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Financial Accounting

Eleventh Edition

Chapter 5

Short-Term Investments and Receivables

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Learning Objectives

5.1 Account for short-term investments

5.2 Apply GAAP for proper revenue recognition

5.3 Account for and control accounts receivable

5.4 Evaluate collectibility using the allowance for uncollectible accounts

5.5 Account for notes receivable

5.6 Show how to speed up cash flow from receivables

5.7 Evaluate liquidity using three new ratios

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Learning Objective 5.1

Account for short-term investments

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Account for Short-Term Investments (1 of 5)

Reasons to Invest in Other Companies

Companies invest in debt or equity securities of other companies for at least two reasons:

Excess cash not immediately needed
Long-term strategic reasons

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Account for Short-Term Investments (2 of 5)

Reasons to Invest in Other Companies

Investments may be classified as short-term or long-term
To be classified as a current asset:

Must be liquid
Must intend to either:

Convert to cash within one year or the operating cycle, whichever is longer, or
Use it to pay a current liability

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Account for Short-Term Investments (3 of 5)

Reasons to Invest in Other Companies

Investments in securities are classified into three categories:

Trading
Held-to-maturity
Available-for-sale

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Account for Short-Term Investments (4 of 5)

Trading

Expected to be sold within near term
Generate income or losses on day-to-day basis

Held-to-Maturity

Investor has intent and ability to hold until they mature

Available-for-Sale

Held with intent of selling in future
Not classified as trading or held-to-maturity

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Exhibit 5-1 Categories of Investments in Securities

Type of security	Trading (1)	Available-for-Sale (2)	Available-for-Sale (3)	Held-to-Maturity (4)	Held-to-Maturity (5)
Asset classification	Current	Current	Long-term	Current	Long-term
Initial measurement	Cost	Cost	Cost	Cost	Cost
Subsequent measurement	Fair value	Fair value	Fair value	Amortized cost	Amortized cost
Unrealized gains/losses	Income statement (other income, gains and losses)	Other comprehensive income (OCI)	Other comprehensive income (OCI)	N/A	N/A
Chapter	5	5	8	8	8

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Trading Securities (1 of 7)

On June 18, 2016, Apple, Inc., buys 5,000 shares of Intel stock for $20 per share, paying $100,000 cash. Apple, Inc., records the purchase of the investment at cost:

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Trading Securities (2 of 7)

Assume that, on June 30, Apple, Inc., receives a cash dividend of $4,000 from Intel. Apple, Inc., records the dividend revenue as:

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Trading Securities (3 of 7)

Unrealized Gains and Losses

Trading securities are reported on the balance sheet at current fair market value

Increase in fair value 🡪 unrealized gain
Decrease in fair value 🡪 unrealized loss

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Trading Securities (4 of 7)

At Apple’s fiscal year end (September 24), the fair market value of Apple’s investment in Intel’s stock is $110,000. Apple would record the following entry to adjust the investment’s value:

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Trading Securities (5 of 7)

On September 30, 2017, the end of Apple’s fiscal year, the fair value of Apple’s investment in Intel’s stock is $105,000.

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Trading Securities (6 of 7)

Realized Gains and Losses

Occur only when the investor sells an investment.

Sale price > carrying amount 🡪 realized gain
Sale price < carrying amount 🡪 realized loss

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Trading Securities (7 of 7)

Suppose Apple, Inc., sells its Intel stock on June 19, 2018 for $107,000. Apple, Inc., makes the following journal entry:

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Account for Short-Term Investments (5 of 5)

Available-for-Sale Securities

Same as Trading Securities

Initial purchase
Dividend revenue
Adjusting to fair value

Different from Trading Securities

Unrealized gains and losses reported as other comprehensive income (loss)
Accumulated other comprehensive income (loss)

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Exhibit 5-2 Accounting and Reporting for Short-Term Investments and Related Revenues, Gains, and Losses (1 of 3)

