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Chapter notes for financial accounting with David Deeds...

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Chapter 7: Reporting and Analyzing Receivables

Accounts Receivable

● A receivable is an amount due from another party. ● Two most common receivables: ○ Accounts receivable: amounts due from customers for credit sales ○ Notes receivable: when the receivable is for a large amount and the credit period is long Recognizing Accounts Receivable ● Sales on Credit ○ Credit sales are recorded by increasing accounts receivable ○ The general ledger has a single accounts receivable account along with other financial statement accounts. ■ A supplementary record is created to maintain a separate account for each customer (accounts receivable ledger) ■ Schedule of accounts receivable shows that the accounts receivable account balance equals the total of the individual accounts receivable accounts in the A/R ledger. ■ Some companies maintain their own credit cards to grant credit to approved customers and to earn interest on any balance not paid within the specified period of time. ● This allows them to avoid the fee charged by credit card companies ■ If a customer owes interest on a bill, we debit interest receivable and credit interest revenue for that amount. Credit Card Sales ● Customers using third-party credit cards (Visa, Mastercard, American Express) can make

single monthly payments instead of several payments to different creditors and can defer their payments. ● Sellers allow customers to use third-party credit and debit cards instead of granting credit directly because: ○ Seller does not have to evaluate credit standing or make decisions about who gets credit and how much. ○ Seller avoids the risk of extending credit to customers who cannot or do not pay (risk is transferred to credit card company. ○ Seller receives cash quicker from the card company sooner than if it had granted credit to customers. Cash received Immediately on Deposit ● Example: TechCom has $100 of credit sales with a 4% fee, and its $96 cash is received immediately on deposit.

Cash received sometime after deposit ● Example: Techcom must wait for the $96 cash payment

● Some firms report credit card expense in the income statement as a type of discount deducted to get from sales to net sales. ○ Other companies classify it as a selling expense or administrative expense. ○ The book classifies it as selling expense.

Valuing Accounts Receivable- Direct Write-Off Method ● Bad debts: expected amount that customers cannot pay what they promised. ○ Total amount of uncollectible accounts is an expense of selling on credit. ● Sellers grant credit because they believe it will increase total sales and net income enough to offset bad debts. ● Two methods to account for uncollectible accounts: ○ Direct write-off method ○ Allowance method

Recording and Writing Off Bad Debts ● Direct-write off method: records loss from an uncollectible account receivable when it is determined to be uncollectible.

● Example: J. Huang determines on January 23 that it cannot collect $520 owed to it by its

customer Justin Kent ● The credit removes its balance from the Accounts receivable ledger (and subsidiary ledger) Recovering a Bad Debt ● Sometimes an account written off is later collected and it is due to: ○ Continual collection efforts ○ Customer’s good fortune ● Example: The account of J. Kent was later collected in full

Assessing the Direct-Write Off Method ● Many publicly-traded companies and thousands of privately held companies use the direct-write-off method ● Bad debts are accounted for using the direct write-off method where an expense is

recognized only when a specific account is deemed uncollectible. ● Companies weight two concepts when using the direct-write off method: ○ Expense recognition (matching) principle ○ Materiality constraint ● Advantages: ○ Simple ○ No estimates required ● Disadvantages ○ Receivables and income temporarily overstated ○ Bad debts expense often not matched with sales Matching Principle Applied to Bad Debts ● The expense recognition principle requires expenses to be reported in the same period as the sales they helped produce. ● Bad debts expense is not recorded in the same period because it is ONLY recorded when an account becomes uncollectible. ○ It could be uncollectible in a different period after the credit sale. Materiality Constraint Applied to Bad Debts ● Materiality constraint states that an amount can be ignored if its effect on the financial statements is unimportant to users’ business decisions. ● Permits the use of the direct write-off method when bad debts expenses are not significant. ○ (Practice problems/solutions on pg. 323) Valuing Accounts Receivable- Allowance Method

● The allowance method of accounting for bad debts matches the estimated loss from uncollectible accounts receivable against the sales they helped produce. ● Why use estimated losses? ○ Because when sales occur, management does not know which customers will not pay their bills. ● At the end of each period the allowance method requires an estimate of the total bad debts expected from that periods’ sales. ● Advantages of the Allowance Method: ○ Records estimated bad debts expense in the same period when sales are recorded ○ Reports accounts receivable on the balance sheet at the estimated amount of cash to be collected ○ Receivables fairly stated ○ Writing off bad debt does not affect net receivables or income ● Disadvantage of the Allowance Method: ○ Estimates required

Recording Bad Debts Expense ● Estimates bad debts expense at the end of each accounting period and records it with an adjusting entry. ● Example: TechCom had credit sales of $300,000. At the end of the first year, $20,000 of credit sales remained uncollected. TechCom estimated that $1,500 of its accounts receivable would be uncollectible.

