ACCT 210 Lecture, Fall 2007

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-1 Financial Assets Chapter 7 © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-2 Learning Objective Learning Objective LO1 To define financial assets and explain their valuation in the balance sheet. © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-3 How Much Cash Should a Business Have? How Much Cash Should a Business Have? $ Every business needs enough cash to pay its bills! © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-4 How Much Cash Should a Business Have? How Much Cash Should a Business Have? Cash Short-term Investments Receivables Financial Assets © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-5 How Much Cash Should a Business Have? How Much Cash Should a Business Have? Accounts receivable Marketable securities (short-term investments) Cash (and cash equivalents) Collections from customers Cash payments “Excess” cash is invested temporarily Investments are sold as cash is needed © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-6 The Valuation of Financial Assets The Valuation of Financial Assets Type of Financial Assets Basis for Valuation in the Balance Sheet Cash (and cash equivalents) Face amount Short-term investments (marketable securities) Current market value Receivables Net realizable value Estimated collectible amount Estimated collectible amount © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-7 Cash Cash Coins and paper money Checks Money orders Travelers’ checks Bank credit card sales Cash is defined as any deposit banks will accept. © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-8 Combined with cash on balance sheet Reporting Cash in the Balance Sheet Reporting Cash in the Balance Sheet Liquid short- term investments Stable market values Matures within 90 days of acquisition Cash Equivalents © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-9 Not available for paying current liabilities Reporting Cash in the Balance Sheet Reporting Cash in the Balance Sheet Not a current asset Listed as an investment “Restricted” Cash © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-10 Bank agrees in advance to lend money. Reporting Cash in the Balance Sheet Reporting Cash in the Balance Sheet Liability is incurred when line of credit is used. Unused line of credit is disclosed in notes. Lines of Credit © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-11 The Statement of Cash Flows The Statement of Cash Flows Summarizes cash transactions for an accounting period. Summarizes cash transactions for an accounting period. Includes cash and cash equivalents. Includes cash and cash equivalents. Statement of Cash Flows © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-12 Learning Objective Learning Objective LO2 To describe the objectives of cash management and internal controls over cash. © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-13 Cash Management 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. Accurately account for cash. Prevent theft and fraud. Assure the availability of adequate amounts of cash. Prevent unnecessarily large amounts of idle cash. © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-14 Using Excess Cash Balances Efficiently Using Excess Cash Balances Efficiently Cash available for long- term investment may be used to finance growth and expansion of the business, or to repay debt. Cash not needed for business purposes may be distributed to the company’s stockholders. © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-15 Internal Control Over Cash 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. • Verify every expenditure before payment. • Promptly reconcile bank statements. • 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. • Verify every expenditure before payment. • Promptly reconcile bank statements. © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-16 Cash Over and Short Cash Over and Short Cash Over and Short is debited for shortages and credited for overages. Cash Over and Short is debited for shortages and credited for overages. On May 5, XBAR, Inc.’s cash drawer was counted and found to be $10 over. © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-17 Learning Objective Learning Objective LO3 To prepare a bank reconciliation and explain its purpose. © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-18 Bank Statements Bank Statements Shows the beginning bank balance, deposits made, checks paid, other debits and credits in the month, and the ending bank balance. Bank Statement © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-19 Reconciling the Bank Statement Reconciling the Bank Statement Explains the difference between cash reported on bank statement and cash balance in depositor’s accounting records. Provides information for reconciling journal entries. © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-20 Reconciling the Bank Statement Reconciling the Bank Statement Balance per Bank + Deposits in Transit - Outstanding Checks ± Bank Adjustments = Adjusted Balance Balance per Depositor + Deposits by Bank (credit memos) - Service Charge - NSF Checks ± Book Adjustments = Adjusted Balance © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-21 Reconciling the Bank Statement Reconciling the Bank Statement All reconciling items on the book side require an adjusting entry to the cash account. Balance per Depositor + Deposits by Bank (credit memos) - Service Charge - NSF Checks ± Book Adjustments = Adjusted Balance © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-22 Reconciling the Bank Statement Reconciling the Bank Statement Prepare a July 31 bank reconciliation statement and the resulting journal entries for the Simmons Company. The July 31 bank statement indicated a cash balance of $9,610, while the cash ledger account on that date shows a balance of $7,430. Additional information necessary for the reconciliation is shown on the next page. © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-23  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.  