INSTRUCTOR’S MANUAL
7-12
MODULE 4 HOW LIQUID ASSETS AFFECT THE STATEMENT OF
CASH FLOWS
Module 4
LO 6
How Liquid Assets Affect the Statement of Cash Flows
Cash equivalents are not considered significant activities to be reported on a statement of cash flows.
◼ The purchase and sale of investments are considered significant investing activities.
• The purchase of investments is reported as an investing cash outflow.
CHAPTER 7 RECEIVABLES AND INVESTMENTS
7-13
Lecture Suggestions
Module 1
LO 1
The fundamental difference between the percentage of sales and percentage of accounts receivable
methods is a difficult concept for students to comprehend. They know how to make the estimate,
but they do not really know what the number that they calculate represents. One tool to use to try
Assume bad debt expense of 1% of credit sales:
Revenue
Bad Debt Expense
Allowance for Bad Debts
100,000
1,000 (a)
INSTRUCTOR’S MANUAL
7-14
Module 1
LO 1
To summarize:
• The percentage of net credit sales method: Sales and Bad Debt Expense both appear on
the income statement. Therefore, when you multiply the credit sales by the applicable
percentage, the figure obtained is the amount of the journal entry. Ignore any balance in
the allowance account.
The direct write-off method is easier to use and does not involve estimates. Why then is the
allowance method required by GAAP? Can you think of any company that could be allowed to
use the direct write-off method?
ABC Company has consistently estimated bad debts as 3% of net credit sales. ABC is not having a
good year and the CFO wants the accountant to change the percentage used this year in order to
Module 1
LO 2
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 reinvest. The days in accounts receivable ratio completes the
picture. The student can then compare the days in accounts receivable to the stated credit terms of
the company. If the terms are net/30 and the average days in accounts receivable are 75 days, this
could cause a significant cash flow problem for the company.
CHAPTER 7 RECEIVABLES AND INVESTMENTS
7-15
Module 2
LO 3
Module 2
LO 4
The formula for calculating interest is
The credit card companies charge a fee to the merchant when a customer uses their charge card.
Do you think when a company discounts a note receivable at the bank it will receive the maturity
value of the note or will there be a fee charged?
If Macy’s accepts its own credit card as a form of payment, will it be treated the same as a
MasterCard sale?
INSTRUCTOR’S MANUAL
7-16
Projects and Activities
Module 1
LO 1
Accounts Receivable
In-class discussion: Accounts receivable and bad debts
Hues, Inc. had an Accounts Receivable balance at December 31, 2016 of $130,000. Their subsidiary ledger
showed the following customer balances:
Honey $ 12,000
◼ 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 does 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 $130,000 will eventually be
written off?
◼ What does Hues do with the estimated amount? Is it an expense for the current year? Should Hues
remove it from Accounts Receivable? Why or why not? Explain how the estimate is accounted
for.
Solution
This deliberately oversimplified exercise may help students arrive on their own at the “theory” of the bad
CHAPTER 7 RECEIVABLES AND INVESTMENTS
In-class discussion: Alternate terminology
The following is taken from the asset section of a recently issued annual report ($ in millions):1
Loans, net of unearned income $644,635
Allowance for loan losses (15,994)
Total loans, net $628,641
What sort of business do you think this company is in? (Their total assets in millions of
dollars are approximately $1,842,530.)
◼ Explain the allowance in terminology that you have learned in this chapter.
◼ Is the basic accounting for these transactions the same as what you have learned for retailing?
Don’t worry about additional industry-specific rules you may not know.
Solution
◼ These amounts are from the balance sheet of Citigroup Inc., a banking and financial services
company.
INSTRUCTOR’S MANUAL
7-18
In class discussion: Determining the allowance for bad debts
In their 2014 Annual Report, IBM has the following footnote regarding Allowance for Uncollectible
Receivables:2
Notes and Accounts Receivable – Trade – An allowance for uncollectible trade receivables is
estimated based on a combination of write-off history, aging analysis, and any specific, known
troubled accounts.
◼ What method or methods does IBM use to estimate its bad debts?
◼ Can a company use a combination of both methods?
◼ Can the company change its method of estimating bad debts?
Solution
◼ IBM uses a combination of methods – they look at specific accounts receivable to determine
2 International Business Machines Corporation, Annual Report, 2014, p. 95.
CHAPTER 7 RECEIVABLES AND INVESTMENTS
Module 3
LO 5
Investments in Highly Liquid Financial Instruments
In-class discussion: Delta Air Lines, Inc. cash and investments
Delta Air Lines, Inc., in their December 31, 2014 Annual Report, lists the following ($ millions)3:
Cash and Cash Equivalents and Short-Term Investments
Short-term, highly liquid investments with maturities of three months or less when purchased
are classified as cash and cash equivalents. Investments with maturities of greater than three
months, but not in excess of one year, when purchased are classified as short-term investments.
Investments with maturities beyond one year when purchased may be classified as short-term
investments if they are expected to be available to support our short-term liquidity needs. All
short-term investments are classified as either available-for-sale or held-to-maturity and realized
gains and losses are recorded using the specific identification method.”
◼ What determines if investments will be classified as short-term or long term?
◼ Should a company have more money in cash or in short term investments?
◼ What does the note mean when it states that “all short-term investments are classified as either
available-for-sale or held-to-maturity?”
◼ What does “realized gains and losses are recorded using the specific identification method” mean?
Solution
◼ The company’s plan for holding the securities, regardless of their characteristics, dictates their
classification as current or noncurrent.
INSTRUCTOR’S MANUAL
Decision
Models
Analyzing Receivables Turnover
You are the credit manager for Wood Products, a retail furniture store. You want to make sure your
Net credit sales, 2016 $6,000,000
Net credit sales, 2015 $5,700,000
Accounts Receivable January 1, 2016 $700,000
Accounts Receivable, December 31, 2015 $720,000
Wood Products credit terms n/45
Wood Products receivable turnover 2015 8.30 times
Industry average receivable turnover 8.5 times
Using the Ratio Analysis Model and the Business Decision Model, determine (1) the receivables turnover
and (2) if the customers are paying their bills on a timely basis.
Solution
Ratio Analysis Model:
1. Formulate the Question. What is the receivables turnover ratio for Wood Products?
2. Gather the Information From the Financial Statements. The ratio uses average
receivables, which is obtained from the two most recent balance sheets and net credit sales,
which is obtained from the income statement.
CHAPTER 7 RECEIVABLES AND INVESTMENTS
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Using the Business Decision Model:
1. Formulate the Question. Are the collections of accounts receivable in line with the credit
terms offered by Wood Products?
2. Gather Information from the Financial Statements and Other Sources. This information
will come from a variety of sources, including, but not limited to:
• The balance sheet which provides information about liquidity.
• The income statement which provides information regarding profitability.
3. Analyze the Information Gathered.
a. Use the Ratio Analysis Model to compute and analyze the receivables turnover
ratio. As the previous analysis suggested, Wood Product’s receivable turnover ratio is
improving and is just slightly below industry average.
b. Are there other liquidity ratios that can be computed? The days’ sales in receivables
is perhaps a more important ratio to be used in the decision. As previously computed, the
days’ sales in receivables for 2016 is 43 days. This needs to be compared to Wood
Product’s credit terms which are net 45 days. Wood is giving their customers 45 days to
pay their bills and they are paying them within 43 days, slightly early!