CHAPTER

4
FINANCIAL ASSETS
What are financial assets of businesses?
 Financial Assets are an assets that can
be readily converted into cash.
 These include cash and bank accounts,
account receivable plus securities and
short term investment accounts.
 These assets can be converted into cash
in a reasonably short period of time - one
year at most, but less time in many
cases.
1. What is cash?
 Cash is a medium of exchange which a
bank will accept for deposit and
immediate credit to the depositor’s
account.
 It is the most liquid of all assets and the
most readily available to pay debts.
 It is central to the operating cycle
because all operating transactions
eventually use or generate cash.
 The criteria generally used to define cash are
 it should be a medium of exchange,
 it should be available immediately for the payment of current
debts, and
 It should be free from any contractual restriction which would
prevent management of the business enterprise from using
it to meet any and all obligations.
 For example; Strictly speaking saving deposit
may not be withdrawn without prior notice to the
bank, but banks very seldom enforce this
requirement.
 Because of the role of cash plays in
financial transactions, internal control of
cash is needed.
Cash Control Methods
 The following ways are used as controlling
method of cash:
 Bank statement
 imprest systems
Bank Statements
 It Shows the beginning bank balance, deposits made, checks paid,
other debits and credits in the month, and the ending bank
balance.
 The cash balance indicated on the monthly bank statement seldom
agrees with the cash balance indicated by the depositor’s ledger
account for cash.
 The bank statement and cash account in the ledger do not agree
even if they are maintain to measure the same quantity. This is due
to that there is time lag between the time that transactions are
recognized by the two parties and some other errors.
 To verify this fact the two independent records should be
compared . When differences arise they must be corrected.
 In correcting the errors of bank statement we may use either of
the two forms of bank reconciliations.
FORMS OF BANK RECONCILIATION

 The two forms of bank reconciliation that

can be used to reconcile in common are:
1. both the bank balance and the
depositor’s records are reconciled to
correct balance, or
2. the bank balance is reconciled to the
balance in the depositor’s records
Bank Reconciliations
 A bank reconciliation is a necessary step in internal control.
 A bank reconciliation is the process of accounting to reconcile
the difference between the balance on a company’s bank
statement and the balance in its Cash account.
 This process involves making additions to and subtractions from
both balances to arrive at the adjusted cash balance.
 The following are the transactions that most commonly appear in a
company’s records but not on its bank statement:
1. Outstanding checks: These are checks that a company has
issued and recorded but that do not yet appear on its bank
statement.
2. Deposits in transit: These are deposits a company has sent to its
bank but that the bank did not receive in time to enter on the bank
statement.
 Transactions that may appear on the bank statement but
not in the company’s records include the following:

1. Service charges (SC): Banks often charge a fee, or service charge,

for the use of a checking account.
2. NSF (nonsufficient funds) checks: An NSF check is a check that a
company has deposited but that is not paid when the bank presents
it to the issuer’s bank.
3. Miscellaneous debits and credits: Banks also charge for other
services, such as printing checks.
The bank notifies the depositor of each deduction by including a
debit memorandum with the monthly statement.
A bank also sometimes serves as an agent in collecting on
promissory notes for the depositor. When it does, it includes a credit
memorandum in the bank statement, along with a debit
memorandum for the service charge.
 Bank reconciliation is used:
a. to arrive at the correct cash balance to be
reported in the balance sheet,

b. to discover errors made in recording cash

transactions, either by the bank or by the
depositors and

c. to provide information necessary to bring the

accounting records up to date
Reconciling the Bank Statement
Balance per Bank Balance per Depositor

+ Deposits by Bank
+ Deposits in Transit (credit memos)

- Service Charge
- Outstanding Checks - NSF Checks

± Bank Errors ± Book Errors

= Adjusted Balance = Adjusted Balance

Reconciling the Bank Statement
All reconciling Balance per Depositor

items on the + Deposits by Bank

book side (credit memos)

require an - Service Charge

adjusting - NSF Checks

entry to the ± Book Errors

cash account.
= Adjusted Balance
Reconciling the Bank Statement
Example
Instruction:- Prepare a July 31 bank reconciliation
statement and the resulting journal entries for the
Simmons Company using the given information below.
Given:- The July 31 bank statement indicated a cash
balance of $9,610, while the cash ledger account on that
date shows a balance of $7,430.

