Chapter 8. Receivables

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1 Chapter 8 Receivables Receivables mean amounts owed to the company by others. Accounts Receivable are receivables resulting from the company rendering services or selling products to the public. The company bills its customers/clients. There is no formal debt instrument. Notes Receivable are amounts owed to the company from promissory notes, which are formal written debt instruments that usually bear interest. Sometimes when customers are slow to pay their accounts receivable, the account receivable is converted into a promissory note that bears interest. Valuing Accounts Receivable A company reports the face value of its accounts receivable on its balance sheet. A principle of GAAP is conservatism. We don't want to show an account receivable as an asset when the company doesn't think that it will be collected. This is misleading to people looking at the balance sheet. A second GAAP principle involved in this topic is matching rule. Under the matching rule, during a period a company should report all of the expenses that helped generate the revenue reported during that period. The fact that some revenue from credit sales will not be collected is considered a Bad Debts expense, and it should be recorded in the year of the sale in question. Two methods are used to write off bad accounts receivable and record the bad debts expense. The two methods are (i), the direct method (also called the direct charge-off method or direct write-off method), and (ii) the allowance method. The allowance method is GAAP. The direct method is not. GAAP also has another principle which is materiality. If something is not a material amount, then you can report it the wrong way. Since it isn't material, the thought is that no one is harmed by doing it wrong. Something is material if a person's actions would have been different if he or she had known of the item in question. Therefore, if a company's bad accounts receivable are so small that they are not a material amount, then you can use the direct method to write off uncollectible accounts. Direct Write-Off Method For Accounts Receivable The direct method charges uncollectible accounts to an expense (a selling expense) in the period of default, which may or may not coincide with the period

2 of the related sale. A debit to Bad Debt expense or Uncollectible Accounts Expense and a credit to Accounts Receivable are made. D. Uncollectible Accounts Expense $100 Cr. Accounts Receivable $100 The direct charge-off method frequently violates the matching rule because accounts are often written off in periods subsequent to the sale. If this expense is not material, then companies may still use it. If a customer later pays the accounts receivable, you first must reinstate the account receivable, and then treat it as being paid. In order the reinstate the account receivable, you reverse the prior journal entry. D. Accounts Receivable $100 Cr. Uncollectible Accounts Expense $100 Then you record that the account has been paid: D. Cash $100 Cr. Accounts Receivable $100 Allowance Method To follow the matching rule, the expense should be recorded in the same period as the related sale. Uncollectible accounts (also called bad debts), the accounting term for nonpayment by customers, are an expense of selling on credit. Under the matching rule, uncollectible accounts expense must appear in the same income statement as the corresponding sale, even if the customer defaults in a later period. An estimate of bad debts must be made at the end of each year. At the time of a credit sale, however, the company does not know whether the customer will eventually pay. Therefore, an estimate of uncollectible accounts must be made at the end of the accounting period. An adjusting entry is then made debiting Uncollectible Accounts Expense (also called Bad Debt Expense, Doubtful Accounts Expense & Provision for Uncollectible Accounts) and crediting Allowance for Uncollectible Accounts (also called Allowance for Bad Debts & Allowance for Doubtful Accounts) for the estimated amount. Uncollectible Accounts Expense is closed out in a manner Short-Term Liquid Assets similar to other expenses and appears in the income statement. D. Uncollectible Accounts Expense $12,000 Cr. Allowance for Uncollectible Accounts $12,000

3 Allowance for Uncollectible Accounts is a contra account to Accounts Receivable that reduces Accounts Receivable to the amount estimated to be collectible. The net number is the net realizable value of the accounts receivable. Accounts Receivable $200,000 Less: Allowance for Uncollectible Accounts 12, $188,000 The two most common methods for estimating uncollectible accounts are the percentage of net sales method and the accounts receivable aging method. Recording the Write-Off of an Uncollectible Account When it becomes clear that a specific account will not be collected, it should be written off by a debit to Allowance for Uncollectible Accounts and a credit to Accounts Receivable. Note that the Uncollectible Accounts Expense account is not involved in the entry. D. Allowance for Uncollectible Accounts $100 Cr. Accounts Receivable $100 After the write-off, the accounts receivable net value does not change. After a specific account has been written off, Accounts Receivable and Allowance for Uncollectible Accounts decrease by the same amount, but the net figure for expected receivables stays the same. Recovery of an Uncollectible Account When a customer whose account has been written off pays in full or in part, two entries must be made: First, the customer's receivable is reinstated by a debit to Accounts Receivable and a credit to Allowance for Uncollectible Accounts for the amount now considered collectible. D. Accounts Receivable $100 Cr. Allowance for Uncollectible Accounts $100 Second, Cash is debited and Accounts Receivable is credited for each collection. D. Cash $100 Cr. Accounts Receivable $100

