Cash, Investments, and Receivables

Transcription

1 Chapter 7 Cash, Investments, and Receivables Key Concepts: 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

2 FINANCIAL ACCOUNTING INSTRUCTOR S MANUAL Chapter Outline LO 1 LO 2 The Forms of Cash Classification as cash indicates that an item is readily available to pay debts. 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 Control Over Cash Cash management is necessary to guarantee that neither too little nor too much cash is on hand. Cash alone does not earn anything, but must be invested Too much cash could make company a takeover target Bank statement details all activity in an account monthly Canceled checks an outstanding check was written but not yet presented for payment, and therefore is not on statement 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 NSF check (Not Sufficient Funds) was deposited, but bank could not collect, and deducted from balance Service charge Customer note and interest: bank acts as collection agent for company, takes payments directly 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) Trace deposits listed to books, list deposits in transit Trace canceled checks to books, list outstanding checks List credit memoranda: items credited on bank's books to company for interest or collections from customers List debit memoranda (the bank debits or reduces the liability to the company on its books): NSF checks, service charges Identify errors by bank or company Reconcile book balance and bank balance to adjusted balance using above items 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. Check written and cashed to establish fund Minor disbursements are reimbursed from it when receipts are presented 7-2 Harcourt, Inc.

3 CHAPTER 7 CASH, INVESTMENTS, AND RECEIVABLES Replenish periodically by totaling receipts and writing a check to bring the cash in the fund up to its original amount 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. 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: Debt securities: one company loans money to another company, most commonly through bonds Specific maturity date 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)? Investment of idle cash for interest, dividends, capital appreciation 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 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: Basis for recognition of income (dividends, interest) Harcourt, Inc. 7-3

4 FINANCIAL ACCOUNTING INSTRUCTOR S MANUAL Value of investment on the balance sheet Classification on the balance sheet as current, noncurrent Debt or equity securities are classified into one of three categories (Exhibit 7-4): Held-to-maturity securities are bonds, and only bonds, that investor is able and intends to hold to maturity Trading securities are stocks and bonds bought for short-term gain, intended to be sold in near term 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. Intent of investor is to hold these bonds until maturity Bonds purchased at face value: Investment is recorded at cost Interest income is recorded in the period earned: may require an adjusting journal entry Held-to-maturity bonds are classified as a noncurrent asset reclassified to current assets when they are one year or less from maturity 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. 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 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. Securities accounts are still adjusted to fair value on balance sheet date Record the proceeds from the sale of the securities 7-4 Harcourt, Inc.

5 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 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) Unrealized gains are recognized on securities, but not on any other assets 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. Accounts receivable are non-interest-bearing 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. Accounts receivable by customer constitutes subsidiary ledger Plant and equipment Accounts payable Valuation of Accounts Receivable 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: 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 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

6 FINANCIAL ACCOUNTING INSTRUCTOR S MANUAL Two approaches to estimate bad debts, using the allowance method: 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 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): Refines the calculation, considering the length of time receivables have been outstanding Groups receivables by age (time outstanding) Estimated uncollectibility increases as receivables get older Accounts receivable turnover is the rate of collection of accounts receivable. Turnover = net credit sales average accounts receivable 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. 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 called a non-interest-bearing note, but does actually require interest to be paid interest-bearing note has interest rate specified on the note 7-6 Harcourt, Inc.

7 CHAPTER 7 CASH, INVESTMENTS, AND RECEIVABLES Interest-Bearing Notes Interest is earned between the issue date and the maturity date. May need accrual for the portion earned up to the period ending date if period ends between the two Increase both the interest receivable and the interest revenue on the books of the payee 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. Still involves payment in the future in excess of the amount received, either as cash, or goods or services, in the present Sometimes called a discounted note 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 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: 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

8 FINANCIAL ACCOUNTING INSTRUCTOR S MANUAL Discounting a note: company can endorse a promissory note over to its bank, and receive cash before the due date 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 LO 8 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: Direct method shows the amount of cash collected Indirect method reflects the cash effect of the change in accounts receivable 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 7-8 Harcourt, Inc.

9 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: Assume bad debt expense of 1% of credit sales of $100,000 LO 4 Assets = Liabilities + SHE + Income Statement Allowance for Doubtful accounts Bad Debt Expense (1000) (1000) OR, allowance of 5% of $50,000 of ending accounts receivable: Assets = Liabilities + SHE + Income Statement Allowance for Doubtful accounts Bad Debt Expense (2500) (2500) Harcourt, Inc. 7-9

10 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 Harcourt, Inc.

11 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 following 1 ($ millions): Cash and cash equivalents $ 311 Short term investments, at cost 83 What is the difference between cash and cash equivalents? 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? 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? What do you think of this method for a personal checkbook? Would a whole dollar approach be appropriate for a company? Would it matter if it were a large or small company? 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 PepsiCo, 1998 Annual Report, page Pepsio, 1998 Annual Report, Note 1. Harcourt, Inc. 7-11

12 FINANCIAL ACCOUNTING INSTRUCTOR S MANUAL 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: 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. 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. 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. 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. 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. 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. Is this a petty cash item? Should the balance of petty cash be increased to accommodate these requests? 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.

