Short-Term Investments & Receivables Chapter 5 Chapter 5 covers short-term investments and receivables. ©2008 Pearson Prentice Hall. All rights reserved.

Learning Objective 1 Account for short-term investments Learning Objective 1 accounts for short-term investments. ©2008 Pearson Prentice Hall. All rights reserved.

Accounting for Short-Term Investments Also called marketable securities Held for one year or less Most liquid asset other than cash Placed into three categories: Short-term investments are also called marketable securities. These are investments that a company plans to hold for one year or less. They allow the company to invest cash for a short period of time and earn a return until the cash is needed. Short-term investments are the next-most-liquid asset after cash. This is why companies report short-term investments immediately after cash and before receivables on the balance sheet. A short-term investment falls into one of three categories: (1) trading investments (2) available-for-sale investments (covered in chapter 10) (3) held-to-maturity investments. Trading Investments Available-for-Sale Held-to-Maturity ©2008 Pearson Prentice Hall. All rights reserved.

Selling price > cost = Gain Trading Investments Held for short time and then sold Gain or loss recorded Dividend revenue may also be received At year-end, trading investments are adjusted to equal their market value Results in an unrealized gain or loss Selling price > cost = Gain Selling price < cost = Loss The purpose of owning a trading investment is to hold it for a short time and then sell it for more than its cost. Trading investments can be the stock of another company. Suppose a company purchases stock, intending to sell the stock within a few months. If the market value of the stock increases, the company will have a gain; if the stock price drops, the company will have a loss. The company may also receive dividend revenue from its investment. At the company’s year end, any trading investments are adjusted to equal their market values. The difference between an investment’s market value and cost is an unrealized gain or loss. ©2008 Pearson Prentice Hall. All rights reserved.

Unrealized Gains & Losses Difference between market price and cost of investment at year-end Unrealized – investment has not been sold Market price > cost = Unrealized gain Market price < cost = Unrealized loss Unrealized gains and losses are recorded on trading investments. At year end, the market value of the investments is compared to their cost. If the market value is greater than cost, an unrealized gain is recorded and the investment account is increased to equal its market value. If the market value is less than cost, an unrealized loss results, and the investment account is decreased to equal market value. The term “unrealized” is used because the company still holds the investment – it has not been sold. These gains and loss amounts will more than likely change as market values fluctuate on investments. ©2008 Pearson Prentice Hall. All rights reserved.

Realized vs. Unrealized Investment sold to third party Gain or loss = difference between selling price and cost Word “realized” usually dropped from title Unrealized Company still owns investment Gain or loss = difference between market value and cost Word “unrealized” is kept in account title It is important to distinguish between an realized gain or loss and an unrealized gain or loss. Realized means that the investment has been sold. The company no longer has possession of it. A gain or loss is recorded for the amount that the selling price exceeded the cost (or vice versa). The word “realized” is seldom used in the account title. Instead, the accounts are just called “gain” or “loss”. Unrealized gains and losses are recorded when the company still owns the investment. It is called unrealized because it has not been sold – no cash has been received. The unrealized loss is the difference between the end-of-period market value and the cost of the investment. It is important to label these as “unrealized” to distinguish them from gains or losses from sales. ©2008 Pearson Prentice Hall. All rights reserved.

Entries to Adjust to Market JOURNAL Date Accounts Debit Credit   Short-term investments $$$ Unrealized gain on investments Adjusted investment to market value (when greater than cost) Unrealized loss on investments Adjusted investment to market value (when less than cost) The entries to adjust trading investments to market are above. Unrealized gain is a credit balance, just like other revenues and gains. By debiting short-term investments, the account is increased to equal market value. If an unrealized loss occurs, the loss account is debited and short-term investments is credited to reduce it to its market value. ©2008 Pearson Prentice Hall. All rights reserved.

