6.1 Cash, Accounts Receivables, and Notes Receivables

Financial Flexibility and Liquidity

  • Investors and creditors are interested in a company's financial flexibility, which is its ability to adapt to change using its financial resources.
  • Liquidity is a key component of financial flexibility, referring to how quickly a company can convert liquid assets into cash to cover operating costs.
  • Common liquid assets include cash, accounts receivables, and notes receivables.

Cash

  • Cash is listed first in the order of liquidity on a company's balance sheet. Approximately 89% of companies report "cash and cash equivalents" as the first item under current assets.
  • Cash includes:
    • Cash on hand (coins, currency, petty cash).
    • Bank account balances (checking and savings accounts).
    • Money orders.
    • Undeposited checks from customers.
    • Cashier's checks and certified checks.
  • The statement of cash flows reconciles changes in cash from the beginning to the end of the year.

Criteria for Classifying an Item as Cash

  • Readily Available: The cash must be available for paying current obligations (e.g., payroll, utility bills) without restrictions.
  • Free from Contractual Restrictions: If cash is restricted and the amount is material, it must be reported separately as a short-term or long-term investment.
Restricted Cash Example: Compensating Balances
  • Compensating balances are often required by banks to support loan arrangements.
    • A lender may require a company to maintain a certain balance to ensure loan repayment ability.
  • If legally restricted, the compensating balance is classified as a short-term or long-term investment, depending on when the funds will be available (i.e., when the loan matures).
    • Short-term investment: if the loan matures within nine months from the balance sheet date.
    • Long-term investment: if the loan matures in five years.
  • Another example of restricted cash is a bond sinking fund, where cash is set aside to ensure the retirement of debt.

Cash Equivalents

  • Cash equivalents are very short-term, highly liquid investments that:
    • Are readily convertible into a known amount of cash.
    • Are so near maturity that there is minimal risk of value change due to interest rate changes.
  • "So near maturity" is defined as three months or less from the purchase date to the maturity date.
  • These short term investments must be interest bearing.
    Investments in stock do not qualify as cash equivalents because their future value is uncertain, and they do not mature.

Examples of Cash Equivalents

  • Treasury Bills (T-Bills): Loans to the U.S. government with maturities of four, thirteen, or twenty-six weeks, sold in denominations of 1,0001,000. If maturity is three months or less from the purchase date, they qualify as cash equivalents.
  • Commercial Paper: Short-term notes issued by corporations with good credit ratings, generally yielding higher returns than T-bills. If maturity is three months or less, they qualify as cash equivalents.
  • Money Market Funds: Represent a mix of treasury bills and commercial paper. If they allow for withdrawal privileges, they qualify as cash equivalents.

Example Problem: Classifying Cash and Cash Equivalents

Determine the amount of cash and cash equivalents to be reported on the December 31 balance sheet:

  1. Commercial savings account with a balance of 600,000600,000: Included.
  2. Commercial checking account with a balance of 900,000900,000 at First Arizona State Bank: Included.
    • Combined total: 1,500,0001,500,000.
  3. Money market fund with check-writing privileges and a balance of 5,000,000: Included.
  4. Bond sinking fund of 1,500,000 (restricted for long-term debt retirement): Excluded.
  5. Commercial paper of 2,100,000 purchased on December 1, maturing in 60 days: Included (since it matures within three months).
  6. Compensating balance of 500,000 at First National Bank to ensure future credit availability: Excluded (not readily available for operating needs).
  7. Investment of 100,000 in IBM Corporation stock, intended to be held through February: Excluded (stock investments don't qualify).
  • Total cash and cash equivalents to be reported: 8,600,000((600,000 + 900,000 + 5,000,000 + 2,100,000).

Items Not Classified as Cash

  • Certificates of Deposit (CDs): Generally treated as short-term or long-term investments due to penalties for early withdrawal (representing a restriction).
  • Postdated Check: A check written with a future date; reported as an account receivable.
  • Insufficient Funds Checks (NSF): Checks from customers lacking sufficient funds; the account receivable is reinstated.
  • IOUs: Represent notes receivable or accounts receivable (e.g., loans to management).
  • Cash Advances: For travel or salaries; treated as prepaid expenses.
  • Restricted Cash: (e.g., bond sinking fund, compensating balance); classified as short-term or long-term investments.
  • Bank Overdraft: Reported as a liability (account payable) on the balance sheet.

Bank Overdraft Example

  • Sparky has two checking accounts: one at Arizona State Bank and another at Chase Bank.
  • Arizona State Bank: 10,000balance.ChaseBank:balance. Chase Bank:(2,500), overdrawn.
  • Because these are separate legal entities (banks), the (2,500) overdrawn account is reported as a current liability (account payable to Chase Bank).
  • Reported cash as of December 31: 10,000 (the positive balance at Arizona State Bank).
  • If both accounts were at the same bank, Sparky could net them and report cash of 7,500((10,000 - 2,500$$).