Chapter 7
Cash, Investments,
and Receivables
Key Concepts:
n
n
n
n
n
n
n
n
n
n
What are the forms in which cash is found in a company?
What techniques do companies use to control cash?
What are the types of investments that companies make?
Why does a company invest in another company?
How are held-to-maturity securities accounted for and reported?
How are trading securities accounted for and reported?
How are available-for-sale securities accounted for and reported?
What is the impact of bad debts on an organization's financial condition?
How is a note receivable different from an account receivable?
How can a company accelerate the inflow of cash?
Harcourt, Inc.
7-1
FINANCIAL ACCOUNTING INSTRUCTOR’S MANUAL
Chapter Outline
LO 1
The Forms of Cash
Classification as cash indicates that an item is readily available to pay debts.
n Cash equivalents are readily convertible to known amount of cash
•
•
original maturity to the investor of less than three months
treasury bills, commercial paper, money market funds
Cash and cash equivalents included as cash on statement of cash flows
LO 2
Control Over Cash
Cash management is necessary to guarantee that neither too little nor too much cash is on hand.
n Cash alone does not earn anything, but must be invested
n Too much cash could make company a takeover target
Bank statement details all activity in an account monthly
n Canceled checks
•
an outstanding check was written but not yet presented for payment, and therefore is not
on statement
n Deposits
•
on company's records, a deposit in transit was made in the last day or two of the month,
doesn't show up on statement
n NSF check (Not Sufficient Funds) was deposited, but bank could not collect, and deducted
from balance
n Service charge
n Customer note and interest: bank acts as collection agent for company, takes payments
directly
n Interest earned
Bank reconciliation should be prepared as soon as the statement is received, by someone independent
of custody, record keeping, and authorization (Exhibit 7-3)
n Trace deposits listed to books, list deposits in transit
n Trace canceled checks to books, list outstanding checks
n List credit memoranda: items credited on bank's books to company for interest or collections
from customers
n List debit memoranda (the bank debits or reduces the liability to the company on its books):
NSF checks, service charges
n Identify errors by bank or company
n Reconcile book balance and bank balance to adjusted balance using above items
n Make the necessary adjustments to correct balance on books
Petty Cash Fund
The petty cash fund is an exception to the “all expenditures by check” rule, for minor amounts.
n Check written and cashed to establish fund
n Minor disbursements are reimbursed from it when receipts are presented
7-2
Harcourt, Inc.
CHAPTER 7 — CASH, INVESTMENTS, AND RECEIVABLES
n Replenish periodically by totaling receipts and writing a check to bring the cash in the fund up
to its original amount
n record expenses in accounting records per receipts
Understand the Accounting for Various Types of Investments Companies Make
LO 3
Investments in Highly Liquid Financial Instruments
Investing Idle Cash
Excess cash is invested during slower months, used to build up inventory during busier months.
n CD—Certificate of Deposit
•
•
•
classified as cash equivalent if its original maturity to the investor is three months or less
classified as short-term investment when purchased if it extends longer than three months
interest is calculated for the time invested, usually a fraction of a year
I=P*R*T
•
adjustment for interest may be needed if year-end comes between purchase and maturity
Investments in Stocks and Bonds
Two forms of investment in another company:
n Debt securities: one company loans money to another company, most commonly through
bonds
• Specific maturity date
n Equity securities: one company has ownership interest in another company, usually in the
form of common or preferred stock
• No maturity date
Why does one company (investor) invest in another (investee)?
n Investment of idle cash
•
for interest, dividends, capital appreciation
n In order to gain influence over the other company, for example, to control a chief supplier of
raw materials
•
equity method of accounting for investment is used if investor is able to secure influence
over investee
♦ appropriate when at least 20% of the common stock of the investee is owned
n In order to gain control of investee
•
normally requires ownership of more than 50% of investee’s stock
♦ consolidated financial statements are prepared, combining statements of the
individual entities into a single set of statements
♦ investor is the parent, investee is the subsidiary
Investments Without Significant Influence
Investments in debt or equity securities of other companies present accounting questions:
n Basis for recognition of income (dividends, interest)
Harcourt, Inc.
7-3
FINANCIAL ACCOUNTING INSTRUCTOR’S MANUAL
n Value of investment on the balance sheet
n Classification on the balance sheet as current, noncurrent
Debt or equity securities are classified into one of three categories (Exhibit 7-4):
n Held-to-maturity securities are bonds, and only bonds, that investor is able and intends to
hold to maturity
n Trading securities are stocks and bonds bought for short-term gain, intended to be sold in
near term
n Available-for-sale securities are neither held-to-maturity nor trading securities
Investments in Held-to-Maturity Securities
Held-to-maturity securities are bonds purchased on their issuance date from issuer or on the open
market after they have been outstanding for a time.
n Intent of investor is to hold these bonds until maturity
n Bonds purchased at face value:
•
•
Investment is recorded at cost
Interest income is recorded in the period earned: may require an adjusting journal entry
n Held-to-maturity bonds are classified as a noncurrent asset
•
reclassified to current assets when they are one year or less from maturity
n Should the investor change plans and sell the bonds before maturity, the difference between
the sale proceeds and the amount paid is recognized as a gain or loss
•
investor’s gain or loss is reported in the “other income and expenses” section of the
income statement
Investments in Trading Securities
Trading securities are current assets because the investor’s intent is to hold them for a short time, to
profit from increases in market prices.
