Understanding Receivables

• Receivables represent claims against customers for cash, goods, or services.
• Receivables are classified as current or noncurrent, and as trade or nontrade.
• Current receivables are expected to be collected within one year or the operating cycle, whichever is longer.

Trade Receivables

• Trade receivables arise from normal business operations and credit sales.
• Trade receivables include accounts receivable, which are verbal promises to pay within 30 to 60 days.
• Trade receivables include notes receivable, which are written promises with specified terms like interest rate and due date.

Nontrade Receivables

• Nontrade receivables include advances to employees or officers.
• Amounts receivable from the government, such as GST or income tax refunds, are nontrade receivables.
• Dividends and interest receivable are classified as nontrade.
• Amounts owed by insurance companies are also nontrade receivables.

Journal Entries for Receivables

• An account receivable entry involves debiting accounts receivable and crediting revenue by the same amount, such as $100.
• A collection entry involves debiting cash and crediting accounts receivable, for example for $100.

Balance Sheet Valuation

• Receivables are reported at their net realizable value (NRV).
• NRV is the net amount of cash expected to be collected, potentially differing from the legally receivable amount.
• NRV is calculated as Gross accounts receivable less Estimated uncollectible accounts.

Factors Affecting Valuation

• Several items affect the net valuation of receivables, including: trade (quantity) discounts; cash (sales) discounts; sales returns and allowances; no collectible accounts.

Trade Discounts vs Cash Discounts

• Trade discounts are given for different quantities purchased and are often quoted as a percentage.
• Trade discounts are not usually recorded; revenue is charged net of the discount.
• Cash discounts encourage faster customer payments and are recorded.
• An example of a cash discount is "2/10, n/30," meaning a 2% discount if paid within 10 days, with the gross amount due in 30 days.

Recording Cash Discounts - Gross Method

• The gross method records receivables at the gross invoice price before any cash discount.
• Discounts are recorded when customers pay within the discount period.
• "Sales Discounts" are deducted from sales on the income statement.
• The gross method is the most common method.

Recording Cash Discounts - Net Method

• The net method records accounts receivable net of discounts.
• Discounts forfeited by customers are recorded when not taken.
• This method is preferred but rarely used.
• "Sales Discounts Forfeited" is recorded as "Other revenue" if the customer does not take the discount.

Example - Gross Method

• Sale of $2,000 of goods with terms 3/10, n/30 and a 5% trade discount.
• Trade discount is 5% of $2,000 = $100, so net sales after trade discount $1,900.
• Cash discount assumed at sale is 3% of $1,900 = $57, so net amount recorded is $1,843.
• Recording: Debit Accounts Receivable $1,900, Credit Sales $1,900.
• if payment is received within 10 days: Debit Cash $1,843, debit Sales discount $57, credit Accounts recievable $1,900.
• if payment is not received within 10 days: Debit Cash $1,900, Credit Accounts receivable $1,900.

Example - Net Method

• Sale of $2,000 of goods with terms 3/10, n/30 and a 5% trade discount.
• Trade discount is 5% of $2,000 = $100, so net sales after trade discount $1,900.
• Cash discount assumed at sale is 3% of $1,900 = $57, so net amount recorded is $1,843.
• Recording: Debit Accounts Receivable $1,843, Credit Sales $1,843.
• if payment is received within 10 days: Debit Cash $1,843, credit Accounts recievable $1,843.
• if payment is not received within 10 days: Debit Cash $57, credit Sales discount forfeited $57.

Sales Returns

• Sales returns occur when customers return purchased goods due to defects, wrong items shipped, or dissatisfaction.
• When a return occurs, the company adjusts its accounts receivable to reflect the decrease in the amount owed by the customer.

Sales Allowances

• Sales allowances reduce the sales price granted to the customer after the sale, often for minor defects or other issues not leading to a full return.
• In these cases, customers accept the product at a discounted price, and the receivable amount is reduced accordingly.

Bad Debt Expense

• Bad Debt Expense is also known as Uncollectible Accounts Expense.
• Bad Debt Expense represents the estimated receivables that a company does not expect to collect.
• Bad debt expense is reported on the Income Statement, reducing net income.
• Two methods to account for bad debt expense are the Direct Write-Off and Allowance methods.

Direct Write-Off Method

• The Direct Write-Off Method records bad debt expense only when a specific account receivable is considered uncollectible and is written off.
• This is used only when the firm cannot reliably estimate uncollectible accounts receivable or if uncollectible amounts are immaterial.
• A/R is overvalued on the balance sheet using this method.
• This method provides poor matching of revenues and expenses.

