Financial Assets
A D V E R T I S E M E N T
Chapter 7 discusses financial assets: Cash, Accounts
Receivable, Short Term Investments.
What are financial assets
Financial assets include Cash, and those assets that can be
converted to cash in a reasonably short period of time - one year at most, but
less time in many cases. We will study the following financial assets:
- Cash
- Cash Equivalents
- Short Term Investments
- Accounts Receivable
Valuation of financial assets
Financial assets are valued as of balance sheet date, when
financial statements are prepared. They are valued at the equivalent of their
current Cash value - what they would be worth if we could convert them to cash
now. In the case of Cash, it is already at it's current value. Short Term
Investments are reported at their current market value. Accounts Receivable are
adjusted for possible bad debts.
Cash and Cash Equivalents
Cash is just as the word suggests. It includes cash money
including paper and coins, checks and money orders to be deposited, money
deposited in bank accounts that can be accessed quickly. The term liquid refers
to Cash, and the ease or difficulty of converting an asset into Cash.
Cash Equivalents are highly liquid short term investments
that can be turned into Cash very quickly. These include US Treasury bills,
money market accounts and high grade commercial paper. When corporations
need to borrow money for a very short time, they often sell commercial paper.
These come due within a few months at most, and pay a higher interest rate than
other investments.
Bank Reconciliation
Banks send statements to their depositors each month. A bank
reconciliation compares the information in the bank statement with the company's
Cash account, and finds any discrepancies. These are recorded or dealt with as
needed. The process is fairly simple.
The bank balance and book Cash balance are listed on a piece
of paper (now we often use computers). Some items show up on the bank statement,
but have not been reflected in the books yet. These items will be added to or
subtracted from the book balance.
Some transactions have been recorded in the books, but have
not yet cleared the bank. These include deposits in transit, which are not yet
posted in the bank's records - those made after the date of the bank statement.
And outstanding checks - those which have been written and mailed, but haven't
cleared the bank yet. These items are added to or subtracted from the bank
balance.
Once all items have been included, the adjusted bank and book
balances should be equal. If they are not, the reconciliation needs to be
reviewed and corrected until the two amounts are equal.
Bank Reconciliation
| Adjustments to Bank Balance |
Adjustments to Book Balance |
| Add Deposits in transit |
Add anything on bank statement that increases cash
balance, but has not been recorded in the books: bank collections,
interest earned |
| Subtract Outstanding checks |
Subtract anything on bank statement that decreases
cash balance, but has not been recorded in the books: bank charges and
fees, bad checks, interest charges |
| Bank errors (add or subtract as needed); notify bank
of error; these don't happen very often, but we need to watch for them |
Add or subtract for accounting errors relating to
deposits or checks. |
| Do not record any of these adjustments in the books. |
These adjustments must be entered as journal
entries, so the books agree with the bank balance. |
Short Term Investments
Short Term Investments include stocks and bonds that the company
intends to hold only for a short time, and then sell and convert back to Cash.
We consider it a good practice to convert unneeded cash to an investment
account, where it can earn interest, dividends or show capital gains. These are
shown on the balance sheet at their current market value, even if that is higher
than the price paid for the investments. This is one of the few times we
increase a balance sheet item above it's historic cost.
Accounts Receivable
Companies often sell to their customers on credit. The amount
the customers owe is called Accounts Receivable (AR). We would record AR at the
same time the sale is made, deducting any cash paid at the time of purchase,
etc. When customers pay, we subtract the payment from their accounts receivable
balance.
Most companies use an Accounts Receivable Subsidiary Ledger,
which is similar to the General Ledger. The subsidiary ledger contains detailed
information about each customer's account - purchases, payments, returns,
adjustments, etc. Most companies send statements at the of each month, listing
the monthly transactions and ending balance due from each customer.
Uncollectible Accounts
When businesses sell on credit, they run the risk that some
customers will not pay their bill. Legitimate complaints, errors in billing ,
etc. are dealt with in an appropriate manner, and the books are adjusted as
needed to correct any errors, or show returns and allowances (price
adjustments). Still, some customers don't pay their bill, for any of a variety
of reasons, and we must have a way to deal with this in the books, and on the
financial statements.
We do this by setting up an account that is a companion to
Accounts Receivable. It is called the Allowance for Uncollectible Accounts (or
something similar - Allowance for Doubtful Accounts is often used
Allowance for Doubtful Accounts is called a contra-asset
account. It is a companion to Accounts Receivable, and has an opposite balance.
When we net the two balances, we get the amount we expect to collect from
customers, allowing for those who don't pay.
The allowance account is established each year, at balance
sheet date. We usually prepare an Accounts Receivable aging report, which gives
us a history of customers accounts tabulated in columns, each column
representing one month. We can quickly see which customers are late paying their
bills by 30 day, 60 days, 90 days, etc. We would expect that if a customer
hadn't paid their bill after 90 days there is a good chance they won't pay at
all. The risk of loss goes up as accounts go unpaid for longer periods of time.
Companies use the aging report to make a dollar estimate of
how much they will lose in unpaid account balances. At that time we have no way
to know exactly which customers won't pay. But by tracking its business history
a company can estimate a dollar amount that they believe is reasonable.
When the allowance account is established, an expense account
is also debited. That account is called Uncollectible Accounts Expense, Bad Debt
Expense, Provision for Bad Debt, or something similar. So the loss due to bad
debts is recognized as a normal business expense on the Income Statement.
Writing Off Bad Debts
Periodically, and no less than once a year, a company must
review it's accounts receivable and identify any customers who have not paid
their bill for a very long time, generally over 90 days. Information is gathered
about these customers, and attempts at collection should be made. However, the
customer may be out of business, bankrupt, etc. and it is unlikely the company
will be paid by these customers.
When this happens, the debt is no good and should be removed
from the books. We do that by making an entry to both Accounts Receivable and
the allowance account, reducing the balance in both accounts. Writing off bad
debt should be done with management's approval. Potentially collectible accounts
should be pursued; only legitimately uncollectible accounts should be written
off.
The allowance method is acceptable for accounting, and
correct under GAAP. However, no allowance expense is permitted for tax returns.
Only accounts actually written off can be expensed on a tax return, and then
only in the year the account is deemed uncollectible.
Financial Analysis
Financial statements contain valuable information, but it must
be analyzed to make relevant and correct decisions. Certain ratios are commonly
used by investors and analysts. These are not difficult. All the information you
need is already in the financial statements, as required by GAAP. And these
ratios are used by thousands of people on a daily basis. No college degree or
great math skills are required to use financial ratios.
Ratios can be used to evaluate a company's performance over a
number of years. It can also be used to compare several different companies.
Bankers often use ratios when considering a loan application. And investors
calculate ratios to decide which stocks to buy or sell.
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