n
n
n
n
Recorded at cost, which includes broker fees and commissions
Dividends recorded as dividend income
When securities are sold, gain or loss is recorded as “other income and expenses”
At end of the accounting period, securities still held are marked to market, that is, individually
adjusted to reflect their current market value on the balance sheet
•
•
sum of the increases and decreases results in an unrealized gain or loss on trading
securities, an other income and expense item
investment accounts are adjusted to reflect the market value
n When a security that has been adjusted to market value is sold, the gain or loss on the sale is
the difference between cash proceeds and the adjusted fair value at the most recent reporting
date, not the cost
Investments in Available-for-Sale Securities
Accounting for available-for-sale securities is similar to that for trading securities, but unrealized
gains or losses on these items at the end of the accounting period when they are marked to market, are
accumulated in stockholders' equity on the balance sheet, not recognized as other income on the
income statement.
n Securities accounts are still adjusted to fair value on balance sheet date
n Record the proceeds from the sale of the securities
7-4
Harcourt, Inc.
CHAPTER 7 — CASH, INVESTMENTS, AND RECEIVABLES
•
•
•
record realized gain or loss equal to the difference between original cost and selling price
remove unrealized gain or loss from equity
remove investment at its adjusted value from assets
The Controversy over Fair Value Accounting
n Use of Fair Value is an exception to the cost principle
•
•
•
investments are reported at either amortized cost or fair market value, which in some
cases may exceed cost
inventories reported at lower of cost or market
property, plant, and equipment are reported at original cost less accumulated depreciation
(depreciated cost)
n Unrealized gains are recognized on securities, but not on any other assets
n This is a controversial topic, because different methods are used to evaluate different assets
Accounts Receivable
LO 4
Accounts receivable versus notes receivable = oral promise versus written promise to pay.
n Accounts receivable are non-interest-bearing
n Notes receivable are usually interest-bearing and have specific due dates
Subsidiary ledger has detail on each of a number of items that make up one general ledger account
known as a control account.
n Accounts receivable by customer constitutes subsidiary ledger
n Plant and equipment
n Accounts payable
Valuation of Accounts Receivable
n Allowance for doubtful accounts, a valuation account, is also called allowance for bad
debts, or allowance for uncollectible accounts
•
gross accounts receivable less allowance for doubtful accounts equals net recoverable
amount of accounts receivable
♦ also called net realizable value, or accounts receivable, net
Two methods of accounting for bad debts:
n Direct write-off method
•
creates a timing problem because it does not match expense (bad debts) associated with
sales with period in which sales were made
♦ violates the matching principle
n Allowance method estimates bad debts before they occur
•
•
report bad debt expense on the income statement, and increase allowance for doubtful
accounts
♦ allowance is a contra asset, that is, it reduces the asset to its net realizable value
to write off a specific customer's account, reduce both the allowance for doubtful
accounts and the accounts receivable account.
♦ After the write off, there is no change in net realizable value
Harcourt, Inc.
7-5
FINANCIAL ACCOUNTING INSTRUCTOR’S MANUAL
Two approaches to estimate bad debts, using the allowance method:
n Income statement method matches bad debts with revenues
•
•
bases estimate on credit sales of the period
use historical average percent of credit sales that resulted in bad debts, applied to current
period’s credit sales
♦ debit bad debt expense, credit allowance for this number
n Balance sheet method matches bad debts with net balance of accounts receivable at the end
of the period
•
•
bases estimate on historical percentage of ending accounts receivable that resulted in bad
debts
apply to current period’s ending accounts receivable
IMPORTANT: this method does not yield the amount to debit to bad debt expense
and credit to the allowance. The amount calculated is the ending balance of the
allowance account. It is necessary to subtract any existing balance to arrive at the
debit to bad debt expense
Aging of accounts receivable is variation of the percent of accounts receivable method (Exhibits 7-5
and 7-6):
n Refines the calculation, considering the length of time receivables have been outstanding
n Groups receivables by age (time outstanding)
n Estimated uncollectibility increases as receivables get older
Accounts receivable turnover is the rate of collection of accounts receivable.
n Turnover = net credit sales ÷ average accounts receivable
n Days in accounts receivable is the days an item spends, on average, in accounts receivable
360 ÷ turnover
LO 5
Notes Receivable
Notes receivable, or promissory note, is a written promise to pay a specific amount at a specific time
in the future, usually with interest.
n
n
n
n
n
n
n
n
Maker, who will pay the money, has a note payable and interest expense
Payee, who will receive the money, has a note receivable and interest revenue
Principal is the amount borrowed, or the goods or services received by the maker
Term is the time the note will be outstanding
Maturity date is when the note is due to be repaid
Maturity value is the amount due on the maturity date
Interest is the difference between the principal and the maturity value
Implicit interest is not specified on face of a note, but is implied because the principal is
different from the maturity value
•
•
7-6
called a non-interest-bearing note, but does actually require interest to be paid
interest-bearing note has interest rate specified on the note
Harcourt, Inc.
CHAPTER 7 — CASH, INVESTMENTS, AND RECEIVABLES
Interest-Bearing Notes
Interest is earned between the issue date and the maturity date.
n May need accrual for the portion earned up to the period ending date if period ends between
the two
n Increase both the interest receivable and the interest revenue on the books of the payee
n On the maturity date,
•
•
To accrue interest since the last adjustment: Increase both interest receivable and interest
revenue
To record collection of the note and interest receivable: increase cash by the amount of
the note and interest receivable and decrease both notes receivable and interest receivable
Non-Interest-Bearing Notes
LO 6
Non-interest-bearing note carries implicit rather than explicit interest.
n Still involves payment in the future in excess of the amount received, either as cash, or goods
or services, in the present
n Sometimes called a discounted note
n For the payee upon receipt of a note receivable:
•
•
increase notes receivable by the amount to be collected.
