ACCOUNT DEBIT CREDIT Accounts receivable 10,000 Sales 10,000 To record the sale of merchandise to Sophie Company

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1 CURRENT RECEIVABLES Receivables are the amount owed to the organization by its customers and/or others. Current receivables will be collected within one year or the current operating cycle which ever is longer. Noncurrent receivables will be collected at some later date beyond the operating cycle. Trade receivables are those owed by customers in the ordinary course of business. Accounts receivable are promises to pay that are not supported by any written documents. Notes receivable are evidenced by a written note and normally carry an interest rate. ACCOUNTS RECEIVABLE Trade accounts receivable are evidenced by invoices that reflect the exchange price of the goods or services. This exchange price is affected by trade discounts and cash discounts. a. Trade discounts Trade discounts are typically quoted as a percentage of the list price of the item. This allows the seller to give the buyer a discount without having to adjust the list price. The account receivable is recorded on the seller s books at the amount net of the trade discount. b. Cash discounts (sales discounts) Cash or sales discounts are incentives offered to the buyer to pay the invoice early. They are typically quoted as a percentage discount on the invoice price is paid within a limited period of time. For example, if the terms are 2/10, net/30. The buyer can take a 2% discount on the invoice price if the invoice is paid within the first 10 days. If the invoice is not paid within 10 days then the total amount is due on the 30 th day. Most business organizations use the gross method for recording cash discounts. Under this method the total invoice is booked as an account receivable. At the time the payment is received the discount is recorded. Example: assume that Spencer Company sold $10,000 worth of merchandise to Sophie Company under terms of 2/10, net/30. Within the first 10 days Sophie Company pays the invoice less the 2% discount. The following reflects the journal entries to record the sale and the collection on Spencer Company s books. Accounts receivable 10,000 Sales 10,000 To record the sale of merchandise to Sophie Company Cash 9,800 Sales discounts 200 Accounts receivable 10,000 To record the collection of the receivable from Sophie Company net of the 2% discount Valuation of Accounts Receivable F:\Teaching\3321\web\module3\c7\tnotes\C7b.doc 2/16/2007 1

2 Short-term receivables are valued and reported on the balance sheet at net realizable value. The net amount reported in the balance sheet is the amount that management expects to actually collect in the future. This requires estimation by management based on the best information available at the time. Sales Returns and Allowances In certain industries sales returns and allowances can be material. If there is a history of returns and allowances then the company might be required to establish an allowance to accounts receivable (a contra asset account) estimating the amount included in the accountants receivable that are currently reported in the balance sheet. Uncollectible Accounts Receivable There are two methods of recording uncollectible accounts. Direct write-off method Under the direct write-off method the accounts are not written off until it has been determined that they are uncollectible. The journal entry is a debit to bad debt expense and a credit to the account receivable. This method is not GAAP and so therefore will not be used in any future examples. Allowance method Under the allowance method we use estimates to establish an allowance account allowance for doubtful accounts which is a contra-asset account offsetting accounts receivable. The net of the two accounts is the net realizable receivables reported in the balance sheet. There are two methods of estimating the amount that should be reported in the allowance account. a) Balance Sheet Approach Using the balance sheet approach we are interested in reporting net realizable receivables correctly in the balance sheet. This is accomplished by examining the aged accounts receivable and establishing the amount that should be allocated to the allowance account based on management s estimate of the accounts that may become uncollectible in the future. The whole point of this approach is to get the correct balance in the allowance account so that net realizable receivables are fairly stated in the balance sheet. The resulting charge to bad debt expense in the current period is a residual as a result of this analysis. Example: Spencer Company has the following aged accounts receivable at year end December 31, Customer Balance Current 30 Days 60 Days 90 Days Over 90 Days Able Supply Company Barney Custom Supply 1, Casey Grooming Dogs Unlimited 1, Totals 3, ,100 1, F:\Teaching\3321\web\module3\c7\tnotes\C7b.doc 2/16/2007 2

3 Based on past experience the credit manager has determined the following amounts should be allocated to the allowance for doubtful accounts to properly reflect the net realizable receivables as of December 31, Age Amount % Required Current 800 2% Days 1,100 3% Days 1,000 4% Days 600 5% 30 Over 90 Days % 40 3, This means that the balance in the allowance for doubtful accounts should have a balance of $159 after all of the year-end adjusting journal entries have been posted. The following is the T- Account of the allowance for doubtful accounts before any year-end adjustment. Description Debit Credit Balance Beginning balance (200) Accounts written off during Accounts reinstated during As we can see, prior to posting any adjusting journal entry the allowance for doubtful accounts account has a debit balance of $10. If we need a credit balance of $159 in order to bring the accounting records current then the adjusting journal entry will be as follows: Bad debt expense 169 Allowance for doubtful accounts 169 To record bad debt expense by adjusting the allowance for doubtful accounts After the above adjusting journal entry has been posted to the accounting records the allowance for doubtful accounts account will reflect the correct balance of $159. Description Debit Credit Balance Beginning balance (200) Accounts written off during Accounts reinstated during Required adjusting journal entry at 12/31/ (159) The purpose of the balance sheet approach is to fairly state net realizable receivables in the balance sheet b) Income Statement Approach F:\Teaching\3321\web\module3\c7\tnotes\C7b.doc 2/16/2007 3