Reporting on Financial Statements Balance Sheet Trading Investment Reported at current market value Listed directly under “cash” in the current asset section Income Statement Gains and losses From sales of investments Investment revenue From dividends or interest earned Unrealized gain or loss From entry to adjust to market value On the balance sheet, trading investments at their current market value. They appear on the balance sheet in the current asset section immediately after cash because short-term investments are almost as liquid as cash. On the income statement, there can be up to three accounts related to trading investments. If trading investments are sold during the period, a gain or loss will be incurred. Investments also can earn interest revenue and dividend revenue. If the company has any trading investment at the end of the period, the entry to adjust to market will result in an unrealized gain or loss. For trading investments these three items are reported on the income statement as Other revenue, gains, and (losses) section. ©2008 Pearson Prentice Hall. All rights reserved.

©2008 Pearson Prentice Hall. All rights reserved. JOURNAL Date Accounts Debit Credit Nov 6 Trading investment $35,000   Cash  Nov 27 $850 Dividend revenue Exercise 5-18 shows the journal entries for trading investments and cash. ©2008 Pearson Prentice Hall. All rights reserved.

E5-18 12-31 Unrealized loss _______ Trading Investments ________ JOURNAL Date   Accounts Debit Credit 12-31 Unrealized loss _______ Trading Investments ________ What would be the amount of the unrealized loss? Exercise 5-18 continues the display of journal entries to address unrealized losses. Compute the difference between the cost and market value. ©2008 Pearson Prentice Hall. All rights reserved.

©2008 Pearson Prentice Hall. All rights reserved. JOURNAL Date   Accounts Debit Credit 1-11 Cash $36,000 Trading Investments $33,000 Gain on sale of investments  $3,000 Exercise 5-18 shows continues the display of journal entries to show how to account for a gain in the sale of investments. ©2008 Pearson Prentice Hall. All rights reserved.

©2008 Pearson Prentice Hall. All rights reserved. Receivables Monetary claims against others Third most liquid asset Accounts Receivable Amounts owed by customers for selling goods or services Notes Receivable Lending money to outsiders More formal than accounts receivable Receivables are the third most liquid asset—after cash and short-term investments. They are monetary claims against others. The two major types of receivables are accounts receivable and notes receivable. A business’ accounts receivable are the amounts collectible from customers from the sale of goods and services. Accounts receivable, which are current assets, are sometimes called trade receivables or merely receivables. Notes receivable are more formal contracts than accounts receivable. For a note, the borrower signs a written promise to pay the lender a definite sum at the maturity date. This is why notes are also called promissory notes. ©2008 Pearson Prentice Hall. All rights reserved.

Learning Objective 2 Apply internal controls to receivables Learning Objective 2 shows how to apply internal controls to receivables. ©2008 Pearson Prentice Hall. All rights reserved.

Internal Control over Cash Collections on Account Separate cash-handling from cash-accounting duties Cash-handling One person receives customer checks and makes deposits Cash-accounting Another person makes entries to customer accounts Businesses that sell on credit receive most of their cash receipts on account. Internal control over collections on account is important. An important element of internal control deserves emphasis here—the separation of cash-handling and cash-accounting duties. One person, usually a supervisor and not the bookkeeper, should open incoming mail and make the daily bank deposit. The bookkeeper should not be allowed to handle cash. Only the remittance advices would be forwarded to the bookkeeper to credit customer accounts. Removing cash handling from the bookkeeper and keeping the accounts away from the supervisor separates duties and strengthens internal control. ©2008 Pearson Prentice Hall. All rights reserved.

Accounting for Uncollectible Receivables Extending credit to customers bears some risk Risk: Some customers do not pay the amount owed Cost: Uncollectible accounts Extending credit to customers can have the benefit of increased sales. Customers who do not have cash immediately available can use credit. Unfortunately, some customers don’t pay their debts. Companies need to have a way to account for uncollectible accounts. ©2008 Pearson Prentice Hall. All rights reserved.

