Chapter Summary

Financial assets are cash and other assets that convert directly into known amounts of cash. The three basic categories are cash, marketable securities, and receivables. In the balance sheet, financial assets are listed at the current value. For cash, this means the face amount; for marketable securities, current market value; and for receivables, net realizable value.

The objectives of cash management are accurate accounting for cash transactions, the prevention of losses through theft or fraud, and maintaining adequate--but not excessive--cash balances.

The major steps in achieving internal control over cash transactions are as follows: (1) separate cash handling from the accounting function, (2) prepare departmental cash budgets, (3) prepare a control listing of all cash received through the mail and from over-the-counter cash sales, (4) deposit all cash receipts in the bank daily, (5) make all payments by check, (6) verify every expenditure before issuing a check in payment, and (7) promptly reconcile bank statements.

The cash balance shown on the month-end bank statement usually will differ from the amount of cash shown in the depositor's ledger. The difference is caused by items that have been recorded by either the depositor or the bank, but not recorded by both. Examples are outstanding checks and deposits in transit. The bank reconciliation adjusts the cash balance per the books and the cash balance per the bank statement for any unrecorded items and thus produces the correct amount of cash to be included in the balance sheet at the end of the month.

The purpose of a bank reconciliation is to achieve the control inherent in the maintenance of two independent records of cash transactions: one record maintained by the depositor and the other by the bank. When these two records are reconciled (brought into agreement), we gain assurance of a correct accounting for cash transactions.

Under the allowance method, the portion of each period's credit sales expected to prove uncollectible is estimated. This estimated amount is recorded by a debit to Uncollectible Accounts Expense and a credit to the contra-asset account Allowance for Doubtful Accounts. When specific accounts are determined to be uncollectible, they are written off by debiting Allowance for Doubtful Accounts and crediting Accounts Receivable.

Under the direct write-off method, uncollectible accounts are charged to expense in the period that they are determined to be worthless.

The allowance method is theoretically preferable because it is based on the matching principle. However, only the direct write-off method may be used in income tax returns.

The most liquid financial asset is cash, followed by cash equivalents, marketable securities, and receivables. The liquidity of receivables varies depending on their collectibility and maturity dates.

The allowance for doubtful accounts should provide for those receivables that may prove to be uncollectible. However, users of financial statements may also want to evaluate the concentrations-of-credit-risk disclosure and, perhaps, the credit ratings of major debtors. The accounts receivable turnover rate provides insight as to how quickly receivables are collected.

These effects are summarized in the table on page 298.

When securities are purchased, they are recorded at cost. Interest and dividends generally are recognized as revenue when they are received. When securities are sold, the cost is compared to the sales price, and the difference is recorded as a gain or a loss. At the end of each accounting period, the balance of the controlling account is adjusted to reflect the current market value of the securities owned.

Interest is a contractual amount that accumulates (accrues) day by day. The amount of interest accruing over a time period may be computed by the formula Principal x Rate x Time.

Whether interest revenue is recognized as it accrues or as it is received depends on the materiality of the amounts involved.

This is the first of three chapters in which we explore the issues involved in accounting for assets. The central theme in these chapters is the valuation of assets.

The valuation of assets affects not only the balance sheet but also the measurement of net income. With respect to cash, there is little question as to the appropriate valuation. The savings and loan crisis in the late 1980s, however, showed that the valuation of notes receivable requires professional judgment and can be a measurement of critical importance.

In the next two chapters, we explore the valuation of inventories and of plant assets. For each of these assets, you will see that several alternative valuation methods are acceptable. These different methods, however, may produce significantly different results. An understanding of these alternative accounting methods is essential to the proper use and interpretation of financial statements and in the preparation of income tax returns.