Financial Assets: Cash, Receivables, and Short-Term Investments

Financial Assets

Introduction to Financial Assets

Financial assets are resources owned by a business that are highly liquid and can be easily converted into cash. These assets are crucial for a company's operations and liquidity management. The main categories of financial assets include cash, cash equivalents, marketable securities, and receivables.

• Cash: The most liquid asset, used for day-to-day transactions.

• Cash Equivalents: Short-term, highly liquid investments with maturities of three months or less.

• Marketable Securities: Investments in debt or equity securities that can be quickly sold in public markets.

• Receivables: Amounts owed to the company by customers or others, typically from sales on credit.

Example: Apple Inc.'s balance sheet shows that financial assets, including non-trade receivables, comprise over 80% of its total assets, highlighting their importance in large corporations.

Money Flows Among Financial Assets

Financial assets interact dynamically within a business. Cash is collected from customers, used for payments, and any excess is often invested in marketable securities. These investments can be liquidated as needed to meet cash requirements.

Valuation of Financial Assets

Financial assets are reported in the balance sheet at their current values, which differ depending on the asset type:

• Cash: Reported at face amount.

• Short-term Investments (Marketable Securities): Reported at fair market value.

• Receivables: Reported at net realizable value (the amount expected to be collected).

Type of Financial Asset	Basis for Valuation in the Balance Sheet
Cash (and cash equivalents)	Face amount
Short-term investments (marketable securities)	Fair market value
Receivables	Net realizable value

Cash and Cash Equivalents

Defining Cash

Cash includes money on deposit in banks and items accepted for deposit, such as coins, paper money, checks, money orders, travelers’ checks, and bank card sales. Most companies maintain several bank accounts and a small amount of cash on hand. The Cash account in the general ledger is often a control account, with a subsidiary ledger for each bank account and cash supply.

Cash Equivalents

To qualify as a cash equivalent, an investment must:

• Be very safe.

• Have a stable market value.

• Mature within 90 days of acquisition.

Examples: Money market funds, U.S. Treasury Bills, high-grade commercial paper.

Restricted Cash

Restricted cash is a bank balance not available for normal operations, such as cash earmarked for repaying a noncurrent liability or serving as a compensating balance. Restricted cash is presented in the balance sheet under “Investments and Restricted Funds.”

Lines of Credit

A line of credit is a prearranged agreement with a bank to borrow up to a specified limit. The company can draw funds as needed, creating a liability when used. Unused lines of credit increase liquidity and are disclosed in the notes to financial statements.

Cash Management and Internal Controls

Objectives of Cash Management

Cash management involves planning, controlling, and accounting for cash transactions and balances. The main objectives are:

• Accurate accounting for cash receipts, disbursements, and balances.

• Prevention or minimization of losses from theft or fraud.

• Anticipation of borrowing needs and ensuring adequate cash availability.

• Prevention of excessive idle cash.

Internal Control Over Cash

Internal controls over cash are designed to prevent fraud, ensure efficient management, and maintain accurate records. Major steps include:

• Separating cash handling from record-keeping.

• Preparing cash budgets and control listings of receipts.

• Depositing all receipts daily and making payments by check (except petty cash).

• Verifying expenditures before issuing checks and reconciling bank statements promptly.

Cash Over and Short

Cash Over and Short is an account used to record discrepancies between actual cash receipts and recorded amounts. Shortages are debited, and overages are credited to this account.

Example: If cash sales are $4,500 but only $4,485 is in the register, the $15 shortage is debited to Cash Over and Short.

Bank Reconciliation

Purpose and Process

A bank reconciliation explains differences between the bank statement balance and the company’s accounting records. It ensures both records agree, providing assurance of correct cash accounting.

• Outstanding Checks: Issued by the company but not yet paid by the bank.

• Deposits in Transit: Recorded by the company but not yet by the bank.

• Service Charges, NSF Checks, Interest, and Miscellaneous Items: May appear in the bank statement but not yet in the company’s records.

