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CHAPTER 1 ACCOUNTING FOR RECEIVABLES Receivables Defined

- Receivables include all money claims against other entities, including people, business firms, and other organizations. Receivables are usually a significant portion of the total current assets.

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Accounts Receivable Accounts receivable are amounts that customers owe the company for normal credit purchases. Customers do not sign formal written promise to pay but they agree to abide by the company’s customary credit terms. Since accounts receivable are generally collected within two months of the sale, they are considered a current asset and usually appear on balance sheets below short-term investments and above inventory. They are non-interest bearing― except on some past due accounts. Notes Receivable

- Notes receivable are amounts owed to the company by customers or others who have signed -

formal promissory notes in acknowledgment of their debts. Notes are used for credit periods of more than two months and for large amount of money. Promissory notes have the advantage of strengthening a company's legal claim against those who fail to pay as promised. They are also more liquid than accounts receivable because they can be discounted/transferred to any financial institution. Notes that are due in one year or less are considered current assets, and notes that are due in more than one year are considered long-term assets.

NOTE: Accounts receivable and notes receivable that result from company sales are called trade receivables, but there are other types of receivables as well. For example, interest receivable, tax refundable, and receivables from officers and employees (Wage advances, formal loans to employees), and loans to other companies create other types of receivables. If significant, these nontrade receivables are usually listed in separate categories on the balance sheet because each type of nontrade receivable has distinct risk factors and liquidity characteristics. - Receivables of all types are normally reported on the balance sheet at their net realizable value, which is the amount the company expects to receive in cash.

Characteristics of Notes Receivable

- A simple promissory note appears below.

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- The face value of a note is called the principal, which equals the initial amount of credit

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provided. The maker of a note is the party who receives the credit and promises to pay the note's holder. The maker classifies the note as a note payable. The payee is the party that holds the note and receives payment from the maker when the note is due. The payee classifies the note as a note receivable. Due (Maturity) date—the date a note is to be paid. The period of time between the issuance and due date of a short-term note may be stated in either days or months. When the term of a note is stated in days, the due date is the specific number of days after its issuance. The day on which a note is dated is not included; the day on which a note falls is included. Thus, a note dated today and maturing tomorrow involves only one day’s interest. When the term of a note is stated as a certain number of months after issuance date the due date is determined by counting the number of months from the issuance date. For example a 3 month note dated June 5 will be due on September 5; a two month note dated July 31 will be due on September 30. Interest― is a charge made for the use of money over a period of time. To the maker of the note, or borrower it is an expense. To the payee of the note it is revenue. Interest rates are usually stated on an annual basis, regardless of the actual period of time involved. Promissory notes can be interest bearing(above) and non-interest bearing. Calculating Interest (for interest-bearing notes) Notes generally specify an interest rate, which is used to determine how much interest the maker of the note must pay in addition to the principal. Interest on short-term notes is calculated according to the following formula:

For example, interest on a four-month, 9%, $1,000 note equals $30.

- When a note's due date is expressed in days, the specified number of days is divided by 360 or 365 in the interest calculation. You may see either of these figures because accountants used a 360-day year to simplify their calculations before computers and calculators became widely available, and many textbooks still follow this convention. In current practice, however, Compiled by Solomon Z.

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financial institutions and other companies generally use a 365-day year to calculate interest. Therefore, you should be prepared to calculate interest either way. The interest on a 90-day, 12%, $10,000 note equals $300($10,000 x 0.12 x 90/360) if a 360day year is used to calculate interest, and the interest equals $295.89 ($10,000 x 0.12 x 90/365)if a 365-day year is used.

- Maturity Value—the amount that the maker must pay on a note on its maturity date (due date). The maturity value of a non-interest bearing note is the face amount. The maturity value of an interest-bearing note is the sum of the face amount and the interest. Example: On May 1, 2007 X Co. purchased merchandise on account for $5,000 from Y Co. giving a written promise to pay after 90 days (non-interest bearing note) a) What is the due date? Due date: Days remaining in May (31-1) ……… 30 Days in June …………………………30 Days in July to maturity date …………30 (due date) (date of payment included) 90 days b) How much is maturity value? Maturity Value = Face amount = $5,000 Example: On July 6, 2007 X Co. purchased merchandise on account for $8,000 from ABC trading signing a 90 day, 12% promissory note.(assume a year of 360 days) a) Due date: Days remaining in July (31- 6) ……… 25 Days in August ………………………31 Days in September …………………..30 Days in October to maturity date …….4 (due date) (date of payment included) 90 days b) Interest = $8,000 x 0.12 × 90/360 = $240 c) Maturity Value = $8,000 + $240 = $8,240 Exercise: Date -------- September 11 Face Value--- $24,000 Period----- 120 days Interest rate ------- 12%

Required: a) Due date? b) Interest? c) Maturity value?

Receivables (Recording and Valuing) Recording Receivable Transactions

- If a customer signs a promissory note in exchange for merchandise, the entry is recorded by debiting notes receivable and crediting sales.

