Lecture #8: Short-Term Investment and Receivables
Cash is the typical means by which companies pay their obligations. Good management requires that companies keep some surplus cash balances. Companies can invest their surplus cash in short-term investments, which earn high-rates of interest. Checking accounts tend to earn little or no interest at all.
Companies can invest their surplus of cash in gov. or corporate bonds, or in corporate stock. These assets can be sold quickly for cash, when companies need to use their money. These investments are held for a short period of time. These investments are called short-term investments. They are classified on the balance sheet as current assets.
For example, if Ford Motor Company’s short-term notes payable is purchased for $40,000, you record the purchase as follows:
When these notes mature, then you record the transaction as:
When you determine the cost of an investment, you must include any commissions paid: For example, if 1,000 shares of Xerox Corp. common stock are purchased as a short-term investment at 70 1/8 (i.e. $70.125 per share), plus a $626 broker’s commission, the entry to record the transaction is:
If you receive cash dividends from holding this stock, then:
When a short-term investment is sold, the difference between the cost of the investment and the cash proceeds from the sale is recorded as a gain or loss. For example, if 500 of the Xerox common shares are sold on Dec. 20 for 69 1/4 per share less a $350 commission, the sale is recorded as follows:
Cash received: 500 X 69.25 - 350 = $34,275 The initial investment: $70,750 / 2 = $35,375
The amount of loss on this investment is: $1,100
Investment in debt obligations usually are maintained in the accounts at the cost until they are sold (or mature). However, marketable equity securities (i.e. stock) are likely to fluctuate in market value. These marketable securities must be reported on the balance sheet at the lower of cost or market value. You compare your cost of purchasing these securities to its market value. Then you select the lower cost to report on the balance sheet. For example, the total firm’s purchase of stock:
The market value is lower, so you record this amount on the balance sheet. You have a market value loss of:
108,475 - 105,700 = $2,775. You have to record this loss in the General Journal:
The Loss on Short-Term Investment account is closed to Income Summary and reported on the income statement. The Allowance to Reduce Short-Term Investments to Market account is a contra account. You subtract this amount off the short-term investments on the balance sheet. This method does recognize changes in market value. You are recognizing all potential losses, but you do not recognize any potential gains in stock prices. This method provides a conservative balance sheet valuation.
Credit Card Sales
Many customers use credit cards, such as VISA, Mastercard, or American Express to charge purchases from various businesses. Benefits for customers:
Benefits for the stores:
Usually businesses are charged 2% to 5% of credit card sales by the credit card companies. This is the business’s cost of using the credit card service. This is deducted from the cash payment to the business. For example, the store immediately received payment for a credit card purchase of $100. The journal entry:
If the business must send the receipts to the credit card company and wait for payment, the entry to record credit card sales is:
When cash is received from the credit card company, the entry to record the receipt is:
You record the credit card expense on the income statement. It can be classified under a deduction from sales, or a selling expense, or as an administrative expense. Arguments can be made for all three alternatives.
1. When you record credit sales, you maintain a record for each customer. These records include:
The total amount of all credit purchases are recorded in the General Ledger under the single account Accounts Receivable. You can also use a supplementary journal called the Accounts Receivable Ledger to facilitate the process of recording transaction.
2. When a company grants credit to its customers, there usually are a few customers who do not pay. The accounts of such customers are called bad debts and are an expense of selling on credit. Why do businesses take this risk? To increase their profits by taking a reasonable loss from bad debts. You have to use the matching principle. This means that bad debt expenses should be reported in the same accounting period as are the revenues they helped to produce. However, there is a period of time (i.e. a year or more) until the business knows that it is unable to collect the debt. To use the matching principle, the business has to estimate its bad debt expenses.
Allowance Method of Accounting for Bad Debts
This method results in two benefits:
(i) The estimated loss is charged to the period in which the revenue is recognized.
(ii) The accounts receivable is reported on the balance sheet at the amount of cash proceeds that is expected from their collection.
1. Recording the estimated bad debts expense.
For example, a company had credit sales of $300,000 during the first year of its operations. At the end of the year, $20,000 remains uncollected in accounts receivable. This company estimates that $1,500 of accounts receivable will be uncollectible. The journal entry:
2. Bad Debts in the accounts and in the financial statements. Recording this on the balance sheet.
3. Writing off a bad debt.
When an account is deemed uncollectible, then you have to write this off. Using the same example, after spending a year trying to collect, this company decided the $100 account of Jack Vale was uncollectible, and made the following entry to write it off:
Two observations about this entry.
Also you keep a record of Jack Vale, so you will never give him credit again.
4. Bad Debt Recoveries.
Sometimes after an account is written off as uncollectible, the customer voluntarily pays all or part of the amount owed. For example, Jack Vale decided to pay his debt of $100. The journal entry to reinstate Jack’s account.
If a business only receives a partial payment, then the business can decide if it wants to reinstate the whole amount.
Estimating the Amount of Bad Debts Expense
You know that at the end of each accounting period, you have to estimate the bad debts expense for the period. The entry takes the form of:
There are two broad alternatives to estimate bad debts expense and sales.
1. Estimating bad debts by focusing on the income statement.
The estimation of bad debts is based on the idea that some particular percentage of a company’s credit sales will become uncollectible. For example, Baker Company had credit sakes of $400,000 in 1990. Based on past experience and the experience of similar companies, Baker Company estimates that 0.6% of credit sales are uncollectible. Using this estimate, Baker Company can expect $2,400 (= $400,000 X 0.006) of bad debts expense to result from this year’s sales.
F Remember this is only an estimate.
2. Estimating bad debts by focusing on the balance sheet. This method is based on the idea that some portion of the receivables on the balance sheet will become uncollectible. There are two techniques.
(i) A simplified balance sheet approach. A company estimates that a certain percentage of its outstanding receivables will become uncollectible. This estimated percentage is based on past experience and the experience of similar companies. For example, assume that on Dec. 31, 1989, Baker Co. estimated that $2,000 of accounts receivables were uncollectible. During 1990, three customers were written off, so the account for Allowance for Doubtful Accounts has a credit balance of $200.
On Dec. 31, 1990, Baker Co. has $50,000 of outstanding accounts receivable. Past experience indicates that 5% of outstanding receivables will become uncollectible. Thus after the adjusting entry is posted, Allowance for Doubtful Accounts should have a $2,500 credit balance. Remember that this account already has a $200 credit balance, so the adjusting entry for Dec. 31, 1990 is:
F Now the balance for Allowance for Doubtful Accounts is $2,500.
(ii) Aging of accounts receivable. Outstanding receivables are classified in terms of how long they have been outstanding. Then the estimation of uncollectible accounts is based on the idea that the longer an amount is outstanding, the more likely it will be uncollectible.
The following example indicates that $2,290 should be recorded in the Allowance for Doubtful Accounts.
F The aging of accounts receivable allows a more detailed examination of outstanding accounts and is usually the most reliable.