13 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. This is a petty cash item. The size of petty cash varies with the size and needs of the company. 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). 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. 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? 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? 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? How would you decide which financial instrument to invest any surplus in? This question introduces the concept, without the mechanics, of cash budgeting. 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. 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. 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

14 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 $ 95 $ 62 Short-term investments 1,978 2,370 Note 2 4 explains the composition of the short-term investments: Overnight investments and time deposits $ 133 $ 322 Corporate notes Asset backed securities U.S. Government agency mortgages Other $ 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 3 5 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 What are the characteristics of the available-for-sale investments that distinguish them from trading or held-to-maturity securities? 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? 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. 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 op. cit., page op. cit., page General Electric Company 1999 Annual Report, page Harcourt, Inc.

15 Note 1 states: In millions Investment securities (note 9) $81,758 $78,717 CHAPTER 7 CASH, INVESTMENTS, AND RECEIVABLES "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 millions Amortized Cost Estimated Fair Value Equity $6,569 $9,479 Debt $74,378 $72,279 Total $80,947 $81,758 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? These investments do not qualify as trading securities and the bonds are not intended to be held to maturity. Amortized cost is the purchase price of the securities less amortization of discount or premium. Only debt securities can be classified in this way, because equity has no maturity date. 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 $ $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 Op cit., page Intel Corporation, 1998 Annual Report. Harcourt, Inc. 7-15

16 FINANCIAL ACCOUNTING INSTRUCTOR S MANUAL Into which classification of securities does this fall? Would you prefer to see this item as a part of income? Why or why not? Should unrealized gains be recognized at all, or would you prefer that only unrealized losses be recognized? Support your answer with relevant accounting principles. Why would the amount jump from $59 million in 1997 to $603 million in 1998? The securities, by their accounting treatment, are available for sale securities. 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. 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. 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 $12,000 Iris 10,000 Jonquil 20,000 Kaffe 30,000 Lily 45,000 Mauve 5,000 Neutra 8,000 $130,000 Is it likely that every one of these customers will pay the entire debt they owe? If not, which one(s) will not pay? How much are they not going to pay? 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? 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? How can Hues remove a specific account from Accounts Receivable in the current year if they do not know specifically who will not pay? How does Hues know at the time of the sales that some of the accounts will not be paid? How can Hues use that information to estimate how much of the $130,000 will eventually be written off? 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 Harcourt, Inc.

17 CHAPTER 7 CASH, INVESTMENTS, AND RECEIVABLES 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. Will every customer pay all they owe? Sadly, no. 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. 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. 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. 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. 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. 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. 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 $ 244,206 Allowance for possible credit losses (6,679) What sort of business do you think this company is in? (Their total assets are approximately $717 billion). Explain the allowance in terminology that you have learned in this chapter. 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. These amounts are from the Balance Sheet of Citigroup Inc., a banking and financial services company. 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

18 FINANCIAL ACCOUNTING INSTRUCTOR S MANUAL 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. 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? 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? 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? The following figures are available from CPC's annual reports 11 ($000): Revenues $344, , ,221 Accounts receivable, net 77,342 86, ,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? The following information is summarized from the management discussion in CPC's 1991 annual report 12, 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 $ 7 Reserve against accounts receivable from a closed facility 3 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 14 Total additions to reserves $ 37 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, Community Psychiatric Centers, 1993 Annual Report. 12 Community Psychiatric Centers, 1991 Annual Report Harcourt, Inc.

19 CHAPTER 7 CASH, INVESTMENTS, AND RECEIVABLES 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 Days in accounts receivable 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. 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. 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

20 FINANCIAL ACCOUNTING INSTRUCTOR S MANUAL As stated in Chapter 2 for 1998: days Days in accounts receivable 22 Days in inventory 9 Total cycle 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. 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: Days in accounts receivable Days in inventory Total cycle Days in accounts payable 36 days 7 days 43 days 51 days LO 7 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 report 14, 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 Further, American maintains an allowance for uncollectible receivables based upon expected collectibility of all receivables, including the receivables transferred." What do you think AMR meant when they said they transfer some of their accounts receivable? Why are these receivables not on the balance sheet? Do you think the receivables were transferred with or without recourse? Why or why not? Why did AMR maintain a provision in their allowance for receivables that are not on the balance sheet? From the wording of the footnote would you imagine that AMR bases their allowance calculation on credit sales or ending accounts receivable? Do you think transferring accounts receivable has an effect on a company s accounts receivable turnover ratio? Why or why not? 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? 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 AMR Corporation, 1992 Annual Report, page Harcourt, Inc.

21 CHAPTER 7 CASH, INVESTMENTS, AND RECEIVABLES 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. 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. The allowance calculation is probably based upon ending accounts receivable. 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 ( ) = about 24%] will be collected much more quickly. 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. Who lost money on this debt? Was it the merchants who made the sales, or the banks that issued the cards? How do banks protect themselves against losses like this? Are they wrong to give up on collection? 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? Who do you suppose would buy these bad debts? 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. 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 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. 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, Harcourt, Inc. 7-21