Steps in Preparing a Bank Reconciliation

1. Compare deposits in the bank statement with company records; add deposits in transit to the bank balance.

2. Compare checks paid by the bank with company records; deduct outstanding checks from the bank balance.

3. Add unrecorded bank credits (e.g., interest) to the company’s records.

4. Deduct unrecorded bank debits (e.g., service charges, NSF checks) from the company’s records.

5. Correct any errors in either record.

6. Ensure adjusted balances agree.

7. Prepare journal entries for adjustments.

Short-Term Investments (Marketable Securities)

Nature and Reporting

Marketable securities are investments in bonds or stocks that can be quickly sold at quoted market prices. They are usually classified as current assets unless management intends to hold them long-term. These securities are reported at fair market value, with unrealized gains or losses recognized in net income.

Example: Companies like Microsoft and Ford invest billions in marketable securities to earn higher returns on excess cash.

Accounting for Marketable Securities

• Purchase: Recorded at cost, including brokerage fees.

• Dividend Revenue: Recognized when received.

• Sale: Gain or loss is recognized as the difference between sale proceeds and cost.

• Year-End Adjustment: Securities are adjusted to market value, with unrealized gains or losses recorded.

Receivables

Accounts Receivable

Accounts receivable arise from credit sales and are typically collected within 30 to 60 days. They are reported at net realizable value, which is the amount expected to be collected after deducting estimated uncollectible accounts.

Internal Control Over Receivables

Controls ensure only valid sales are recorded, credit is extended to creditworthy customers, and collections are properly handled. Steps include:

• Preparing sales orders and reviewing customer credit.

• Ensuring goods shipped match orders.

• Billing and recording sales and collections accurately.

• Restrictively endorsing checks and depositing them daily.

Uncollectible Accounts (Bad Debts)

Some receivables may not be collected. The allowance method estimates uncollectible accounts and matches the expense to the period of the related sales. The direct write-off method records bad debts only when they are deemed uncollectible, but is not generally accepted unless immaterial.

• Allowance Method: Estimates are recorded as an expense and a contra-asset (Allowance for Doubtful Accounts).

• Direct Write-Off Method: Bad debts are expensed when identified.

Estimating Credit Losses

• Balance Sheet Approach (Aging): Estimates uncollectibles based on the age of receivables.

• Income Statement Approach: Estimates uncollectibles as a percentage of net credit sales.

Age Group	Total	Percentage Uncollectible	Estimated Uncollectible
Not yet due	$51,000	1%	$510
1 to 30 days past due	$29,000	3%	$870
31 to 60 days past due	$12,000	10%	$1,200
61 to 90 days past due	$3,000	20%	$600
Over 90 days past due	$5,000	50%	$2,500
Totals	$100,000		$5,680

Factoring Accounts Receivable

Factoring is the sale of accounts receivable to a financial institution for immediate cash. This practice is common among small businesses lacking established credit.

Credit Card Sales

Sales through credit card companies allow merchants to receive cash quickly and avoid bad debts, as well as the costs of credit investigation and collection.

Notes Receivable and Interest Revenue

Promissory Notes

A promissory note is a written promise to pay a definite sum at a future date. The maker is the party promising to pay, and the payee is the party to be paid. Notes receivable are reported as assets.

Interest Calculation

Interest is the charge for using money, calculated as:

$Interest = Principal \times Rate \times Time$

Example: For a $200,000, one-year, 6% note: $200,000 \times 0.06 \times 1 = $12,000$ interest.

If the term is four months: $200,000 \times 0.06 \times \frac{4}{12} = $4,000$ interest.

Defaulted Notes

If a note is not collected at maturity, it is transferred to accounts receivable, including both principal and interest due.

Financial Analysis of Receivables

Accounts Receivable Turnover Rate

This ratio measures how efficiently a company collects its receivables:

$\text{Accounts Receivable Turnover} = \frac{\text{Annual Net Sales}}{\text{Average Accounts Receivable}}$

Average Collection Period

This ratio indicates the average number of days to collect receivables:

$\text{Average Collection Period} = \frac{\text{Days in Year}}{\text{Accounts Receivable Turnover}}$

Summary of Key Learning Objectives

• Financial assets include cash, marketable securities, and receivables, valued at face amount, market value, and net realizable value, respectively.

• Cash management and internal controls are essential for safeguarding assets and ensuring accurate records.

• Bank reconciliations ensure agreement between company and bank records.

• Marketable securities are reported at fair value, with gains and losses recognized in income.

• Receivables require internal controls and estimation of uncollectibles using the allowance or direct write-off methods.

• Notes receivable earn interest, calculated as principal times rate times time.

• Liquidity of receivables is assessed using turnover and collection period ratios.