Financial Accounting Receivables and Sales PDF

Financial Accounting Sixth Edition Receivables and Sales CHAPTER 5 Spiceland Thomas Herrmann Copyright ©2022 McGraw-Hill. All rights...

Financial Accounting Sixth Edition Receivables and Sales CHAPTER 5 Spiceland Thomas Herrmann Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 5-1 aw-Hill Education. PART A RECOGNIZING ACCOUNTS RECEIVABLE Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 5-2 Learning Objective 1 LO5–1 Recognize accounts receivable at the time of credit sales. Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 5-3 aw-Hill Education.  Credit Sales and Accounts Receivable Credit sales transfer goods or services to a customer today while bearing the risk of collecting payment from that customer in the future. At the time of a credit sale, a company will record:  Accounts receivable. Accounts receivable represent amounts owed to a company by its customers from the sale of goods or services on account.  Revenue. Even though no cash is received at the time of the credit sale, the seller records revenue immediately once 5-4 Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr aw-Hill Education. Recording a Credit Sale On March 1, a company provides services to a customer for $500. The customer doesn’t pay cash at the time of service, but instead promises to pay the $500 by March 31. The company records the following at the time of the service: March 1 Debit Credit Accounts Receivable ……………………. 500 Service Revenue …………….......... 500 (Provide services on account) Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 5-5 aw-Hill Education. Recording the Subsequent Receipt On March 1, a company provides services to a customer for $500. The customer later pays the $500 by March 31. The company records the following at the time of the service: March 31 Debit Credit Cash ……………………………………………. 500 Accounts Receivable …………….. 500 (Provide services on account) Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 5-6 aw-Hill Education. Key Point Companies record an asset (accounts receivable) and revenue when they sell goods or services to their customers on account, expecting collection in the future. Once the receivable is collected, the balance of accounts receivable is reduced. Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 5-7 aw-Hill Education. Concept Check 5–1 Which of the following generally is recorded at the time a company provides services to customers on account? a. Accounts receivable b. Interest receivable c. Notes receivable d. Tax refund claims Accounts receivable represent cash owed to the company by its customers from sales or services on account. Nontrade receivables include tax refund claims, interest receivable, and loans by the company to other entities. Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 5-8 aw-Hill Education. Learning Objective 2 LO5–2 Calculate net revenues using returns, allowances, and discounts. Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 5-9 aw-Hill Education. Net Revenues Companies often offer discounts and guarantees that can reduce the amount of cash the company is entitled to receive from those customers: 1. Trade discounts 2. Sales returns 3. Sales allowances 4. Sales discounts Net revenues equals total revenues less any amounts for returns, allowances, and discounts. Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 5-10 aw-Hill Education. Trade Discounts Reduction in list price of a product or service  Used to provide incentives to larger customers or consumer groups to purchase from the company Because sellers are entitled to receive only the discounted amount, sale is recorded at this lower amount. Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr aw-Hill Education. 5-11 Example of a Trade Discount F.Y.Eye typically provides laser eye surgery for $3,000. The company offers laser eye surgery in the month of March for only $2,400. The company records the following at the March 1 time of service: Debit Credit Accounts Receivable ……………………. 2,400 Service Revenue …………….......... 2,400 (Provide services of $3,000 on account for the trade discount price of $2,400) Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr aw-Hill Education. 5-12 Sales Returns and Allowances Customers sometimes return goods or are dissatisfied with products or services because of a deficiency Sales Sales Return Allowances Customer returns Customer does NOT goods previously return goods purchased (a) Seller issues a (a) Seller issues a cash refund if cash refund if original sale was original sale was for cash for cash (b) Seller reduces (b) Seller reduces balance of balance of accounts accounts receivable if receivable if original sale was Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr aw-Hill Education. 5-13 Sales Returns On March 2, F.Y.Eye sells sunglasses to one of its customers for $200 on account. On March 4, the customer decides she doesn’t want eyeglasses and receives full credit from F.Y.Eye. March The4company records the Debitfollowing: Credit Sales Returns………………………… 200 Accounts Receivable ……………... 200 (Customer return on account.) Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 5-14 aw-Hill Education. Sales Allowances The customer having laser eye surgery on March 1 for $2,400 is not completely satisfied with the outcome of the surgery. On March 5, F.Y.Eye allows a $400 reduction in the amount owed by the customer. The company records the following: March 5 Debit Credit Sales Allowances.………………………… 400 Accounts Receivable ……………... 400 (Provide sales allowance for previous credit sale) Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 5-15 aw-Hill Education. Common Mistake Students sometimes misclassify contra revenue accounts—sales returns and sales allowances—as expenses. Like expenses, contra revenues have normal debit balances and reduce the reported amount of net income. However, contra revenues represent reductions of revenues, whereas expenses represent the separate costs of generating revenues. Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 5-16 aw-Hill Education. Sales Discounts Reduction in the amount to be received from a credit customer if collection on account occurs within a specified period. Discount terms, such as 2/10, n/30, are a shorthand way to communicate the amount of the discount and the time period within which it’s available.  The term “2/10,” pronounced “two ten,” for example, indicates the customer will receive a 2% discount if the amount owed is paid within 10 days.  The term “n/30,” pronounced “net thirty,” means that if the customer does not take the discount, full payment net of any returns or allowances is due within 30 days. Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 5-17 aw-Hill Education.  Collection During the Discount Period F.Y.Eye typically provides laser eye surgery for $3,000. The company offers laser eye surgery in the month of March for only $2,400. F.Y.Eye provides laser eye surgery to a customer on March 1 for $2,400 on account with terms of 2/10, n/30. Cash is collected from the customer on March 10, which is within the 10-day discount period. The March 10 company Debit records the following: Credit Cash ……………………………………………. 1,960 Sales Discounts …………………………… 40 Accounts Receivable ……………... 2,000 (Collect cash on account with a 2% sales discount ) Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 5-18 aw-Hill Education. Illustration 5–1 Income Statement Reporting Revenues Net of Sales Returns, Allowances, and DiscountsF.Y.EYE Income Statement (partial) $3,000 less $600 Service revenue $2,400 trade Sales revenue 200 discount Less: Sales returns (200) Less: Sales (400) allowances Less: Sales discounts (40) Net revenues $1,960 Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill 5-19 Education.  Illustration 5–2 Balance of Accounts Receivable after Credit Sales, Sales Return, Sales Allowance, and Collection on Account after Sales Discount Credit sale $2,400 Accounts Receivable after $600 trade Mar. 1 2,400 Mar. 4 Sales return of discount 200 $200 Mar. 2 200 Credit sale of $200 Mar. 5 Sales allowance of 400 $400 Bal. 0 Cash collection of Ending balance Mar. 10 2,000 $1,960 with $40 sales discount Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill 5-20 Education.  Collection After the Discount Period F.Y.Eye typically provides laser eye surgery for $3,000. The company offers laser eye surgery in the month of March for only $2,400. F.Y.Eye provides laser eye surgery to a customer on March 1 for $2,400 on account with terms of 2/10, n/30. Cash is collected from the customer on March 31, which is not within the 10-day discount March 10period. Debit Credit The company Cash records the following: ……………………………………………. 2,000 Accounts Receivable ……………... 2,000 (Collect cash on account) Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 5-21 aw-Hill Education. Key Point Revenues are reported for the amount the company is entitled to receive. This amount equals total revenues minus trade discounts, sales returns, sales allowances, and sales discounts. Trade discounts reduce revenue directly, while sales returns, sales allowances, and sales discounts are recorded in separate contra revenue accounts and subtracted when calculating net revenues. Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 5-22 aw-Hill Education. End-of-Period Adjustment For Contra Revenues The previous discussion deals with how companies record contra revenues—sales returns, sales allowances, and sales discounts—during the year. However, companies also must adjust for these amounts at the end of the year using adjusting entries. The revenue recognition standard requires a company to report revenues equal to the amount of cash the company “expects to be entitled to receive.” Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr aw-Hill Education. 5-23 Concept Check 5–2 The effect of a sales allowance will result in which of the following: a. An increase to net income b. A decrease to net income c. An increase to accounts receivable d. An increase to sales revenue The effect of a sales allowance is to decrease net income. A sales allowance decreases sales revenue in the income statement. A sales allowance also decreases assets by decreasing the balance of accounts receivable. Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 5-24 aw-Hill Education. Concept Check 5–3 Which of the following computations would be used to compute Net Revenues? a. Total Revenue + Accounts Receivable – Sales Allowances – Sales Discounts b. Total Revenue – Sales Returns – Sales Allowances – Sales Discounts c. Total Revenue – Sales Allowances – Sales Discounts d. NetNet Income Revenues – Change is equal in Revenue to Total Accountsless Receivable Sales Returns, Sales Allowances, and Sales Discounts. Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 5-25 aw-Hill Education. PART B ESTIMATING UNCOLLECTIBLE ACCOUNTS Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 5-26 Learning Objective 3 LO5–3 Establish an allowance for uncollectible accounts. Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of 5-27 McGraw-Hill Education. Key Point Customers’ accounts receivable we no longer expect to collect are referred to as uncollectible accounts, or bad debts. Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 5-28 aw-Hill Education. Allowance Method (GAAP) Generally accepted accounting principles (GAAP) require that we account for uncollectible accounts using the allowance method. Companies must:  Estimate the amount of current accounts receivable that will prove to be uncollectible in the future.  Report this estimate as a contra asset to its accounts receivable. Under the allowance method, companies are required to estimate future uncollectible accounts and report those estimates in the current year. Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 5-29 aw-Hill Education. Key Point Under the allowance method, accounts receivable are reported for the net amount expected to be collected. At the end of the current year, estimated future uncollectible accounts are reported in a contra asset account, reducing net accounts receivable. Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 5-30 aw-Hill Education. Applying the Allowance Method 1. At the end of the initial year, establish an allowance by estimating future uncollectible accounts 2. During the subsequent year, write off actual bad debts as uncollectible  Note that actual write-offs may differ from the previous year’s estimate. 3. At the end of the subsequent year, once again estimate future uncollectible accounts. Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr aw-Hill Education. 5-31 Estimating Uncollectible Accounts At the end of 2024, Kimzey is owed $20 million from customers and estimates that 30% will not be collected. The company December 31, 2024 records the following: ($ in millions) Debit Credit Bad Debt Expense ……………………………………. 6 Allowance for Uncollectible Accounts... 6 (Estimate future bad debts) ($20 million × 30% = $6 million) Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr aw-Hill Education. 5-32 Allowance for Uncollectible Accounts Companies report their estimate of future bad debts using an allowance for uncollectible accounts.  Allowance for Uncollectible Accounts is a contra asset account that represents the amount of accounts receivable not expected to be collected. We report the allowance for uncollectible accounts in the asset section of the balance sheet, but it represents a reduction in the balance of accounts receivable.  The difference between total accounts 5-33 Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr aw-Hill Education. Illustration 5–4 Accounting for Uncollectible Accounts and the Accounts Receivable Portion of the Balance ($ in Sheet millions) 2024 2025 (next (current $20 $50 year) $14year) Not collected Credit sales Estimat Collectible by end of during 2024 e $6 year Uncollectible KIMZEY MEDICAL CLINIC Asse Balance Sheet (partial) Contr t December 31, 2024 a Current assets: Asset Accounts receivable $20 Less: Allowance (6) Net accounts receivable $14 Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill 5-34 Education. Common Mistake Because Allowance for Uncollectible Accounts has a normal credit balance, students sometimes misclassify this account as a liability, which also has a normal credit balance. Instead, a contra asset represents a reduction in a related asset. Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 5-35 aw-Hill Education. Illustration 5–5 Income Statement Showing Estimated Bad Debt Expense KIMZEY MEDICAL CLINIC Income Statement For the year ended 2024 ($ in millions) Revenue from credit $50 sales Expenses: $ 6 Bad debt expense 34 40 Other operating $10 expenses Net Income Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill 5-36 Education. Key Point Establishing an allowance for uncollectible accounts correctly reports accounts receivable in the balance sheet at the amount expected to be collected. Bad debt expense is reported in the income statement. Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 5-37 aw-Hill Education. Concept Check 5–4 Which of the following is true regarding Allowance for Uncollectible Accounts? a. It is a liability account. b. It is added to the total of Sales Discounts, Sales Returns, and Sales Allowances. c. It is subtracted from the balance of Accounts Receivable in the balance sheet. d. It appears in the income statement as an expense. The allowance account is a contra asset and is used to record estimated future uncollectible accounts. The balance is subtracted from Accounts Receivable in the balance sheet to arrive at Accounts Receivable’s carrying value. Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr aw-Hill Education. 5-38 Learning Objective 4 LO5–4 Write off accounts receivable as uncollectible. Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 5-39 aw-Hill Education. Example of Writing Off Accounts Receivable On February 23, based on information about a former patient, Kimzey believes it is unlikely the patient will pay his account of $4,000. The company will adjust the allowance and reduce the accounts receivable balance itself as follows: February 23, 2025 Debit Credit Allowance for Uncollectible Accounts … 4,000 Accounts Receivable ……………………… 4,000 (Write off a customer’s account) Overall, the write-off of the account receivable has no effect on total amounts reported in the balance sheet or in the income statement. Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 5-40 aw-Hill Education. Writing Off Accounts Receivable When it becomes clear a customer will not pay, the company writes off the customer’s account balance as uncollectible. The write-off:  Reduces the balance of Accounts Receivable.  Reduces the balance of the contra account Allowance for Uncollectible Accounts. The write-off has no effect on total assets (balance sheet) or total expenses (income statement). 5-41 Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr aw-Hill Education. Collecting on Accounts Previously Written Off Later in 2025, on September 8, Kimzey receives a payment from the customer whose account had been written off of $1,000. The company records the collection using two entries: September 8, 2025 Debit Credit Accounts Receivable ………………………………… 1,000 Allowance for Uncollectible Accounts… 1,000 (Reestablish portion of account previously written off) Cash …………………………………………………………. 5-42 1,000 Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr aw-Hill Education. Concept Check 5–6 When writing off an uncollectible account: a. Bad debt expense is debited. b. Net income is decreased. c. Total assets are unchanged. d. The allowance account is The credited. write-off of an account receivable has no effect on total amounts reported in the balance sheet or in the income statement. There is no decrease in total assets and no decrease in net income. Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 5-43 aw-Hill Education. Learning Objective 5 LO5–5 Adjust the allowance for uncollectible accounts in subsequent years. Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 5-44 aw-Hill Education. Adjusting the Allowance in Subsequent Years At the end of 2025, Kimzey Medical Clinic must once again prepare financial statements.  Suppose that Kimzey has credit sales of $80 million in 2025 and has year-end accounts receivable of $30 million.  What portion of the $30 million in accounts receivable does Kimzey not expect to collect? Kimzey is required to report that estimate in Allowance for Uncollectible Accounts in its year-end balance sheet as a contra asset to accounts receivable. Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 5-45 aw-Hill Education.  Percentage-of-Receivables Method The percentage-of-receivables method is a method of estimating uncollectible accounts based on the percentage of accounts receivable expected not to be collected. This method sometimes is referred to as a balance sheet method because we base the estimate of bad debts on a balance sheet account—accounts receivable. For this method, the percentage may be estimated using current economic conditions, company history, and industry guidelines. Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 5-46 aw-Hill Education.  Aging Method The aging method bases the estimate of future bad debts on the various ages of individual accounts receivable, using a higher percentage for “old” accounts than for “new” accounts.  The older the account, the less likely it is to be collected. The journal entry to estimate future bad debts is identical to the journal entry made using a single Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 5-47 Key Point Using the aging method to estimate uncollectible accounts is more accurate than applying a single percentage to all accounts receivable. The aging method recognizes that the longer accounts are past due, the less likely they are to be collected. Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 5-48 aw-Hill Education. Illustration 5–6 Kimzey’s Accounts Receivable Aging Schedule Days Past Due More than Patients Not Yet Due 1–60 Total 61–120 120 Shirley Akin $ 12,000 12,000 $ Cara Lott 4,000 $ 4,000 Ben Greene $ 5,000 5,000 Anita Hand $ 7,000 7,000 Ima Hertz 9,000 9,000 Noah Luck 8,000 8,000 Phil Sikley 6,000 6,000 Justin Payne 10,000 10,000 Others 15,973,000 8,987,000 3,993,000 986,000 29,939,000 Total Accounts Receivable $16,000,000 $ 9,000,000 $ 4,000,000 $1,000,000 $30,000,000 Estimated Percent % increases Uncollectible 10% 30% 50% 70% with age Estimated Amount Uncollectible $ 1,600,000 $2,700,000 $2,000,000 $ 700,000 $ 7,000,000 Total estimated uncollectible Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill 5-49 Education. Using the Aging Method to Adjust the Allowance in Subsequent Years If the estimated amount uncollectible is $7 million, then Allowance for Uncollectible Accounts needs to have an ending balance of $7 million. We need to: 1) Know the current balance of Allowance for Uncollectible Accounts and then 2) Determine the adjustment needed so that the ending balance will be Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill 5-50 Education.  