Either decrease cash by the amount of cash loaned or increase sales revenue if the note
arises as a result of a sale
•
n
a third account, called Discount on Notes Receivable, another contra asset, is needed to
balance the transaction,
♦ discount represents interest that has not yet been earned, but will over the life of the
note
interest as it is earned (accrued) reduces the Discount on Notes Receivable and increases
interest revenue. At maturity the Discount on Notes Receivable will be zero.
•
if the accounting period ends between the issue date and the maturity date of the note, an
accrual will be necessary to reduce the Discount on Notes Receivable to zero and
recognize the interest revenue.
Accelerating the Inflow of Cash from Sales
LO 7
Cash discounts (see Chapter 5) are used to motivate customers to pay earlier.
Other techniques also used:
n Credit cards (other than the company's own): company pays a fee in return for passing on the
responsibility for collection to another party
•
•
•
•
the company receives cash more quickly, but the customer can still buy on credit
the company remits credit card drafts to the issuer of the card, recording an account
receivable
when reimbursement for these drafts is transmitted to the company, a collection fee, an
expense for the company, is generally deducted
some credit cards allow the company to deposit drafts directly to their bank account, in
essentially the same way as cash and checks are deposited
♦ accelerates collection even more for the company that accepted the credit card, since
this deposit method makes it equivalent to receiving cash
♦ collection fee is charged at the time of deposit
Harcourt, Inc.
7-7
FINANCIAL ACCOUNTING INSTRUCTOR’S MANUAL
n Discounting a note: company can endorse a promissory note over to its bank, and receive
cash before the due date
•
•
•
LO 8
another way to speed collection
note can be sold on the date of issuance or anytime prior to its due date
discounting is usually done with recourse, that is, if the maker fails to pay the bank, the
discounting company is responsible for the debt
♦ creates a contingent liability for the discounting company because of the uncertainty
as to whether it will have to pay the debt
♦ the contingency is not recorded as a liability but is stated in a footnote to the
financial statements
Liquid Assets on the Statement of Cash Flows
Short-term investments may appear on either the operating or investing section of statement of cash
flows.
Accounts receivable are an operating item:
n Direct method shows the amount of cash collected
n Indirect method reflects the cash effect of the change in accounts receivable
•
•
7-8
a decrease is added to net income because if accounts receivable decreases, the company
must have collected more accounts receivable than it added to the account in this period
an increase is deducted because additions (credit sales) exceeded collections, so some of
the sales included in net income have not as yet turned into cash
Harcourt, Inc.
CHAPTER 7 — CASH, INVESTMENTS, AND RECEIVABLES
Lecture Suggestions
Most students have at least a basic understanding of what is involved in balancing a checkbook. If the
bank reconciliation is tied to this, you remove it from the new, complex accounting task category. If a
number of students do not have checking accounts, copy the reconciliation form from the back of a
personal checking statement for distribution. Use it to prepare an example in class.
LO 2
_______________________
Students have trouble with the concept of credit memoranda and debit memoranda. The company's
cash is a liability of the bank, thus the bank increases a liability account (on its books) when the
company earns interest from the bank or the bank collects a note from a third party on behalf of the
company. The bank reduces the liability account when the company’s cash is decreased because of
items such as NSF checks, service charges, check printing, payments made from the account. Identify
students who have worked at banks. They may have trouble with this concept.
A transactions analysis approach helps illustrate how a gain is recognized in two steps. The first part
is accounted for when the security is marked to market. The remainder is recognized when the
security is sold.
LO 3
______________________
Emphasize that the 20% minimum ownership required for significant influence is not intended as an
absolute cutoff point. An owner of 20% or more of a company may not have significant influence in
the management of the company. Influence must be judged case by case.
This fundamental difference between the percentage of sales and percentage of accounts receivable
methods is another very difficult point for students. They know how to make the estimate, but they do
not really know what the number they calculate means. One tool to use to try to help them distinguish
is to emphasize that when you use an income statement number (revenues) to calculate your estimate,
the answer you get is an income statement number (bad debt expense). But when you use a balance
sheet number (ending accounts receivable) to calculate your estimate, you get a balance sheet number
(ending balance of allowance) for your answer, and if you want the income statement number (bad
debt expense) you have to back into it. They can use a transactions analysis to see this:
LO 4
Assume bad debt expense of 1% of credit sales of $100,000
Assets
Allowance for Doubtful accounts
(1000)
=
Liabilities +
SHE
+
Income Statement
Bad Debt Expense
(1000)
+
Income Statement
Bad Debt Expense
(2500)
OR, allowance of 5% of $50,000 of ending accounts receivable:
Assets
Allowance for Doubtful accounts
(2500)
Harcourt, Inc.
=
Liabilities +
SHE
7-9
FINANCIAL ACCOUNTING INSTRUCTOR’S MANUAL
LO 4
Refer to previous discussions of the cash cycle, current ratio, and inventory turnover. Now students
can see the usefulness of these ratios in determining how quickly a company can turn its investment in
inventory into cash to re-invest. The days in accounts receivable ratio completes the picture.
________________________
Learning Objective 4 discusses the use of subsidiary ledgers. A related activity is included in the
Projects and Activities section of Chapter 2 in this Instructor's Resource Kit.