Learning Objective 3 Use the allowance method for uncollectible receivables Learning Objective 3 shows how to use the allowance method for uncollectible receivables. ©2008 Pearson Prentice Hall. All rights reserved.

A contra-asset is always paired with an asset and reduces Allowance Method Amount of uncollectible accounts is estimated An expense is recorded as part of the adjusting process A contra-asset is recorded that reduces accounts receivable on the balance sheet The best way to measure bad debts is by the allowance method. This method records collection losses based on estimates based upon the company’s collection experience. Companies don’t wait to see which customers will not pay. Instead, they record the estimated amount as Uncollectible-Account Expense and also sets up Allowance for Uncollectible Accounts. Other titles for this account are Allowance for Doubtful Accounts and Allowance for Bad Debts. This is a contra account to Accounts Receivable. The allowance shows the amount of the receivables the business expects not to collect. Previously, the Accumulated Depreciation account was explained. This contra-account shows the amount of a plant asset’s cost that has been expensed—the portion of the asset that’s no longer a benefit to the company. Allowance for Uncollectible Receivables serves a similar purpose for Accounts Receivable. The allowance shows how much of the receivable has been expensed. A contra-asset is always paired with an asset and reduces its balance ©2008 Pearson Prentice Hall. All rights reserved.

Entry to Record Uncollectible accounts JOURNAL Date   Accounts Debit Credit Uncollectible accounts expense Allowance for uncollectible accounts Goes on the Income Statement The entry to record uncollectible accounts has a debit to “uncollectible accounts expense”, which will appear on the income statement. The credit is to “allowance for uncollectible accounts” which will appear on the balance sheet directly beneath the accounts receivable. It is subtracted from accounts receivable to show net receivables. Goes on the Balance Sheet netted with accounts receivable ©2008 Pearson Prentice Hall. All rights reserved.

©2008 Pearson Prentice Hall. All rights reserved. Balance Sheet Current assets: Accounts receivable $$,$$$ Less: Allowance for Uncollectible Accounts ( $,$$$) Accounts receivable, net OR On the Balance Sheet, accounts receivable appear in the current assets section, usually right after short-term investments. On a detailed balance sheet, accounts receivable is shown, as well as the allowance for uncollectible accounts. The allowance is subtracted to determine net accounts receivable. On a condensed balance sheet, just the net amount is shown. Accounts receivable, net $$,$$$ ©2008 Pearson Prentice Hall. All rights reserved.

Methods to Estimate Uncollectibles Percent-of-sales Expense is estimated based on credit sales Income Statement approach Aging-of-receivables Accounts receivable analyzed based on how long outstanding Balance Sheet approach The best way to estimate uncollectibles uses the company’s history of collections from customers. There are two basic ways to estimate uncollectibles: (1) Percent-of-sales-method (2) Aging-of-receivables method. The percent-of-sales method computes uncollectible-account expense as a percent of revenue. This method takes an income statement approach because it focuses on the amount of expense to be reported on the income statement. The other popular method for estimating uncollectibles is called aging-of-receivable. This method is a balance-sheet approach because it focuses on accounts receivable. In the aging method, individual receivables from specific customers are analyzed based on how long they have been outstanding. ©2008 Pearson Prentice Hall. All rights reserved.

©2008 Pearson Prentice Hall. All rights reserved. Age of Accounts 1 - 30 Days 31 - 60 Days 61 - 90 Days Over 90 Days $ 110,000 $ 60,000 $ 50,000 $ 15,000 0.5% 1% 60% 40% $ 550 $ 600 $ 30,000 $ 6,000 Exercise 5-23 shows the aging of accounts. $37,150 ©2008 Pearson Prentice Hall. All rights reserved.

