Short-Term Investments and Receivables

Chapter 5

Learning Objective 1
Account for short-term investments.

Short-term Investments
Short-term investments (marketable securities) are investments that a company plans to hold for one year or less.
Short-term investments are the most liquid asset after cash.

Short-term Investments
Suppose that Celestica Inc. purchases McCain Foods Ltd. shares on Dec. 18, paying $100,000 cash. December 18

Short-term Investments
On Dec. 27, Celestica receives a cash dividend of $4,000 from McCain.

Dec. 27

Short-term Investments
Celestica fiscal year ends on Dec. 31, and the investment in McCain has a current market value of $102,000 on this date.

GAIN because the market value ($102,000) is Greater than Celesticas investment cost

Short-term Investments
Unrealized Gain because Celestica has not yet sold the investment

Dec 31

Short-term Investment Unrealized Gain on Investments

2,000
2,000

Short-term Investments
If the Celestica investment in McCain shares had decreased in value to $95,000
Unrealized Loss because Celestica has not yet sold the investment Dec 31 Unrealized Loss on Investments 5,000 Temporary Investments 5,000

Short-term Investments
Balance Sheet temporary assets are current assets

Income Statement temporary asset can either earn Interest Revenue or dividend revenue. All gains & losses are also reported on the income statement

Reporting on the Balance Sheet and the Income Statement

Balance Sheet Current Assets: $ XXX Cash XXX Short-term investments at market value 95,000 Accounts receivable XXX Income Statement Revenues $ XXX Expenses XXX Other revenues, gains, and (losses): Interest revenue XXX Dividend revenue 4,000 Unrealized loss on investment (5,000)

Question #1
ABC Co. purchased a temporary investment in shares of XYZ Co. for $14,000. At year end, the investment had a market value of $12,000. The $2,000 decrease in value in the temporary investment should be: a. recorded as a realized loss on the income statement b. deducted from the value of the asset on the balance sheet c. only disclosed as part of the market value of marketable securities d. both A and B.

Learning Objective 2

Account for receivables

Accounts and Notes Receivable

Receivables are the third most liquid assets after cash and short-term investments

Results from selling goods and services on credit and by lending money
Accounts receivable are a current asset on the balance sheet

Accounts Receivable
GENERAL LEDGER ACCOUNTS RECEIVABLE SUBSIDIARY RECORD

Accounts Receivable Bal. 9,000

Aston Bal. 5,000 Harris Bal. 1,000 Salazar Bal. 3,000

Learning Objective 3
Apply internal controls to receivables.

Establishing Internal Control over Collections

Businesses that sell on credit receive most of their cash receipts by mail

Some controls over accounts receivable are: a)

Learning Objective 4
Use the allowance method for uncollectible receivables.

Accounting for Uncollectible Receivables

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.

Uncollectible Account Expense

Expense on the income statement Must record the expense in the period of sale. If not, assets and earnings will be overstated The entry for the uncollectible account amount is an adjusting journal entry Can use the allowance method for estimating the uncollectible receivables

The Allowance Method

The allowance method records collection losses on the basis of estimates, not waiting to see which customers will pay The Allowance for Uncollectible Accounts (Allowance for Doubtful Accounts) is a contra account to Accounts Receivable Journal entry: Dr Uncollectible-account expense Cr Allowance for uncollectible a/c

The Allowance Method

Balance Sheet (partial) Accounts receivable Less: Allowance for uncollectible accounts Accounts receivable, net Income Statement (partial) Expenses: Uncollectible-account expense

$10,000 900 $ 9,100

$ 2,000

Accounting for Uncollectible Accounts

Income Statement Approach Balance Sheet Approach

Allowance method Direct write-off method

Percentage-of-Sales
It computes uncollectible-account expense as a percentage of revenue.

This method is also called the income statement approach

Percentage-of-Sales
The credit department estimates that uncollectible-account expense is 0.4% of total revenues, which were $200 for 2011.
Dec. 31 (in millions) Uncollectible-Account Expense ($200 0.004) 0.8 Allowance for Uncollectible Accounts Recorded expense for the year

0.8

Percentage-of-Sales
Dec. 31, 2011 (in millions) after adjustment
Allowance for Uncollectible Accounts 0.6 0.8 1.4

Accounts Receivable Bal. 50

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. A percentage of Accounts receivable could also be used.

Aging-of-Receivables
Accounts before the year-end adjustment: Dec. 31, 2011 (in millions)
Accounts Receivable Bal. 50 Allowance for Uncollectible Accounts 0.6

Aging-of-Receivables
Aging the Accounts Receivable Days Overdue 1-30 days 31-60 days 61-90 days 91 + days
Allowance for Accounts Estimated % Uncollectible Receivable Uncollectible Accounts $ 16.5 2 $ 0.33 12.2 5 0.61 3.6 10 0.36 0.7 35 0.20 $ 33.0 $ 1.50

Aging-of-Receivables
Uncollectible-Account Expense 0.9 Allowance for Uncollectible Accounts ($ 1.5 - $ 0.6) Recorded expense for the year
0.9