- Customers frequently sign promissory notes to settle overdue accounts receivable balances. The conversion of accounts receivable to notes receivable has advantages for the payee: i. Earns interest on the balance until paid as this allows the customer more time to pay the balance of the account. Compiled by Solomon Z.

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ii. The notes receivable is more liquid as it can be sold to a bank or other financial institution. Example: On April 26, 20X8 Nile Co. sold merchandise on account for $2,500 for Awash Co., term n/60. On the books of the payee: a) Record the transaction on April 26, 20X8

b) Assume that on June 25 Awash Co. did not pay for Nile Co. according to their term of agreement and both agreed to change the open account to notes receivable with an interest rate of 10% for six months. The change of A/R to N/R is recorded as follows:

c) Record the receiving of cash on December 25, 20X8. When a note's maker pays according to the terms specified on the note, the note is said to be honored. Assuming that no adjusting entries have been made to accrue interest revenue, the honored note is recorded as follows: (Note that the total interest on a six-month, 10%, $2,500 note is $125)

If some of the interest has already been accrued (through adjusting entries that debited interest receivable and credited interest revenue), then the previously accrued interest is credited to interest receivable and the remainder of the interest is credited to interest revenue.

- Adjusting entries that recognize accrued interest are often calculated in terms of days. Suppose a company holds a four-month, 10%, $10,000 note dated October 19, 20X2. If the company uses an annual accounting period that ends on December 31, an adjusting entry that recognizes 73 days of accrued interest revenue must be made on December 31, 20X2. Notice that when you count days, you omit the note's issue date but include the note's due

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date or, in this situation, the date that the adjusting entry is made. Assuming the interest calculation uses a 365-day year, the accrued interest revenue equals $200.

The adjusting entry debits interest receivable and credits interest revenue.

Interest on long-term notes is calculated using the same formula that is used with short-term notes, but unpaid interest is usually added to the principal to determine interest in subsequent years. Remember that any entry to record the subsequent receipt of interest depends on whether reversing entry was made.

Evaluating Accounts Receivable (Uncollectible Receivables)

- A business that sells its goods or services on credit will inevitably find that some of its -

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accounts receivables are uncollectible. Regardless of how thoroughly the credit department investigates the credit worthiness of each prospective customer, some uncollectible accounts will arise as a result of one or more of the following reasons: bankruptcy, closing of the debtor’s business, disappearance of the debtor, and failure of repeated attempt to collect. The operating expense incurred because of the failure to collect receivables is called an expense or loss from uncollectible accounts, doubtful accounts or bad debts. Companies use two methods to account for bad debts: the allowance method(reserve method) and the direct write-off(direct charge off) method

Allowance Method.

- Under the allowance method, an adjustment is made at the end of each accounting period to -

estimate bad debts based on the business activity from that accounting period. The adjusting entry has two purposes: 1. To reduce A/R to its NRV in the balance sheet 2. To match expenses with revenue that helped generate (matching principle) in the income statement.

Example: A company had total A/R of $100,000 at the end of the fiscal year (Dec.31 20X5). If the company estimates that $5,000 in accounts receivable will become uncollectible, the necessary adjusting entry will be as follows:

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The bad debt expense is an administrative expense. Since the specific customer accounts that will become uncollectible are not yet known when the adjusting entry is made, a contra-asset account named allowance for bad debts (allowance for doubtful accounts), is subtracted from accounts receivable to show the NRV of accounts receivable on the balance sheet. Accounts Receivable --------------------------- $100,000 Less: Allow. for Bad Debts -------------------- 5,000 Net Realizable Value --------------------------- $95,000

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After the entry shown above is made, the accounts receivable subsidiary ledger still shows the full amount each customer owes.

Write-off to the Allowance Account

- When a specific customer's account is identified as uncollectible, it no longer qualifies as an -

asset and should be written off against the balance in the allowance for bad debts account. To write off an A/R is to reduce the balance of the customer’s account to zero. Example: Continuing with the above example, if a customer named J. Smith fails to pay a $225 balance, the company records the write-off as follows:

- Remember, general journal entries that affect a control account must be posted to both the -

control account and the specific account in the subsidiary ledger. Under the allowance method, a write-off does not change the NRV of accounts receivable. It simply reduces accounts receivable and allowance for bad debts by equivalent amounts. Before writing off After writing off J. Smith's account J. Smith's account Accounts Receivable

$100,000

$99,775

Less: Allow. for Bad Debts

(5,000)

(4,775)

Net Realizable Value

$95,000

$95,000

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- Customers whose accounts have already been written off as uncollectible will sometimes pay their debts. When this happens, two entries are needed to correct the company's accounting records and show that the customer paid the outstanding balance. 1) The first entry reinstates the customer's accounts receivable balance: 2) The second entry records the customer's payment: Example: Assume Mr. J. Smith paid his account fully on August 11,20X6

- In the future when management looks at J. Smith's payment history, the account's activity will show the eventual collection of the amount owed.