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. © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-24 Reconciling the Bank Statement Reconciling the Bank Statement © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-25 Reconciling the Bank Statement Reconciling the Bank Statement GENERAL JOURNAL Date Account Titles and Explanation P R Debit Credit Jul 31 Cash 30 Interest Revenue 30 31 Supplies Inventory 28 Accounts Receivable 225 Cash 253 © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-26 Used for minor expenditures. Petty Cash Funds Petty Cash Funds Has one custodian. Replenished periodically. Petty Cash Funds © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-27 Learning Objective Learning Objective LO4 To describe how short- term investments are reported in the balance sheet and account for transactions involving marketable securities. © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-28 Short-Term Investments Short-Term Investments Bond Investments Capital Stock Investments Current Assets Almost As Liquid As Cash Readily Marketable Marketable Securities are . . . © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-29 Accounting for Marketable Securities Accounting for Marketable Securities Most short-term investments in marketable securities are classified as available for sale and appear on the balance sheet at their current market value. Classification Management's Intent Treatment of Unrealized Holding Gains and Losses Available-for- sale securities Held for short-term resale (often 6 to 18 months) Reported in stockholders' equity section of the balance sheet Trading securities Held for immediate resale (often within hours or days) Reported in "other" revenue (expense) section of the income statement Held-to-maturity securities Debt securities intended to be held until they mature Not reported. Securities are reported on balance sheet at amortized cost. Classification Management's Intent Treatment of Unrealized Holding Gains and Losses Available-for- sale securities Held for short-term resale (often 6 to 18 months) Reported in stockholders' equity section of the balance sheet Trading securities Held for immediate resale (often within hours or days) Reported in "other" revenue (expense) section of the income statement Held-to-maturity securities Debt securities intended to be held until they mature Not reported. Securities are reported on balance sheet at amortized cost. © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-30 Purchase of Marketable Securities 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 $43.98 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 $43.98 per share, plus a brokerage commission of $80. Total Cost: (4,000 × $43.98) + $80 = $176,000 Cost per Share: $176,000 ÷ 4,000 = $44.00 © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-31 Recognition of Investment Revenue 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. 4,000 × $0.30 = $1,200 © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-32 Sales of Investments Sales of Investments On December 18, Foster Corporation sells 500 shares of its Coca-Cola stock for $46.04 per share, less a $20 brokerage commission. On December 18, Foster Corporation sells 500 shares of its Coca-Cola stock for $46.04 per share, less a $20 brokerage commission. Sales Proceeds: (500 × $46.04) - $20 = $23,000 Cost Basis: 500 × $44 = $22,000 Gain on Sale: $23,000 - $22,000 = $1,000 © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-33 Adjusting Marketable Securities to Market Value 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 $42,000. Prior to any adjustment, the company’s Marketable Securities account has a balance of $44,000 (1,000 × $44 per share). On December 31, Foster Corporation’s remaining shares of Coca-Cola capital stock have a current market value of $42,000. Prior to any adjustment, the company’s Marketable Securities account has a balance of $44,000 (1,000 × $44 per share). Unrealized Loss: $42,000 - $44,000 = ($2,000) © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-34 Learning Objective Learning Objective LO5 To account for uncollectible receivables using the allowance and direct write-off methods. © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-35 Accounts Receivable Accounts Receivable If a company makes credit sales to customers, some accounts inevitably will turn out to be uncollectible. If a company makes credit sales to customers, some accounts inevitably will turn out to be uncollectible. PAST DUE © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-36 Reflecting Uncollectible Accounts in the Financial Statements Reflecting Uncollectible Accounts in the Financial Statements At the end of each period, record an estimate of the uncollectible accounts. At the end of each period, record an estimate of the uncollectible accounts. Contra-asset account Contra-asset account Selling expense Selling expense © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-37 The Allowance for Doubtful Accounts The Allowance for Doubtful Accounts Accounts receivable Less: Allowance for doubtful accounts Net realizable value of accounts receivable The net realizable value is the amount of accounts receivable that the business expects to collect. © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-38 Writing Off an Uncollectible Account Receivable 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. When an account is determined to be uncollectible, it no longer qualifies as an asset and should be written off. © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-39 Writing Off an Uncollectible Account Receivable Writing Off an Uncollectible Account Receivable Assume that on January 5, K-Max determined that Jason Clark would not pay the $500 he owes. K-Max would make the following entry. © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-40 Writing Off an Uncollectible Account Receivable Writing Off an Uncollectible Account Receivable Assume that before this entry, the Accounts Receivable balance was $10,000 and the Allowance for Doubtful Accounts balance was $2,500. Let’s see what effect the write-off had on these accounts. © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-41 Writing Off an Uncollectible Account Receivable Writing Off an Uncollectible Account Receivable Before Write-Off After Write-Off Accounts receivable $ 10,000 9,500 $ Less: Allow. for doubtful accts. 2,500 2,000 Net realizable value $ 7,500 7,500 $ Notice that the $500 write-off did not change the net realizable value nor did it affect any income statement accounts. © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-42 Monthly Estimates of Credit Losses 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. Two Approaches to Estimating Credit Losses: 1. Balance Sheet Approach 2. Income Statement Approach © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-43 Estimating Credit Losses — The Balance Sheet Approach Estimating Credit Losses — The Balance Sheet Approach  Year-end Accounts Receivable is broken down into age classifications.  