Additional information that are necessary for the

reconciliation are shown on the next slide.
Outstanding checks totaled $2,417.
A $500 check mailed to the bank for deposit had not
reached the bank at the statement date.
The bank returned a customer’s NSF check for $225
received as payment of an account receivable.
The bank statement showed $30 interest earned on the
bank balance for the month of July.
Check 781 for supplies cleared the bank for $268 but
was
erroneously recorded in our books as $240.
A $486 deposit by Simian Company was erroneously
credited to our account by the bank.
Reconciling the Bank Statement
Example
Balance per bank statement, July 31 $ 9,610
Additions:
Deposit in transit 500
Deductions:
Bank error $ 486
Outstanding checks 2,417 2,903
Adjusted cash balance $ 7,207

Balance per depositor's records, July 31 $ 7,430

Additions:
Interest 30
Deductions:
Recording error $ 28
NSF check 225 253
Adjusted cash balance $ 7,207
 Reconciling the Bank Statement
Example
GENERAL JOURNAL
P
Date Account Titles and Explanation R Debit Credit
Jul 31 Cash 30
Interest Revenue 30

31 Supplies Inventory 28
Accounts Receivable 225
Cash 253
 Imprest Systems
 Imprest system is a kind of financial accounting system,
and is most commonly used for petty cash.
 It consists of a cash balance which is replenished at the
end of the period or when circumstances require it
 Most companies need to keep some currency and coins
on hand for small payments.
 These currency and coins are needed for paying
expenses that are impractical to pay by check,
 Thus, this helps to control a cash fund and cash
advances.
PETTY CASH FUND
 a petty cash fund is established at a fixed amount. It is
a common form of imprest system.
 The fund is periodically reimbursed, based on the
documented expenditures, by the exact amount
necessary to restore its original cash balance.
 The replenishment check is equal in amount to the
expenditures made from the fund. As each cash
payment is made, a voucher or receipt is placed in the
fund in lieu of the cash removed.
 The vouchers should reviewed and canceled when the
fund is replenished
Example:
 Assume that on January 1, 2011 ABC company established a
petty cash of Birr 250. On January 20, 2011 the Cashier
requested replenishment for the bills paid during the period.
The following itemized list of payments from petty cash was
presented on January 20 for replenishment and on January
31, 2011 in connection with the month end audit.

List Jan. 20 Jan.31

Cash in fund Birr 9.00 Birr 150.00
Office sup. Exp. 171.00 77.00
Miscl. Expenses 65.00 25.00
Cash (over) & short 5.00 (2.00)
Total Birr 250.00 Birr 250.00
 What should be the entry on January 1, January 20
and December 31, 2011?
 January 1
 Establishment of petty cash

Debit Petty cash 250.00

Credit Cash at Bank 250.00

To record the establishment of petty cash fund

 To record the replenishment of petty cash
Jan. 20, 2011
Office supplies expenses 171
Miscellaneous expenses 65
Cash over and short 5
Cash 241
To record expenses incurred since Jan. 1 and to
replenish petty cash
 The cash over and short account is classified as
revenue when it has a credit balance and expense
when it has a debit balance.
 Cash Over and Short is debited for shortages and
credited for overages.
 Jan. 31, 2011
Office supplies expanses 77
Miscellaneous Expenses 25
Cash over and short 2
Cash 100
 To record expenses incurred since Jan. 20 and to replenish petty
cash

 The petty cash fund should be replenished at the end of the

accounting period so that the expenses paid from the fund are
recorded in the proper period and the end cash balance is stated
correctly.
 CHANGE FUND
 Change Fund:- A change fund is an
imprest fund used to facilitate the collection
of money from customers.
 The amount of the change fund is deducted
from the total cash on hand at the close of
business each day to determine the daily
cash collection.
 The cash should be counted and checked
against the cash register tape daily.
2. SHORT TERM INVESTMENTS
 Investment that matures within or holds for 12 months or less
than.
 This is an investment that a company can afford to invest excess
cash in stocks and bonds.
 Why business invest these cash in short term investment?
 to earn higher interest than what would be earned from a
normal savings account.
 To change unproductive cash balances into productive
resources through the purchase of short term investments.
 To earn a return as interest, dividends and if all goes well an
increase in market value
 In summary, short term investments which are classified in the
balance sheet as current assets must be readily salable and should
not be held for purposes of reinforce business relations with the
issuing entity
 Recording Transactions of short term investments
 At acquisition, short term investments are recorded at cost, the price of
the item in the market plus any cost incurred to the acquisition, such as
brokerage commissions and transfer taxes.
 Bonds acquired between interest dates are traded on the basis of the price
plus the interest accrued since the most recent interest payment.
 The accrued interest is separate asset which is purchased with the bonds.
 The cost of these two assets should be separated to achieve a clear
picture of the results of the investment in bonds.

