Copyright © by Houghton Mifflin Company. All rights reserved.1 Principles of Accounting 2002e Belverd E. Needles, Jr. Marian Powers Susan Crosson Multimedia Slides by: Harry Hooper Santa Fe Community College

Chapter 9 Short-Term Liquid Assets

Copyright © by Houghton Mifflin Company. All rights reserved.3 LEARNING OBJECTIVES 1.Identify and explain the management issues related to short-term liquid assets., 2.Explain cash, cash equivalents, and the importance of electronic funds transfer. 3.Account for short-term investments.

Copyright © by Houghton Mifflin Company. All rights reserved.4 4.Define accounts receivable and apply the allowance method of accounting for uncollectible accounts, using both the percentage of net sales method and the accounts receivable aging method. 5.Define and describe a promissory note, and make calculations and journal entries involving promissory notes. LEARNING OBJECTIVES (continued) LEARNING OBJECTIVES (continued)

OBJECTIVE 1 Identify and explain the management issues related to short-term liquid assets. Management Issues Related to Short-Term Liquid Assets

Copyright © by Houghton Mifflin Company. All rights reserved.6 u Most companies experience seasonal cycles of business activity during the year. 4 Weak sales, strong sales. 4 Expenditures are greater, expenditures are smaller. u Companies must carefully plan cash inflows, outflows, borrowing, and investing. Managing Cash Needs During Seasonal Cycles

Copyright © by Houghton Mifflin Company. All rights reserved.7 Seasonal Cycles and Cash Requirements for a Home Improvement Company

Copyright © by Houghton Mifflin Company. All rights reserved.8 u Companies sell on credit to be competitive and to increase sales. u When setting terms, management must consider terms being offered by competitors and the needs of customers. u Most companies develop control procedures and establish a credit department, to increase likelihood of customers paying on time. Setting Credit Policies

Copyright © by Houghton Mifflin Company. All rights reserved.9 The Credit Department u Examines each customer who applies for credit. u Approves or rejects credit sales. u Requests information about a potential credit customer, including resources, debts, references, and credit bureaus. u Decides whether to extend credit to the customer.

Copyright © by Houghton Mifflin Company. All rights reserved Receivable turnover. 2. Average days’ sales uncollected. Analyzing Credit Policies u Two common measures of the effect of a company’s credit policies.

Copyright © by Houghton Mifflin Company. All rights reserved.11 Receivable Turnover u Receivable turnover (R/T) measures the relative size of accounts receivable (A/R) and the success of a company’s credit and collection policies. Receivable Turnover = Net Sales Average Net A/R R/T = $2,175,236,000 ($430,825,000 + $390,740,000) / 2 R/T = $2,175,236,000 $410,782,500 R/T = 5.3 times

Copyright © by Houghton Mifflin Company. All rights reserved.12 u Average days’ sales uncollected (ADSU) measures, on average, how long it takes to collect accounts receivable. Average Days’ Sales Uncollected ADSU = 365 days Receivable turnover = = 68.9 days

Copyright © by Houghton Mifflin Company. All rights reserved.13 Receivable Turnover for Selected Industries

Copyright © by Houghton Mifflin Company. All rights reserved.14 u Companies that have significant A/R may be unwilling or unable to wait until the A/R are collected to get their cash. u Many companies set up finance companies to help their customers finance their purchases. u Some companies borrow the funds they need and use their A/R as collateral. u Funds can also be raised by selling or transferring (factoring) their A/R to another entity called a factor. u Factoring can be done with or without recourse. Financing Receivables

Copyright © by Houghton Mifflin Company. All rights reserved.15 u The factor bears any losses from uncollectible accounts. u A company’s acceptance of credit cards is an example of factoring. u The factor charges a higher fee than with recourse. Factoring Without Recourse

