ACG 2021 Financial Accounting Chapter 5 – Accounting for Short-Term Investments and Accounts Receivable

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.)

Trading Investments Use of Excess Cash Buy Low, Sell High Most often, stock or bonds of another company

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

Reporting Short-Term Investments Balance Sheet Current Assets Trading investments reported at current market value Income Statement Interest and dividend revenue reported under Other Revenue. Gains and losses reported under Other Revenue. Including Unrealized Gains and Losses

Accounting for Trading Investments Record Purchase Adjust 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. May 18 Short-term investment 100,000 Cash 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. May 31 Short-Term Investment 2,000 Unrealized Gain on Investments 2,000 Adjusted investment to market value

Short-Term Investments Cost 100,000 Adjustment to market value 2,000 Balance 102,000 What happens if at the next reporting period, if we sell Ford’s stock for $105,000? What’s the entry? What if we sell the stock for $95,000? What’s the entry?

Realized Gain / (Loss) When Investor Sells Asset Realized Gain Sales Price > Investment Balance Realized Loss Sales Price < Investment Cash 105,000 Short-Term Invest 102,000 Gain on Sale of Invest 3,000 Sold at a gain Cash 95,000 Loss on Sale of Invest 7,000 Short-Term Invest 102,000 Sold at a loss

Accounting for Dividends Rcv’d On May 27, Oracle receives a cash dividend of $4,000 from Ford. May 27 Cash 4,000 Dividend revenue 4,000 Received cash dividend

Reporting on the Balance Sheet and the Income Statement

ACG 2021 Financial Accounting Accounting for: Accounts Receivable

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

Issues When Extending Credit Benefits Increase Sales Volume Grow market share Grow Business Consequences Customers 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

Accounting for Accounts Receivable Main 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

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

Issues in Accounting for Receivables Measure and report receivables at net 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

Uncollectible Receivables Allowance method record losses based on an estimate of uncollectible accounts. Percent-of-sales method computes expense as a percent of revenue income statement approach Aging-of-receivables method Computes ending allowance account balance individual receivables are analyzed based on how long they have been outstanding balance sheet approach

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

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 =

Uncollectible Accounts Percent-of-Sales Total 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 Accounts 330 Recorded expense for the year Allowance for Uncollectible Accounts Accounts Receivable 3,105 Net Accounts Receivable $3,105 – 350 = $2,755 20 330 Bal. 3,105 Bal. 350

Aging-of-Receivables Critical Point!!!!

Aging-of-Receivables Dec 31 Uncollectible-Account Expense 214 Allowance for Uncollectible Accounts 214 Recorded expense for the year Allowance for Uncollectible Accounts Accounts Receivable 3,105 Net Accounts Receivable $3,105 – 384 = $2,721 170 214 Bal. 3,105 Bal. 384 End Bal (384) – Beg Bal (170) = Expense (214)

Aging-of-Receivables Current balance in allowance account is $170. Calculate the adjustment needed to bring the balance to $384. Expense: $384 – $170 = $214

Financial Statements using The Allowance Method Balance Sheet (partial) Accounts receivable $10,000 Less: Allowance for uncollectible accounts – 900 Accounts receivable, net $ 9,100 Accounts receivable, net of allowance for doubtful accounts of $701 and $767 at December 31, 2005 and 2006, respectively. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26,136 52,394 Income Statement (partial) Expenses: Uncollectible-account expense $ 2,000

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?

Aging-of-Receivables Comparing the Methods Allowance Method Percent-of-Sales Aging-of-Receivables Adjusts Allowance for Uncollectible Accounts BY Calculating Expense Adjusts Allowance for Uncollectible Accounts TO Calculating Ending Allowance Balance ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

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 Pipe 61 Accounts Receivable – Miller Auto Sales 39

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.

Basic Accounting for Accounts Receivable Provided $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

ACG 2021 Financial Accounting Accounting for Notes Receivable and Cash Flow Issues

Some Definitions Creditor Debtor Debt Instrument Equity Security 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

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.

Notes Receivable Notes Receivable – L. Holland 1,000 Cash 1,000 Laura 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 4/12) 30 Interest Revenue 30 Accrued interest revenue

Notes Receivable To record collection of the note on Feb. 28, 20X6: Cash 1,045 Note Receivable – L. Holland 1,000 Interest Receivable 30 Interest Revenue (1,000 x .09 x 2/12) 15 Collected note at maturity

How to Speed Up Cash Flow Credit card or bankcard sales Selling receivables (Factoring) Discounting notes receivable

How to Speed Up Cash Flow Recording a credit card or bankcard sale Cash 97,000 Financing Expense 3,000 Sales Revenue 100,000 To record a credit card sale of $100,000 and a 3% financing fee ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

How to Speed Up Cash Flow Recording the sale of receivables Cash 95,000 Financing Expense 5,000 Trade Accounts Receivable 100,000 Sold accounts receivable ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

Reporting on the Statement of Cash Flows Receivables bring in cash when the business collects from customers. Operating Activities Investment transactions change Cash Investing Activities

ACG 2021 Financial Accounting Acid Test & Days Sales in Receivables Ratios

Ratios Acid Test Ratio = Day’s Sales in Receivables = Cash + ST Investments + Net Receivables Acid Test Ratio = Total Current Liabilities Average Net Accounts Receivable Day’s Sales in Receivables = Average Daily Sales

Acid-Test Ratio A stringent test of liquidity Measures entity’s ability to pay its current liabilities immediately

Days’ Sales in Receivables 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.

BBBB and BBY Ratios BlackBoard Best Buy Acid Test FYE 2005 1.8 FYE 2006 .58 Day’s Sales in Receivables FYE 2006 78 Best Buy FYE 2006 .70 FYE 2007 .69 FYE 2007 5.06

End of Chapter 5