Search 72,336 tutors
FIND TUTORS

Financial Assets

This lesson discusses financial assets: Cash, Accounts Receivable, Short Term Investments.

What are financial assets?
Financial assets include Cash, and those assets that can be converted to cash in a reasonably short period of time - one year at most, but less time in many cases. We will study the following financial assets:

  • Cash
  • Cash Equivalents
  • Short Term Investments
  • Accounts Receivable

Valuation of Financial Assets

Financial assets are valued as of balance sheet date, when financial statements are prepared. They are valued at the equivalent of their current Cash value - what they would be worth if we could convert them to cash now. In the case of Cash, it is already at it's current value. Short Term Investments are reported at their current market value. Accounts Receivable are adjusted for possible bad debts.

Cash and Cash Equivalents

Cash is just as the word suggests. It includes cash money including paper and coins, checks and money orders to be deposited, money deposited in bank accounts that can be accessed quickly. The term liquid refers to Cash, and the ease or difficulty of converting an asset into Cash.

Cash Equivalents are highly liquid short term investments that can be turned into Cash very quickly. These include US Treasury bills, money market accounts and high grade commercial paper. When corporations need to borrow money for a very short time, they often sell commercial paper. These come due within a few months at most, and pay a higher interest rate than other investments.

Bank Reconciliation

Banks send statements to their depositors each month.

A bank reconciliation compares the information in the bank statement with the company's Cash account, and finds any discrepancies. These are recorded or dealt with as needed. The process is fairly simple.

The bank balance and book Cash balance are listed on a piece of paper (now we often use computers). Some items show up on the bank statement, but have not been reflected in the books yet. These items will be added to or subtracted from the book balance.

Some transactions have been recorded in the books, but have not yet cleared the bank. These include deposits in transit, which are not yet posted in the bank's records - those made after the date of the bank statement. And outstanding checks - those which have been written and mailed, but haven't cleared the bank yet. These items are added to or subtracted from the bank balance.

Once all items have been included, the adjusted bank and book balances should be equal. If they are not, the reconciliation needs to be reviewed and corrected until the two amounts are equal.

Bank Reconciliation

Adjustments to Bank Balance Adjustments to Book Balance
Add Deposits in transit Add anything on bank statement that increases cash balance, but has not been recorded in the books: bank collections, interest earned
Subtract Outstanding checks Subtract anything on bank statement that decreases cash balance, but has not been recorded in the books: bank charges and fees, bad checks, interest charges
Bank errors (add or subtract as needed); notify bank of error; these don't happen very often, but we need to watch for them Add or subtract for accounting errors relating to deposits or checks.
Do not record any of these adjustments in the books. These adjustments must be entered as journal entries, so the books agree with the bank balance.

Short Term Investments

Short Term Investments include stocks and bonds that the company intends to hold only for a short time, and then sell and convert back to Cash. We consider it a good practice to convert unneeded cash to an investment account, where it can earn interest, dividends or show capital gains. These are shown on the balance sheet at their current market value, even if that is higher than the price paid for the investments. This is one of the few times we increase a balance sheet item above it's historic cost.

Accounts Receivable

Companies often sell to their customers on credit. The amount the customers owe is called Accounts Receivable (AR). We would record AR at the same time the sale is made, deducting any cash paid at the time of purchase, etc. When customers pay, we subtract the payment from their accounts receivable balance.

Most companies use an Accounts Receivable Subsidiary Ledger, which is similar to the General Ledger. The subsidiary ledger contains detailed information about each customer's account - purchases, payments, returns, adjustments, etc. Most companies send statements at the of each month, listing the monthly transactions and ending balance due from each customer.

Uncollectible Accounts

When businesses sell on credit, they run the risk that some customers will not pay their bill. Legitimate complaints, errors in billing , etc. are dealt with in an appropriate manner, and the books are adjusted as needed to correct any errors, or show returns and allowances (price adjustments). Still, some customers don't pay their bill, for any of a variety of reasons, and we must have a way to deal with this in the books, and on the financial statements.

We do this by setting up an account that is a companion to Accounts Receivable. It is called the Allowance for Uncollectible Accounts (or something similar - Allowance for Doubtful Accounts is often used).

Allowance for Doubtful Accounts is called a contra-asset account. It is a companion to Accounts Receivable, and has an opposite balance. When we net the two balances, we get the amount we expect to collect from customers, allowing for those who don't pay.

The allowance account is established each year, at balance sheet date. We usually prepare an Accounts Receivable aging report, which gives us a history of customers accounts tabulated in columns, each column representing one month. We can quickly see which customers are late paying their bills by 30 day, 60 days, 90 days, etc. We would expect that if a customer hadn't paid their bill after 90 days there is a good chance they won't pay at all. The risk of loss goes up as accounts go unpaid for longer periods of time.

Companies use the aging report to make a dollar estimate of how much they will lose in unpaid account balances. At that time we have no way to know exactly which customers won't pay. But by tracking its business history a company can estimate a dollar amount that they believe is reasonable.

When the allowance account is established, an expense account is also debited. That account is called Uncollectible Accounts Expense, Bad Debt Expense, Provision for Bad Debt, or something similar. So the loss due to bad debts is recognized as a normal business expense on the Income Statement.

Writing Off Bad Debts

Periodically, and no less than once a year, a company must review it's accounts receivable and identify any customers who have not paid their bill for a very long time, generally over 90 days. Information is gathered about these customers, and attempts at collection should be made. However, the customer may be out of business, bankrupt, etc. and it is unlikely the company will be paid by these customers.

When this happens, the debt is no good and should be removed from the books. We do that by making an entry to both Accounts Receivable and the allowance account, reducing the balance in both accounts. Writing off bad debt should be done with management's approval. Potentially collectible accounts should be pursued; only legitimately uncollectible accounts should be written off.

The allowance method is acceptable for accounting, and correct under GAAP. However, no allowance expense is permitted for tax returns. Only accounts actually written off can be expensed on a tax return, and then only in the year the account is deemed uncollectible.

Financial Analysis

Financial statements contain valuable information, but it must be analyzed to make relevant and correct decisions. Certain ratios are commonly used by investors and analysts. These are not difficult. All the information you need is already in the financial statements, as required by GAAP. And these ratios are used by thousands of people on a daily basis. No college degree or great math skills are required to use financial ratios.

Ratios can be used to evaluate a company's performance over a number of years. It can also be used to compare several different companies. Bankers often use ratios when considering a loan application. And investors calculate ratios to decide which stocks to buy or sell.

Sign up for free to access more accounting resources like . WyzAnt Resources features blogs, videos, lessons, and more about accounting and over 250 other subjects. Stop struggling and start learning today with thousands of free resources!