4 Estimating the Allowance for Uncollectible Accounts Aging of Accounts Receivable Method Under the aging of accounts receivable method (also called the percentage of receivables basis, or the balance sheet method), customer accounts are placed into a "not yet due" category or into one of several "past due" categories. The amounts in each category are totaled; each total is then multiplied by a different percentage (a probability of default to each age category) for estimated bad debts. The sum of these products represents estimated bad debts on ending Accounts Receivable. Again, the debit is to Uncollectible Accounts Expense and the credit to Allowance for Uncollectible Accounts. Under the aging method, however, the entry is for the amount that brings Allowance for Uncollectible Accounts to the computed figure. In other words, if you decide that a total of $3,000 of your accounts receivable will not be paid, and your allowance has a credit balance of $1,000, you would credit the allowance (and debit bad debt expense) for $2,000. Percentage of Sales Method Under the percentage of sales method (also called the percentage of credit sales method or the income statement method), the estimated percentage for uncollectible accounts is multiplied by net sales (or net credit sales) for the period. The resulting figure is then used in the adjusting entry. Any previous balance in Allowance for Uncollectible Accounts is irrelevant in making the adjusting entry. Any previous balance in Allowance for Uncollectible Accounts represents amounts from previous years that have not yet been written off and is irrelevant in making the adjusting entry under this method. In other words, if you have net sales of $300,000 and you believe that 1% of your sales will not be collected, you would place $3,000 into the allowance. Notes Receivable A promissory note has two parties, the maker and the payee. The maker promises to pay specified amounts to the payee. A promissory note has certain characteristics. For example, it must have a due date (a maturity date). A demand note is a promissory note that is due on demand (at any time). A promissory note usually provides for the payment of interest. When the interest is paid is negotiated by the parties. For example, interest could be paid

5 monthly, quarterly or annually. Interest on notes with terms of a year or less usually provide that interest is paid at maturity. The maturity value is the amount paid by the maker at the maturity date of the promissory note. Promissory notes are created: As part of a company lending money to someone As consideration in the sale of expensive merchandise with extended payments (e.g., sales of automobiles) or other assets. In exchange for a delinquent account receivable. When the promissory note is being issued to take the place of an accounts receivable, the maker is usually a customer to whom credit was extended, and the maker needs more time to pay the amount due. So, the company is converting it into a interest bearing promissory note. Assume that a $6,000, 10%, six-month promissory note was issued: D. Notes Receivable $6,000 Cr. Accounts Receivable $6,000 When the note matures, the maker pays the principle and the accrued interest. D. Cash $6,300 Cr. Notes Receivable $6,000 Interest Revenue 300 As was noted when we discussed adjusting entries. You are supposed to accrue the interest revenue in the period it was earned even though it hasn't been paid. Assume that a 3-month promissory note is issued in December: Dec. 1 D. Notes Receivable $6,000 Cr. Accounts Receivable $6,000 Dec.31 D. Interest Receivable $50 Cr. Interest Revenue $50 A promissory note is honored when it is paid in full at its maturity date. March 1 D. Cash $6,150 Cr. Notes Receivable $6,000 Interest Receivable 50 Interest Revenue 100

6 Dishonor of Notes Receivable If the note is dishonored, then the company just has an account receivable again. No more interest will accrue thereafter: D. Account Receivable $6,300 Cr. Notes Receivable $6,000 Interest Revenue 300 Managing Accounts Receivable When a company has accounts receivable, they need to watch the following steps carefully: Extending Credit Pay attention to which customers you are extending credit. (e.g., look at credit reports, ask for guarantees or letters of credit). Your credit policies have to be competitive, but you want to make sure that you do not extend credit to the people who will not pay you. Establishing a Payment Period Again, your policies have to be competitive. Consider offering incentives for customers to pay early (e.g., sales discounts). Monitoring Collections -- Check to see whether customers are paying you. An accounts receivable aging schedule should be prepared at least monthly. It helps identify problem accounts. Evaluating the Receivable Balance -- When evaluating the company s credit policies management looks at two measures: (i) Receivables Turnover Ratio, and (ii) Average Collection Period. Receivables Turnover Ratio The Receivables Turnover Ratio tells you how many times you give and collect credit (accounts receivable) during the year, on average: Net Credit Sales Average Net Accounts Receivable

7 Average Collection Period The Average Collection Period (also called Number of Days' Sales in Receivables, and the Number of Days Sales Uncollected) is supposed to reflect the number of days it takes to collect a firm s accounts receivable: Receivables Turnover Ratio I prefer to think of this ratio as follows: First, calculate the amount of credit sales made in one day: Net Credit Sales Second, take this number and divide it into the average net accounts receivables: Average Net Accounts Receivable One Day s Credit Sales This tells you how many days sales make up a company s average accounts receivable or how long it takes the company to collect its accounts receivable. Accelerating Cash Receipts Sometimes a company may wish to sell its accounts receivables (e.g., the company needs cash faster than can be obtained by collecting its accounts receivable). A company can sell its accounts receivable to a factor. The factor charges a fee to purchase the accounts receivable. This is treated as an expense (operating expense or other expense): D. Cash $588,000 Service Charge Expense 12,000 Cr. Accounts Receivable $600,000

8 This is similar to the treatment that is received when a Company makes a VISA or MasterCard credit card sale. The credit card company is agreeing to issue credit to your customers so that you don t have to: D. Cash $970 Service Charge Expense 30 Cr. Sales $1,000

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