ACCOUNTING FOR RECEIVABLES CHAPTER 8

Agenda Learning goals Vocabulary Types of accounts receivable Accounts receivable Valuing accounts receivable Recognize notes receivable Disposing of notes receivable Statement presentation and management of receivables

Learning goals Record accounts receivable transactions Calculate the net realizable value of accounts receivable and account for bad debt Account for notes receivable Demonstrate the presentation, analysis, and management of receivables

Vocabulary Accounts receivable Notes receivable Trade receivables Net realizable value Bad debt expense Allowance method Percentage of sales approach Income statement approach Percentage of receivables approach Aging schedule Balance sheet approach Promissory note Dishonoured note Turnover ratio

Types of Receivables Amounts due from individuals and other companies Accounts receivable: –Amounts owed by customers on account –Expected to be collected within 30 days Notes receivable (trade receivables): –Supported by formal instruments of credit –For periods of 30 days or longer –Interest bearing

The three primary accounting problems associated with accounts receivable are: 1. Recognizing accounts receivable. 2. Valuing accounts receivable. 3. Disposing of accounts receivable. ACCOUNTS RECEIVABLE

1. RECOGNIZING ACCOUNTS RECEIVABLE DateParticularsDebitCredit July 1 When a business sells merchandise to a customer on credit, Accounts Receivable is debited and Sales is credited. Accounts Receivable – Adorable Junior 1,000 Sales 1,000

1. RECOGNIZING ACCOUNTS RECEIVABLE (cont.) DateParticularsDebitCredit July 5 When a business receives returned merchandise previously sold to a customer on credit, Sales Returns and Allowances is debited and Accounts Receivable is credited. Sales Returns and Allowances 100 Accounts Receivable 100

1. RECOGNIZING ACCOUNTS RECEIVABLE (cont.) DateParticularsDebitCredit July 31 Cash ($1,000 – $100)900 Accounts Receivable When a business collects cash from a customer for merchandise previously sold on credit, Cash is debited and Accounts Receivable is credited.

1. RECOGNIZING ACCOUNTS RECEIVABLE (cont.) DateParticularsDebitCredit July 31 Accounts Receivable (18% or 1.5% per month on $900) Interest Revenue When financing charges are added to a balance owing, Accounts Receivable is debited and Interest Revenue is credited.

1. RECOGNIZING ACCOUNTS RECEIVABLE (cont.) DateParticularsDebitCredit July 31 Cash [($1000-$100)*98%] Sales Discount [($1000-$100)*2%] Accounts Receivale When discount is provided due to early payment Cash and Sales Discount are debited and Accounts Receivable is credited.

1. RECOGNIZING ACCOUNTS RECEIVABLE (cont.) Sales on credit cards that are not directly associated with a bank are reported as credit sales, not cash sales. –Unlike bank credit card sales - treated as cash sales –Receipt of cash from nonbank credit cards is recorded as follows

Practice Do the practice question on page 412

To ensure that receivables are not overstated, they are stated at their net realizable value. Net realizable value is the net amount expected to be received in cash and excludes amounts that the company estimates it will not be able to collect. 2. VALUING ACCOUNTS RECEIVABLE

When receivables are written down to their net realizable value due to credit losses, owner’s equity must also be reduced. –Done by recording bad debt expense

Two methods of accounting for uncollectible accounts are: 1. Allowance method 2. Direct write-off method 2. VALUING ACCOUNTS RECEIVABLE (cont.) ACCOUNTS RECEIVABLE (cont.) 2. VALUING ACCOUNTS RECEIVABLE (cont.) ACCOUNTS RECEIVABLE (cont.)

Under the direct write-off method, no entries are made for bad debts until an account is determined to be uncollectible at which time the loss is charged to Bad Debts Expense. No attempt is made to match bad debts to sales revenues or to show the net realizable value of accounts receivable on the balance sheet. DIRECT WRITE-OFF METHOD

Periera Company writes off E. Schaefer’s $200 balance as uncollectible on January 12. When this method is used, Bad Debts Expense will show only actual losses from uncollectibles. DateParticularsDebitCredit Jan. 12 Bad Debt Expense200 Accounts Receivable – E. Schaefer

The allowance method is required when bad debts are deemed to be material (significant) in amount. Uncollectible accounts are estimated and the expense for the uncollectible accounts is matched against sales in the same accounting period in which the sales occurred. THE ALLOWANCE METHOD (2 Steps) THE ALLOWANCE METHOD (2 Steps) Why?

Estimated uncollectible amounts are debited to Bad Debts Expense (operating expense)and credited to Allowance for Doubtful Accounts (a contra asset account) at the end of each period. THE ALLOWANCE METHOD Step 1-Record Estimated Uncollectible THE ALLOWANCE METHOD Step 1-Record Estimated Uncollectible DateParticularsDebitCredit Dec. 31 Bad Debts Expense24,000 Allowance for Doubtful Accounts

ADORABLE JUNIOR GARMET Balance Sheet (partial) Current assets Cash $ 14,800 Accounts receivable$200,000 Less: Allowance for doubtful accounts 24, ,000 Net Realizable Value Why not just show the Net Realizable Value, and omit the rest?