Adjustment needed = Aging schedule - Balance $37,150 Balance in Allowance $7,400 Adjustment needed JOURNAL Date   Accounts Debit Credit 12-31 Uncollectible accounts expense _______ Allowance for uncollectible accounts ______ Exercise 5-23 shows the journal entry for uncollectible accounts. ©2008 Pearson Prentice Hall. All rights reserved.

Allowance for Uncollectible Accounts Balance before adjustment $7,400 Adjusting entry $29,750 Balance per aging schedule $37,150 Exercise 5-23 shows the T-account that displays the allowance for uncollectible account entries. ©2008 Pearson Prentice Hall. All rights reserved.

Uncollectible Accounts Methods Percent-of-Sales Aging-of-Receivables Adjust Allowance for Uncollectible Accounts Adjust Allowance for Uncollectible Accounts BY TO Comparing the two methods will help highlight their differences. The percent-of-sales method computes uncollectible accounts expense without regard to the balance in the allowance for uncollectible accounts. The aging method, on the other hand, focuses on the amount of receivables that are not likely to be collected. Then, adjusts the allowance to equal that amount. The Amount of UNCOLLECTIBLE ACCOUNT EXPENSE The Amount of UNCOLLECTIBLE ACCOUNTS RECEIVABLE ©2008 Pearson Prentice Hall. All rights reserved.

Writing Off a Specific Account The allowance is used to absorb specific accounts that are determined to uncollectible When it’s determined a customer cannot pay, the following entry is made: JOURNAL Date   Accounts Debit Credit Allowance for uncollectible accounts $$$$ Accounts receivable When management decides that a specific accounts receivable is uncollectible, the account is “written off”. The purpose of the Allowance for Uncollectible Accounts is to absorb these write offs. The Allowance is adjusted at the end of one year, so it can be used the following year for actual accounts receivable that are uncollectible. The entry to record the write off has a debit to the Allowance and a credit to the customer’s accounts receivable. ©2008 Pearson Prentice Hall. All rights reserved.

Direct Write-Off Method Less preferable than allowance method Does not match expenses with revenues Accounts Receivable overstated Uncollectible Accounts Expense used for write offs No Allowance for Uncollectible Accounts There is another, less preferable, way to account for uncollectible receivables. Under the direct write-off method, the company waits until a specific customer’s receivable proves uncollectible. Then the accountant writes off the customer’s account and records Uncollectible-Account Expense. The direct write-off method uses no allowance for uncollectibles. As a result, receivables are always reported at their full amount, which is more than the business expects to collect. Assets on the balance sheet are overstated. Also, The direct write-off method causes a poor matching of uncollectible-account expense against revenue. ©2008 Pearson Prentice Hall. All rights reserved.

©2008 Pearson Prentice Hall. All rights reserved. Accounts Receivable Sales on account Payments on account Uncollectible accounts written off Activity in accounts receivable during the year is illustrated in this t-account. Sales on account increase the account and customer payments on account decrease it. When a specific account is determined to be uncollectible, accounts receivable is decreased. ©2008 Pearson Prentice Hall. All rights reserved.

What is the normal balance of the Allowance? Allowance for Uncollectible Accounts Uncollectible accounts written off Uncollectible account adjustment What is the normal balance of the Allowance? The allowance for uncollectible accounts has a normal credit balance. It is increased with the entry to record uncollectible accounts expense and decreased when specific accounts are written off. ©2008 Pearson Prentice Hall. All rights reserved.

Learning Objective 4 Account for notes receivable Learning Objective 4 shows how to account for notes receivable. ©2008 Pearson Prentice Hall. All rights reserved.

Notes Receivable Terms Creditor Debtor Interest Maturity Date Maturity Value Principal Term Party to whom money is owed; lender Party that owes money; borrower Cost of borrowing money; percent Date debtor must pay the note Sum of principal and interest on note Notes Receivable terminology includes: Creditor: The party to whom money is owed. The creditor is also referred to as the lender. Debtor: The party that borrowed and owes money on the note. The debtor is also called the maker of the note or the borrower. Interest: Interest is the cost of borrowing money. The interest is started in an annual percentage rate. Maturity date: The date on which the debtor must pay the note. Maturity value: The sum of principal and interest of the note. Principal: The amount of money borrowed by the debtor. Term: The length of time for which the note was signed by the debtor Amount borrowed by debtor Length of time money is borrowed ©2008 Pearson Prentice Hall. All rights reserved.

