Liquid Assets

A firm's primary liquid assets are

  1. Cash
  2. Receivables
  3. Marketable Securities

Cash and Cash Equivalents

Cash creates mangement control problems because of the ease with which it can be converted to uses outside the firm. It also generates problems in terms of how much cash should the firm have on hand. Too little cash means the firms is likely to have problems covering current expenses (wages, utilities), too much cash means the firm is not getting a return on funds that it could if the excess cash were invested in other short term assets. On the balance sheet firms indicate their cash and cash equivalents. Cash is obvious and includes all the forms of cash the firm has on hand (petty cash, bank balances, etc.). Cash equivalents are items that can be converted to cash in a very short time. For example commercial paper with a maturity of less than 30 days is considered a cash equivalent. When bank balances are restricted firms should report cash with the amount restricted identified. Restricted cash amounts may come about because of lenders requiring that compensating balances be maintained by firms with outstanding loan balances.


Receivables can be separated into two categories, trade receivables, and nontrade receivables. Trade receivables are further categorized as Accounts Receivable, and notes receivable. Accounts receivable are accounts for which credit sales were allowed. Thus, accounts receivable should only be associated with the sale of goods on credit. They should not include other forms of receivables. Notes receivables represent short-term lending activity of the firm. In many cases the receivables that are not credit sale receivables will be grouped under the label notes receivable. Nontrade receivables include advances to officers, advances to subsidiarys, damage deposits, deposits for guarantees, and dividend and interest receivables.

Recording Receivables

Recording recievables occur when the goods have been transfered to the customer. Some firms entice customers to pay early by offering discounts if the account is paid in full by the end of a specified time period. For example, if the firm is offering 2/10 net 30, it is offering the customer a 2 percent discount if paid in 10 days and requires the full amount in 30 days. When discounts are offered firms must decide how to record the discount. The decision is whether to assume that everyone will take advantage of the discount and record the receivable at its net value (net method) or wait until the customer pays the bill and adjust accordingly when the customer pays within the discount period (gross method). The decision about which method to use depends on the type of information management is looking for. Is management interested the total number of discounts taken or forfeited. Under the net method the number of discounts forfeited is recorded when the customer fails to take advantage of the discount intially recorded. Under the gross method only the discount taken is recorded. Both accounts indicate something about the receivables policy of the firm.

Gross Method (assuming 2/10 net 30)
Accounts Receivable	$10,000
	Sales			$10,000

(within discount period)
Cash	$9,800
	Sales Discounts		$200
	Accounts Receivable	$10,000

(outside discount period)
Cash        $10,000
	Accounts Receivable	$10,000
Net Method (assuming 2/10 net 30)
Accounts Receivable   $9,800
	Sales	              $9,800

(within discount period)

Cash      $9,800
		Accounts Receivable   $9,800

(outside discount period)

Accounts Receivable     $200
	      Sales Discounts Forfeited    $200

Cash         $10,000
         Accounts Receivable  $10,000

Uncollectible Accounts

Whenever firm's offer to sell goods on credit there is a possiblity that the customer will ultimately fail to pay some or all of the account. The unpaid account becomes an expense of offering goods on credit and should be recognized during the period the cost is incurred. There are two methods of writing off the bad debt, the direct-write-off method and the allowance for doubtful accounts. The direct-write-off method debits bad debt expense and credits accounts receivable when the firm determines that the account is uncollectible. This approach, while targeting a specific account not being paid, has several draw backs. First, while the specific account is identified the period that the original sale occurred is ignored. Thus, there is a mismatch between the expense of selling on credit and the period that the expense is actually recognized. Second, by not recognizing the potential for accounts to become uncollectible the amounts reported on the financial statements are overstated in terms of the actual amount the firm will ultimately collect. Finally, the use of the direct method allows managers to manipulate earnings numbers through the timing of the write-offs. The ability to delay or expedite write-offs can have significant effect on reported profits for the period. Consequently, generally accepted accounting principles do not allow firms to use the direct-write-off method when losses from bad debts is significant, predictable, and occur frequently.