Actual uncollectible accounts are debited to Allowance for Doubtful Accounts and credited to Accounts Receivable at the time the specific account is written off. THE ALLOWANCE METHOD Step 2: Recording the Write-Off of an Uncollectible Account THE ALLOWANCE METHOD Step 2: Recording the Write-Off of an Uncollectible Account DateParticularsDebitCredit Mar. 1 Allowance for Doubtful Accounts500 Accounts Receivable - Nadeau

When there is recovery of an account that has been written off: 1.Reverse the entry made to write off the account THE ALLOWANCE METHOD- Recovery of an Uncollectible DateParticularsDebitCredit July 1 2.Record the collection in the usual manner. DateParticularsDebitCredit July 1 Accounts Receivable – Nadeau500 Allowance for Doubtful Accounts 500 Cash 500 Accounts Receivable 500

Companies use either of two methods in the estimation of uncollectible accounts: A.Percentage of sales B.Percentage of aged receivables Both bases are GAAP; the choice is a management decision. BASES USED FOR THE ALLOWANCE METHOD

In the percentage of sales basis (income statement approach), management establishes what amount of net CREDIT sales are expected to be uncollectible (usually from past experience). Bad Debt Expense is then determined by applying the percentage to the sales base of the current period. The TOTAL amount is charged to Bad Debt. Observe… A. PERCENTAGE OF SALES BASIS This basis better matches expenses with revenues. DateParticularsDebitCredit Dec. 31 Bad Debt Expense 3,000 Allowance for Doubtful Accounts 3,000

Under this method, management estimates what the TOTAL value of bad debt currently is by applying a percentage to the actual, existing accounts receivable balances at the end of the period. Also known as the balance sheet approach This percentage can be applied to 1.The total receivable balance, or 2.To accounts receivable balances grouped by age. (see pg 416) B. PERCENTAGE OF AGED RECEIVABLES BASIS

The amount of the adjusting entry is the difference between the required balance in the allowance account, and the current balance. This basis produces the better estimate of net realizable value of receivables. Observe… B. PERCENTAGE OF AGED RECEIVABLES BASIS (cont.) Desired Balance

B. PERCENTAGE OF AGED RECEIVABLES BASIS (cont.) So, if the balance in the Allowance account is already $2,200, then the adjusting entry to bring the Allowance up to the present estimated of Net Realizable Receivables is… DateParticularsDebitCredit Dec. 31 Bad Debt Expense($3,245 - $2,200) 1,045 Allowance for Doubtful Accounts 1,045

Two Methods for Estimating the Allowance: Percentage of Sales: Calculates bad debt expense as a percentage of net credit sales –Based on past experience and company’s credit policy –Example: 2% of credit sales of $1,200,000 = $24,000 Better matches revenues and expenses Also called the income statement method Percentage of Receivables Calculates the percentage of receivables that are estimated to be uncollectible Based on past experience and credit policy Can be applied to total receivables balance or amounts grouped by age Requires an aging schedule to be prepared Better estimate of net realizable value Also called the balance sheet method

Comparison of Approaches Income Statement Approach Percentage of Sales Matching Sales Bad Debts Expense Percentage of Receivables Net Realizable Value Allowance for Doubtful Accounts Accounts Receivable Balance Sheet Approach

Do the following starting on page 434: BE8-6, 7, 8 E8-3, E8-4 P8-5A

To accelerate the receipt of cash from receivables, owners frequently: 1. sell to a factor, such as a finance company or a bank, and 2. make credit card sales. 3. DISPOSING OF ACCOUNTS RECEIVABLE

A factor buys receivables from businesses for a fee and collects the payments directly from customers. Credit cards are frequently used by retailers who wish to avoid the paperwork of issuing credit. Retailers can receive cash more quickly from the credit card issuer. 3. DISPOSING OF ACCOUNTS RECEIVABLE (cont.)

Three parties are involved when credit cards are used in making retail sales: 1. the credit card issuer, 2. the retailer, and 3. the customer. The retailer pays the credit card issuer a percentage fee of the invoice price for its services. CREDIT CARD SALES

BANK CARD SALES Sales resulting from the use of VISA and MasterCard are considered cash sales by the retailer. These cards are issued by banks. Upon receipt of credit card sales slips from a retailer, the bank immediately adds the amount to the seller’s bank balance.

