SHORT TERM INVESTMENTS Accounting Help

Companies with large amounts of liquid resources often hold most of these resources in, the form of marketable securities rather than cash.

Mark-to-Market: A New Principle of Asset Valuation·

Accounting principles are not “carved in stone.” Rather, they evolve and change as the accounting profession seeks to increase the usefulness of accounting information. A 1993 change in the way companies account for short-term investments provides an excellent
case in point.

Short-term investments once appeared in the balance sheet at the lower of their cost or current market value. This valuation method reflected the cost principle. tempered by conservatism. But in 1993, the FASB changed the rules. Short-term investments. in marketable securities now appear in the balance sheet at their current market value as of the balance sheet date

Marketable securities are classified as one of three types: (1) available-for-sale securities, (2) trading securities, or (3) held-to-maturity securities. These classifications are based, in large part, on management’s intent regarding the length of time the securities will be held. Most corporations classify, their marketable securities as available for sale. In view of this fact, the remainder of our discussion focuses exclusively on this particular classification.

Mark-to-Market A New Pririeiple of Asset Valuation·

Mark-to-Market A New Pririeiple of Asset Valuation·

ACCOUNTS RECEIVABLE

One of the key factors underlying the growth of the American economy is the trend toward selling goods and services on account. Accounts receivable comprise the largest financial asset of many merchandising companies.

Accounts receivable are relatively liquid assets, usually converting into cash within a period of 30 to 60 days. Therefore, accounts receivable from customers usually appear in the balance sheet. immediately after cash and short-term investments in marketable securities.

Assets that are relatively close to cash are referred to as current assets.Sometimes companies sell merchandise on longer-term installment plans, requiring 12,24, Of even 48 months to collect the entire amount receivable from the customer. By definition, the normal period of time required to collect accounts receivable is part of a company’s operating cycle. Therefore, accounts receivable arising from normal sales transactions usually are classified as current assets, even if the credit terms extend beyond ope year

Un collectible Accounts .

We have stated that accounts receivable are shown in the balance sheerat the estimated collect amount-e-called nerreaizablevalul!.No business wants 10 sell merchandise on’ account to customers who will be unable to pay. Muny companies even maintain their own credit departments that. investigate the creditworthiness or each prospective customer.

Nonetheless, if a company makes credit sales tohundrcds-e-pcrhaps thousands-s- · of customers, some accounts inevitably will turn out to be uncollectible. . .. A limited amount of uncollectible accounts is not on lycxpectcd=-itis evidence of a sound credit policy. Ifthe credit department is overly cautions. ‘the business may lose munysalesopportunlties by rejecting customers who should have L)cenconsitiercd lIC- . ·ceptable credit risks

Renflectlng  U ncollectible Accounts in the Financial Statements

An account’ receivable that has been determined to be un collectible IS no longer-an asset. The loss of this asset represents anexpene termed Un collectible Accounts Expense

‘In measuring’ business income; one of the most fundamental principles of accounting IS that revenue should be (offset by the expenses Incurred in generating

the lt revenue. Un collectible accounts expense is caused by selling goods Oil credit to customers who fail to-pay their bills, Therefore, this expense is incurred in the time period in which the related sales. are made, even though specific accounts receivable may not
be-determined to be uncollectible until a later accounting period.Thus an account receivable. that originates fromacreditsale in January’ and is determined to be un collectible in August represents an expense in January.