Copyright © by Houghton Mifflin Company. All rights reserved.16 u The seller of the receivables is liable to the purchaser if the receivable is not collected. u The factor charges a lower fee than without recourse. u The seller of the receivables has a contingent liability. u A contingent liability is a potential liability that can develop into a real liability if a possible subsequent event occurs. Factoring With Recourse

Copyright © by Houghton Mifflin Company. All rights reserved.17 u The bank deducts the interest from the maturity value of the note to determine the proceeds. u The holder of the note (usually the payee) endorses the note and delivers it to the bank. u The bank expects to collect the maturity value of the note. u The bank has recourse against the endorser/seller of the note (contingent liability). u The company who sells the note must disclose the contingent liability. Discounting (Selling) Notes Receivable

Copyright © by Houghton Mifflin Company. All rights reserved.18Discussion Q. Q. Indicate whether each of the following is related to (a) managing cash needs during seasonal cycles, (b) setting credit policies, or (c) financing receivables. 1. Selling accounts receivable to a factor. 2. Borrowing funds for short-term needs during slow periods. 3. Conducting thorough checks of new customers’ ability to pay. 4. Investing cash that is not currently needed for operations.

A. 1. c 2. a 3. b 4. a KEY (a) managing cash needs during seasonal cycles. (b) setting credit policies. (c) financing receivables. KEY (a) managing cash needs during seasonal cycles. (b) setting credit policies. (c) financing receivables.

OBJECTIVE 2 Explain cash, cash equivalents, and the importance of electronic funds transfer. Cash and Cash Equivalents

Copyright © by Houghton Mifflin Company. All rights reserved.21 u Most liquid of all assets. u Consists of coins and currency on hand, checks and money orders from customers, and deposits in bank checking accounts. u Compensating balance. 4 A minimum amount that a bank requires a company to keep in its account as part of a credit-granting arrangement. 4 Restricts liquidity and increases interest rate. 4 SEC requires disclosure in a note to the financial statements.Cash

Copyright © by Houghton Mifflin Company. All rights reserved.22 u Excess cash should be invested to earn interest. u Short-term investments with a maturity term of 90 days or less when purchased. u Shown on balance sheet at cost. u Examples: time deposits, certificates of deposit, government securities such as U.S. Treasury notes. Cash Equivalents

Copyright © by Houghton Mifflin Company. All rights reserved.23 Cash on Hand u Kept for cash registers and for paying expenses that are impractical to pay by check. u Kept in an imprest (petty cash) fund. 4 The fund is established at a fixed amount. 4 Receipts are maintained for expenditures. 4 The fund is periodically reimbursed to restore it to its fixed amount.

Copyright © by Houghton Mifflin Company. All rights reserved.24 u EFT (Electronic Funds Transfer) 4 A company has cash transferred from its bank to another company’s bank instead of writing checks. 4 Wal-Mart Stores, Inc. makes 75% of its payments to suppliers this way. u Debit cards. 4 A customer’s retail purchase is deducted directly from his/her bank account. 4 The bank documents transactions for the retailer. 4 The retailer must develop new internal controls. Banking and Electronic Funds Transfer

Copyright © by Houghton Mifflin Company. All rights reserved.25Discussion Q. Q. What items are included in the cash account? What is a compensating balance?

Copyright © by Houghton Mifflin Company. All rights reserved.26 A. A. 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. If this balance is unavailable to pay current liabilities during the year, what should be disclosed in the financial statements?

OBJECTIVE 3 Account for short-term investments. Short-Term Investments

Copyright © by Houghton Mifflin Company. All rights reserved.28 u Investments with a maturity of more than 90 days, but are intended to be held only until cash is needed for current operations. Short-Term Investments or Marketable Securities

Copyright © by Houghton Mifflin Company. All rights reserved.29 Long-Term Investments u Intended to be held for more than one year. u Classified in an investments section of the balance sheet. u Intended to be held for an indefinite time.