7-10
Harcourt, Inc.
CHAPTER 7 — CASH, INVESTMENTS, AND RECEIVABLES
Projects and Activities
The Forms of Cash
LO 1
In-class discussion: PepsiCo cash and investments
PepsiCo, in their 1998 Annual Report, lists among their assets the following1 ($ millions):
Cash and cash equivalents
Short term investments, at cost
$ 311
83
n What is the difference between cash and cash equivalents?
n What is the difference between cash equivalents and short-term investments? Could any of
the short-term investments become cash equivalents in a future period?
Solution
n Cash is self-explanatory. Remind students that cash includes the petty cash fund, which may
be a separate ledger account but is not separately listed on the balance sheet. Many students
think that cash has to be in the form of cash “in hand.” Remind them that it can be in the bank
(or a number of banks) in a variety of different types of accounts. You might even want to
explain how companies often keep separate accounts for specialized purposes, such as payroll
accounts. Cash equivalents are “highly liquid” but not immediately accessible. A footnote to
PepsiCo’s 1998 Annual Report states:
Cash equivalents represent funds temporarily invested, with maturities of
three months or less. All other investment portfolios are primarily classified
as short-term investments.2
Short-term investments in equity securities (stocks) have no maturity date and thus would not be
classified as cash equivalents. Investments in debt securities (bonds, etc.) that have original maturities
to the investor beyond the three-month period that would classify them as cash equivalents, but within
a short period, are short-term investments.
Control Over Cash
LO 2
In-class discussion: Accuracy of reconciliation
You are busy reconciling your checking account statement. Noting that you are carrying all your
calculations to the penny, your friend is surprised. She keeps her checkbook in whole dollars, and
reconciles the account the same way. As long as her checkbook ties to the bank's balance to within a
dollar or two, why worry?
n What do you think of this method for a personal checkbook?
n Would a whole dollar approach be appropriate for a company? Would it matter if it were a
large or small company?
Solution
n For a personal account, this probably would not present any particular problem, as long as the
account holder is careful to keep complete, up-to-date records and an adequate balance to
cover any error that might occur. Errors can, of course, occur with to-the-penny balancing,
too.
1
2
PepsiCo, 1998 Annual Report, page 24.
Pepsio, 1998 Annual Report, Note 1.
Harcourt, Inc.
7-11
FINANCIAL ACCOUNTING INSTRUCTOR’S MANUAL
n However a company's books, as noted previously, must be accurate and short-cuts are not
acceptable. Remind students that the person reconciling a company's (large or small) bank
statement is managing someone else's money. The reconciliation is done to the penny. These
are issues of internal control as well as simple record-keeping. Finally, the time saved by
whole-dollar reconciliation is negligible.
LO 2
Control Over Cash
Ethical questions: Petty cash
Determine and defend the proper action for each situation below:
n The custodian of the petty cash fund for a small company routinely “borrows” a couple of
dollars from the box when she is short of train fare, or needs to pick up groceries on the way
home and is short of cash. She is always very careful to leave a scrap of paper in the box
indicating how much she has borrowed, and always repays the money within a day or two, or
at least on payday on Friday.
n A company maintains enough cash in the petty cash box so that they can cash small personal
checks for employees, up to $20. Any employee is allowed to use this service.
n A small company, in an attempt to separate custody of the petty cash fund from the
accounting and reconciliation of the balances, has given responsibility for the cash box to the
company's receptionist, who has no accounting experience but is mature and responsible, and
has worked for the company for five years.
Solution
n This situation is alarmingly common, especially in small companies where everyone is “one
big family.” The issue is one of control as much as ethics. No matter how honest the
custodian of the fund may be, that fund is not intended as a source of personal loans for one
person. This situation is risky, and the fact that it is done regularly is particularly troubling.
Under the right (wrong?) circumstances the borrowing could escalate into a more serious
problem.
n As long as the practice is done with the knowledge and consent of management, and is
available to everyone, there is no ethical or control problem inherent in cashing employees'
personal checks. The company would have to ensure that the practice is not abused, that the
amounts of the checks do not begin to inflate, or that bad checks do not occur in more than
“rare instances.”
n The actual dispensing of petty cash to reimburse properly documented expenses is not a
function that requires an “accounting person.” Any individual who is trustworthy and has
basic math skills can handle it. The goal of separation of duties is more important so the
arrangement is probably a good one. Some consideration might be given to the receptionist's
location. The area may be too open to the public and “unprotected." The duties as petty
cashier should not interfere with the receptionist's primary responsibilities.
Food for thought: What constitutes “petty” cash?
The professional staff of a consulting firm travels extensively, often on very short notice, to distant
locations throughout the world. The staff have expressed the opinion that they much prefer their travel
advances (which vary from a couple of hundred dollars to four or five thousand dollars, depending
upon the trip) in cash or travelers' checks rather than a check. They do not always find it convenient, or
even possible, to cash a check before they get under way. The company does not think this is an
unreasonable position, and is trying to decide how they will accomplish it.
n Is this a petty cash item?
n Should the balance of petty cash be increased to accommodate these requests?
n Draft a memo to the Controller of the company outlining your ideas about how to
accommodate this need. In considering a solution, you should be aware that, because of the
7-12
Harcourt, Inc.
CHAPTER 7 — CASH, INVESTMENTS, AND RECEIVABLES
locations of some of the customers, credit cards are not always an option. Credit cards are
still not everywhere you want to go.
