1. Define financtal assets and explain their valuation in the .balance sheet.
2. Describe the ,objectives of cash management.
3. Explain means of achieving internal control over cash transactions,
4: Peoare a bank reconciliation and explain its purpose.
5. Account for uncolleciible receivables using the allowance and direct write-off methods.
6.valuate the liquidity of various financial assets.
7. Explain how transactions discussed in this chapter affect net income and cash flows.
8. Account for transactions involving marketable securities.
U.S. COMPANIES ARE PILING UP CASH. IS THAT A PROBLEM?
What a windfall. General Motors disclosed that it ended a recent ~ear with cash reserves .of $17 billion- $2 billion more than analysts had expected and some $4 billion more than the company says it needs as a .cushion against future economic downturns. GM attributed the late-year cash surge to a well-timed tax . refund and bettermanag~ment of inventory and receivables. Result: what, GM Chief Financial Officer J absolute powerhouse cash position.”
Why is this huge cash buildup happening now? After years of restructuring, corporate balance sheets are bearing fruit. “Companies are better managed, and they’re returning strong earnings and lots of cash, ‘.• says Abby Joseph Cohen, market ,strategist for Goldman, Sachs & Co. Restru.:turl~g has boosted earnings at a,much faster rate than revenue growth. But fearing a coming slwdown, companies are also throttling back capacity expansion, leaving them sitting on excess cash.
Every business needs enough cash to pay its bills. But cash-rich. companies like General Motors, Intel, and ‘ Microsoft realize that cash is not a very “productive” asset-that is, it generates little or no revenue. In fact, banks are prohibited by I~w from paying interest on corporate checking accounts. Therefore, many financially sound companies store much of their cash in highly IiqUig, low-risk financial investments such as money
How Much Cash Should a Business Have?
Most business people would say. “As little as necessary.” ‘
In a well-managed company, daily cash receipts are deposited promptly in the bank. Often. a principal source of-these daily receipts is the collection of accounts receivable. If the daily receipts exceed routine cash outlays, the company can meet its obligations while maintaining relatively low balances in its bank accounts. – Cash that will not be needed in the immediate future often is invested in highly liquid, short-term securities, These,investments are more productive-than cash. because they earnrevenue=-in the forms of interest and dividends. If the business should need more cash than it has in its bank-accounts, it can easily convert some of its investments back into cash
The Valuatlnn of Financial Assets
In the balance sheet. financial assets are shown at their current values, meaning the amounts of cash that these assets represent. Interestingly, current’ value is measured differently for each type of financial asset, The current value of cash is simply its face amount. But the current value of marketable securities may change daily, based on fluctuations in stock prices, interest rates, and other factors. Therefore, short-term investments appear in the balance sheet at their
current market values. (Notice that the valuation of these investments represents an exception to the cost principle.)
Accounts receivable, like cash, have stated face amounts. But large companies usuall)’ do not expect to collect every dollar of their accounts receivable. Some customers simply will be unable to’ make full payment. Therefore, receivables appear in the balance sheet at the estimated collectible amount-called net realizable value.
These three methods of determining the current value of financial assets are summarized below:
Account~ts define cash as money on deposit in banks and any items that banks will accept (or deposit. These items include not only coins and paper money, but also checks, money orders, and travelers’ checks. Banks ‘also accept drafts signed by customers using bank credit, cards. such as Visa and MasterCard. Thus sales to customers using bank cards are cash sales, not credit sales, to the enterprise that makes the sale.
Most companies maintain several bank accounts as well as keep a small amount of cash ‘on hand. Therefore, the Cash accounting the general ledger is often a controlling account. A cash subsidiary ledger includes separate accounts corresponding to each bank , account and each supply of cash on hand within the organization
Reporting Cash In the Balance Sheet
Cash is listed first in the balance sheet because it is the most liquid of all current assets. For purposes of balance sheet presentation, the balance in the Cash controlling account is combined with that of the controlling account for cash equivalents.
Some short-term investments are so liquid that they are termed cash equivalents. Examples include money market funds, U.S. Treasury bills, and high-grade commercial paper (very short-term notes payable that are issued by large, creditworthy corporations). These assets are considered so similar to cash that they are combined with the amount of cash in the balance sheet. Therefore, the first asset listed in thebalance sheet often is called Cash and Cash Equivalents
Some bank accounts are restricted as to their use, so they are not available to meet the normal operating needs of the company. For example, a bank account may contain cash specifically earmarked for the acquisition of plant assets. Bank accounts in some foreign countries are restricted by laws that prohibit transferring the money to another country, Cash that is not available for paying current liabilities should not be viewed as a current asset. Therefore, restricted cash should ‘be listed just below the current asset section of the balance sheet in the section entitled “Investments and Funds.”