The Uncollectible Accounts Ex.pense account created by the debit part of this entry is closed into the Income Summary account in the same manner as any other expense account. The Allowance for Doubtful Accounts that was credited in the above journal entry will appear in the balance sheet as a deduction from the face amount of the accounts receivable. It serves to reduce the accounts receivable to their net realizable value in the balance sheet. as shown by the following illustration

How much is the estimated net realizable value of the accounts receivable

How much is the estimated net realizable value of the accounts receivable

The Allowance for Doubt ful Accounts

There is no way of telling in .advance which accounts receivable will prove to be uncollectible. It is therefore not possible to credit the accounts of specific customers for our estimate of probable uncollectible accounts. Neither should we credit the Accounts Receivable controlling account in the general ledger. If the Accounts Receivable controlling account were to be credited with the estimated amount of doubtful accounts. this controlling account would no longer be in balance ‘with the total of the numerous customers’ accounts in the subsidiary ledger. The only practical alternative. therefore. is to credit a separate account called Allowance for Doubtful Accounts with the amount estimated to be uncollectible. . .

The Allowance for Doubtful Accounts often is described as a contra-asset account or a valuation account. Both of these terms indicate that the Allowance for Doubtful Accounts has a credit-balance. which is offset against the asset Accounts Receivable to produce a more useful and reliable measure of a company’s liquidity

Monthly Adjustments of the Allowance Account

In the adjusting entry made by World Famous Toy Co. at January 31. the amount of the adjustment ($10.000) was equal to the estimated amount of uncollectible accounts. This is true .only ‘because January was the first month of operations and this was the company’s first estimate of its uncollectible accounts. In future months. the amount of the adjusting entry will depend on two factors

(1) the estimate of un collectible accounts and (2) the current balance in the Allowance for Doubtful Accounts. Before we illustrate the adjusting entry for a future month, let us first see why the balance in the allowance account may change during the accounting period.

Writing Off an Un collectible Account Receivable

Whenever an account receivable from. a specific customer is. determined to be uncollectible, it no longer qualifies as an asset and should be written off. To write off an account receivable is to reduce the balance of the customer’s account to zero. Thejournal entry to accomplish this consists of a credit to the Accounts Receivable controlling account in the general ledger (and ‘to the customer’s account in the subsidiary ledger) and an offsetting debit to the Allowance ‘ior Doubtful Accounts

To illustrate, assume that early in February, World Famous Toy Co. learns that Discount Stores has gone out ‘of business and that the $4,000 account receivable from this customer is now worthless. The entry to write off this uncollectible account receivable is

Writing off a receivable

Writing off a receivable

The important thing to note in this entry is that the debit is made to the Allowance for Doubtful Accounts and not to the Uncollectible Accounts Expense account. The estimated expense of credit losses is charged to the Uncollectible Accounts Expense account at the end of each accounting period. When a particular account receivable is later determined to be worthless and is written off, this action does not represent an additional expense but merely confirms our previous estimate of the expense. If the Uncollectible Accounts Expense account were first charged with estiinatedcredit losses and then later charged with proven credit losses, we would be double-counting the actual uncollectible accounts expense,

Notice also that the entry to write off an uncollectible account receivable reduces both the asset account and the contra-asset account by the same amount. Thus writing off an uncollectible account does not change the net realizable value of accounts receivable in the balance sheet. The.following iI1ustration shows the net realizable value of World Famous Toy Co.’s accounts receivable before and after the write-off of the account receivable from .Discount stores

What happens to net

What happens to net

Let us repeat the point that underlies the allowance approach. Credit losses should be recognized in the period in which the sale occurs, not the period in which the account is determined to be uncollectible. The reasoning for this position is based on the matching principle

Write-Offs Seldom Agree with Prevlous Estimates

The’ total amount of accounts receivable actually writ ten off will seldom, if ever, be exactly equal to the estimated amount previously credited to’ the Allowance for Doubtful Accounts.

If the amounts written off as uncollectible turn out to be less than the estimated amount, . the Allowance for Doubtful Accounts will continue to show a credit balance. If the amounts written off as uncollectible are greater than the estimated amount, the Allowance for Doubt ful Accounts will acquire a temporary debit balance. which will be eliminated by the adjustment at the ‘end of the period

Recovery of an Account Receivable Prevlously Written Off

Occasionally a receivable that has been written off as worthless will later be collected in full or in part. Such collections are often referred to as recoveries of bad debts. Collection of an account receivable previously written off is evidence that the write-off was an error; the receivable should therefore be reinstated as an asset.