Allowance Method

• The Allowance Method records estimated bad debt expense in the same accounting period as the sale (matching concept).
• Receivables are reported at their estimated realizable value, net of an Allowance for Doubtful Accounts.
• Value is calculated as Gross accounts receivable less Estimated uncollectible accounts.

Estimating Uncollectible Accounts - The Allowance Method

• The estimate of uncollectible accounts may be based on the Percentage of Sales (Income Statement approach).
• Estimate of uncollectible accounts may also be based on Outstanding Accounts Receivable (Balance Sheet approach).
• Many companies use the % of sales method during the year, adjusting at year-end based on the receivables approach.

Balance Sheet Approach

• This approach uses past collection experience to estimate uncollectible accounts, without identifying specific accounts.
• Focus is on reporting accounts receivable at its net realizable value.
• The Balance sheet approach does not focus on matching bad debt expense to sales.
• Any existing balance in Allowance for Doubtful Accounts is used to calculate the current year’s bad debt expense.
• Percentage-of-receivables or aged receivable analysis can be used.

Aged Receivable Analysis

• Considers the aging of outstanding invoices to estimate uncollectible accounts.
• Uses different percentages of uncollectibility for different aging buckets to determine Bad Debt Expense, for example 460,000 x.04 (4%), 18,000 x.15 (15%), 14,000 x.20 (20%) 55,000 x.25 (25%).
• Required balance in allowance less current balance = Bad Debt Expense.

Balance Sheet Presentation

• Short-term accounts receivable are shown at their net realizable value.
• Accounts Receivable less Allowance for Doubtful Accounts equals Net Realizable Value

Allowance Method - Writing Off Accounts Receivable

• Establishing allowance for bad debt would involve debiting bad debt expense and crediting allowance for doubtful accounts
• When a customer's account is uncollectible, allowance for doubtful accounts is debited and accounts receivable is credited
• When payment is received after write off, accounts receivable is debited and allowance for doubtful accounts is credited. Subsequently cash is debited and accounts receivable is credited.

Cash Collection Formula

• Cash Collection = Beginning account receivable + Net credit sales = "To be Collected" . Subtract Ending account receivable and Written Off to determine "Collected during the period"

Calculation of Ending Balance in Allowance Account

• Ending Balance = Beginning balance + Bad debt expense + Recovery of written off amount − Receivables written off

Income Statement Approach

• This uses the relationship between sales and bad debts.
• This matches the estimated cost of bad debts to sales generated in the same accounting period.
• Any existing balance in the balance sheet account (Allowance for Doubtful Accounts) is ignored when calculating the current year’s bad debts expense.

Income Statement Approach Example

• If Dockrill Corp. reports net credit sales of $400,000, and the company estimates bad debts at 2% of net credit sales, estimated bad debts expense $8,000
• To record this, debit Bad Debts Expense ($8,000) and credit Allowance for Doubtful Accounts ($8,000).

Receivables as an Immediate Source of Cash

• Loans can be secured by pledging receivables, i.e., committing the proceeds of the receivables to paying off the loan.
• When accounts receivable are sold to a third party, it is called factoring.

Factoring

• Factoring involves selling receivables to a third party.
• Traditionally factoring is without recourse, meaning without recourse, the factor assumes the risk of any inability to collect.
• Sometimes the sale is with recourse, meaning the seller of the receivable is liable to the factor for the uncollectible amount.
• If receivables are with recourse, the seller will carry a liability, Recourse Obligation.
• Often the financing cost is unusually high.
• A firm using a factor can eliminate staff.
• Factor approves account debtors' credit, the client submits invoices, the factor receives and processes the invoices, the factor verifies invoices, the factor disburses advances, the factor disburses rebates to clients and the factor reports to the client

Factoring Costs - Flat Fee

• Flat-fee plus interest approach is common among large factors, less common with smaller firms.
• In factoring client pays a flat processing fee and can drawn advances
• The factor charges the client interest on the client interest on the advances
• The factor remits the outstanding reserve balances after payment upon collections

Factoring Fees Cost

• Assuming 100,000 in receivables, a 4% reserve, 2% factor fee and 10% interest (90 days) results in net proceeds of $91,650.

Assignment of Accounts Receivable

• When accounts receivable are assigned, the borrower assigns rights to specific accounts receivable as collateral for a loan.
• Account receivable assigned is reclassified.
• Borrower maintains the receivable records and remits them to the Lender as payment.
• The loan and the receivables are not offset

Pledging Accounts Receivables

• It is less formal than assignment.
• Rights to specific receivables are not noted as collateral, and accounts receivable are not reclassified
• The receivables in bulk are transferred to a trustee.
• The cash flows from the receivables are used to pay the loan.