Copyright © by Houghton Mifflin Company. All rights reserved.30 u May be Short- or Long-Term Investments u Debt securities that management intends to hold to their maturity whose cash value is not needed until that date. Held-to-Maturity Securities

Copyright © by Houghton Mifflin Company. All rights reserved.31 Example of Held-to-Maturity Securities 12/1 Short-Term Investments 97,000 Cash 97,000 12/31 Short-Term Investments 750 Interest Income 750 3/31 Cash 100,000 Short-Term Investments 97,750 Interest Income 2,250 Buy U.S. Treasury bills at $97,000, which mature in 120 days at $100,000.

Copyright © by Houghton Mifflin Company. All rights reserved.32 u Always Short-Term Investments. u Debt and equity securities that are bought and held principally for the purpose of being sold in the near term. u Frequently bought and sold to generate profits on short-term changes in their prices. u Classified as current assets on the balance sheet. u Valued at fair (market) value. u 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. Trading Securities

Copyright © by Houghton Mifflin Company. All rights reserved.33 10/25 Short-Term Investments1,200,000 Cash 1,200,000 Original purchase 12/31 Unrealized Loss on Investments 80,000 Allowance to Adjust Short-Term Investments to Market 80,000 Recognition of unrealized loss on trading portfolio Example of Trading Securities

Copyright © by Houghton Mifflin Company. All rights reserved.34 3/2 Cash 350,000 Short-Term Investments 300,000 Realized Gain on Investments 50,000 Sale of part of a portfolio at a gain 12/31 Allowance to Adjust Short-Term Investments to Market 118,000 Unrealized gain on Investments 118,000 Recognition of unrealized gain on trading portfolio

Copyright © by Houghton Mifflin Company. All rights reserved.35 4 May be Short- or Long-Term Investments. 4 Debt and equity securities that do not meet the criteria for either held-to-maturity or trading securities. 4 Accounted for in the same way as trading securities except that the unrealized gain or loss is not reported on the income statement. 4 It is reported as a special item in the stockholders’ equity section of the balance sheet. 4 Dividend and interest income for all three categories is shown in the Other Income and Expenses section of the income statement. Available-for-Sale Securities

Copyright © by Houghton Mifflin Company. All rights reserved.36Discussion Q. Q. What are unrealized gains and losses on trading securities? On what statement are they reported? A. A. 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. Unrealized gains and losses are reported on the income statement.

OBJECTIVE 4 Define accounts receivable and apply the allowance method of accounting for uncollectible accounts, using both the percentage of net sales method and the accounts receivable aging method. Accounts Receivable

Copyright © by Houghton Mifflin Company. All rights reserved.38 Accounts Receivable u Accounts Receivable (A/R) are short-term liquid assets that arise from sales on credit to customers. u Trade credit terms vary by industry. u Installment A/R arise from the sale of goods on terms that allow the buyer to make a series of time payments. 4 Used frequently by department stores, appliance stores, used car dealers, furniture stores, etc. 4 Although the payment period may be 24 months or more, are still classified as current assets if customary in the industry.

Copyright © by Houghton Mifflin Company. All rights reserved.39 Accounts Receivable (continued) u Receivables from other than regular customers (employees, owners, officers) are shown separately with a title such as Receivables from Employees. u Normally, individual customer accounts receivable have debit balances. u If a customer has a credit balance, this is shown as a current liability on the balance sheet.

Copyright © by Houghton Mifflin Company. All rights reserved.40 Accounts Receivable as a Percentage of Total Assets for Selected Industries

Copyright © by Houghton Mifflin Company. All rights reserved.41 u Accounts owed by customers who will not or cannot pay are called uncollectible accounts or bad debts. 4 A loss or an expense of selling on credit. 4 Companies sell on credit to increase their volume of sales. Uncollectible Accounts

Copyright © by Houghton Mifflin Company. All rights reserved.42 The Direct Charge-Off Method u The direct charge-off method recognizes the loss at the time the A/R is determined to be uncollectible. 4 Reduces A/R and increases Uncollectible Accounts Expense. 4 Used for federal tax purposes but not GAAP, because it violates the matching principle.

