Chapter 07 – Financial Assets
Financial and Managerial Accounting, 17e 7-1
7 FINANCIAL ASSETS
Chapter Summary
This is the first in a series of chapters analyzing major balance sheet items. Topical
coverage includes cash, short term investments in marketable securities, and receivables.
Accounting practices concerning these assets are often highly procedural.
Discussion of cash is organized around a series of critical internal control issues. Topics
include: accounting for cash over and short; use of a voucher system to foster separation of
duties; and, preparation of the bank reconciliation. Discussion of each topic emphasizes how the
firm can achieve the objectives of efficient cash management.
Fair value accounting of short term investments in marketable securities is another major
topic discussed.
The remainder of the chapter concentrates on accounting for uncollectible accounts
receivable. The allowance method is discussed in detail. Coverage is provided for both the
balance sheet and income statement methods, and a brief discussion of the direct charge-off
method is included. Discussion of the accounts receivable turnover ratio continues the financial
statement analysis begun in an earlier chapter.
Learning Objectives
1. Define financial assets and explain their valuation in the balance sheet.
2. Describe the objectives of cash management and internal control over cash.
3. Prepare a bank reconciliation and explain its purpose.
4. Describe how short-term investments are reported in the balance sheet and account for transactions
involving marketable securities.
5. Account for uncollectible accounts receivable using the allowance and direct write-off methods.
6. Explain, compute, and account for notes receivable and interest revenue.
7. Evaluate the liquidity of a company’s accounts receivable.
Chapter 07 – Financial Assets
Brief topical outline
A How much cash should a business have?
1 The valuation of financial assets
B Cash
1 Reporting cash in the balance sheet
a Cash equivalents
b Restricted cash
c Lines of credit
2 Cash management
3 Internal control over cash
a Cash over and short
4 Bank statements
5 Reconciling the bank statement
a Normal differences between bank records and accounting records
b Steps in preparing a bank reconciliation
c Illustration of a bank reconciliation
d Updating the accounting records
C Short-term investments – see Case in Point (page 297)
D Accounting for marketable securities
1 Purchase of marketable securities
2 Recognition of investment revenue
3 Sale of investments
a Investments sold at a gain
b Investments sold at a loss
4 Adjusting marketable securities to market value
– see Case in Point (see 300)
E Accounts receivable
1 Internal control over receivables
2 Uncollectible accounts
a Reflecting uncollectible accounts in the financial statements
3 The allowance for doubtful accounts
a Monthly adjustments of the allowance accounts
4 Writing off an uncollectible account receivable
a Write-offs seldom agree with previous estimates
5 Monthly estimates of credit losses
a Estimating credit losses-the balance sheet approach
b Estimating credit losses-the income statement approach
6 Recovery of an account receivable previously written off
7 Direct write-off method
8 Factoring accounts receivable – see Your Turn (page 308)
9 Credit card sales
a Bank credit cards
b Other credit cards
Chapter 07 – Financial Assets
Financial and Managerial Accounting, 17e 7-3
F Notes receivable and interest revenue
1 Nature of interest
a Computing interest
2 Accounting for notes receivable
a Illustrative entries
b If the maker of a note defaults
G Financial analysis and decision making – see Your Turn (page 312)
and Ethics, Fraud & Corporate Governance (page 313)
H Concluding remarks
Topical coverage and suggested assignment
Homework Assignment
(To Be Completed Prior to Class)
Class
Meetings
on Chapter
Topical
Outline
Coverage
Discussion
Questions
Brief
Exercises
Exercises
Problems
1
A
3, 4, 5
1, 3, 5, 6
1, 2
2
B
7, 8, 9
8
3
C-D
12, 13,
9, 12, 14
3, 4
*4
*E-H
15
*15
*5, 6
* Optional assignment, time permitting.
Comments and observations
Teaching objectives for Chapter 7
Our specific teaching objectives in this chapter are to:
1 Explain the flow of financial resources among financial assets, and the valuation of
those assets in the balance sheet.
2 Briefly describe the presentation of cash, cash equivalents, and restricted cash in
the balance sheet.
3 Explain the objectives of cash management.
4 Discuss the basic internal control concepts relating to cash receipts and cash
payments.
5 Explain the importance of reconciling bank accounts; illustrate the preparation of a
bank reconciliation and the related entries to update the accounting records.
6 Explain the nature of investments in marketable securities, and their role in
Chapter 07 – Financial Assets
efficient cash management.
7 Illustrate journal entries to record transactions arising out of investments in
marketable securities.
8 Discuss the accounting principles applicable to the valuation of accounts receivable
stressing the matching principle.
9 Demonstrate the recognition of credit losses using allowance methods, with
emphasis on the aging schedule (balance sheet) approach.
10 Illustrate write-offs and recoveries of accounts receivable when an allowance is in
use.
11 Contrast the direct write–off method with the “allowance” method.
12 Briefly discuss various types of credit card sales, emphasizing that “bank card”
sales actually are cash sales.