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Exhibit 5-2 Accounting and Reporting for Short-Term Investments and Related Revenues, Gains, and Losses (2 of 3)

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Exhibit 5-2 Accounting and Reporting for Short-Term Investments and Related Revenues, Gains, and Losses (3 of 3)

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Ethics and the Current Ratio

Lenders often require a current ratio of a specified amount – 1.5 or higher is common
There are several strategies for increasing the current ratio:

Launch a major sales effort
Pay off current liabilities before year-end
Reclassifying investments as current assets

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Learning Objective 5.2

Apply GAAP for proper revenue recognition

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Apply GAAP for Proper Revenue Recognition (1 of 12)

Revenue recognition

Revenue recognized when earned

Goods delivered
Services performed

Recorded at the amount of:

Cash received, or
Fair market value of assets received in the exchange

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Apply GAAP for Proper Revenue Recognition (2 of 12)

Contract (written or oral)

An agreement between two parties that creates enforceable rights or performance obligations

Five steps

Identify the contract(s)
Identify the performance obligation
Determine the transaction price
Allocate the transaction price to the performance obligations
Recognize revenue when the entity satisfies the obligations

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Apply GAAP for Proper Revenue Recognition (3 of 12)

Assume Apple, Inc., delivers a truckload of iPhones to an AT&T Wireless warehouse in Florida. On the truck are 30,000 iPhones, each of which Apple, Inc., sells to AT&T Wireless for $100 on account. Apple, Inc. will allow a 2% discount if paid within 30 days:

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Apply GAAP for Proper Revenue Recognition (4 of 12)

Each iPhone that Apple, Inc. delivered to AT&T had a cost of $60.

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Apply GAAP for Proper Revenue Recognition (5 of 12)

Shipping Terms
FOB (free on board) shipping point – ownership changes hands and revenue is recognized when goods leave the shipping dock
FOB (free on board) destination – ownership changes hands and revenue is recognized at the point of delivery to the customer

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Apply GAAP for Proper Revenue Recognition (6 of 12)

Collection within the Discount Period

Assume AT&T fulfills its obligation to pay within the discount period:

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Apply GAAP for Proper Revenue Recognition (7 of 12)

Collection Outside of the Discount Period

Now, assume AT&T does not fulfills its obligation to pay within the discount period:

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Apply GAAP for Proper Revenue Recognition (8 of 12)

Sales Refunds, Returns, and Allowances
Customer’s right to return unsatisfactory or damaged goods
Credit memo – document authorizing a credit to the customer’s account receivable

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Apply GAAP for Proper Revenue Recognition (9 of 12)

Suppose Cox Department Store allows customers to return merchandise within 60 days for a full refund. In June, the store’s total sales are $2,000,000 (cash sales). The cost of merchandise sold is $1,200,000.

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Apply GAAP for Proper Revenue Recognition (10 of 12)

Based on past experience, approximately 5% of merchandise sold will be returned.

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Apply GAAP for Proper Revenue Recognition (11 of 12)

In July, within the allowable return period, customers returned merchandise of $90,000 that cost $54,000 for refund.

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Apply GAAP for Proper Revenue Recognition (12 of 12)

Companies normally disclose sales revenue at the net amount (after sales discounts, returns, and allowances have been subtracted).

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Learning Objective 5.3

Account for and control accounts receivable

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Account for and Control Accounts Receivable (1 of 7)

Receivables

Third most liquid asset (after cash and short-term investments)
Monetary claims against others
Acquired by:

Selling goods and services (accounts receivable)
Lending money (notes receivable)

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Account for and Control Accounts Receivable (2 of 7)

Journal entries to record receivables

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Account for and Control Accounts Receivable (3 of 7)

Accounts Receivable

Current assets
Sometimes called trade receivables
Serves as a control account

Summarizes total receivable for each customer
Subsidiary ledger kept with separate account for each customer

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Account for and Control Accounts Receivable (4 of 7)