Solution
n This is a petty cash item. The size of petty cash varies with the size and needs of the
company.
n The company in the question found that the requests for cash for travel were increasing, and
often the petty cash fund, already with a standing balance of $2,500, could not meet a request.
Once a week or more, situations arose where the cashier had no warning about these needs
(the sudden out-of-town trip).
n The first step was to increase the petty cash balance to $5,000. The company opened a special
bank account for travel funds, accessible on demand. Messengers were employed who could
be sent to obtain cash from this account within 30 minutes. When possible, the employees
would advise the cashier of their need for funds in advance so that a check could be written
and cashed against the travel account. This cash was designated for the employee, not
mingled with the regular petty cash funds.
n Employees had company credit cards that they could use for both paying their travel
expenses, and to obtain cash advances. However, many found that they needed to keep cash
available because at some of the locations they visited (many were remote) the credit cards
were useless. Night and weekend employees often held a standing cash advance in a safe but
accessible place so that they were ready to go even if the cashier were not available. The
company ledger had an asset, “travel advances.”
Investing Idle Cash
LO 3
Food for thought: Try out the treasurer’s job!
How does a company determine that they have “idle” cash and need to put it to work?
n Which items in a company's ledger would you consider if you want to calculate the company's
cash needs within one week? Within one month? Within three months? Within one year?
Beyond one year?
n Where would you look for the sources of the cash to fill these needs? Do you think you could
set up a schedule that would match sources and uses of cash, and predict the company's cash
surplus or shortfall in the near and distant future?
n How would you decide which financial instrument to invest any surplus in?
Solution
This question introduces the concept, without the mechanics, of cash budgeting.
n The company considers such needs as payroll and accounts payable due within the current
week. They also look at deadlines beyond the immediate ones to take advantage of cash
discounts. Within a month, there are again payables, and recurrent items such as rent and
utilities. Lease and mortgage payments are both short- and long-term obligations. The
company may have committed to large payments for assets or other purchases that will
require large amounts of cash in the future, or anticipate retirement of long-term debt. All
these can be scheduled fairly accurately.
n The needs are matched to current cash and investment balance, with maturities noted, and
receivables and other expected cash inflows. The difference will be the cash surplus or
shortfall in each time period.
n Any surplus is invested in instruments that mature in time for the company’s need for the
cash. The company balances the optimal returns desired against the ability to access the cash
as necessary. (Also see Food for thought, AMR cash and investments.)
Harcourt, Inc.
7-13
FINANCIAL ACCOUNTING INSTRUCTOR’S MANUAL
Food for thought: AMR cash and investments
AMR Corporation, in their December 31, 1998, Annual Report, lists the following 3($ millions):
Cash
Short-term investments
$
1998
95
1,978
1997
62
2,370
$
Note 24 explains the composition of the short-term investments:
Overnight investments and time deposits $ 133
$ 322
Corporate notes
950
921
Asset backed securities
498
428
U.S. Government agency mortgages
169
305
Other
228
394
$ 1,978
$ 2,370
Note 2 also states:
"All short-term investments are classified as available-for-sale and stated at fair value. Net
unrealized gains and losses, net of deferred taxes, are reflected as an adjustment to
stockholders' equity."
Note 35 does not outwardly refer to investments of this type. In this note, titled COMMITMENTS
AND CONTINGENCIES, to summarize, AMR includes a discussion of plans to acquire 144 aircraft
from Boeing and future planned expenditures of $2.1 billion over the next five years for
…modifications to aircraft, renovations of, and additions to, airport and office
facilities, and the acquisition of various other equipment and assets. AMR expects to
spend approximately $625 million of this amount in 1999.
n What are the characteristics of the available-for-sale investments that distinguish them from
trading or held-to-maturity securities?
n Explain the relationship between AMR's cash and investments, and their long-term financial
commitments. What is the relevance of AMR's Note 3, quoted in part above?
Solution
n Trading securities are held with the specific intent of sale in the near future. Available-forsale securities are marketable, but may not be sold as quickly. The company’s plan for
holding the securities, regardless of their characteristics, dictates their classification as current
or non-current. Held-to-maturity securities are debt securities, and the company’s intent is to
keep them until the maturity date.
n Questions could well arise concerning AMR’s large balances. The note on commitments and
contingencies explains in part their short- and long-term needs for cash, so that a reader will
see why they have built up this reserve, why it changes, and what future demands for
substantial amounts of cash are. Further notes also disclose commitments for such items as
leases and pensions, which also demand large amounts of cash.
LO 3
Investments in Available-for-Sale Securities
In-class discussion: GE investment securities
GE's balance sheet contains the following line item in their 1999 annual report, 6
3
AMR Corporation, 1998 Annual Report, page 38.
op. cit., page 44.
5
op. cit., page 44.
6
General Electric Company 1999 Annual Report, page 36.
4
7-14
Harcourt, Inc.
CHAPTER 7 — CASH, INVESTMENTS, AND RECEIVABLES
1999
$81,758
In millions
Investment securities (note 9)
1998
$78,717
Note 1 states:
"Investments in debt and marketable equity securities are reported at fair value based primarily on
quoted market prices or, if quoted prices are not available, discounted expected cash flows using
market rates commensurate with credit quality and maturity of the investment. Substantially all
investment securities are designated as available for sale, with unrealized gains and losses
included in share owners' equity, net of applicable taxes and other adjustments. Unrealized losses
that are other than temporary are recognized in earnings. Realized gains and losses are accounted
for on the specific identification method."7
Note 9 lists: in millions8
1999
Amortized Cost
Estimated Fair Value
$6,569
$9,479
Debt
$74,378
$72,279
Total
$80,947
$81,758
Equity
n
n
n
n
Why has GE classified these investments as available for sale?
