Accounting for Receivables

• This lecture discusses the accounting and control of credit transactions focusing on receivables

Learning Objectives

• Identify different types of receivables
• Understand how companies recognize accounts receivables
• Distinguish between valuation methods and bases for accounts receivables
• Describe the entry to record disposition of accounts receivables
• Compute maturity data and interest on notes receivable
• Understand how companies recognize notes receivable
• Learn how companies value notes receivable
• Describe the entries to record the disposition of notes receivable
• Understand statement presentation and analysis of receivables

Accounting for Receivables

• Different types of receivables include: accounts, notes and other receivables
• Accounts receivables: involve recognizing, valuing, and disposing of accounts receivables
• Notes receivables involve: Determining maturity date, computing interest, recognizing, valuing and disposing of notes receivable
• Statement presentation and analysis: involves presentation and analysis

Types of Receivable

• Receivables are amounts due from individuals and other companies expected to be collected in cash

Accounts Receivable

• Represent amounts owed by customers from the sale of goods and services

Notes Receivable

• Claims which formal instruments of credit are issued as proof of debt

Other Receivable

• Nontrade items, such as interest, loans to officers, advances to employees, and income taxes refundable

Accounting for Accounts Receivables

• There are 3 main accounting issues: Recognizing, valuing and disposing of accounts receivable

Recognizing Accounts Receivables

• Assume ABC company sells merchandise to XYZ company for $1,000 with terms 2/10, n/30 on July 1, 2022.
• Journal entry to record the sale on ABC's books:
• Debit Accounts receivable $1,000
• Credit Sales $1,000
• On July 5, XYZ returns $100 worth of merchandise to ABC
• Journal entry:
• Sales return and allowances debit by $100
• Accounts receivable credit by $100
• On July 10, ABC receives payment from XYZ for the balance:
• Journal entry:
• Cash debit by $882
• Sales discount (900 x 0.02) debit by $18
• Accounts receivable credit by $900

Valuing Accounts Receivables

• Accounts receivables are reported as assets on the statement of financial position
• They’re reported at the amount the company expects to collect
• Sales on account raise the possibility of accounts not being collected
• Valuation can be difficult because the amount of uncollectible receivables is unknown

Methods of Accounting for Uncollectible Amounts

• Direct Write-off Method
  • Undesirable: no matching, receivable not stated at net realizable value, and not acceptable for financial reporting
• Allowance Method
  • Losses are estimated; better matching, receivable stated at net realizable value, and required by IFRS

Direct Write-Off Method of Uncollectible Accounts

• Under the direct write-off method, when a company deems an account uncollectible, the loss is charged to Bad Debts Expense
• Example: On December 12, Warden company writes-off an uncollectible $200 balance from M.E. Doran
• Journal entry:
  • Debit Bad Debts Expense $200
  • Credit Accounts receivable $200

Allowance Method of Uncollectible Accounts

• Companies estimate uncollectible accounts receivable
• To record the estimated uncollectible accounts, debit Bad debts expense and credit Allowance for doubtful account
• To write-off actually uncollectible accounts, debit Allowance for doubtful account and credit Accounts receivable

Recording Estimated Uncollectible Accounts

• Hampson Furniture has credit sales of $1,200,000 in 2022 and $200,000 remains uncollectible at December 31. If the credit management estimates that $12,000 will be uncollectible, record this adjusting entry:
  • Debit Bad debts expense $12,000
  • Credit Allowance for doubtful accounts $12,000

Presentation of allowance for doubtful accounts

• Hampson furniture statement of financial position partial presentation:
  • Current assets: prepaid expense $25,000, merchandise inventory $310,000, accounts receivable $200,000 less allowance for doubtful debt $12,000, cash $14,800
  • Total Current Asset = $537,800
• Recording the Write-Off of Uncollectible Account:
  • The financial vice-president of Hampson Furniture authorizes a write-off of the $500 balance owed by R.A. Ware on March 1, 2022
  • Debits allowance for doubtful accounts and credit account receivable

Valuing Accounts Receivables

• The write-off only affects the statement of financial position accounts
• Example of the impact of write-off
  • Before write-off: accounts receivable $200,000, allowance for doubtful accounts $12,000, the cash realizable value is $188,000
  • After write-off: accounts receivable becomes $199,500, allowance for doubtful accounts $11,500 and cash realizable value stays at $188,000

Recovery of an Uncollectible Account

• On July 1, R.A. Ware pays the $500 amount that Hampson had written off on March 1
• Debit Accounts receivable and credit Allowance for doubtful account with $500
• Debit Cash and credit Accounts receivable with $500

Bases Used for Allowance Method

• Percentage of Sales
  • Emphasizes income statement relationships and involves matching sales with bad debts expense.
• Percentage of Receivables
  • Stresses cash realizable value, focusing on the statement of financial position relationships

Percentage-of-Sales

• Gonzalez company uses the percentage of sales basis and concludes that 1% of net credit sales will become uncollectible
• If net credit sales are $800,000 for 2022, the adjusting entry would be;
  • Debit for Bad debts expense $8,000
  • Credit Allowance for doubtful accounts $8,000 Emphasis is put on revenues being paired with expenses
• When the adjusting entry is made, the allowance for doubtful accounts is ignored

Percentage-of-Receivables

• Calculate total estimated bad debts using an aging schedule
• Determine uncollectible percentage using number of days past due
• If the trial balance shows Allowance for Doubtful Accounts with a credit balance of $528, the adjusting entry will be: -Debit Bad debts expense $1,700 -Credit Allowance for doubtful account $1,700
• (2,228-528 = 1,700)

Valuing Accounts Receivables

• Percentage of Sales approach:
  • Focuses on estimating bad debt expense
  • Existing balance in the allowance account is ignored for journal entry, achieving a match of expense and revenues
• Percentage of Receivable approach:
  • Aims for accurate valuation of receivables on the statement of financial position
  • Can use an aging schedule
  • Balance in allowance account is considered for journal entry.