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Account for and Control Accounts Receivable (5 of 7)

Notes Receivable

More formal contract
Borrower signs formal contract to pay lender

Definite sum plus interest
At maturity date

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Account for and Control Accounts Receivable (6 of 7)

Other Receivables

Miscellaneous category for all other receivables
Examples

Interest receivable
Advances to employees

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Account for and Control Accounts Receivable (7 of 7)

Internal Controls Over Cash Collections on Account

Separation of duties – opening mail and making deposits
Separate cash handling and recording duties

Bookkeeper should not handle cash

Bank lockbox system

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Learning Objective 5.4

Evaluate collectibility using the allowance for uncollectible accounts

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Evaluate Collectibility Using the Allowance for Uncollectible Accounts (1 of 14)

Credit Sales

Benefits

Customers can buy on credit, so sales and profits increase

Costs

Company cannot collect from some customers
Recorded as uncollectible-account expense

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Evaluate Collectibility Using the Allowance for Uncollectible Accounts (2 of 14)

Allowance Method

Records losses from failure to collect receivable
Based on company’s past collection experiences
Record Uncollectible-Account Expense
Set up contra-account

Allowance for Uncollectible Accounts
Shows the amount the business expects not to collect

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Evaluate Collectibility Using the Allowance for Uncollectible Accounts (3 of 14)

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Evaluate Collectibility Using the Allowance for Uncollectible Accounts (4 of 14)

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Evaluate Collectibility Using the Allowance for Uncollectible Accounts (5 of 14)

Two basic ways to estimate uncollectibles:

Percent-of-sales method

Uncollectible-account expense computed as a percent of revenue
Income statement approach

Aging-of-receivables method

Specific accounts are analyzed based on how long they have been outstanding
Balance sheet approach

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Evaluate Collectibility Using the Allowance for Uncollectible Accounts (6 of 14)

Percent-of-Sales Method

Assume Apple’s accounts have the following balances before the year-end adjustments:

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Evaluate Collectibility Using the Allowance for Uncollectible Accounts (7 of 14)

Percent-of-Sales Method

Apple’s credit department estimates uncollectible-account expense is .0004% of total revenues, which are $182,795 million.

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Evaluate Collectibility Using the Allowance for Uncollectible Accounts (8 of 14)

Percent-of-Sales Method

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Evaluate Collectibility Using the Allowance for Uncollectible Accounts (9 of 14)

Aging-of-Receivables Method

Suppose Apple’s receivables accounts show the following before the year-end adjustments:

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Exhibit 5-4 Aging Accounts Receivable of Apple Inc.

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Evaluate Collectibility Using the Allowance for Uncollectible Accounts (10 of 14)

Aging-of-Receivables Method

The aging method will bring the balance of the allowance account ($10) to the needed amount as determined by the aging schedule ($86).

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Evaluate Collectibility Using the Allowance for Uncollectible Accounts (11 of 14)

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Evaluate Collectibility Using the Allowance for Uncollectible Accounts (12 of 14)

Writing Off Uncollectible Accounts: At the beginning of the year, Apple had these accounts receivable (in millions):

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Evaluate Collectibility Using the Allowance for Uncollectible Accounts (13 of 14)

Write Off Uncollectible Accounts. Early in fiscal 2015, Apple, Inc.’s credit department determines that Apple, Inc., cannot collect from RS and TM. Apple, Inc., then writes off these receivables with the following entry:

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Evaluate Collectibility Using the Allowance for Uncollectible Accounts (14 of 14)

Writing Off Uncollectible Accounts

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Exhibit 5-5 Comparing the Percent-Of-Sales and Aging Methods for Estimating Uncollectible Accounts

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Direct Write-Off Method (1 of 2)

Alternative way to account for uncollectible receivables
Records expense when specific customer’s account proves to be uncollectible
Less preferable, not in conformance with GAAP

No allowance for uncollectible 🡪 may overstate assets on the balance sheet
Fails to recognize uncollectible accounts in the same period in which the related revenue is earned

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Direct Write-Off Method (2 of 2)

The journal entry to write off RS and TM using the direct write-off method is as follows:

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Computing Cash Collections from Customers

Receivables typically hold five items:

If you know all other items except for collections, you can compute collections by solving for X.