Let us assume; for example, that a past-due account receivable in the amount of $200 from J. B. Barker was written off on February 16 by the following entry:

Barker account considered

Barker account considered

Barker account reinstated

Barker account reinstated

Notice that this entry is exactly the opposite of the entry made when the account was written off as uncollectible. A separate entry will be made in the cash receipts journal to record the collection from Barker. This entry will debit Cash and credit Accounts Receivable (1. B. Barker

Monthly Estimates of Credit Losses

At the end of each month, management should again estimate the probable amount of uncollectible accounts and adjust the Allowance for Doubtful Accounts to this new estimate.

To illustrate, assume that at the end of February the credit manager of World Famous Toy Co. analyzes the accounts receivable and estimates that approximately $11,000 of these accounts will prove uncollectible. Currently, the Allowance for Doubtful Accounts has a credit balance of only $6,000, determined-as follows

Current balance in the

Current balance in the

To increase the balance in the allowance account to $11,000 at February 28, the month end adjusting entry must add $5,000 to the allowance. The entry will be:

Estimating Credit Losses-The Balance Sheet Approach

The most widely used method of estimating the probable amount of uncollectible accounts is based on aging the accounts receivable. This method is sometimes called the balance sheet approach because the method emphasizes the proper balance sheet- valuation of accounts receivable.

“Aging” accounts receivable means classifying each receivable according to its age. An aging schedule for the accounts receivable of Valley Ranch Supply is illustrated below.

,Analysis of Accounts Receivable by Age

,Analysis of Accounts Receivable by Age

.An aging schedule is useful to management i~ reviewing the status of individual accounts receivable and in evaluating the overall effectiveness of credit and collection policies. ‘In ‘addition, the schedule is used as the basis for estimating the amount of uncollectible accounts. ‘

The longer an account is past due, the greater’ the likelihood that it will riot be collected in full. Based on past experience, the credit manager estimates the percentage of .credit losses likely to occur in each age group of accounts receivable. This percentage, when applied to the total dollar amount in the’ age group, gives the estimated uncollectible portion for that group. By adding together the estimated uncollectible portions for all age groups, the required balance in the Allowance for Doubtful Accounts is determined.

The following schedule lists the group totals from the aging schedule and shows how the estimated total amount of uncollectible accounts is, computed:

An’ Alternative Approach to Estimating Credit losses

The procedures just discussed describe the balance sheet approach to estimating and recording credit losses. This approach is based on an aging schedule, and the Allowance for Doubtful Accounts is adjusted to. a required balance. An alternative method; called the income statement approach, focuses on estimating the uncollectible accounts expense for the period. Based on past experience; the uncollectible accounts expense is estimated at some percentage of net credit sales. The adjusting entry is made in the full amount of the estimated expense, without regard for the current balance in the Allowance for Doubtful Accounts.

To illustrate; assume that a company’s past experience indicates that about 2% .of .its credit sales will prove to be un collectible. If credit sales for September amount to $150,000, the month-end adjusting entry to record un collectible accounts expense is:

The income statement approach

The income statement approach

This approach is fast and simple-s-no aging schedule is required and no consideration is given to the existing balance in the Allowance for Doubtful Accounts. The aging of accounts receivable, however, provides a more reliable estimate of un collectible accounts because of the consideration given to the age and collectibility of specific accounts receivable at the balance sheet date

In past years, many small companies used the’ income statement approach in preparing monthly financial statements but used the balance sheet method in annual financial statements. Today, however, most businesses. have computer software that quickly and easily prepares monthly aging schedules. of accounts receivable. Thus most businesses today use the balimce sheet approach in their monthly .~swell ;:IS annual financial statements.

Posted on November 23, 2015 in Financial Assets

Share the Story

Back to Top
Share This