on the note is the recipient of the cash at maturity. The maker on the note is the debtor who owes the money. Notes also include information about the principal, interest rate, and due date.

40. Notes Receivable and Interest Revenue
The interest formula includes three variables:
Interest = Principal × Interest Rate × Time
When computing interest for one year, “Time” equals 1. When the computation period is less than one year, then “Time” is a fraction.
For example, if we needed to compute interest for 3 months, “Time” would be 3/12.
Most Notes Receivable have an interest rate associated with them. Interest is a charge made for the use of money. For the borrower, this is the interest expense they will incur and for the lender, this is the interest revenue they will receive.
Interest is calculated as Principal times the Interest Rate times the Time the note was outstanding.
When computing interest for one year, “Time” equals 1. When the computation period is less than one year, then “Time” is a fraction.

41. Notes Receivable and Interest Revenue
On November 1, Hall Company loans $10,000 to Porter Company on a 3 month note earning 12 percent interest. On December 31st, Hall Company needs an adjusting entry to record the interest revenue on the Porter Company note.
On November 1, Hall Company loans $10,000 to Porter Company on a 3 month note earning 12 percent interest. On December 31st, Hall Company needs an adjusting entry to record the interest revenue on the Porter Company note. This entry is a debit to Interest Receivable and a credit to Interest Revenue for $100.
The $200 in interest is calculated as the original note amount of $10,000 times the interest rate of 12 percent times the outstanding time of 2 months over 12 months.
$10,00012% 2/12 = $200

42. Notes Receivable and Interest Revenue
What entry would Hall Company make on February 1, the maturity date?
$10,00012% 3/12 = $300
What entry would Hall Company make on the maturity date of the note?
The maturity date of the note is February 1st of the next year.
On February 1st, Hall Company would debit Cash for $10,300. That is the original note amount of $10,000 plus the interest of $300. They would credit Notes Receivable for $10,000. The interest is divided between two accounts. Interest Receivable is credited for $200. Remember, this is removing the Interest Receivable created in the previous adjusting entry. Interest Revenue is credited for $100. This is the interest revenue Hall Company earned in the current year.
If Porter Company defaulted on the note, Hall Company would make a similar entry, except instead of debiting Cash they would debit Accounts Receivable for the entire amount.

43. Financial Analysis and Decision Making
Accounts Receivable Turnover Rate
This ratio provides useful information for evaluating how efficient management has been in granting credit to produce revenue.
The Accounts Receivable Turnover ratio provides useful information for evaluating how efficient management has been in granting credit to produce revenue. It is calculated as Net Sales divided by Average Accounts Receivable. Average Accounts Receivable is determined by adding together the beginning Accounts Receivable balance and the ending Accounts Receivable balance and dividing this total by 2.
Net Sales
Average Accounts Receivable

44. Financial Analysis and Decision Making
Avg. Number of Days to Collect A/R This ratio helps judge the liquidity of a company’s accounts receivable.
The Average Number of Days to Collect Accounts Receivable ratio helps users judge the liquidity of a company’s accounts receivable. It is calculated as Days in the Year divided by the Accounts Receivable Turnover ratio.
Days in Year
Accounts Receivable Turnover Ratio

45. End of Chapter 7
End of chapter 7.