Accounting for Notes Receivable To record the receipt of a note receivable, the following entry is made: JOURNAL Date   Accounts Debit Credit Notes Receivable $$,$$$ Cash When a company issues a note receivable, the account is debited and cash is credited. ©2008 Pearson Prentice Hall. All rights reserved.

Accounting for Notes Receivable Interest needs to be accrued on any note receivable outstanding at year end: JOURNAL Date   Accounts Debit Credit Interest receivable $$,$$$ Interest revenue If there are notes receivable outstanding at year-end, an adjusting entry is made to record the interest accrued on the note. Interest receivable (current asset) is debited and interest revenue is credited. The amount of interest is computed by multiplying the principal by the interest rate by the time the note has been outstanding. The days are counted from the date the note was issued until the end of the year. Time = date note is signed to end-of-year Interest is computed by the formula: Principal x rate x time ©2008 Pearson Prentice Hall. All rights reserved.

Accounting for Notes Receivable When payment is received on note, the following entry is made JOURNAL Date Accounts Debit Credit Cash   Notes Receivable Interest receivable Interest revenue For maturity value For principal When payment is received on the note, cash is debited for the maturity value – principal plus interest. Notes receivable is credited for the principal – the same amount that was debited in the original entry. Interest receivable is credited for the amount it was debited for in the adjusting entry. Interest revenue is computed from the beginning of the year to the date of payment. Zeroes out adjustment For remaining interest earned ©2008 Pearson Prentice Hall. All rights reserved.

Credit and Bank Card Sales Credit Cards American Express and Discover Bank Cards VISA and MasterCard Both charge the retailer a fee The merchant sells merchandise and lets the customer pay with a credit card, such as Discover or American Express, or with a bankcard, such as VISA or MasterCard. This strategy may dramatically increase sales, but the added revenue comes at a cost. ©2008 Pearson Prentice Hall. All rights reserved.

Learning Objective 5 Use two new ratios to evaluate a business Learning Objective 5 shows how to use two new ratios to evaluate a business. Use two new ratios to evaluate a business ©2008 Pearson Prentice Hall. All rights reserved.

Days’ Sales in Receivables How long it takes a company to collect its average amount of receivable Compute one day’s sales Days’ sales in receivables Net Sales 365 Days After a business makes a credit sale, the next step is collecting the receivable. Days’ sales in receivables, also called the collection period, tells a company how long it takes to collect its average level of receivables. Shorter is better because cash is coming in quickly. The longer the collection period, the less cash is available to pay bills and expand. Days’ sales in receivables can be computed in 2 logical steps. First, compute one day’s sales (or total revenues). Then divide one day’s sales into average receivables for the period. Average receivables One Day’s Sales ©2008 Pearson Prentice Hall. All rights reserved.

©2008 Pearson Prentice Hall. All rights reserved. Acid-Test Ratio Also called quick ratio A more stringent measure of a company’s ability to pay its current liabilities Cash + Short-term investments + net receivables Total current liabilities Managers, stockholders and creditors care about the liquidity of a company’s assets. The current ratio measures ability to pay current liabilities with current assets. A more stringent measure of ability to pay current liabilities is the acid-test or quick ratio. This ratio eliminates the less liquid current assets from the numerator – inventory and prepaid expenses. ©2008 Pearson Prentice Hall. All rights reserved.

©2008 Pearson Prentice Hall. All rights reserved. End of Chapter Five Are there any questions? ©2008 Pearson Prentice Hall. All rights reserved.