● Estimated bad debts expense → income statement (under selling expense or administrative expense) ○ Offsets the $300,000 credit sales ● Allowance for Doubtful accounts: ○

contra asset account that is used instead of reducing accounts receivable directly because at the time of the adjusting entry, the company does not know which customers will not pay.

○ The allowance for doubtful accounts has the effect of reducing accounts receivable to its estimated realizable value. ■ Realizable value refers to the expected proceeds from converting an asset into cash ○ Allowance for doubtful accounts → balance sheet ■ Decreases assets

Writing off a Bad Debt ● When specific accounts are identified as uncollectible, they are written off against the

allowance for doubtful accounts.

● Bad debts expense was not debited in the write-off because it was recorded in the period when sales occurred. ● Posting this write-off entry to the Accounts Receivable account removes the amount of the bad debt from the general ledger (also posted to the A/R subsidiary ledger). ● The write-off doesn’t affect the realizable value of accounts receivable. ○ Neither total assets nor net income is affected by the write-off of a specific account. ○ Assets and net income are affected in the period when bad debts expense is predicted and recorded with an adjusted entry. Recovering a Bad Debt ● Always requires two journal entries ● Some customers volunteers to pay all or part of the amount owed to try to improve their credit standing because it was jeopardized from not paying it in the past. ● Two entries: ○ Reverse the write-off and reinstate the customer’s account ○ Record the collection of the reinstated account ● Example: J. Kent pays in full his account previously written off

● If we believe a customer will pay later in full, we return the entire amount owed to A/R, but if we expect no further collection, we return only the amount paid. ○ (practice problems/solutions on page 325) Estimating Bad Debts- Percent of Sales Method ● Allowance method requires an estimate of bad debts expense to prepare an adjusting entry at the end of each period. ● Percent of sales method: ○ Income statement method ○ Based on the idea that a given percent of a company’s credit sales for the period is uncollectible. ○ Example: Musicland has credit sales of $400,000 in 2016. Musicland estimates . 6% of credit sales to be uncollectible

● When using percent of sales method, the unadjusted balance in Bad debts expense always equals $0, the adjusting entry amount always equals the % of sales. Estimating Bad Debts- Percent of Receivables Method

● Accounts receivable method (balance sheet method) use balance sheet relations to estimate bad debts. ○ Mainly the relation between accounts receivable and the allowance amount. ○ Goal of the bad debts adjusting entry: make allowance for doubtful accounts balance equal to the portion of accounts receivable that is estimated to be uncollectible. ● Estimated balance is computed in two ways: ○ Computing the percent uncollectible from total accounts receivable ○ Aging accounts receivable ● Percent of accounts receivable method assumes that a given percent of a company’s receivables is uncollectible. ● Estimated dollar amount of uncollectible accounts: ○

Total dollar amount of all receivables x percent to be uncollectible

● Example: Musicland has $50,000 of accounts receivable. Experience suggests that 5% of its receivables is uncollectible. ○ So this means: ■ After the adjusting entry is posted, we want the allowance for doubtful accounts to show a $2,500 credit balance (5% of $50,000). ■ During 2016, accounts of customers are written off on February 6, July 10, and November 20 and the account shows a $200 credit balance before December 31, 2016.

● The aging of accounts receivable method is an examination of specific accounts and is usually the most reliable of the estimation methods. ● A debit balance implies that write-offs for that period exceed the total allowance. Estimating Bad Debts- Summary of Methods ● Percent of sales → income statement focus ○ Good job at matching bad debts expense with sales ● Accounts receivables method → balance sheet focus ○ Better job at reporting accounts receivable at realizable value

(problems and solutions on pg 329) Notes Receivable ● Promissory note: written promise to pay a specified amount of money usually with interest, either on demand or at a definite future date. ● Used in transactions such as: ○ Paying for products and services ○ Lending and borrowing money ● Sellers prefer to receive notes when the credit period is long and when the receivable is for a large amount. ● Principal of a note: a specified amount of money ● Maker of the note: the person who signed the note and promised to pay it at maturity ● Payee of the note: the person to whom the note is payable ● Interest: the charge for using the money until its due date ○ To a borrower, interest is an expense ○ To a lender, interest is revenue

Computing Maturity and Interest ● The maturity date of a note is the day the note (principal and interest) must be repaid. ● Period of a note is the time from the note’s contract date to its maturity date. ● When months are used, the note matures and is payable in the month of its maturity on the same day of the month as its original date.

