Chapter 7 - Summary LO 1 Define financial assets and explain their valuation in the balance sheet. 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. LO 2 Describe the objectives of cash management. 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. LO 3 Explain means of achieving internal control over cash transactions. 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. LO 4 Prepare a bank reconciliation and explain its purpose. 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. LO 5 Account for uncollectible receivables using the allowance and direct write-off
methods. 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. LO 6 Evaluate the liquidity of various financial assets. 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. LO 7 Explain how transactions discussed in this chapter affect net income and cash
flows. These effects are summarized in the table on page 298. *LO 8 Account for transactions involving marketable securities. 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. **LO 9 Explain, compute, and account for the accrual of interest revenue. 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. |