Chapter 10. Learning Objectives. Receivables. Receivables. Horngren, Best, Fraser, Willett: Accounting 6e 2010 Pearson Australia

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1 PowerPoint to accompany Chapter 10 Receivables Learning Objectives 1. Design internal controls for receivables 2. Use the allowance method to account for bad debts 3. Use the direct write-off method to account for bad debts 4. Account for bills receivable 5. Report receivables on the balance sheet 6. Use the acid-test ratio and days sales in receivables to evaluate a business Receivables Accounts receivable (Trade receivables) Bills receivable (Notes receivable)

2 Objective 1 Design internal controls for receivables. Establishing Internal Control What are some controls over accounts receivable? Control over mail receipts Approval for write-off Separation of duties The Credit Department Companies grant credit to customers in order to increase sales. The credit department evaluates customers who apply for credit cards.

3 Why Have Credit sales? The benefit: The business increases revenues and profits by making sales to good customers who cannot pay cash immediately. The cost: The business will be unable to collect from some of its credit customers. Accountants label this cost bad debts expense The Allowance Method Firms with significant credit sales will use the allowance method to measure bad debts This makes an estimate of what debts will go bad based on experience This is recorded in a contra account related to accounts receivable Allowance for doubtful debts Objective 2 Use the allowance method to account for bad debts

4 Methods for Estimating Bad Debts Percentage of Sales Ageing of Accounts Receivable Percentage of Sales This is also called the income statement approach. It is based on prior experience of the business. It is calculated as a percentage of credit sales. It ignores the current balance of the allowance account. The percentage used is adjusted as needed to reflect collection experience. Percentage of Sales Example The credit department of Anna s Boutique estimates (based on prior experience) that 1% of net credit sales are uncollectible. Net credit sales for the year just ended (Dec 31) were $500,000. What is the adjusting entry? $500, % = $7,500.

5 Percentage of Sales Example Dec 31, Bad Debts Expense 7,500 Allowance for Bad Debts 7,500 Recorded bad debts expense for the year Percentage of Sales Example What is the effect of this adjusting entry? Decrease in Net Profits Decrease in net Accounts Receivable Ageing of Accounts Receivable This approach is also called the balance sheet approach because it focuses on accounts receivable. Individual accounts receivable from specific customers are analysed according to the length of time they remain outstanding.

6 Ageing of Receivables Example Assume that International Hospital s past collection experience indicates the following: Length of time % uncollectible 1-30 days days days days 8.0 Ageing of Receivables Example Length Amount % 1-30 $1,900,000 2 $ 38, ,000, , , , , ,000 Total $4,100,000 $143,000 Accounts Receivable Allowance for Bad Debts Ageing of Receivables Example The allowance account is adjusted to this $143,000 balance: Assume that the account currently has a credit balance of $100, What is the adjustment?

7 Ageing of Receivables June 30 Bad Debts Expense 43,000 Allowance for Bad debts 43,000 To record the allowance for bad debts What if the account had a debit balance of $1,000? Ageing of Receivables Allowance for Bad Debts Adjustment 1, ,000 Adjusted balance 143,000 Comparing the Percentage of Sales and Ageing Methods p.406

8 Writing Off Bad Debts What happens when it becomes apparent that an account will not be able to be collected? It must be written off. How? Debit Allowance for Bad Debts. Credit Accounts Receivable. Recoveries How is the collection of a previously written off account recorded? Debit Accounts Receivable (to reinstate the account) and Credit Allowance for Bad Debts. Then Debit Cash and Credit Accounts Receivable (to record the collection). Objective 3 Use the direct write-off method to account for bad debts.

9 Direct Write-Off Method Using this method, an account is written off only when it becomes uncollectible. No allowance account is created. This method is simple to use but: The balance sheet is overstated. (No contra account). The income statement is understated. Credit-card and Bankcard Sales These save retailers the cost of a credit department. The retailer is required to pay a fee (called a discount) for usage. Credit-card and Bankcard Sales How would Anna s Boutique record a $100 credit card sale with a 3% service charge? Accounts Receivable (credit card) 97 Credit Card Charge 3 Sales Revenue 100 To record a credit card sale of $100 less a 3% service charge fee

10 Credit-card and Bankcard Sales How would Anna s Boutique record a $200 bankcard sale with a 3% service charge? Cash 196 Credit Card Charge 4 Sales Revenue 200 To record a bankcard sale of $200 less a 2% service charge Debit-card Sales Using a debit card is like paying with cash. Bills Receivable: An Overview A bill receivable may arise from a sale or may be given in settlement of an account receivable. The Acceptor pays the Drawer the maturity value. The maturity value is paid on the maturity date and includes principal plus interest. See Exhibit 10-5 page 411 of the textbook.

11 Identifying a Bill s Maturity Date When the period is given in days the maturity date is determined by counting the days from the date of issue. When the period is given in months the maturity date is on the same day of the month as the date the bill was issued. Although the period of the bill is usually less than one year interest rates are usually stated as an annual rate. Calculating Interest on a Bill Principal Rate Time = Interest Calculate interest on the bill due to State Bank. Principal: $10,000 Interest: 10% Time: June 1, 2006, to August 29, 2006 $10,000 10% = $ Objective 4 Account for bills receivable.

12 Recording Bills Receivable Assume the accounting period ended June 30. How much interest was earned by the bank as of June 30? $10,000 10% (30* 365) = $82.19 * 30 days from June 1 to June 30 Recording Bills Receivable June 30 Interest Receivable Interest Revenue To accrue interest on the bill (adjusting entry) Recording Bills Receivable How does the bank record the collection at maturity? August 29 Cash 10, Bill Receivable 10, Interest Receivable Interest Revenue Record interest on bill

13 Discounting a bill Receivable The drawer (one who will receive the money) may sell (discount) a bill so they receive money now, rather than at maturity. From the previous example State Bank discounts the bill on June 21, discount rate is 12% (this is not the actual interest rate). $10, % 70* / 365 = $ *70 days is June 21 to August 29 Discounting a Bill Receivable How does the bank record the discounting? June 21 Cash 10, Bill Receivable 10, Interest Revenue Record interest on bill $10.77 = $10, $ Dishonoured Bills Receivable If the maker of the bill fails to pay the maturity value to the new payee, then the original payee legally must pay the bank the amount due (unless the discounting is without recourse). This gives rise to a contingent liability for the drawer when they discount a bill.

14 Objective 5 Report receivables on the balance sheet. Reporting Receivables Some companies report a single amount for their current receivables in the body of the balance sheet. They use a note to the financial statements to give more details. See BHP Billiton's example page 416 textbook. Objective 6 Use the acid-test ratio and days sales in receivables to evaluate a business.

15 Acid-test Ratio This is a more stringent test of liquidity than the current ratio. It measures the entity s ability to pay its current liabilities immediately. Acid-test ratio = (Cash + Short-term investments + Net current receivables) Total current liabilities Days Sales in Receivables It is a measure of the time it takes to collect receivables. A smaller number indicates a quick conversion to cash. Days Sales in Receivables One day s sales = Net sales 365 days Days sales in average accounts receivable = Average net accounts receivable One day s sales

16 PowerPoint to accompany End of End of Chapter 10

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