Copyright © by Houghton Mifflin Company. All rights reserved.43 u Bad debt losses are matched against the sales they help produce. u At the time of sale, management cannot identify which customers will not pay. u To observe the matching rule, losses from uncollectible accounts must be estimated. u The estimate becomes an expense in the fiscal year in which the sales are made. Uncollectible Accounts and the Allowance Method

Copyright © by Houghton Mifflin Company. All rights reserved.44 u Uncollectible Accounts Expense appears on the income statement as an operating expense. u Allowance for Uncollectible Accounts appears on the balance sheet as a contra- asset account that is deducted from Accounts Receivable. 4 Reduces the accounts receivable to the amount expected to be realized in cash. u Accounts receivable may be shown “net,” with the amount of the Allowance for Uncollectible Accounts shown in a note to the financial statements.

Copyright © by Houghton Mifflin Company. All rights reserved.45 u Assume that of $100,000 in sales, $6,000 are estimated to be uncollectible. u Uncollectible Accounts Expense would be recorded as follows: To record the estimated uncollectible accounts expense for the year 12/31 Uncollectible Accounts Expense 6,000 Allowance for Uncollectible Accounts 6,000 To record the estimated uncollectible accounts expense for the year Example of the Allowance Method

Copyright © by Houghton Mifflin Company. All rights reserved.46 u It is necessary to estimate the expense to cover expected losses for the year. u Management makes the final decision. u Can be optimistic or pessimistic about expected losses. 4 If optimistic, expense smaller and net income higher. 4 If pessimistic, expense larger and net income smaller. u In either case, the estimated loss should be realistic, based on experience, the economy, etc. Estimating Uncollectible Accounts Expense

Copyright © by Houghton Mifflin Company. All rights reserved.47 u “How much of this year’s net sales will not be collected?” u The answer is the amount of uncollectible expense for the year. u Usually based on the company’s historical losses. 12/31 Uncollectible Accounts Expense 12,000 Allowance for Uncollectible Accounts 12,000 To record uncollectible accounts expense at 2% of $600,000 net sales expense at 2% of $600,000 net sales u Allowance for Uncollectible Accounts contains the accumulated amounts from previous years. Percentage of Net Sales Method

Copyright © by Houghton Mifflin Company. All rights reserved.48 u “How much of the year-end balance of A/R will not be collected?” u The difference between the amount determined to be uncollectible and the actual balance of Allowance for Uncollectible Accounts is the expense for the year. u The target balance less the actual balance equals expense. u The aging of A/R is the process of listing each customer’s account according to the due date of the account. u The older the account, the less likely that it will be paid. Accounts Receivable Aging Method

Copyright © by Houghton Mifflin Company. All rights reserved.49 Example of Accounts Receivable Aging Method Targeted Balance for Allowance for Uncollectible Accounts$2,459 Less Current Credit Balance of Allowance for Uncollectible Accounts 800 Uncollectible Accounts Expense$1,659 12/31 Uncollectible Accounts Expense 1,659 Allowance for Uncollectible Accounts 1,659 Allowance for Uncollectible Accounts 12/ /31 Adjustment 1,659 12/31 Balance 2,459

Copyright © by Houghton Mifflin Company. All rights reserved.50 Example of Accounts Receivable Aging Method Target Balance for Allowance for Uncollectible Accounts$2,459 Plus Current Debit Balance of Allowance for Uncollectible Accounts 800 Uncollectible Accounts Expense$3,259 12/31Uncollectible Accounts Expense 3,259 Allowance for Uncollectible Accounts3,259 Allowance for Uncollectible Accounts 12/31 Adjustment3,259 12/31 Balance2,459 12/31 800

Copyright © by Houghton Mifflin Company. All rights reserved.51

Copyright © by Houghton Mifflin Company. All rights reserved.52 Why Accounts Written Off Will Differ from Estimates  Accounts written off less than estimated uncollectible accounts  credit balance in allowance account at year end.  Accounts written off greater than estimated uncollectible accounts  debit balance in allowance account at year end.