The second method of recognizing uncollectible accounts creates a contra asset account to offset reported Accounts Receivable called the "Allowance for Doubtful Accounts". The allowance account is adjusted each period to reflect the bad debt experience relative to expected bad debt experience (based on prior periods). In each period the allowance for doubtful accounts is credited and bad debt expense is debited. The resulting balance in the allowance for doubtful accounts at the start of the next period should be the expected bad debts for the next period. When an account is determined to be uncollectible the write-off occurs to the allowance account rather than to bad debts. Below are examples of each method when an account goes bad.

Direct Method


Accounts Receivable	$1,000
	     Sales	                $1,000

Account uncollectible

Bad Debt Expense      $1,000
           Accounts Receivable       	$1,000

Allowance for Doubtful Accounts


Accounts Receivable   $1,000
           Sales                $1,000

Account uncollectible

Allowance for Doubtful Accounts     $1,000
	      Accounts Receivable             $1,000

As mentioned above the allowance for doubtful accounts is adjusted at the end of each period to provide for an appropriate allowance amount to begin the next period. There are two methods for estimating the amount of bad debts expected for the period's sales. The two methods are percentage of sales or percentage of accounts receivable. In each method the firm adjusts its allowance account at the end of the period to reflect its past experience with bad debts based either on sales volume or accounts receivable. The percentage of sales method is illustrated in the following example:

Assume that the firm has $500,000 of credit sales each period
and expects that 1 percent of those sales will be uncollectible.
To reflect this in the current period's expense the following adjustment
is made to the allowance account

Bad Debt Expense       $5,000
	Allowance for Doubtful Accounts  $5,000

After this adjustment the account will begin the next period
with a $5,000 credit balance.  Bad Debt Expense for the current
period is $5,000 reflecting the estimated cost of offering 
sales on account.

The more interesting entry is the one necessary when the bad experience with bad debts is more or less than the expected amount. If the bad debt experience is more than expected the allowance account will have a debit balance at the end of the accounting period. If the bad debt experience is less a credit balance will remain. In each case the bad debt expense and the allowance account must be adjusted to prepare for the uncollectible accounts from the current period sales. Here are some examples of how this might work.

Assume the information available in the example above.  Also assume
that the firm's actual bad debt experience (amount written off 
to allowance account) is $4,000. Thus, at the end of the period the 
firm must make the following adjustment to the allowance account and to
record the bad debt experience.

Bad Debt Expense   $4,000
      Allowance for Doubtful Accounts    $4,000

After this entry the allowance for doubtful accounts will have
a $5,000 credit balance to begin the next period.  

Alternatively, assume that the actual amount written-off against the
allowance account for the period is $6,000.  At the end of the period
the allowance has a debit balance of $1,000.  To adjust the allowance
account and report the debt experience the following entry is made

Bad Debt Expense $6,000
    Allowance for Doubtful Accounts   $6,000

After this entry the allowance for doubtful accounts will have a $5,000
credit balance.

The second method of estimating bad debt experience is often referred to as the aging of accounts receivable method. In this method accounts are ranked with regard to the period they have been outstanding. Based on prior experience the firm determines what percentage of each group of outstanding accounts is likely to go bad. Obviously, the older the account the larger percentage likely to go unpaid. This method is more time consuming and costly but is more representative of which accounts are likely to go bad. Refer to your text for an example of this method.

Marketable Securities

FASB 115 requires that marketable securities be classified as one of three types, held-to-maturity, trading securities, and securities available for sale. Two of these categories, trading securities and available for sale securities, are reported on the financial statements at "fair value (analogous to market value)". Securities classified as held-to-maturity are reported at historical cost.

Tradable Securities
Trading securities are those which the company actively buys and sells. Gains and losses and these securities are recorded in the Unrealized Holding Loss or Unrealized Holding Gain on Valution of Trading Securities. The gain or loss is reported on the income statement of the current period.
Available for Sale
Securities that are classified as available for sale are those that do not fit the descripition of a trading security or held to maturity (discussed below) security. These are reported at fair value but gains or losses on the securities do not affect current period income. Gains and losses are reported as increases or decreases to the stockholder's equity account.
Held to Maturity
Securities in this classification are those that the firm shows an intent and ability to hold to maturity. They are recorded at acquisition cost. If the acquisition cost and the eventual maturity values are different the firm must amortize the difference over the maturity period as an adjustment to interest revenue.

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Professor Omer