What does GE mean by “amortized cost"?
Which of these securities could have been classified as held-to-maturity securities?
Why are the unrealized gains and losses included in share owners' (stockholders') equity?
Solution
n These investments do not qualify as trading securities and the bonds are not intended to be
held to maturity.
n Amortized cost is the purchase price of the securities less amortization of discount or
premium.
n Only debt securities can be classified in this way, because equity has no maturity date.
n Available for sale securities are marked to market each period, and the unrealized gains or
losses are accumulated in stockholders' equity in a separate equity, or contra equity, account.
The underlying theory for this treatment is that the inclusion in income of fluctuations in the
value of available for sale securities that are not actively being traded could lead to volatility
in reported earnings. These securities may be held long enough for market conditions to "turn
around".
Investments in Available-for-Sale Securities
LO 3
Food for thought: Significance of Intel Corporation's Investments
The December 26, 1998 balance sheet for Intel Corporation contains a line that reads:
Accumulated other comprehensive income (in millions)
1998
$ 603 1997
$58
The related footnote states:
"Accumulated other comprehensive income presented in the accompanying balance
sheet consists of the accumulated net unrealized gain on available for sale
investments."9
7
Op. cit., page 57.
Op cit., page 63.
9
Intel Corporation, 1998 Annual Report.
8
Harcourt, Inc.
7-15
FINANCIAL ACCOUNTING INSTRUCTOR’S MANUAL
n Into which classification of securities does this fall?
n Would you prefer to see this item as a part of income? Why or why not?
n Should unrealized gains be recognized at all, or would you prefer that only unrealized losses
be recognized? Support your answer with relevant accounting principles.
n Why would the amount jump from $59 million in 1997 to $603 million in 1998?
Solution
n The securities, by their accounting treatment, are available for sale securities.
n Since the gain on marketable securities can only be realized by the company if they sell the
shares, it is not relevant except to show readers that the company has some very healthy
investments. The market is volatile, so the gain is only as good as the market on the particular
day on which the unrealized gain or loss is calculated. Unrealized amounts are an unreliable
addition to income. Students' opinions may vary, although they are usually surprisingly
conservative.
n This is an interesting discussion because experts with many years of experience do not agree.
Students should realize that their arguments can be as valid as anyone else's if they have solid
accounting theory behind them.
n The increase in the amount of unrealized gain may be attributable to a healthy stock market.
LO 4
Accounts Receivable
In-class exercise: Accounts receivable and bad debts
Hues, Inc. had an Accounts Receivable balance at December 31, 1998, of $130,000. Their subsidiary
ledger showed the following customer balances:
Honey
Iris
Jonquil
Kaffe
Lily
Mauve
Neutra
$12,000
10,000
20,000
30,000
45,000
5,000
8,000
$130,000
n Is it likely that every one of these customers will pay the entire debt they owe?
n If not, which one(s) will not pay? How much are they not going to pay?
n If Hues is certain that some of the accounts will be uncollectible, but we do not know which
customers and how much, what should Hues do?
n Suppose Hues decides to wait until an account actually becomes uncollectible. Eventually,
the $45,000 Lily account cannot be collected, in the year following the sale. Which
fundamental principle is violated?
n How can Hues remove a specific account from Accounts Receivable in the current year if
they do not know specifically who will not pay?
n How does Hues know at the time of the sales that some of the accounts will not be paid?
n How can Hues use that information to estimate how much of the $130,000 will eventually be
written off?
n What does Hues do with the estimated amount? Is it an expense for the current year? Should
Hues remove it from accounts receivable? Why or why not? Explain how the estimate is
accounted for.
7-16
Harcourt, Inc.
CHAPTER 7 — CASH, INVESTMENTS, AND RECEIVABLES
Solution
This deliberately oversimplified exercise may help students arrive on their own at the “theory” of the
bad debt allowance. Present it before discussing the allowance in detail, perhaps even before students
read the section in the text, so that they think it through themselves in simple terms before they
convince themselves that they do not understand the accounting terminology. Proceed one question at
a time.
n Will every customer pay all they owe? Sadly, no.
n Who is not going to pay, and how much, is the problem. Hues has no idea whatsoever, or
they would not have extended credit to that customer in the first place.
n What does Hues do? Some students will suggest a “wait and see what happens” attitude, or
will say that a company should always try to collect everything.
n If Hues waits until the $45,000 account goes bad, about 35 percent of last year's ending
balance is written off, a very significant number. The matching principle is violated.
n How can Hues remove one customer from the books this year? They can't! They have to
account for the possibility of bad debts before they happen, in a non-specific way, an
estimate.
n Hues knows some accounts will not be collected from their own past experience. Other
businesses in the neighborhood talk about bad debt problems. The newspapers contain
articles discussing the effects of unpaid accounts on business.
n Hues has historical information on bad debts, so it can calculate a mathematical “average” bad
debt percentage to apply to this year's ending accounts receivable, to estimate the bad debt
expense that will result from this year’s sales.
n Hues wants to recognize the expense in the year of the sale. Because Hues has no customer to
credit, the estimated expense cannot be credited to Accounts Receivable. But Hues is certain
it will eventually collect less than the total accounts receivable. At this point, ask if students
notice this is similar to Accumulated Depreciation, which reduced an asset without altering
the historical cost balance of the asset account itself. This bad debt estimate, whatever name
it is given, creates another contra account. Students should realize that the name it is given
(and they'll find there are many) is not important, but its function is the important part. Refer
to it as a “BUT” on the balance sheet. We have $130,000 of accounts receivable, BUT we
only realistically expect to collect, for example, $92,000.