Disposing of Accounts Receivable

• Companies may sell accounts receivables for cash because: receivables may be the only reasonable source of cash, and the billing and collection processes are often time-consuming and costly

Sales of Accounts Receivable

• Factor
  • Buys receivables from businesses and collects the payment directly from customers.
  • Typically charges commission to the company selling the receivables
  • The fee ranges from 1-3% of the amount of receivables purchased

Factoring Example

• Hendredon Furniture factors $600,000 of receivables to Federal Factors
• Federal Factors assesses a service charge of 2%
• Journal entry:
  • Debit Cash $588,000
  • Debit Service charge expense $12,000
  • Credit Accounts receivable $600,000
    • ($600,000 x 2% = $12,000)

Credit Card Sales

• Retailers treats credit card sales as cash sales
• Retailers pay the card issuer a fee of 2 to 4% for transaction processing
• The sales are recorded similar to depositing checks from cash sales

Credit Card Sales Example

• Anita Ferreri buys $1,000 of compact discs for her restaurant from Karen Kerr Music Company, using her visa First Bank Card
• First Bank charges a service fee of 3%
• Journal entry:
  • Cash debit $970
  • Service charge expense debit $30
  • Sales credit $1,000

Notes Receivables

• A promissory note is a written promise to pay a specified amount of money on demand or at a definite time

Notes Receivables Uses

• When individuals/companies lend or borrow money
• When transaction amount and credit period exceed normal limits
• In settlement of accounts receivable

Elements of a Note

• Payee
  • The promissory note is a note receivable
• Maker
  • The promissory note is a note payable

Determining the Maturity Date

• Note can be expressed in terms of month or days

Determining the Maturity Date formula

• The Interest = Face Value of Note x Annual Interest Rate x Times in Terms of One year

Interest computation example

• Terms of Note:
  • $ 730, 18%, 120 days: Interest = $ 730 x 18% x 120/360 = $ 43.80
  • $1,000, 15%, 6 months: Interest = $1,000 x 15% x 6/12 = $ 75.00 -$2,000, 12%, 1 year: Interest = $2,000 x 12% x 1/1 = $240.00

Recognizing Notes Receivable

• Calhoun Company wrote $1,000, two-month, 12% promissory note to settle an open account. Wilma Company makes the following journal entry to record it:
  • Debit Notes receivable $1,000
  • Credit Accounts receivable $1,000

Valuing Notes Receivable

• Companies report short-term notes receivables at their cash (net) realizable value, like accounts receivable
• Estimation of cash realizable value and bad debts expense are done similarly
• Allowance for Doubtful Accounts is used

Disposing Notes Receivable

• Notes may be held to their maturity date
• Maker may default and payee must make an adjustment to the account
• Holder increases conversion to cash by selling the note receivable

Honoring Notes Receivable

• A note is honored when its maker pays it in full at its maturity date

Dishonoring Notes Receivable

• When a note is not paid in full at maturity
• A dishonored note receivable is no longer negotiable

Example of Notes Receivable Honor

• Betty Company lends Wayne Higley Inc. $10,000 on June 1, accepting a five-month, 9% interest-bearing note
• Assuming that Betty Company presents the note to Wayne Higley Inc. on the maturity date, Betty Company's entry to record the collection is:
  • Debit Cash $10,375
  • Credit Notes receivable $10,000
  • Credit Interest revenue $375

Notes Receivable Honor with Financial Statements

• If Betty Company prepares financial statements as of September 30, it must accrue interest
• Betty Co. would make an adjusting entry as follows: Debit Interest receivable and Credit Interest revenue, both with $300
• Honoring of the Wayne Higley Inc. note on November 1 would be recorded by Betty Company as:
• Debit Cash $10,375
• Credit Notes receivable $10,000
• Credit Interest receivable $300
• Credit Interest revenue $75

Dishonoring Notes Receivable Entry

• Wayne Higley Inc. cannot pay on November 1; if Betty Company expects eventual collection it makes the following entry as the note is dishonored:
• Debit Accounts receivable $10,375
• Credit Notes receivable $10,000
• Credit Interest revenue $375

Statement Presentation and Analysis

• Identify major receivable types in the statement of financial position or notes
• S/P: Report short-term receivables as current assets
• S/P: Report gross amount of receivables and allowance for doubtful accounts
• I/S: Report bad debts and service charge expense as selling expenses
• I/S: Report interest revenue under "Other" in the nonoperating section

Ratio Analysis

• Net Credit Sales / Average Net Accounts Receivable = Accounts Receivable Turnover
• Assess the liquidity of receivables and measure how often a company collects receivables during the period

Average Collection Period

• Days in year / Accounts Receivable Turnover = Average Collection Period in Days Used to assess the effectiveness of credit and collection policies and collection period should not exceed credit term period