As a condition for granting a loan. banks often require the borrower to maintain a compensating balance (minimum average balance) on deposit in a non-interest-bearing checking account, This agreement does not actually prevent the borrower from using the cash, but it does mean the company must quickly replenish this bank account. Compensating balances are included in the amount of cash listed in the balance sheet, but these balances should be disclosed in the notes accompanying the financial statements
Lines of Credit
Many businesses arrange lines of credit with their banks. A line of
credit means that the bank has agreed in advance to lend the company any amount of . money up to a specified limit. The company can borrow this money at any time simply . by drawing checks on a special. bank account. A liability to the bank arises as soon as any money is borrowed-c-thatis, as soon as a portion of the credit line is used “. – The unusedponion of a line of credit is neither an asset nor a liability; it represents only the ability to borrow money quickly and easily. Although an unused line of credit does not appear as an asset or a liability in the balance sheet. it increases the company’s solvency. Thus unused lines of credit usually are disclosed in notes accompanying the financial statements.’
The term cash management refers to planning. controlling, and accounting tor cash . transactions and cash balances. Because cash moves so readily between .Hints and other-financial assets, cash management. really means the management resources.Efficient management of these resources is essential to the success-even to the survival-of every business organization: The basic objectives of cash management are as follows
Using Excess Cash Balances Efficiently
Cash equivare.its are safe, liquid investments, but they generate only a modest rate of return. These investments are useful for investing temporary surpluses of cash, which soon will be needed for other purposes. If a business has large amounts of cash that can be invested on a long-term basis, however. it should expect to earn a higher rate of return than is available from cash equivalents. Cash
that is available for long-term investment may be used to finance growth and expansion of the business, or to repay debt. If the cash is not needed for business ‘purposes, it may be distributed to the company’s stockholders.
Internal Control over Cash
Internal control over cash is sometimes regarded merely as a means of preventing fraud and theft. A good-system of internal control, however. will also aid in achieving the other objectives of efficient cash management. including accurate accounting for cash transactions. anticipating the need for borrowing, and the maintenance of adequate but not excessive cash balances.
A company may supplement its system of internal control by obtaining a fidelity bond from an insurance company. Under a fidelity bond, the insurance company agrees to reimburse an employer for proven losses resulting from fraud or embezzlement by bonded employees.
Cash Over and Short
In handling over-the-counter cash receipts, a few errors in making change inevitably will occur. These errors may cause a cash shortage or overage at the end of the day when the cash is counted and compared with the reading on the cash register.
For example, assume that total cash sales recorded on the point-of-sale terminals during the day amount to $4,500.00. However, the cash receipts in the register drawers total only $4,487.30. The following entry would be made to adjust the accounting records for this $12.70 shortage in the cash receipts
The account entitled Cash Over and Short is debited with shortages and credited’ with overages. If the account has a debit balance, it appears in the income statement as miscellaneous expense; if it has a credit balance, it is shown as miscellaneous revenue.
To achieve adequate internal control over cash disbursements, all payments-except those from petty cash-should be made by check. The use of checks automatically provides a written record of each cash payment. In addition, adequate internal control requires that every transaction requiring a cash payment be verified, approved, and recorded before a check is issued. Responsibility for approving cash disbursements should be clearly separated from the responsibility for signing checks.
The Voucher System
One widely used method of establishing internal control over cash disbursements is a voucher system. In a typical voucher system, the accounting department is responsible for approving cash payments and for recording the transactions.
In approving an expenditure, the accounting department will examine such supporting documents as the supplier’s invoice, the purchase order, and the receiving report. Once payment has been approved, the accounting department signs a voucher authorizing payment and records the transaction in the accounting records. (Other names for a “voucher” include invoice approval form and check autharization.i The voucher and supporting documents then are sent to the treasurer or other official in the finance department. This official reviews the voucher and supporting documents before issuing a check. When the check is signed, the voucher and supporting documents are perforated or stamped “PAID” to eliminate any possibility of their being presented later in support of another check
Each month the bank provides the depositor with a statement of the depositor’s account, accompanied by the checks paid and charged to the account durins the month. 1 As ilustrated below; a bank statement shows the balance on deposit at the beginning of the month, the deposits, the checks paid, any other additions and subtractions during the month, and the new balance at the end of the month. (To keep the illustration short, we have shown a limited number of deposits rather t1:an one for each business day in the month.)
Reconciling the Bank Statement
A bank reconciliation is a schedule explaining any differences between the balance shown in the bank statement and the balance shown in the depositor’s accounting records. Remember that both the bank and the depositor are maintaining independent records of the deposits, the checks, and the current balance of the bank account. Each month, the depositor should prepare a bank reconciliation to verify that these independent sets of records are in agreement. This reconciliation may disclose internal control failures, such as unauthorized cash disbursements or failures to deposit cash receipts, as well as errors in either the bank statement or the depositor’s accounting records. In addition, the reconciliation identifies certain transactions that must be recorded in the depositor’s accounting records and helps to determine the actual amount of cash on deposit.
For strong internal control, the employee who reconciles the bank statement should not have any other responsibilities for cash.