Example: On January 31, 2011, ABC company placed an order with the broker to buy 100,
$1000, at 9% XYZ company bonds which mature on November 30, 2014, with interest dates
May 31 and November 30. The bonds were purchased on the same day at 1030, plus
accrued interest of $1,500 for two months. The brokerage commission was $500.

The total cost of the bonds and the total cash outlay are computed as follows
The total cost of the bonds and the total cash
outlay are computed as follows
Market price of bonds ($1030 x 100) $103,000
Add: Brokerage commission 500
Total cost of Bonds 103,500
Add: Accrued interest for 2 months on $100,000 @9% per 1500
year
Total cash outlay $105,000

The journal entry required to record the purchase of the bond is given below

Short term investment 103500

Accrued interest receivable 1500
Cash 105000

April 30, 2011 ABC company sold the XYZ company bonds at 1047.50 plus
accrued interest for five months. The amount of the brokerage commission is
$500. How much is the cash amount received from sales of the bond?
Computation of cash received from sales of bonds:
Market price of bonds ($1047.50 x 100) $104,750
Less Brokerage commission 500
Proceeds on sales of Bonds $104,250
Add: Accrued interest for 5 months on $100,000 @9%P.A 3750
Total cash received $108,000

Journal entry to record the sale of bonds on April 30, 2011 is as follows

Cash $108,000
Short term investment $103,500
Accrued Interest receivable 1,500
Interest Revenue 2,250
Gain from sales of short term investment 750
A principle of Asset Valuation: Market to Market

 The cost principle states to record short term investments on

the balance sheet at the lower of their cost or market value.
This is conservatism view
 But in 1993 FASB has changed the rule of lower of cost
or market in to Market to market principle.
Now, short term investments appear in the balance sheet at
their current market value as of the balance sheet date.
Then the value of marketable securities is adjusted to
current market value, an offsetting entry is made to an
account entitled unrealized Holding Gains or Loss on
investment.
The balance is located as special stockholders’ equity
account in the balance sheet
 For example: ABC company has marketable
securities that had a cost of 300,000. But on the
date of balance sheet it has a market value of
320,000.
 Prepare the journal entry and Present the
marketable securities in the balance sheet

Marketable securities 20,000

Unrealized holding gain on investment 20,000
Presentation of marketable securities in the
Balance sheet
ABC company
Balance sheet
October 31, 2011
Assets Liabilities
Current Assets XY xxxxx
Cash
xxxxxx
Marketable securities (cost, 300,000;
market value, 320,000) 320,000
Stockholders’ equity
. Capital stock xxxxx
. Retained Earning xxxxx
. Unrealized holding gain
Total assets xxxxxxx On investment 20,000
Total xxxxxxx
 3. ACCOUNTS RECEIVABLE
 Account receivables are relatively liquid assets, usually
converting into cash within a period of 30 to 60 days.
 Account receivables are current assets. The period used to
defined Current assets is typically one year or the company’s
operating cycle, which ever is longer.
 The operating cycle which defined the normal period required
to convert cash into inventories, inventories into account
receivable and account receivables into cash.
 Therefore, all accounts receivable arising from normal sales
activity are generally classified as current assets, even if the
credit terms extend beyond one year.
 The accounts receivable of business enterprises may not be
collected as whole due to some reasons.
 Thus, there are some uncollectable accounts receivables.
Uncollectible Accounts
 IfIf aa company
company makes
makes credit
credit sales
sales to
to customers,
customers, some
some
accounts
accounts are
are expected
expected to
to be
be uncollectible.
uncollectible.
 Two
Two methods
methods of
of accounting
accounting for
for uncollectible
uncollectible accounts
accounts
are
are used
used inin practice-the
practice-the allowance
allowance method
method and
and the
the
direct
direct write-off
write-off method.
method.
 When
When itit isis highly
highly probable
probable that
that some
some accounts
accounts will
will
prove
prove uncollectible
uncollectible and and the
the dollar
dollar amount
amount cancan be
be
reasonably
reasonably estimated,
estimated, estimates
estimates of
of bad
bad debt
debt expense
expense
should
should be be made
made and
and recorded
recorded in
in the
the period
period in
in which
which
the
the sale
sale takes
takes place.
place.
Example:
Z-company sold on account to its customers during
the month of September 2013. On September 30, 2013
the account receivable amount is Birr 300,000. On
this date the manager reviews the accounts
receivable and estimated that approximately Birr
10,000 of these account will prove to be
uncollectable.