4 Using the income statement approach we are interested in matching bad debt expense with sales revenue for the current period. The estimate is actually an estimate of the bad debt expense, normally as a percentage of credit sales. The ending balance of the allowance account is not really of concern to management. Example: The following information pertains to Spencer Company for the year ended December 31, Cash Sales (net) 10,000 Credit sales 5,000 Sales returns and allowances 1,000 Sales discounts 500 Net credit sales 3,500 Based on prior experience the controller estimates that bad debt expense should be approximately 5% of net credit sales. Therefore the adjusting journal entry using the income statement approach will be as follows: Bad debt expense 175 Allowance for doubtful accounts 175 To record bad debt expense for 2000 based on 5% of net credit sales Analysis of bad debt expense: Net credit sales 3,500 Provision for bad debts 5% Bad debt expense 175 As we can see from the above example, the object of using the income statement approach is to get a proper matching of bad debt expense to net credit sales. There is no consideration being given to the presentation of net realizable receivables. Accounts Written Off When an account is deemed uncollectible it must be removed from the balance of accounts receivable--that is, the account must be written off. In previous periods, an allowance has been set aside using one of the allowance methods. At this point, the allowance is used to write off the uncollectible account. Example: On February 1, 2001, Spencer Company wrote off a $500 as uncollectible. The following journal entries must be recorded remove the account and reduce the balance of accounts receivable. F:\Teaching\3321\web\module3\c7\tnotes\C7b.doc 2/16/2007 4

5 Allowance for doubtful accounts 500 Accounts receivable 500 To record the removal of an uncollectible account receivable Collection of Accounts Written Off If there is a collection on an account previously written off, using one of the allowance methods we must first reestablish the account in accounts receivable and then record the collection. Example: On April 1, 2001, Spencer Company received payment $500 on the account that had previously been written off as uncollectible. The following journal entries must be recorded in order to (1) get the account back on the books and (2) record the collection of the account. Accounts receivable 500 Allowance for doubtful accounts 500 Cash 500 Accounts receivable 500 To record the reinstatement of an account receivable and the receipt of the payment on said account NOTES RECEIVABLE Notes receivable are evidenced by a written promissory note normally with terms that require interest on the outstanding balance. Short-term notes are typically reported at face value, whereas long-term notes are reported at the present value of the expected future cash collections. Note Issued at Face Value If a note is issued at the market rate of interest then the face amount and the net present value are the same. The note is therefore record at face value in the accounting records. The collection of interest payments are recorded as interest income as received. Example: Spencer Company receives a $100,000 note receivable in exchange for cash. The note is to be repaid in five years with interest payable at 10% per annum. The market rate of interest at the time the note was issued is 10%. The following journal entries reflect the issuance of the note and the receipt of interest at the end of the first year. F:\Teaching\3321\web\module3\c7\tnotes\C7b.doc 2/16/2007 5

6 Note receivable 100,000 Cash 100,000 Cash 10,000 Interest revenue 10,000 To record the receipt of a note receivable and the receipt of the first interest payment at the end of year 1 Zero-Interest-Bearing Notes A zero-interest-bearing note is one that is issued at an amount less than the face value. Interest is included in the face value of the note, but is not specifically stated in the contract. The difference between the cash paid and the amount to be received in the future is interest income. We use the effective interest method to record the interest income earned in the interim accounting periods before the final cash collection is made. Example: Spencer Company received a zero-interest-bearing note of $100,000 in exchange for cash. The note is to be repaid in five years. The implied rate of interest on the note is 10% per annum. The following is the present value of the note that will be recorded in Spencer Company s books when received. Analysis of Present Value of Note Receivable: Face amount of note 100,000 PV of $1, n=5, i=10% Present value of note 62,092 Note receivable 100,000 Discount on note receivable 37,908 Cash 62,092 To record the receipt of a zero-interest-bearning note receivable At the end of each year interest income will be recorded as amortization of the discount. The following is an amortization table for the entire life of the note. F:\Teaching\3321\web\module3\c7\tnotes\C7b.doc 2/16/2007 6

