Accounting: The Language of Business - Vol. 2 (Intermediate: Part 136)

The appearance of corporations in the United States and the creation of the railroad were the catalysts that transformed bookkeeping into the practice of accounting.

Circulus. “1860–1880 History of Accounting.”

 Of the two factors, the railroad was by far the most powerful. For goods and people to reach their destinations, you need distribution networks, shipping schedules, fare collection, competitive rates, and some way to evaluate whether all of this is being done in the most efficient way possible. Enter accounting with its cost estimates, financial statements, operating ratios, production reports, and a multitude of other metrics to give businesses the data that they needed to make informed decisions.

 

*Investopedia*

Short-Term Operating Assets: Cash and Receivables (Part A)

by

Charles Lamson

Introduction

Would a balance sheet seem complete without cash? Nearly all firms report cash on their balance sheet and view it as a factor in day-to-day operations and growth. However, most companies sell the majority of these goods and services on credit and wait to receive the related cash flows. Why do businesses sell on credit and delay cash collection? The answer is simple: credit sales increase sales volume, motivating companies to trade off the risk that buyers will not pay against the benefits of increased sales.

Companies do mitigate this risk. For example, Levi Strauss & Company (Levi's), the global apparel company, analyzes new distributors for creditworthiness before it makes any sales on credit. Some portion of a company's receivables, however, will not be collected. Management must exercise judgment to estimate the losses expected from uncollected accounts receivable. It is impossible, though, to determine the amount of accounts receivable that will ultimately become uncollectable with perfect accuracy.

The financial statements disclose information related to these estimates. Levi's net accounts receivable from customers were $479 million, or about 16.0% of its total assets, at the end of fiscal 2016. Levi's estimated that it would not collect about $12 million, representing roughly 2.4% of accounts receivable, and reduced its accounts receivable by this amount. Levi's, like any other company, carefully monitors customers' accounts receivable to improve cash collections and make adjustments to its credit terms and policies.

Cash and receivables are parts of a company's short-term operating assets. As noted in the case of Levi's, receivables can make up a significant portion of a company's liquidity position. Receivables require proper credit management to ensure that a company can convert sufficient resources into cash needed to liquidate current obligations when they become due. Companies hold short-term operating assets such as inventory, supplies, and prepaid expenses in order to provide goods and services to customers on a timely basis.

In the next several posts, we will focus on cash and receivables, addressing two important issues: measurement and classification. Proper measurement and classification of cash and receivables enables a financial statement user to accurately assess a company's short-term liquidity position. Cash typically does not pose a significant measurement issue but may not always be available for use in the current operating cycle. Receivables involve both measurement (due to the risk of not collecting the cash) and classification issues (due to the timing of the expected collection). Any significant delay in the collection of receivables can adversely affect a company's operating cycle and liquidity position.

Accounting for Cash and Cash Equivalent

We begin our discussion of accounting for cash by reviewing key terminology and introducing concepts such as restricted cash, compensating balances, and required disclosures [For most of the relevant authoritative literature for this topic; see FASB ASC 305—Cash and Cash Equivalents and ASC 210-10—Balance Sheet—Overall for U.S. GAAP and IASC, International Accounting Standard 7, “Statement of Cash Flows” (London, UK: International Accounting Standards Committee, Revised) for IFRS.] We'll discuss internal controls over cash in a future post.

Review of Cash and Cash Equivalents

Together, transactions involving cash and cash equivalents are part of the firm's overall cash management activities. Companies add cash equivalents to cash in one line entitled “cash and cash equivalents” on the balance sheet. The statement of cash flows was introduced in Part 70. In the next several parts, we focus on the definition and measurement of cash.

Cash consists of coins, currency, and bank deposits, as well as negotiable instruments such as checks and money orders. Firms generally classify cash as a current asset unless it is restricted from use in the current operating cycle.

Cash equivalents are short-term, highly-liquid Investments with original maturities of three months or less; examples include treasury bills, commercial paper, certificates of deposit, and money market funds. Cash equivalents are cash substitutes that companies can easily convert back into cash if needed in the operating cycle. Original maturity is the length of time from the investment's purchase date to its due date. For example, a 3-year treasury instrument acquired with two months remaining until its due date qualifies as a cash equivalent because the company will hold it for less than three months.

Bank overdrafts occur if a company writes checks in amounts that exceed the balance in its account. That is, the account has a negative balance. Firms typically report bank overdrafts as current liabilities on the balance sheet rather than as “negative assets.” If material, firms also must disclose bank overdrafts in the notes or list them separately on the face of the balance sheet. 

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 443-444*

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