13 Explain why accounts receivable may be viewed as “nonproductive” assets, and
identify several ways of converting receivables quickly into cash.
14 Explain and illustrate accounting for notes receivable.
General comments
In Chapter 7, we emphasize the importance of strong internal control over cash transactions.
Internal control is of special importance with respect to cash for two reasons. First, cash is the
asset most susceptible to theft or embezzlement. Second, however, is that cash transactions affect
every category of financial statement account. Thus, cash transactions absolutely must be
recorded properly if the accounting records are to be reliable. If a company does not have
adequate internal control to assure that cash receipts and cash payments are recorded properly,
errors may exist virtually anywhere in the accounting records and financial statements.
The importance of properly recording cash transactions also explains our emphasis upon
bank reconciliations in this chapter. A bank reconciliation brings to light most errors in recording
the dollar amounts of cash receipts or cash disbursements during the period.
A continuing goal in this edition is to focus upon the use of financial accounting
information not only by outsiders, but also by management. Therefore, we have supplemented
our coverage of cash management with an introduction that describes the flow of funds from one
form of financial asset to another over the course of the operating cycle. We highly recommend
an in-class review of Exercise 10, which makes a good point and is based on data from an actual
company.
We discuss Exercise 7 or 13 in class to review fair value accounting. Both exercises stress
the importance of the change from the perspective of the user of the financial statements.
Chapter 07 – Financial Assets
Financial and Managerial Accounting, 17e 7-5
In large and small businesses alike, the accounting practices used in accounting for
uncollectible accounts receivable are changing. For example, the income statement approach is
now seldom used. As all accounts receivable software automatically produces an aging schedule,
the income statement approach no longer provides a significant time advantage. As a result,
most businesses now use the balance sheet approach in their monthly financial statements as well
as in their audited annual statements.
The direct write-off method of computing uncollectible accounts expense is now the only
approach allowable for income tax purposes. As a result, many small businesses, and also larger
businesses in which the allowance for doubtful accounts is not material, are switching to this
method for financial reporting purposes.
We want to recommend several specific Problems and Cases for use in the second and
third class meetings on this chapter. Problem 4 provides efficient yet comprehensive coverage of
the “balance sheet” method of accounting for receivables. Case 3 provides a good review of the
accounting theory underlying this chapter, and Case 4 is an excellent “decision oriented” case
relating cash flows and credit policies.
Supplemental Exercises
Group Exercise
Video rental stores carry out a large volume of small cash transactions. Make a listing of
what you feel are the critical internal control concerns at such a store. When your list is
complete, visit a store and through observation and interviews prepare a report in which you
explain how the internal control concerns are being addressed. Explain why you feel the controls
in place either are or are not adequate.
Internet Exercise
Visit the website of ADP, Inc. at www.adp.com. Access the most recent annual report
and examine the balance sheet and the notes to the financial statements. What kind of
transactions give rise to most of ADP’s receivables? Explain how ADP discloses the magnitude
of its allowance for uncollectible accounts. Why do you suppose that the allowance for
uncollectible accounts does not appear in the balance sheet itself?
Chapter 07 – Financial Assets
CHAPTER 7 NAME #
10-MINUTE QUIZ A SECTION
Indicate the best answer for each question in the space provided.
Use the following data for questions 1 and 2.
At the end of the month, the unadjusted trial balance of Four Star Company included the
following accounts:
Debit Credit
Sales (75% represent credit sales) ………………………………… $1,280,000
Accounts Receivable …………………………………………………. $875,000
Allowance for Doubtful Accounts ……………………………….. $10,750
1 Refer to the above data. If the income statement method of estimating uncollectible
accounts expense is followed, and uncollectible accounts expense is estimated to be 2%
of net credit sales, the net realizable value of Four Star accounts receivable at the end of
the month is:
a $855,800. b $845,050. c $19,200 d $1,250,050
2 Refer to the above data. If Four Star uses the balance sheet approach in estimating
uncollectible accounts, and aging the accounts receivable indicates the estimated
uncollectible portion to be $24,000, the uncollectible accounts expense for the month is:
a $24,000. b $13,250. c $34,750. d $10,750.
3 Which of the following items is reported in neither the income statement nor the
statement of cash flows?
a Sale of marketable securities at a loss.
b Sale of marketable securities at a gain.
c Adjustment of available-for-sale marketable securities owned to current market
value at balance sheet date.
d Investment of excess cash in marketable securities.
4 Fair value is the balance sheet valuation standard for:
a Investments in all financial assets.
b Investments in available-for-sale marketable securities.
c Investments in capital stock of any corporation.
d Stockholders’ equity of any publicly traded corporation.
5 Cash equivalents:
a Include amounts of cash available through an unused line of credit.
b Are investments in the publicly traded stocks and bonds of large corporations.
c Are usually included in the term “cash” in the balance sheet and the statement of
cash flows.
d Is another term for financial assets.