An adjusting entry on September 30, 2013 is

Uncollectiable accounts expense 10,000

Allowance for Doubtful accounts 10,000

 The Allowance for Doubtful accounts is a deduction

from the face amount of accounts receivable when
it appears in the balance sheet
 It reduces the accounts receivable to their net
realizable value in the balance sheet
Reflecting Uncollectible Accounts in
the Financial Statements

At
At the
the end
end of
of each
each period,
period,
record
record an
an estimate
estimate of
of the
the
uncollectible
uncollectible accounts.
accounts.

Selling
Sellingexpense Contra-asset
expense Contra-assetaccount
account
 Approaches to estimate the Allowance for
Doubtful Accounts
 There is no way to tell in advance which account
receivable will prove to be uncollectable
 Therefore, an alternative solution is applied to
estimate uncollectible accounts and credit a
separate account called “ Allowance for Doubtful
Accounts”.
 It is described as contra –asset account or a
valuation account.
 The balance of allowance for doubtful account is
offset against the accounts receivable to produces
net realizable values
 The net realizable value is the amount of accounts
receivable that the business expects to collect.

Accounts Receivable xxxxxx

Less: Allowance for Doubtful accounts xxxx
= Net realizable value of accounts receivable XXXXXX

To estimate the allowance for doubtful accounts there are

two general approaches.
1. The balance sheet approach and
2. The income statement approach
 1. The Balance sheet Approach

 The balance sheet approach; the most widely used method of estimating
the probable amount of uncollectible accounts; is based on aging the
accounts receivable.
 Aging accounts receivable means classifying each receivable according
to its age
 Under aging method, the longer an account is past due, the greater the
likelihood that it will not be collected in full.
 If the allowance for doubtful account has a credit balance prior to
adjustment of the current period, the credit balance should be deducted
from the total amount of estimated uncollectible balance of current
period.
 If the Allowance for doubtful account has a debt balance, prior to the
adjustment of the current period, the debit balance should be added
with the current uncollectible amounts
 Estimating Credit Losses — The
“Balance Sheet” Approach

 Year-end
Year-end Accounts
Accounts Receivable
Receivable is
is broken
broken
down
down into
into age
age classifications.
classifications.


 Each
Each age
age grouping
grouping has
has aa different
different
likelihood
likelihood ofof being
being uncollectible.
uncollectible.

 Compute
Compute aa separate
separate allowance
allowance for
for each
each
age
age grouping.
grouping.
 EXAMPLE:

At December 31, 2003, the receivables for East Co, were

categorized as follows:


At December 31, 2003, the receivables for
EastCo, Inc. were categorized as follows:

 
At December 31, 2003, the receivables for
EastCo, Inc. were categorized as follows:

  
East
East Co’s
Co’s unadjusted
unadjusted balance
balance in
in
the
the allowance
allowance account
account is
is $500.
$500.
Based
Based on
on the
the computation,
computation, the
the
desired
desired balance
balance isis $1,350.
$1,350.
2. The Income Statement Approach
 An income statement approach focuses on
estimating the uncollectible accounts
expenses for the period
 Based on prior experience the
uncollectible account expense is estimated
at some percentage of net credit sales
 The adjusting entry is made in the full
amount of the estimated expenses, without
regard for the current balance in the
Allowance for Doubtful accounts
 Focus is on determining the amount to
record on the income statement as
Uncollectible Accounts Expense.
The Income Statement Approach to Estimating Credit
Losses
Net
Net Credit
Credit Sales
Sales
 %
% Estimated
Estimated Uncollectible
Uncollectible
Amount
Amount of
of Journal
Journal Entry
Entry
Example 1:
Assume that a company's past experience indicates that
about 2% of its credit sales will prove to be
uncollectible. If credit sales for September amount to be
Birr 150,000, the month end adjusting entry to record
uncollectible accounts expense is
Uncollectible accounts expense 3,000
Allowance for Doubtful accounts 3,000
Adjusting journal entry
 Uncollectible Accounts
Summary
%
%of
ofReceivables
Receivables Aging
Agingof
ofReceivables
Receivables %
%of
ofSales
Sales

Emphasis
Emphasisonon Emphasis
Emphasisonon Emphasis
Emphasison
onMatching
Matching
Realizable
RealizableValue
Value Realizable
RealizableValue
Value

Accts. Accts. Sales

Rec. All. for Rec. All. for Uncoll.
Doubtful Doubtful Accts.
Accts. Accts. Exp.