Accounts Receivable
LO 4
In-class discussion: Alternate terminology
The following is taken from the asset section of a recently issued annual report ($in millions):
Loans, net of unearned income
Allowance for possible credit losses
$ 244,206
(6,679)
n What sort of business do you think this company is in? (Their total assets are approximately
$717 billion).
n Explain the allowance in terminology that you have learned in this chapter.
n Is the basic accounting for these transactions the same as what you have learned for retailing?
Don’t worry about additional industry-specific rules you may not know.
Solution
n These amounts are from the Balance Sheet of Citigroup Inc., a banking and financial services
company.
n The allowance is their bad debt allowance. The unearned income (not addressed in the
question) results from the deferral of commitment fees and loan origination costs. These are
amortized over the life of the loan at the related loan’s yield.
Harcourt, Inc.
7-17
FINANCIAL ACCOUNTING INSTRUCTOR’S MANUAL
n Accounting for loans and loan impairments is covered by separate standards as well as by
banking regulations, but the basic principle is the same. The company makes an allowance
for the possibility that everyone who borrows money will not necessarily pay it back.
Outside assignment: The impact of bad debts
A Wall Street Journal article 10 said the following about Community Psychiatric Centers (CPC), a
health care provider, for the quarter ending August 31, 1991: “Net income fell to $435,000, or one cent
a share, after $23 million of charges largely for uncollected bills. In the year-earlier quarter, profit was
$19.7 million.…" Subsequently, in the company's fourth quarter, an additional write-down of accounts
receivable increased the reserve by another $14 million, making the total write-down to bad debts for
the year $37 million.
n Community Psychiatric had a reserve for bad debts. Can you explain why a company with a
reserve might still find it necessary to write off an additional amount of this magnitude?
n Did this write-down have an effect on average “days in accounts receivable?” Do you think it
might have been intended to have an effect on this ratio?
n The headline on the article read “Stock Plummets.” The price of the stock fell 35 percent in
two days. Revenues only decreased 5%. Why did investors react so strongly to the bad debt
figure with revenues almost stable?
n The following figures are available from CPC's annual reports 11($000):
Revenues
Accounts receivable, net
1992
$344,274
77,342
1991
392,873
86,087
1990
371,221
115,803
Calculate CPC's average days in accounts receivable for 1990 through 1992 (use accounts receivable
instead of average accounts receivable in 1990). Are these figures consistent with your answers
above?
Solution
n The following information is summarized from the management discussion in CPC's 1991
annual report12, concerning the composition of the $23 million, and the additional $14
million:
($ million)
Reserve for accounts receivable from a health care plan, under
negotiation, with uncertain results
Reserve against accounts receivable from a closed facility
Addition to general reserve for uncollectible accounts, “to reduce
days of revenue in accounts receivable to previous
historical levels”
Additional reserve, fourth quarter, “to provide an adequate allowance”
Total additions to reserves
$ 7
3
13
23
14
$ 37
n CPC wanted to reduce days in accounts receivable, as well as provide for unusually large bad
debts. They cited in the management discussion a slowdown in billing and collection activity:
“… significant increase in admissions (16%) during the first two quarters coupled with
increased volume and complexity of managed care contracts overburdened the hospitals'
patient business operations …"
10
“Community Psychiatric's Net Fell 98% In Fiscal Third Quarter; Stock Plummets,” The Wall Street
Journal, September 30, 1991.
11
Community Psychiatric Centers, 1993 Annual Report.
12
Community Psychiatric Centers, 1991 Annual Report.
7-18
Harcourt, Inc.
CHAPTER 7 — CASH, INVESTMENTS, AND RECEIVABLES
n Stockholders were unhappy because management appeared to have “dropped the ball.”
Stockholders questioned whether the company could continue to successfully manage its
affairs. Revenues must be collected to be useable. Perhaps stockholders overreacted. An
administrative correction caused a stock reaction that may have been somewhat out of
proportion. Management did cite steps being taken to improve the financial results.
However, it is interesting to note that several securities and shareholder class action lawsuits
were filed subsequent to this announcement, against the company, its officers and directors,
charging breach of fiduciary duty, waste of corporate assets, gross mismanagement, making
false and misleading statements, and failure to disclose material adverse information. The
suits were subsequently consolidated into a single action. Late in 1994 the company installed
a new management team. In 1995, they reached an agreement to settle the lawsuits for $46.5
million in cash and the company’s common stock. They continued to maintain that the claims
were without merit, but believed that it was prudent to settle rather than incur additional
expense and management time in continued defense.13
n
Days in accounts receivable
1992
86.7
1991
94
1990
114
The comparative ratios indicate a clear effort to reduce the time accounts receivable are outstanding.
However, CPC did so at least in part in 1991 by increasing the dollars they consider uncollectible, not
by actually collecting more dollars. This is hardly news to give a stockholder confidence. The proof
of the remedial measures is in the following year's (1992) performance, without the additional writeoffs. The days in accounts receivable average for 1992 was 86.7, indicating that indeed collections
were made a priority.