Copyright © by Houghton Mifflin Company. All rights reserved.53 u When it is clear that a specific A/R will not be collected, the amount should be written off. 1/15 Allowance for Uncollectible Accounts 250 Accounts Receivable 250 u Does not impact the net realizable value of A/R. u Recovery of Accounts Receivable written off. 9/1 Accounts Receivable 100 Allowance for Uncollectible Accounts 100 9/1 Cash 50 Accounts Receivable 50 Writing Off an Uncollectible Account

Copyright © by Houghton Mifflin Company. All rights reserved.54Discussion Q. Q. According to generally accepted accounting principles, at what point in the cycle of selling and collecting does a loss on an uncollectible account occur? A. A. According to GAAP, a loss from an uncollectible account occurs at the time the sale on credit is made.

OBJECTIVE 5, Define and describe a promissory note, and make calculations and journal entries involving promissory notes. Notes Receivable

Copyright © by Houghton Mifflin Company. All rights reserved.56 u A promissory note is an unconditional promise to pay a definite sum of money on demand or at a future date.. u The signer of the note is called the maker. u The entity to whom payment is to be made is called the payee. u 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. u The maker regards them as notes payable in the current liability section of the balance sheet. Notes Receivable

Copyright © by Houghton Mifflin Company. All rights reserved.57 u Many companies accept notes receivable in settlement of past-due accounts. u Notes produce interest income. u Notes represent a stronger claim than do accounts receivable. u Selling or discounting notes is a common financing method. Notes Receivable (continued)

Copyright © by Houghton Mifflin Company. All rights reserved.58 A Promissory Note

Copyright © by Houghton Mifflin Company. All rights reserved.59 Computations for Promissory Notes u Several terms are important in accounting for promissory notes. 1. Maturity date. n The date on which the note must be paid. 2. Duration of note. n The length of time in days between a promissory note’s issue date and its maturity date. 3. Interest and interest rate. n The cost of borrowing money or the return for lending money. n Usually stated on an annual basis. 4. Maturity value. n The total proceeds of a at the maturity date.

Copyright © by Houghton Mifflin Company. All rights reserved.60 6/1 Notes Receivable4,000 Accounts Receivable4,000 Received 12%, 30 day note in payment of A/R 7/1 Cash4,040 Notes Receivable 4,000 Interest Income 40 Collected 12%, 30 day note $4,000 x 12/100 x 30/360 = $40 7/1 Accounts Receivable4,040 Notes Receivable4,000 Interest Income 40 Record dishonored note Illustrative Accounting Entries

Copyright © by Houghton Mifflin Company. All rights reserved.61 9/1 Interest Receivable Interest Income To accrue 30 days’ interest earned on a note receivable 10/30 Cash 2, Notes Receivable 2, Interest Receivable Interest Income Receipt of note receivable plus interest Recording Adjusting Entries

Copyright © by Houghton Mifflin Company. All rights reserved.62Discussion Q. Q. What is a promissory note? Who is the maker? Who is the payee? A. A. 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 © by Houghton Mifflin Company. All rights reserved.63 1.Identify and explain the management issues related to short-term liquid assets., 2.Explain cash, cash equivalents, and the importance of electronic funds transfer. 3.Account for short-term investments. OK, LET’S REVIEW...

Copyright © by Houghton Mifflin Company. All rights reserved.64 4.Define accounts receivable and apply the allowance method of accounting for uncollectible accounts, using both the percentage of net sales method and the accounts receivable aging method. CONTINUING OUR REVIEW...

Copyright © by Houghton Mifflin Company. All rights reserved.65 promissory note 5.Define and describe a promissory note, and make calculations and journal entries involving promissory notes. AND FINALLY...