Accounts after the year-end adjustment: Dec. 31, 2011 (in millions)
Accounts Receivable Bal. 50

Allowance for Uncollectible Accounts 0.6 Adj. 0.9 1.5

Comparing the Percentage-of-Sales and Aging Methods

Allowance Method
Percentage-of-Sales Method Aging-of-Receivables Method

Adjusts Allowance for Uncollectible Accounts

BY Amount of UNCOLLECTIBLEACCOUNT EXPENSE

Adjusts Allowance for Uncollectible Accounts

TO Amount of UNCOLLECTIBLE RECEIVABLES

Writing Off Uncollectible Accounts

Suppose that early in 2012, 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 Accounts Accounts Receivable Customer # Accounts Receivable Customer # Wrote off uncollectible receivables

0.6
0.4 0.2

Recovery of Uncollectible Accounts Previously Written Off

1. Reinstate the Accounts Receivable

2. Record the collection of cash

Combining the Percentage-of-Sales and the Aging Methods

For interim statements (monthly or quarterly), companies use the percentage-of-sales method because it is easier to apply
At the end of the year, companies use the aging method to ensure that Accounts Receivable is reported at net realizable value

Direct Write-Off Method

Using this method, an account is written off only when it is decided that a specific customers receivable is uncollectible. February 2, 2011 Uncollectible-Account Expense 3,000 Accounts Receivable Smith Inc. 3,000 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 uncollectibleaccount expense against revenue and overstates net income.

Question #2
ABC Co. has the following information on its unadjusted trial balance at Dec. 31, 2011: Accounts receivable 40,000 Allowance for uncollectible accounts 1,200 (debit) The company uses the aging of receivables method and determined that $2,000 of receivables would not be collected. What amount should be reported as the bad debt expense on the Dec. 31, 2011 income statement? a. $2,000 b. $800 c. $2,400 d. $3,200

Learning Objective 5
Account for notes receivable.

Notes Receivable
Notes receivable are more formal than accounts receivable
The principal amount of the note is the amount borrowed by the debtor

The maturity value includes principal plus interest

The creditor has a note receivable The debtor has a note payable

Accounting for Notes Receivable

On August 31, 2010, Alberta Treasury loaned money at 9% interest due on Feb. 28/11. The entry is as follows:

August 31, 2010 Note Receivable Cash Made a loan

1,000

1,000

How much interest revenue is accrued at December 31, 2010?

Accounting for Notes Receivable

Interest = Principal Rate Time $1,000 9% 4/12 = $30

December 31, 2010 Interest Receivable Interest Revenue Accrued interest revenue

30

30

Accounting for Notes Receivable

The bank collects the note on February 28, 2011.
February 28, 2011 Cash 1,045 Note Receivable Interest Receivable Interest Revenue ($1,000 9% 2/12) Collected note and interest at maturity

1,000 30 15

How to Speed up Cash Flow

Credit card sales the merchant sells merchandise and lets the customer pay with a credit card such as Visa, Mastercard, etc.
Debit card sales the customer uses their debit card to pay for the merchandise Selling (factoring) receivables the company sells its receivables to another business

How to Speed Up Cash Flow

Recording a credit card sale. Cash 485 Financing Expense 15 Sales Revenue 500 To record a credit card sale of $500 and a 3% financing expense

How to Speed Up Cash Flow

Recording a debit card sale.

Cash 64.48 Interac fee (assumed rate) 1.00 Sales Revenue 65.48 To record a sale of groceries for 65.48

How to Speed Up Cash Flow

Recording the sale of receivables. Cash Financing Expense Accounts Receivable Sold accounts receivable 95,000 5,000 100,000

Question #3
If the adjusting entry to accrue interest on a note receivable is omitted, then: a. Assets, net income, and shareholders equity are overstated b. Assets, net income, and shareholders equity are understated c. Liabilities are understated, net income is overstated and shareholders equity is overstated d. Assets are overstated, net income and shareholders equity are understated

Learning Objective 6
Use ratios to evaluate a business

Decision Making: Using Ratios

Investors and creditors use ratios to evaluate the financial health of a company
To help them measure the liquidity of companies, they use: a) Current ratio b) Quick ratio c) Days sales in receivables

Current Ratio
This measures the entitys ability to pay its current liabilities with current assets.
Current ratio = Current assets Current liabilities Rule of thumb: A strong current ratio is 1.50

Acid-Test Ratio
This is a stringent test of liquidity which measures the entitys ability to pay its current liabilities immediately.
(Cash + Short-term investments + receivable Total current liabilities

This ratio value is extremely high and indicates great liquidity for this company.

Days Sales in Receivables

One days sales = Net sales 365 days
Days sales in average accounts receivable = Average net accounts receivable One days sales

A smaller number indicates a quick conversion to cash.

Reporting on the Cash Flow Statement

Receivables bring in cash when the business collects from customers.

These transactions are reported as operating activities on the cash flow statement.

Question #4
Net sales total $600,000. Beginning and ending accounts receivable are $52,000 and $38,000 respectively. Calculate days sales in receivables (rounded). a. b. c. d. 32 days 23 days 43 days 27 days

End of Chapter 5