Illustration 5–7 Balance of Kimzey’s Allowance for Uncollectible Accounts Allowance for Uncollectible Accounts ($ in millions) 6 Beg. balance for Write-offs in 2025 4 2025 2 ? Bal. before 7 adjustment Year-end December 31, 2025 ($ in millions) adjustment Debit Credit Bad Debt Expense ……………………………………. Ending balance 5 for 2025 Allowance for Uncollectible Accounts... 5 (Estimate future bad debts) Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill 5-51 Education. Illustration 5–8 Accounts Receivable Portion of the Balance Sheet KIMZEY MEDICAL CLINIC Balance Sheet (partial) December 31, 2025 Assets ($ in millions) Current assets: Accounts receivable $30 Less: Allowance for uncollectible accounts (7) Net accounts receivable $23 Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill 5-52 Education. Illustration 5–9 Bad Debt Expense in the Income Statement KIMZEY MEDICAL CLINIC Income Statement For the year ended 2025 ($ in millions) Revenue from credit sales $80 Expenses: Bad debt expense $ 5 Other operating expenses 50 55 Net income $25 Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill 5-53 Education. Key Point The year-end adjusting entry for future uncollectible accounts is affected by the current balance of Allowance for Uncollectible Accounts before adjustment. The current balance before adjustment equals the balance of the allowance account at the beginning of the current year (or end of last year) less actual write-offs in the current year. Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 5-54 aw-Hill Education. Concept Check 5–7 Which of the following is true about the aging method? a. No estimate for uncollectible accounts needs to be made. b. Older accounts are more likely to be collected. c. It is not acceptable for GAAP. d. Older The aging accounts are lessthat method recognizes likely theto be longer collected. accounts are past due, the less likely they are to be collected. The aging method should provide a more accurate estimate of total uncollectible accounts compared to using a single percentage. Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr aw-Hill Education. 5-55  Understanding the Balance of Allowance for Uncollectible Accounts–Credit Balance Before Adjustment Allowance for Uncollectible Accounts ($ in millions) 6 Beg. balance for Write-offs in 2025 4 2025 2 Bal. before ? adjustment 7 Year-end Credit here indicates that the balance of the adjustment allowance account at the beginningEnding of the balance year (or end of last year) for 2025 may have been too high. Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill 5-56 Education.  Understanding the Balance of Allowance for Uncollectible Accounts–Debit Balance Before Adjustment Allowance for Uncollectible Accounts ($ in millions) 6 Beg. balance Write-offs 8 Bal. before 2 adjustment ? 7 Year-end adjustment Debit here indicates that the balance Endingof balance the allowance account at the beginning of the year (or end of last year) may have been too low. Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill 5-57 Education. Illustration 5-10 Excerpt from Tenet Healthcare Corporation’s Annual Report TENET HEALTHCARE CORPORATION Notes to the Financial The preparation of financial statements, Statements in conformity with (excerpt) accounting principles generally accepted in the United States of America (“GAAP”), requires us to make estimates and assumptions that affect the amounts reported in our Consolidated Financial Statements and these accompanying notes. We regularly evaluate the accounting policies and estimates we use. In general, we base the estimates on historical experience and on assumptions that we believe to be reasonable given the particular circumstances in which we operate. Although we believe all adjustments considered necessary for a fair presentation have 5-58 been included, Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Illustration 5-11 Excerpt from Tenet Healthcare Corporation’s Annual Report TENET HEALTHCARE CORPORATION Notes to the Financial Statements (excerpt)Indemnit y, Self- Pay, Medicar Medica Manag and Age e id ed Care Other Total 0–60 days $172 $34 $906 $126 $1,238 61–120 9 14 259 84 366 days 120–180 4 7 162 60 233 days Over 181 4 14 291 330 639 days Total $189 $69 $1,618 $600 $2,476 Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill 5-59 Education. Subsidiary Ledgers A subsidiary ledger contains a group of individual accounts associated with a particular general ledger control account.  For example, the subsidiary ledger for accounts receivable keeps track of all increases and decreases to individual customers’ accounts. The balances of all individual accounts then sum to the balance of total accounts receivable in the general ledger and reported in the balance sheet. Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 5-60 aw-Hill Education. Concept Check 5–8 On December 31 before adjusting entries, a company’s balance of Allowance for Uncollectible Accounts is a credit of $2,000. What does a “credit” balance prior to adjusting entries indicate? a. The company did not estimate bad debts last year. b. Last year’s estimate of bad debts was too low. c. The company’s estimate equals actual bad debts. d. Last year’s estimate of bad debts was too high. The Allowance for Uncollectible Accounts is a contra account with a credit balance. The balance is reduced (debited) for actual bad debts. If the account balance at the end of the year is a credit, then estimated bad debts for this year are greater than this year’s actual bad debts. Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 5-61 aw-Hill Education. Concept Check 5–9 On December 31 before adjusting entries, a company reports the following balances: Accounts Receivable $100,000 Allowance for Uncollectible Accounts $2,000 (debit) The company estimates bad debts to be 20% of accounts receivable. The adjusting entry would include: a. A debit to Bad Debt Expense for $22,000 b. A credit to Allow. for Uncollectible Accts for $18,000 Bad debts are estimated to be $20,000 (= $100,000 × 20%). c. current The A credit to Allow. $2,000 for Uncollectible debit balance Accts. of the Allowance needsfor a $20,000 credit adjustment of $22,000 to be equal to $20,000 credit. (Debit balance of $2,000 + Credit of $22,000 = Credit balance d. $20,000.) of A debitTheto adjustment Bad DebtofExpense $22,000 isfor $20,000 recorded as a debit to Bad CopyrightDebt Expense ©2022 McGraw-Hill. and No All rights reserved. a reproduction creditorto Allowance distribution for consent of McGr without the prior written 5-62 aw-Hill Education. Learning Objective 6 LO5–6 Contrast the allowance method and direct write-off method when accounting for uncollectible accounts. Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 5-63  Direct Write-Off Method (Not GAAP) For tax reporting, companies use an alternative method commonly referred to as the direct write-off method. Under this method, bad debts are written off only at the time they actually become uncollectible.  Unlike the allowance method, which requires estimation of uncollectible accounts before they even occur the direct write-off method is generally not allowed for financial reporting under GAAP.  The direct write off method is only used in financial reporting if uncollectible accounts Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 5-64 aw-Hill Education. Example of Writing Off Accounts Receivable Using the Direct Write Off Method A company provides services on account for $100,000 in 2024, but makes no allowance for uncollectible accounts at the end of the year. Then, in the following year on September 17, 2025, an account of $2,000 becomes uncollectible. The company records the actual write-off as September follows. 17, 2025 Debit Credit Bad Debt Expense………………………………… 2,000 Accounts Receivable ……………………… 2,000 (Write off a customer’s account directly) Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 5-65 aw-Hill Education.  Illustration 5–12 Comparing the Allowance Method and the Direct Write- off Method for Recording Uncollectible Accounts 2024 Allowance Method Direct Write-off Method Year-end Bad Debt Expense 2,000 No adjustment Adjustment (Estimate = Allowance for Uncollectible Accounts $2,000) 2,000 Bad Debt Expense 2025 2,000 Actual Write- Allowance for Uncollectible Accounts Accounts Receivable offs 2,000 2,000 (Actual = Accounts Receivable $2,000) The difference between the two 2,000 methods is in the timing. Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill 5-66 Education. Common Mistake Some students erroneously think firms should reduce total assets and record bad debt expense at the time the bad debt actually occurs. However, companies anticipate future bad debts and establish an allowance for those estimates. Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 5-67 aw-Hill Education. Key Point The direct write-off method waits to reduce accounts receivable and record bad debt expense until accounts receivable prove uncollectible in the future. This leads to accounts receivable being overstated in the current year. The direct write-off method generally is not acceptable for financial reporting. Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 5-68 aw-Hill Education. PART C NOTES RECEIVABLE AND INTEREST Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 5-69 aw-Hill Education. Learning Objective 7 LO5–7 Account for notes receivable and interest revenue. Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 5-70 Illustration 5–13 Note Receivable Notes receivable are assets. We classify notes receivable as either current or noncurrent, depending on the expected collection date. If the time to maturity is longer than one year, the note receivable is a long-term asset. Face $ 10,000 Date value February 1, 2024 Due date Six months after date I promise to pay to the Payee order of Kimzey Medical Clinic Ten thousand and no/100 dollars Justin Payne Interest for value received with interest at the rate of rate 12%. Maker Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill 5-71 Education. Recording Notes Receivable Kimzey provided $10,000 of services to Justin Payne, who is not able to pay immediately Justin Payne signs a promissory note, offering to pay $10,000 plus 12% interest February 1, 2024 in six monthsDebit (August 1) Receivable ………………………………… Credit Notes 10,000 Service Revenue ……………………………. 10,000 No interest (Accept is recorded a six-month, on February 12% note receivable for 1 services provided) Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr aw-Hill Education. 5-72 Accepting a Note Receivable to Replace an Existing Accounts Receivable Over time, it became apparent that Justin would not be able to pay quickly, so Kimzey required Justin to sign a six-month, 12% promissory note on February 1, 2024. When Justin signs the note, Kimzey records the following transaction to reclassify the existing February account receivable as aDebit 1, 2024 note receivable. Credit Notes Receivable ………………………………… 10,000 Accounts Receivable ……………………………. 10,000 (Reclassify accounts receivable as notes receivable)5-73 Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr aw-Hill Education. Key Point Notes receivable are similar to accounts receivable except that notes receivable are formal credit arrangements made with a written debt instrument, or note. Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 5-74 aw-Hill Education. Interest Calculation and Collection of Notes Receivable Kimzey accepted a six-month, 12% promissory note. The terms of the six-month note mean that Kimzey will charge Justin Payne one-half year of interest, or 6%, on the face value. Interest on Kimzey’s note receivable is calculated as follows. Face Annual Fraction Inter = value × interest × of the est = $10,00 × rate year × $600 0 12% 6/12 Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 5-75 aw-Hill Education. Key Point We calculate interest as the face value of the note multiplied by the stated annual interest rate multiplied by the appropriate fraction of the year that the note is outstanding. Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 5-76 aw-Hill Education. Collection of Notes Receivable After six months, Kimzey collects the full amount owed by Justin, including interest. Kimsey records the following entry: August 1, 2024 Debit Credit Cash …………………………………………………. 10,600 Notes Receivable ………………………… 10,000 Interest Revenue ………………………… 600 (Collect note receivable and interest) (Interest revenue = $10,000 × 12% × 6/12) Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 5-77 aw-Hill Education. Illustration 5–14 Calculating Interest Revenue over Time for Kimzey Medical Clinic Let’s assume Justin Payne issued the previous six- month note to Kimzey on November 1, 2024, instead of February 1, 2024. 2024 2025 Nov. 1 May 1 (Note (Note due) issued) Nov. Dec. Jan. Feb. Mar. Apr. $100 $100 $100 $100 $100 $100 2 months of 4 months of interest interest revenue revenue In 2024 = $200 in 2025 = $400 Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill 5-78 Education. Accrue Interest Payne issued the a six-month note to Kimzey on November 1, 2024. The $10,000 face value (principal) and $600 interest on the six-month note are not due until May 1, 2025.  Because Kimzey earns two months of interest in 2024, it must accrue that interest of $200 on December 31, 2024 (even though no cash has been collected). The adjusting entry to accrue interest revenue follows: 31, 2024 December Debit Credit Receivable ……………………………… Interest 200 Interest Revenue …………………………… 200 Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr aw-Hill Education. 5-79  Collect Note Receivable and Interest On December 31, 2024, Kimzey accrues interest for note receivable accepted on November 1, 2024. On May 1, 2025, the maturity date, Kimzey collects the note of $10,000 and the interest of $600. May 1, 2025 Debit Credit Cash ……………………………………………………. 10,600 Notes Receivable …………………………… 10,000 Interest Receivable (from 2024) …….. 200 Interest Revenue (from 2025) ………… 400 (Collect note receivable and interest) Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr aw-Hill Education. 5-80 Key Point We record interest earned on notes receivable but not yet collected by the end of the year as interest receivable and interest revenue. Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 5-81 aw-Hill Education. Concept Check 5–10 A company accepts a note receivable of $5,000 on September 1, 2024, that matures in 10 months and has stated interest of 6%. What amount of interest revenue will the company record in 2024 and 2025? a. 2024 = $100; 2025 = $150 b. 2024 = $125; 2025 = $125 c. 2024 = $150; 2025 = $100 d. 2024 = Face Interes $0; 2025 =Annual $250 Fraction = × interest × t value of the 2024: Interest Revenue rate Revenu = $5,000 × year 6% × e4/12 = $100 2025: Interest Revenue = $5,000 × 6% × Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr aw-Hill Education. 