BANK CARD SALES We purchase a CDs for our restaurant from Karen Kerr Music Co. for $1,000 using our Royal Bank VISA card. The service fee that the Royal charges is 3.5 percent. DateParticularsDebitCredit July 31 Credit Card Expense ($1,000 x 3.5%) 35 Sales 1,000 Cash965

A promissory note is a written promise to pay a specified amount of money on demand or at a definite time. The party making the promise is the maker. The party to whom payment is made is called the payee. NOTES RECEIVABLE

Accounts Receivable/ Notes Receivable Accounts receivable – is an informal promise to pay Results from credit sale Due in a short period of time Doesn’t incur interest unless overdue Note receivable – is a written promise to pay, which gives the payee a stronger legal claim. Results from: financing a purchase, lending money, or extending an A/R Incurs interest for the entire time Both are credit instruments, valued at their net realizable values, and can be sold to a 3rd party

Interest rate The cost of borrowing others’ money. It is an expense, not the repayment of debt Face Value The price of a note or bond, written on the actual contract (note) Term The length of the note or bond before it is due Maturity When the note/bond’s face value is due, along with any outstanding interest IMPORTANT TERMS

Interest is always calculated as follows: IMPORTANT TERMS Principal Principal of Note X X = Annual AnnualInterestRate Time in Time in Terms of One Year Interest $10,000 X 6% X 4/12 = $200 Monthly interest is $200/4 = $50

We now will look at the following three procedures for dealing with notes: –Acquisition –Adjustment/valuation –Disposal/termination Note: these three steps are similar to many things we will look at this semester. Best to look for trends and processes. NOTES RECEIVABLE

RECOGNIZING NOTES RECEIVABLE Acquisition Acquisition Wilma Company receives a $1,000, 6% promissory note, due in two months (July 1) from Brent Company to settle an open account. DateParticularsDebitCredit May 1 Notes Receivable1,000 Accounts Receivable – Wilma Company If a note is exchanged for cash instead of A/R, credit cash

Like accounts receivable, short-term notes receivable are reported at their net realizable value. The notes receivable allowance account is Allowance for Doubtful Notes. VALUING NOTES RECEIVABLE

DateParticularsDebitCredit May 31 Interest Receivable5 5Interest Revenue VALUING NOTES RECEIVABLE Adjustment/Valuation Adjustment/Valuation Recording interest If they do not, no entry will be recorded until the note matures and pays interest.

DateParticularsDebitCredit May 31 Cash1,010 5Interest Receivable VALUING NOTES RECEIVABLE Disposal/Termination Disposal/Termination Notes are normally held to their maturity date, at which time the principal plus any unpaid interest is collected – known as honouring the notes. 5Interest Revenue 1,000Notes Receivable - Wilma Company When the note is honoured it is paid in full at its maturity date. The amount due at maturity is the principal of the notes plus interest for the length of time the note is outstanding.

DateParticularsDebitCredit May 31 Cash1,010 10Interest Receivable VALUING NOTES RECEIVABLE Disposal/Termination Disposal/Termination If Wilma company does NOT adjust monthly, the journal entry will look like this: 1,000Notes Receivable - Wilma Company

DISHONOUR OF NOTES RECEIVABLE A dishonoured note is a note that is not paid in full at maturity. A dishonoured note receivable is no longer negotiable. Since the payee still has a claim against the maker of the note, the balance in Notes Receivable is usually transferred to Accounts Receivable. DateParticularsDebitCredit Sept. 30 Accounts Receivable - Wilma Company1,010 1,000Notes Receivable - Wilma Company 10Interest Revenue

DateParticularsDebitCredit Sept. 30 Accounts Receivable - Wilma Company Interest Revenue Interest Receivable 1,010 1,000 5 If interest was accrued during the duration of the note

DISHONOUR OF NOTES RECEIVABLE Allowance for Doubtful Accounts Notes Receivable – Highly Interest Receivable To record dishonouring of not that will not be collected DateParticularsDebitCredit Sept. 30

BALANCE SHEET PRESENTATION OF RECEIVABLES Both the gross amount of receivables and the allowance for doubtful accounts should be reported. Why?

Management of Receivables Receivables turnover ratio: = Net Credit Sales ÷ Average Gross Receivables –Measures the number of times that receivables are collected in a period –Higher the number, the more liquid are receivables Collection period: = 365 ÷ Receivables Turnover Ratio –Calculates the average number of days that accounts receivable are outstanding –Should not be longer than the credit term period (time allowed for payment)

Management of Receivables Operating Cycle: = Days Sales in Inventory + Collection Period –Calculates the number of days to complete the operating cycle Average time that it takes to purchase inventory, sell it on account, and then collect cash from customers.

USING THE INFORMATION IN THE FINANCIAL STATEMENTS Financial ratios are calculated to evaluate the short-term liquidity of a company. Recall these ratios: 1. current ratio, 2. acid test (quick) ratio, 3. receivables turnover, and the 4. A/R collection period (in days).

Do the following starting on page 435: BE8-9 to 12 P8-8A P8-10A