Chapter 9

Short-Term Liquid Assets

Overview

• Short-term liquid assets are financial assets, such as cash, accounts receivable, notes receivable, and short-term investments, that can be converted readily to cash



• The quick ratio (short-term liquid assets divided by current liabilities) indicates whether short-term liquid assets are adequate.



• Three main management issues related to short-term liquid assets.
• Managing cash needs during seasonal cycles - Careful planning of expected cash inflows and outflows is especially important when sales and expenditures are stronger in some periods than in others.



• Setting credit policies - The receivable turnover and average days' sales uncollected are commonly used to measure the effectiveness of a company's credit policies. These ratios vary considerably from industry to industry.
• The receivable turnover is computed by dividing net credit sales by average net accounts receivable. It shows how many times, on average, receivables were collected during the period.



• The average days' sales uncollected is computed by dividing 365 days by the receivable turnover. It shows how many days, on average, accounts receivable are outstanding.



• Financing receivables - Occasionally, companies cannot afford to wait until their receivables are collected. Accordingly, there are ways to obtain cash before collection from customers occurs.
• Establish finance companies.



• Pledge their accounts receivable as collateral on a loan.



• Factoring, or selling its accounts receivable to a bank or finance company (known as the factor) for cash.
• Without recourse, the factor bears any losses from uncollectible accounts. Credit cards are an example of factoring without recourse.



• With recourse means that the seller bears the risk. This risk is disclosed in the financial statements as a contingent Iiability, a potential liability that can develop into a real liability depending on a future event.

• Discounting, or selling notes receivable, is yet another way companies maintain liquidity.

Cash and cash equivalents

• Cash - includes coin, currency, checks from customers, checking account deposits, and compensating balances.



• Compensating balance - is a minimum account balance required by a loan agreement.



• Cash equivalents (e.g., CDs, U.S. Treasury notes) are any security with a term of ninety days or less in which idle cash is invested.



• Cash on hand should be kept in a petty cash fund operated on an imprest system.

Accounts receivable

• Accounts receivable - classified as current assets and represent payments due from credit customers.



• Trade receivables - Wholesalers and retailers usually allow customers to pay for merchandise over a period of time (i.e., they extend credit) because the customer cannot or will not make full payment immediately.



• Installment accounts receivable - Most companies that sell on credit have credit departments whose responsibility it is to approve or refuse credit to individuals or companies. In some retail businesses, installment accounts receivable are common. Under these terms, the buyer is allowed to make a series of payments over an extended period of time. These receivables are considered current assets if the terms are the industry norm.



• Uncollectible accounts - (also called bad debts), the accounting term for nonpayment by customers, are an expense of selling on credit.



• Two methods of accounting for uncollectible accounts.



• Direct charge-off method
• an expense is recorded when a specific customer's account is written off.
• violates the matching principle, which requires that the expense be recorded in the same period as the related sale.
• Not GAAP



• Allowance method - required by GAAP
• Losses from bad debts appear in the same income statement as the corresponding sale.



• Requires estimating bad debts, because at the time of sale the company does not know whether the customer eventually will pay,



• Adjusting journal entry - Dr. Uncollectible Accounts Expense, Cr Allowance for Uncollectible Accounts for the estimated amount.
• Uncollectible Accounts Expense is closed out in a manner similar to other expenses and appears in the income statement.



• Allowance for Uncollectible Accounts is a contra-asset account to Accounts Receivable that reduces Accounts Receivable to the amount estimated to be collectible.



• Net realizable value of accounts receivable is equal to Accounts Receivable minus the Allowance for Uncollectible Accounts. This amount must be presented in the financial statements.



• Estimating uncollectible account expense



• Percentage of net sales method.
• Estimate of uncollectible amount is some percent of current year's net sales



• Any previous balance in Allowance for Uncollectible Accounts is irrelevant in making the adjusting entry.



• Aging method.
• Estimate is based on some amount or percent of the ending accounts receivable balance that are "past due"
• Customer accounts are placed into a "not yet due" category or into one of several "past due" categories (called the aging of accounts receivable).



• The amounts in each category are totaled; each total is then multiplied by a different percentage for estimated bad debts.



• The sum of these products represents estimated bad debts on ending Accounts Receivable.



• The balance in Allowance for Uncollectible Accounts is adjusted to reflect the estimated uncollectible amount.



• Write-off of a specific account under the allowance method.



• When it becomes clear that a specific account will not be collected, it should be written off.
• Journal entry: Dr. Allowance for Uncollectible Accounts, Cr. Accounts Receivable.



• The debit is not made to Uncollectible Accounts Expense.



• After an account has been written off, Accounts Receivable and Allowance for Uncollectible Accounts decrease by the same amount, but the net figure for expected receivables stays the same.



• When a customer whose account has been written off pays in full or in part, two entries must be made.



• Reinstate the customer's receivable. Journal entry: Dr Accounts Receivable, Cr Allowance for Uncollectible Accounts for the amount now considered collectible.



• Record the collection. Journal entry: Dr. Cash, Cr. Accounts Receivable



• The net realizable value of Accounts Receivable is unchanged.

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