Interest Computation ● To calculate interest: ○ Principal amt. x Annual Interest Rate x Time expressed in fraction of year

Recognizing Notes Receivable ● When a company holds a large number of notes, it sometimes sets up a controlling account and a subsidiary ledger for notes ● Example: To record the receipt of a note, we use the $1,000, 90-day, 12% promissory note.

● When a seller accepts a note from an overdue customer as way to grant a time extension on a past-due receivable, it will often collect part of the past-due balance in cash. ○ This payment reduces the customer’s debt (and sellers risk) and produces a note for a smaller amount. ● Example: TechCom agreed to accept $232 in cash along with a $600, 60-day, 15% note from Jo Cook to settle her $832 past-due account

Valuing and Settling Notes ● Recording an Honored Note: ○ The maker of the note usually honors the note and pays it in full. ○ Example: J. Cook pays the note above on its due date

● Interest revenue, also called interest earned, is reported on the income statement Recording a Dishonored Note ● When a note’s maker is unable or refuses to pay at maturity, the note is dishonored. ○ Dishonoring a note does not relieve the maker of its obligation to pay. ● The balance of notes receivable should include only those notes that have not matured. ● When a note is dishonored, we remove the amount of this note from the Notes Receivable account and charge it back to an account receivable from its maker. ● Example: J. Cook dishonors the note above at maturity

● Two purposes or charging a dishonored note: ○ Removes the amount of the note from the Notes Receivable account and records the dishonored note in the maker’s account ○ If the maker of the dishonored note applies for credit in the future, his/her account will reveal all past records, including the dishonored note Recording End-of-Period Interest Adjustment ● When notes receivable are outstanding at the end of a period, any accrued interest earned is computed and recorded. ● Example: On December 16 (all in the first accounting period), TechCom accepts a

$3,000, 60-day, 12% note from a customer in granting an extension on a past-due account. When Tech Com’s accounting period ends on December 31, $15 of interest has accrued on this note ○

($3,000 x 12% x 15/360)

○ Adjusting entry to record this revenue:

○ Interest revenue appears on the income statement and interest receivable appears on the balance sheet as a current asset. ○ Example: when the December 16 note is collected on February 14 (new accounting period), Tech Com’s entry to record the cash receipt is: ○ Total interest earned on the 60-day note is $60. The $15 credit to Interest receivable on Feb. 14 reflects the collection of the interest from December 31 adjusting entry. The $45 interest reflects TechCOm’s revenue from holding the note from January 1 to February 14 (problems and solutions on pg 333)

Disposal of Receivables ● Companies can convert receivables to cash before they are due ● Converting receivables is done by: ○ Selling them ○ Using them as a security for a loan Selling Receivables ● When a company sells its receivables, it is called factoring ○ The buyer is the factor and charges the seller a factoring fee, and then the buyer takes ownership of the receivables and receives cash when they are due. ○ The seller receives cash earlier and can pass the risk of bad debts to the factor ○ The company selling the receivables always receives less cash than the amount of receivables sold because of factoring fees ○ Example: TechCom sells $20,000 of its accounts receivable and is charged a 4% factoring fee

Pledging Receivables ● A company can raise cash by borrowing money and pledging its receivables as security for the loan. ● Pledging receivables does not transfer the risk of bad debts to the lender because the borrower retains ownership of the receivables ● If the borrower defaults on the loan, the lender has a right to be paid from the cash receipts of the receivable when collected. ● Example: TechCom borrows $35,000 and pledges its receivables as security

Recognition of Receivables ● GAAP and IFRS refer to the realization principle and earnings process. Valuation of Receivables ● Both GAAP and IFRS require that receivables be reported net of estimated uncollectibles. ● Both systems require that expense for estimated uncollectibles be recorded in the same period when any when any revenues from those receivables are recorded. ● US GAAP and IFRS require the allowance method Accounts receivable turnover ● Measure of both the quality and liquidity of accounts receivable. It indicates how often, on average, receivables are received and collected during the period.

● Accounts receivable turnover = net sales / average accounts receivable, net...