7 Date Cash Received Interest Revenue Amortization of Discount Carrying Amount Issue date 62,092 End of year 1 0 6,209 6,209 68,301 End of year 2 0 6,830 6,830 75,131 End of year 3 0 7,513 7,513 82,644 End of year 4 0 8,264 8,264 90,909 End of year 5 100,000 9,091 9,091 (0) The journal entry at the end of year 1 to reflect the interest earned would be as follows: Discount on note receivable 6,209 Interest revenue 6,209 At the end of the five years the carrying amount of the note receivable will be $100,000, which is the amount the Spencer Company will receive when the note is paid off. Interest-Bearing Notes If the stated interest rate and the effective interest rate are different the interest-bearing note will be issued at a premium or discount. The interest collected in each accounting period is adjusted for the amortization of premium or discount. Notes Received for Cash and Other Rights If a note is received in exchange for cash and other rights (such as the right to purchase merchandise at a bargain price) the value of the right will be treated as a discount against the note receivable. The debit side of this entry will be to a deferred debit account such as prepaid purchases. When the merchandise is purchased the value carried in the deferred debit account will be charged added to the cost of the purchased merchandise. Notes Received for Property, Goods or Services A note received in exchange for property, goods or services must be valued based on the fair value of the property, goods or services exchanged. Gains or losses should be record and the difference between the fair value and the face value of the note receivable will be treated as a discount on note receivable. Example: Spencer Company sold an office building with a book value of $20,000 and a fair market value of $50,000 in exchange for a 5-year note receivable of $60,000 with no stated interest rate. The journal entry to record this transaction will establish the carrying value of the note receivable as the fair value of the property exchanged. The difference is charge to the discount on notes receivable account. F:\Teaching\3321\web\module3\c7\tnotes\C7b.doc 2/16/2007 7

8 Note receivable 60,000 Discount on note receivable 10,000 Building 20,000 Gain on sale of building 30,000 Analysis of discount on note receivable: Face value of note 60,000 Fair value of building 50,000 Discount on note receivable 10,000 The discount will be amortized using the effective interest method over the five years so that the face amount of the note receivable when paid off will be $60,000, the amount received. Imputed Interest Is a note is received with no stated interest or an unreasonably low rate of interest then the recipient of the note will need to record the note receivable with an appropriate discount so that the carrying amount reflects the market rate of interest. This is called the imputed interest rate. Imputed interest is demonstrated in the above example where Spencer Company received a zerointerest-bearing note receivable. Valuation of Notes Receivable Short-term notes receivable are recorded and reported at net realizable value. Long-term notes receivable must be recorded and reported at the present value of the expected future cash flows determined using the market interest rate at the date the note was issued. FINANCING WITH RECEIVABLES Secured Borrowing If a company uses its receivables as collateral for a loan, its customers are not notified of the transaction. The company continues to collect the receivables and the financial institution is not involved unless the debtor is unable to repay the loan. In such a situation the financial institution will step in and collect the receivables in payment of the loan. Sales of Receivables If receivables are actually sold (factored) the purchasing company (factor) collects the receivables from the customers. In this situation, the company actually removes the receivables from the books and records a loss on the transaction. Example: Spencer Company sold $500,000 of its accounts receivable to a factor. The factor will hold back $20,000 for possible sales discounts, sales returns, and sales allowances. The factor charges a 5% fee for purchasing the accounts receivable. Spencer Company will record the following journal. F:\Teaching\3321\web\module3\c7\tnotes\C7b.doc 2/16/2007 8

9 Cash 455,000 Due from factor 20,000 Loss on sale of receivables 25,000 Accounts receivable 500,000 Analysis of loss: Face value of receivables 500,000 Discount charged by factor 5% Loss on sale of receivable 25,000 Discounting a Note As with accounts receivable, notes receivable may be pledged as collateral for a loan or may be sold outright. If they are sold the transaction is called discounting a note. The financial institution is purchasing the future cash flow of the note and will apply a discount rate equal to the amount of interest required in order to purchase the note. This discount is the financing fee incurred by the seller of the note. PRESENTATION AND ANALYSIS Presentation of Receivables Receivables should be presented with appropriate disclosure in the notes to the financial statements according to the following criteria. (1) Segregated based on the different types of receivables (2) Valuation accounts are disclosed and offset the appropriate receivables (3) Current receivables will be converted into cash within on year or the operating cycle (4) Disclosure of possible loss contingencies on receivables (5) Disclose receivables that have been pledged as collateral (6) Disclose significant concentrations of credit risk Analysis of Receivables An important ratio that is used to analyze the liquidity of an entities accounts receivable is the receivables turnover ratio. This is calculated as follows: Accounts Receivable Turnover = Net Sales Average Trade Receivables (net) Example: Spencer Company has net sales of $2,375,000 for the year ended December 31, The accounts receivable on January 1, 2001 were $240,000. At December 31, 2001 the accounts receivable balance was $260,000. What are the inventory turnover ratio and the average collection period for accounts receivable? ACCOUNTS RECEIVABLE TURNOVER RATIO F:\Teaching\3321\web\module3\c7\tnotes\C7b.doc 2/16/2007 9

10 Net Sales 2,375,000 = Average Trade Receivables (net) [(240, ,000)/2] Net Sales 2,375,000 = Average Trade Receivables (net) 250,000 Net Sales Average Trade Receivables (net) = 9.5 AVERAGE COLLECTION PERIOD FOR ACCOUNTS RECEIVABLE 365 Days 365 = Accounts Receivable Turnover Days Accounts Receivable Turnover = Days F:\Teaching\3321\web\module3\c7\tnotes\C7b.doc 2/16/