Year-end Accounts Receivable is broken down into age classifications.  Each age grouping has a different likelihood of being uncollectible.  Each age grouping has a different likelihood of being uncollectible.  Compute a separate allowance for each age grouping.  Compute a separate allowance for each age grouping. © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-44 Estimating Credit Losses — The Balance Sheet Approach Estimating Credit Losses — The Balance Sheet Approach At December 31, the receivables for EastCo, Inc. were categorized as follows:  © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-45 Estimating Credit Losses — The Balance Sheet Approach Estimating Credit Losses — The Balance Sheet Approach At December 31, the receivables for EastCo, Inc. were categorized as follows:   © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-46 Estimating Credit Losses — The Balance Sheet Approach Estimating Credit Losses — The Balance Sheet Approach At December 31, the receivables for EastCo, Inc. were categorized as follows:    © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-47 EastCo’s unadjusted balance in the allowance account is $500. Per the previous computation, the desired balance is $1,350. EastCo’s unadjusted balance in the allowance account is $500. Per the previous computation, the desired balance is $1,350. Estimating Credit Losses — The Balance Sheet Approach Estimating Credit Losses — The Balance Sheet Approach © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-48 Let’s look at another way to estimate credit losses! Let’s look at another way to estimate credit losses! © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-49 Estimating Credit Losses — The Income Statement Approach Estimating Credit Losses — The Income Statement Approach Uncollectible accounts’ percentage is based on actual uncollectible accounts from prior years’ credit sales. Focus is on determining the amount to record on the income statement as Uncollectible Accounts Expense. © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-50 Estimating Credit Losses — The Income Statement Approach Estimating Credit Losses — The Income Statement Approach Net Credit Sales  % Estimated Uncollectible Amount of Journal Entry Net Credit Sales  % Estimated Uncollectible Amount of Journal Entry © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-51 Estimating Credit Losses — The Income Statement Approach Estimating Credit Losses — The Income Statement Approach In 2007, EastCo had credit sales of $60,000. Historically, 1% of EastCo’s credit sales has been uncollectible. For 2007, the estimate of uncollectible accounts expense is $600. ($60,000 × .01 = $600) Now, prepare the adjusting entry for December 31, 2007. In 2007, EastCo had credit sales of $60,000. Historically, 1% of EastCo’s credit sales has been uncollectible. For 2007, the estimate of uncollectible accounts expense is $600. ($60,000 × .01 = $600) Now, prepare the adjusting entry for December 31, 2007. © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-52 Estimating Credit Losses — The Income Statement Approach Estimating Credit Losses — The Income Statement Approach © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-53 Uncollectible Accounts Summary Uncollectible Accounts Summary Aging of Receivables Aging of Receivables Emphasis on Realizable Value Emphasis on Realizable Value Accts. Rec. All. for Doubtful Accts. Balance Sheet Focus Balance Sheet Focus % of Credit Sales % of Credit Sales Emphasis on Matching Emphasis on Matching Sales Uncoll. Accts. Exp. Income Statement Focus Income Statement Focus © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-54 Concentrations of Credit Risk Concentrations of Credit Risk Concentrations of credit risk occur if a significant portion of a company’s receivables are due from a few major customers or from customers operating in the same industry or geographic region. Concentrations of credit risk occur if a significant portion of a company’s receivables are due from a few major customers or from customers operating in the same industry or geographic region. The FASB requires disclosure of all significant concentrations of credit risk in the notes to the financial statements. The FASB requires disclosure of all significant concentrations of credit risk in the notes to the financial statements. © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-55 Recovery of an Account Receivable Previously Written Off Recovery of an Account Receivable Previously Written Off GENERAL JOURNAL Date Account Titles and Explanation P R Debit Credit Accounts Receivable (X Customer) $$$$ Allowance for Doubtful Accounts $$$$ Cash $$$$ Accounts Receivable (X Customer) $$$$ Subsequent collections require that the original write-off entry be reversed before the cash collection is recorded. Subsequent collections require that the original write-off entry be reversed before the cash collection is recorded. © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-56 Direct Write-Off Method Direct Write-Off Method This method makes no attempt to match revenues with the expense of uncollectible accounts. © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-57 Income Tax Regulations and Financial Reporting Income Tax Regulations and Financial Reporting Direct write-off method required to calculate taxable income. Taxable Income Financial Statement Income GAAP GAAP GAAP GAAP Allowance methods better match expenses with revenues. © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-58 Internal Controls for Receivables Internal Controls for Receivables Separate the following duties:  Maintenance of the accounts receivable subsidiary ledger.  Custody of cash receipts.  Authorization of accounts receivable write-offs.  Maintenance of the accounts receivable subsidiary ledger.  Custody of cash receipts.  Authorization of accounts receivable write-offs. © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-59 Management of Accounts Receivable Management of Accounts Receivable Credit Terms Minimize Accounts Receivable Extending credit encourages customers to buy from us . . . . . . but it ties up resources in accounts receivable. © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 7-60 Management of Accounts Receivable Management of Accounts Receivable Factoring Accounts Receivable Credit Card Sales