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Learning Objective 5.5

Account for notes receivable

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Account for Notes Receivable (1 of 6)

Creditor	Party to whom money is owed; lender
Debtor	Party that borrowed and owes money; maker, borrower
Interest	Cost of borrowing money; stated as annual percentage rate
Maturity Date	Date at which debtor must pay the note
Maturity Value	The sum of principal and interest
Principal	Amount of money borrowed by the debtor
Term	Length of time from when the note was signed to when payment must be made

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Exhibit 5-6 Promissory Note

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Accounting for Notes Receivable (2 of 6)

Consider the promissory note in Exhibit 5-6. After Lauren Holland signs the note, Continental Bank gives her $1,000 cash. The bank makes the following entry to record the loan.

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Accounting for Notes Receivable (3 of 6)

Continental Bank earns interest revenue during September, October, November, and December. At December 31, 2016, the bank accrues 9% interest revenue for four months:

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Accounting for Notes Receivable (4 of 6)

Continental Bank reports these amounts in its financial statement at December 31, 2016 as follows:

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Accounting for Notes Receivable (5 of 6)

The bank collects the note on February 28, 2017.

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Accounting for Notes Receivable (6 of 6)

Interest

Rates usually expressed as an annual percent
Fraction used for time periods less than an year

Months/12
Days/365

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Learning Objective 5.6

Show how to speed up cash flow from receivables

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Show How to Speed up Cash Flow from Receivables (1 of 5)

Strategies to shorten credit cycle and collect cash more quickly:
Sales discounts for early payment
Charge interest after a certain time period
Adopt more effective credit and collection procedures
Emphasize credit card or bankcard sales

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Show How to Speed up Cash Flow from Receivables (2 of 5)

Credit Card or Bankcard Sales. Apple, Inc., sells a computer and peripheral devices for $5,000 at one of its stores, and the customer pays with a VISA card. VISA charges companies a 2% processing fee.

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Show How to Speed up Cash Flow from Receivables (3 of 5)

Selling (Factoring) Receivable
Sells receivables to another company, a factor
Factor pays discounted price for receivable and then tries to collect from the customer to earn revenue
Benefits company with immediate receipt of cash
Expensive and lose control over collection
Used by companies with

Weak or insufficient credit history (start-ups)
Significant amount of debt

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Show How to Speed up Cash Flow from Receivables (4 of 5)

Selling (Factoring) Receivables. A company wishes to speed up cash flow and therefore sells $100,000 of accounts receivable, receiving cash of $95,000.

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Show How to Speed up Cash Flow from Receivables (5 of 5)

Reporting on the Statement of Cash Flows

Current Assets

Receivables
Short-term investments

Receivables 🡪 operating activities
Investments 🡪 investing activities

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Learning Objective 5.7

Evaluate liquidity using three new ratios

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Evaluate Liquidity Using Three New Ratios (1 of 5)

Quick (Acid-Test) Ratio

Higher ratio indicates easier to pay current liabilities
What is considered acceptable varies based on the industry

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Evaluate Liquidity Using Three New Ratios (2 of 5)

Quick (Acid-Test) Ratio

Apple’s quick ratio is .67
Indicates Apple has $0.67 quick assets to pay each $1 of current liabilities

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Evaluate Liquidity Using Three New Ratios (3 of 5)

Accounts Receivable Turnover

(Dollars in millions, taken from Apple, Inc.’s financial statements)

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Evaluate Liquidity Using Three New Ratios (4 of 5)

Days’ Sales Outstanding

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Evaluate Liquidity Using Three New Ratios (5 of 5)

Days’ Sales Outstanding

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