Estimating Bad Debts(Uncollectibles)

- Established companies rely on past experience and perhaps modified in accordance with

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future business activity to estimate uncollectibles at the end of the fiscal period. But new companies must rely on published industry averages until they have sufficient experience to make their own estimates. Companies use two methods to estimate uncollectibles 1. Estimate based on Sales (Sales or Income Statement Method)

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Percentage of credit sales method. Some companies estimate bad debts as a percentage of credit sales. The adjusting entry doesn’t take into consideration the existing balance in the AFD account. The question to be answered is not “how large uncollectible allowance is needed to reduce our receivables to NRV?” Instead, the question is stated as “How much uncollectible accounts expense is associated with this year’s volume of credit sales?” This method stresses the relationship between uncollectible account expense and credit sale rather than the valuation of receivables at the balance sheet date. Example: Assume that AFD account for a company had a credit balance of $400 before adjustment. If a company has $500,000 in credit sales during an accounting period and company records indicate that, on average, 1% of credit sales become uncollectible, the adjusting entry at the end of the accounting period will be as follows:

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- If AFD account had a debit balance of $400 before adjustment, the entry would be the same. - If estimates fail to match actual bad debts, the percentage rate used to estimate bad debts is -

adjusted on future estimates. Notice that companies with small amount of cash sale may base the estimation on total net sales for the period rather than total credit sale. 2. Estimate Based On Analysis of Receivables (Receivables or Balance Sheet

Method)

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Percentage of Total Accounts Receivable Method. One way companies derive an estimate for the value of bad debts under the allowance method is to calculate bad debts as a percentage of the accounts receivable balance. Unless actual write-offs during the just-completed accounting period perfectly matched the balance assigned to the allowance for bad debts account at the close of the previous accounting period, the account will have an existing balance. If write-offs were less than expected, the account will have a credit balance, and if write-offs were greater than expected, the account will have a debit balance. The receivables method determines the desired (target) balance in the AFD account. Thus, unlike the sales method, to have this desired balance the balance in the AFD account before adjustment must be considered in making the adjustment. If AFD account has debit balance, the required adjustment is the desired balance plus the debit balance. If AFD account has credit balance, the required adjustment is the desired balance minus the credit balance. Example: A company has $100,000 in accounts receivable at the end of an accounting period and company records indicate that, on average, 5% of total accounts receivable become uncollectible. Required: Make adjusting entry on Dec.31 assuming that the AFD account has a $200 debit balance before adjustment.

Notice that the required balance is $5,000(5% of $100,000). Thus AFD account must be adjusted by $5,200 to have a credit balance of $5,000.

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If the AFD account had a $300 credit balance instead of a $200 debit balance, a $4,700 adjusting entry would be needed to give the account a credit balance of $5,000. If it had zero balance, the adjusting would be made by $5,000

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Aging Method. The process of analyzing the receivable accounts in terms of the length of time they are past due is sometimes referred to as Aging the Receivables . The base point to determine age is the due date. A past-due A/R will not necessarily be uncollectible but is always viewed with some suspicion. The fact that a receivable is past due suggests that the customer is either unable or unwilling to pay. The question “How long past due?” is pertinent. In general, the longer an account balance is overdue, the less likely the debt is to be paid. Each category's overall balance is multiplied by an estimated percentage of uncollectibility for that category, and the total of all such calculations serves as the estimate of bad debts (desired balance). Example: The accounts receivable aging schedule shown below includes five categories for classifying the age of unpaid credit purchases.

Required: Make adjusting entry on Dec.31 assuming that the AFD account has an existing credit balance of $400 before adjustment.

- The desired (target) balance is $5,000. So the adjustment required is only for $4,600. - The information in the aging schedule may be useful to management for purposes other than estimating uncollectible accounts. If the age of many customer accounts that are past due has increased i. Collection efforts must be strengthened Compiled by Solomon Z.

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ii. The company may have to find other sources of cash to pay debts within discount period and to finance other activities iii. Change credit policies Direct Write-Off Method.

- This method does not maintain any provision for uncollectbility. So there is no estimation and

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adjustment at the end of each accounting period. We have to wait the time in which a customer’s account is determined to be uncollectible (worthless). Before determining that an account balance is uncollectible, a company generally makes several attempts to collect the debt from the customer. Recognizing the bad debt requires a journal entry that increases a bad debts expense account and decreases accounts receivable from a specific customer. Example: When a customer named J. Smith fails to pay a $225 balance, the company records the write-off as follows:

Remember, general journal entries that affect a control account must be posted to both the control account and the specific account in the subsidiary ledger.

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Recovery of Cash under Direct Write-Off Method Customers whose accounts have already been written off as uncollectible will sometimes pay their debts. When this happens, two entries are needed to correct the company's accounting records and show that the customer paid the outstanding balance as discussed earlier. Entry 1--- to reinstate the account Entry 2--- to record the collection Example: Consider the above example and assume that on August 11, 20X6, J. Smith paid his account which was written off earlier. 20X6 Au...