Normal Differences. Between Bank Records. And Accounting Records
The balance shown in a monthly· bank statement seldom equals the balance appearing in the depositor’s accounting records. Certain transactions recorded.by the depositor may not have been recorded by the bank. The most common examples are:
• Outstanding checks. Checks issued and recorded by the company but not yet presented to the bank for payment.
• Deposits in transit. Cash receipts recorded by the depositor but that reached the bank too late to be included in the bank statement for the current month.
• Credits for interest earned. The checking accounts ‘of unincorporated businesses often earn interest. At month-end, this interest is credited to the depositor’s account and reported in the bank statement. (As previously mentioned, current law prohibits interest on corporate checking accounts.)
• Miscellaneous bank charges and credits. Banks charge for services-such as printing checks, handling collections of notes receivable, and processing NSF checks. The bank deducts these charges from the depositor’s account and notifies the depositor by including a debit memorandum in the monthly bank statement. If the bank collects a note receivable on behalf of the depositor, it credits the depositor’s account and issues a credit memorandum.
Steps In Preparing a Bank Reconciliation
The specific steps in preparing a bank reconciliation are as follows:
1. Compare deposits listed on the bank statement with the deposits shown in the accounting records. Any deposits not yet recorded by the bank are deposits in transit and should be added to the balance shown in the bank statement.
2. Arrange paid checks in sequence by serial numbers and compare each check with the corresponding entry in the accounting records. Any checks issued but not yet paid by the bank should be listed as outstanding checks to be deducted from the balance reported in the bank statement.
3. Add to the balance per the depositor’s accounting records any credit memoranda issued by .he bank that have not been recorded by the depositor.
4.”Deduct from the balance per the depositor’s records any debit memoranda issued by . the bank that have not been recorded by the deposi tor
5. Make appropriate adjustments to correct any errors in either the bank statement or the depositor’s accounting records.
6. Determine that the adjusted balance of the bank statement is equal to the adjusted balance in the depositor’s records.
7. Prepare journal entries to record any items in the bank reconciliation listed as adjustments to the balance per depositor’s records.
illustration of a Bank Reconciliation
The July bank statement sent by the bank to Parkview Company was illustrated on page 281. This statement shows a balance of cash on deposit at July 31 of $5.000.17. Assume that on July 31, Parkview’s ledger shows a bank balance of $4.262.83. The employee preparing the bank reconciliation has identified the following reconciling items:
1. A deposit of $410.90 made after banking hours on July 31 does not appear in the bank statement. .
2. Four checks Issued in July have not yet been paid by the bank. These checks are:
3. Two credit memoranda were included in the bank statement
4. Three debit memoranda’ accompanied the bank statement
5. Check !o’A>. %7;’5was issued July 20 in the amount of $85 but was erroneously recorded in the C:M;.i’.’ ,MJments journal as ~58.The check, in payment of telephone expense, was-paid by the bank and correctly listed at $85 in the bank statement. In Parkview’s
ledger, the Cash account is overstated by $27 because of this error ($85 – $58 = $27). .
The July 31 bank reconciliation for Parkview Company is shown below. (The numbered arrows coincide both with the steps in preparing a bank reconciliation listed on page 283 and with the reconciling items just listed.)
Updating the Accounting Records
The last step in reconciling a bank statement is to update the depositor’s accounting records for any unrecorded cash transactions brought to light. In the bank reconciliation, every adjustment to the balance p.er depositor’s records is a cash receipt or a cash payment that has not been recorded in the depositor’s accounts. Therefore, each of these items should be recorded
In this illustration and in our assignment material, we will follow a policy of making one journal entry to record the unrecorded cash receipts and another to record the unrecorded cash reductions, (Acceptable alternatives would be to make separate journal entries for each item or to make one compound entry for all items.) Based on our recording policy, the entries to update the accounting records of Parkview Company are:
Petty Cash Funds
We have emphasized the importance of making all significant cash disbursements by check. However, every business finds it convenient to have a small amount of cash on hand with which to make some minor expenditures. Examples of these expenditures include such things as small purchases of office supplies, taxi fares, and doughnuts for an office meeting.
To create a petty cash fund, a check is drawn payable to “Petty Cash” for a round -amount, such as $200, which will cover these small expenditures for a period of two or. three weeks. This check is cashed and the money is kept.on hand in a petty cash box.
One employee is designated as the custodian of the fund.
The custodian makes all payments from this fund and obtains a receipt or prepares a “petty cash voucher” explaining the nature and amount of each expenditure. At the end of the period (or when the fund runs low), a check is drawn payable to Petty Cash reimbursing the fund for the expenditures made during the period. The issuance of this check is recorded by debiting the appropriate expense accounts and crediting Cash. As a practical matter, the entire debit portion of this entry often is charged to the Miscellaneous Expense account.
The Cash Budget as a Control Device
Many businesses prepare detailed cash budgets that include forecasts of the monthly cash receipts and expenditures of each department within the organization. Management (or the internal auditors) will investigate any cash flows that differ significantly from the budgeted amounts. Thus each department manager is held accountable for the monthly cash transactions occurring within his or her department.