Outside assignment: Follow-on to previous assignment
In Chapter 2, you were asked to examine the current ratio for Gateway (Chapter 2, LO 4, “Gateway
Current Ratio"). At that time you had no information about how to further explore the components of
this ratio. You now know two other items, the days in inventory and the days in accounts receivable,
that help to refine the analysis of the current ratio.
n The days in accounts receivable and days in inventory are included in the 1998 annual report
for Gateway. Do these change your opinion of Gateway's current ratio? Explain why or why
not.
n What additional information would you find useful? How would it help you?
13
Community Psychiatric Centers, 1993 through 1995 Annual Reports.
Harcourt, Inc.
7-19
FINANCIAL ACCOUNTING INSTRUCTOR’S MANUAL
Solution
n As stated in Chapter 2 for 1998:
Days in accounts receivable
Days in inventory
Total cycle
days
22
9
31
Days in accounts payable
38
In approximately 31days, an inventory purchase becomes cash. Note also that the
company takes approximately 38 days to pay for the inventory purchases.
Student responses, as to a change in their opinions of the current ratio, will vary.
n In addition to analyzing Gateway’s days in accounts payable, students may want to compare
Gateway to Dell Computer (or to other computer manufacturers) to gain perspective on what
is “good.” Dell, in the same year, showed:
LO 7
Days in accounts receivable
Days in inventory
Total cycle
36 days
7 days
43 days
Days in accounts payable
51 days
Accelerating the Inflow of Cash from Sales
In-class discussion: AMR accounts receivable and allowance
AMR Corp. in Note 3 to their December 31, 1992, annual report14, stated that "…American transfers
on a continuing basis …an undivided interest in a designated pool of receivables …" They disclosed
approximately $300 million of these transferred receivables, not reflected on AMR's balance sheet, at
the end of 1992. Further, “American maintains an allowance for uncollectible receivables based upon
expected collectibility of all receivables, including the receivables transferred."
n What do you think AMR meant when they said they “transfer” some of their accounts
receivable?
n Why are these receivables not on the balance sheet?
n Do you think the receivables were transferred with or without recourse? Why or why not?
n Why did AMR maintain a provision in their allowance for receivables that are not on the
balance sheet?
n From the wording of the footnote would you imagine that AMR bases their allowance
calculation on credit sales or ending accounts receivable?
n Do you think transferring accounts receivable has an effect on a company’s accounts
receivable turnover ratio? Why or why not?
n This statement does not appear in the 1998 Annual Report of AMR Corporation. Why do you
think it was an accounting issue in 1992 but not in 1998?
Solution
n The transfer of accounts receivable is similar to the discounting of notes. AMR transferred to
a bank the right to collect a portion of their accounts receivable, probably large accounts with
companies with established credit ratings.
14
7-20
AMR Corporation, 1992 Annual Report, page 44.
Harcourt, Inc.
CHAPTER 7 — CASH, INVESTMENTS, AND RECEIVABLES
n The accounts were not on the balance sheet because American “collected” them. The bank
gave AMR the book value of the accounts, less a collection fee.
n The fact that AMR maintained a bad debt allowance for these receivables, however, indicates
that the receivables were factored with recourse. AMR in reality plainly stated this in the
footnote. The full text of the above quote is, “…American transfers on a continuing basis and
with recourse to the receivables an undivided interest…." (Emphasis added.) AMR allowed
for the possibility that some of these receivables, like any other receivable, could be
uncollectible.
n The allowance calculation is probably based upon ending accounts receivable.
n This acceleration of collection would positively affect the turnover ratio. The early inflow of
cash from the bank would shorten the number of days that at least some portion [and for AMR
the note indicates it is a fairly significant portion—300 ÷ (947 + 300) = about 24%] will be
collected much more quickly.
n The economy in 1998 is different from the 1992 economy. AMR used other methods to
obtain financing. Discounting accounts receivable can be an expensive way to borrow
money.
Accelerating the Inflow of Cash from Sales
LO 7
Food for thought: Credit card debt
Occasionally banks that issue major credit cards “auction off” millions of dollars of their bad credit
card debt. The banks have exhausted their usual extensive means of collection. They offer to sell the
lists of the debtors, with all the information the bank has, to the highest bidders. The debt sells for a
penny or two on the dollar.
n Who lost money on this debt? Was it the merchants who made the sales, or the banks that
issued the cards?
n How do banks protect themselves against losses like this? Are they wrong to give up on
collection?
n What does an auction like this mean for the people who owe the money and have not paid?
What if you knew that your name, address, telephone number, employer, and other personal
data were on that list?
n Who do you suppose would buy these bad debts?
Solution
n The merchants collected their money, less a fee, from the issuing bank a long time ago. It is
the issuing bank who lost the money.
n The banks have reserves for bad debts and charge everyone who owns a credit card (and uses
it and then elects to pay in installments instead of when the bill comes) an interest rate
intended to make up for those who do not pay. It is now public knowledge that these rates are
steep. An article in the Wall Street Journal reports that banks borrow at 4% to 5% and loan
the money to customers at 17%.15
n The people who owe have now had their names and credit information passed on to yet
another party. Their credit rating is already ruined, as the first place the information went was
to a credit bureau. Now these debtors are subject to being called by yet another collection
agency, but they are either inured to it by now, or have disappeared so that they cannot at least
for now be found to be called. When you choose to use a credit card, you also choose to give
up part of your privacy.
n Some “private” collection agencies find enough money from these lists to make them worth
their relatively small purchase price.
15
Hays, Laurie, “Banks’ Marketing Blitz Yields Rash of Defaults,” The Wall Street Journal,
September 25, 1996.
Harcourt, Inc.
7-21