Income
Income
Balance
BalanceSheet
Sheet Balance
BalanceSheet
Sheet Statement
Statement
Focus
Focus Focus
Focus Focus
Focus
Writing Off an Uncollectible Account
Receivable

When an account is determined to be uncollectible,

it is no longer qualifies as an asset and should be
written off.
 Writing Off an Uncollectible Account Receivable
 Assume that on January 5, K-Max determined that Mr X would not pay the
$500 he owes.

 Before writing of the uncollectible account, the Accounts Receivable balance

was $10,000 and the Allowance for Doubtful Accounts balance was
$2,500.Let’s see what effect the write-off had on these accounts.

K-Max would make the following entry.

 Writing Off an Uncollectible Account
Receivable

Before After
Write-Off Write-Off
Accounts receivable $ 10,000 $ 9,500
Less: Allow. for doubtful accts. 2,500 2,000
Net realizable value $ 7,500 $ 7,500

Notice that the $500 write-off did not change the net realizable value
and did it affect any income statement accounts.
 Recovery of an Account Receivable Previously Written
Off
Subsequent
Subsequent collections
collectionsrequire
requirethat
that the
theoriginal
originalwrite-off
write-off
entry
entrybe
bereversed
reversed before
beforethe
thecash
cashcollection
collectionis
isrecorded.
recorded.

GENERAL JOURNAL
P
Date Account Titles and Explanation R Debit Credit
Accounts Receivable (X Customer) $$$$
Allowance for Doubtful Accounts $$$$

Cash $$$$
Accounts Receivable (X Customer) $$$$
 Direct Write-Off Method
This method makes no attempt to match
revenue with the expense of uncollectible
accounts.
Accounts Receivable Bad Debt Expense (Using Aging Schedul
e For Uncollectible Accounts).mp4
 Notesreceivable
Notes receivableand
andInterest
Interest Revenue

Revenue
Account receivables usually do not bear interest
 Account receivables usually do not bear interest
 When interest will be charged, creditors usually require the debtors to
 Whena interest
sign will be charged,
formal promissory note.creditors usually require the debtors to sign
a formal promissory note.
 Maker of the note is the person who sign the note and thereby to pay
 Theamount
the person who sign
of the the note and thereby to pay is maker of the note
note.

 The person
The persontotowhom
whompayment
payment is to
is be
to made is called
be made the payee
is called of the of
the payee note.
the
 note.
The maker of the note is expected to pay cash at the maturity date of the
note
 The maker of the note is expected to pay cash at the maturity date of
 If the
the term of a note is expressed in days, the exact number of days in each
note
month must be considered in determining the maturity date of the note
 If the term of a note is expressed in days, the exact number of days in
 The day
each on which
month must bea note is datedinis determining
considered not counted, the
but maturity
the date on which
date it
of the
matures is included.
note

 For example:
The day on A two
which a daysisnote
note dated dated
is today
not will but
counted, matures
the the on
date daywhich
after
tomorrow.
it matures is included.
 For example: A two days note dated today will matures the day after
tomorrow.
 Example
 Assume that on December 1 a 90 day, 6% note receivable is acquired from a
customer, ”A” in settlement of an existing account receivable of 60,000.
 The entry or acquisition of the note is as follows
Notes Receivable 60,000
Accounts receivable 60,000
The entry to record the interest accrued end of accounting period Dec. 31.
and others are as follows
Interest receivable 300
Interest Revenue 300
Entry on the date of maturity of note
Cash 60,900
Notes Receivable 60,000
Interest receivable 300
Interest Revenue 600
 Dishonored Notes
 When the maker of a note fails to pay on the due date, the note
receivable is considered to be dishonored. A dishonored note is no
longer negotiable.
 The note receivable that cannot be collected at the maturity date is
said to be have been defaulted by the maker.
 Immediately after the default of a note, an entry should be made by
the holder to transfer the amount due from the notes receivable
account to an account receivable from the debtor.
 Assume that On March 1, customer A had defaulted on the note
used in the preceding example. In this case the entry on March 1
should be as follows
Account receivable (A) 60,900
Notes Receivable 60,000
Interest Receivable 300
Interest Revenue 600