5-82 ANALYSIS RECEIVABLES ANALYSIS Tenet vs. CVS Health Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill. 8-83 ANALYSIS - Learning Objective 8 LO5–8 Calculate key ratios investors use to monitor a company’s effectiveness in managing receivables. Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr aw-Hill Education. 5-84 Receivables Turnover Ratio Number of times during a year the average accounts receivable balance is collected Average Collection Period Number of days the average accounts receivable balance is outstanding Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 5-85 aw-Hill Education. Illustration 5–15 Comparison of Receivables Ratios between Tenet Healthcare and CVS Health Receivables Turnover Ratio Average Collection Period Tenet Healthcare $18,479 ÷ $2,669 = 6.9 365 ÷ 6.9 = 52.9 CVS Health $256,776 ÷ $18,624 = 13.8 365 ÷ 13.8 = 26.4 Tenet:  Higher receivables turnover  Shorter collection period  More efficiently collects cash from patients Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill 5-86 Education. Key Point The receivables turnover ratio and average collection period can provide an indication of management’s ability to collect cash from customers in a timely manner. Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr aw-Hill Education. 5-87 Concept Check 5–11 Which of the following would be true for a company that has an accounts receivable turnover of 10? a. The company turns over their accounts receivable more than once a month. b. The company would have an average collection period of 36.5 days. c. The company would be considered as doing an efficient job of collecting receivables if the terms were net 30. d. The company would have an average collection period of 20 days. The average collection period is computed as 365 divided by the accounts receivable turnover of 10 (= 36.5 days). Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr aw-Hill Education. 5-88 APPENDIX PERCENTAGE-OF-CREDIT-SALES METHOD Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent McGraw 7-89 -Hill. APPENDIX - Learning Objective 9 LO5–9 Estimate uncollectible accounts using the percentage-of-credit-sales method. Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 5-90  Percentage-of-Credit-Sales Method we can estimate uncollectible accounts using an income statement account—credit sales. Estimating uncollectible accounts using a percentage of credit sales is aptly referred to as the percentage-of-credit-sales method. Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr aw-Hill Education. 5-91 Illustration 5–16 Adjusting for Estimates of Uncollectible Accounts Percentage-of-Receivables Percentage-of-Credit Sales Method Method Estimate of Uncollectible Estimate of Uncollectible Accounts 10.0% of credit sales in 2025 Accounts 20% of Accounts Receivable year will not be collected. at the end of 2025 will not be 10.0% of $80 million = $8 collected. million. 20% of $30 million = $6 Ignore $2 million existing million. balance of Allowance account Adjusting and add $8 million. Adjust Allowance account Entry ($ in millions) Adjusting Entry ($ in millions) Badfrom Debt Expense Bad Debt Expense $2 4million existing balance to 8 estimate of $6 million Allowance for Uncoll. Accts. Allowance for Uncoll. Accts. 4 8 Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill 5-92 Education. Illustration 5–17 Financial Statement Effects of Estimating Uncollectible Accounts Percentage-of- Percentage-of- Receivables Method Credit-Sales Method ($ in millions) ($ in millions) Income Statement Effect Income Statement Revenues $80 Effect $80 Bad debt expense Revenues (8) Net income (4) Bad debt expense $72 $76 Net income Balance Sheet Effect Balance Sheet Effect $30 Accounts receivable $30 Accounts receivable (10)* Less: Allowance (6)* $20 Net accounts $24 Less: Allowance receivable Net accounts *$6 = $2 + $4 receivable (adjustment) *$10 = $2 + $8 (adjustment) Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill 5-93 Education. Key Point When applying the percentage-of- credit-sales method, we adjust the allowance for uncollectible accounts for the current year’s credit sales that we don’t expect to collect (rather than adjusting at the end of the year for the percentage of accounts receivable we don’t expect to collect). Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr aw-Hill Education. 5-94 Concept Check 5–12 On December 31 before adjusting entries, a company reports the following balances: Accounts Receivable $100,000 Allowance for Uncoll. Accts. $2,000 (credit) Credit Sales $500,000 The company estimates bad debts to be 4% of credit sales. The adjusting entry would include: a. A debit to Bad Debt Expense = $18,000 b. A credit to Allowance for Uncoll. Accts. = $24,000 c. A credit to Allowance for Uncoll. Accts. = $22,000 The d. adjustment equals A debit to Bad $500,000 Debt × 4% Expense = $20,000. The = $20,000 adjusting entry includes a debit to Bad Debt Expense and a credit to Allowance for Uncollectible Accounts. Copyright ©2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written conse nt of McGraw-Hill Education. 5-95 End of Chapter 5 Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 5-96