Accounts Receivable Generally, two major issues: How to Record Sales Discounts How to Record Doubtful Receipts

Accounts Receivable Discounts The most prevalent is the cash discount for early payment on the account. Example: 2/10, n/30

Accounts Receivable Discounts The most prevalent is the cash discount for early payment on the account. Example: 2/10, n/30 2% discount if paid within 10 days

Accounts Receivable Discounts The most prevalent is the cash discount for early payment on the account. Example: 2/10, n/30 Net amount due in 30 days.

Usually for firms whose clients generally take advantage of the discounts Accounts Receivable Discounts Two methods to record the discount: Gross Method: record primary sale at gross amount Usually for firms whose clients generally don’t take advantage of the discounts Net Method: record primary sale at net-of-discount amount

Gross Method Jan 1Accts Rec10,000 Sales10,000 Accounts Receivable Discounts Example: Jan 1 st, sell $10,000 of product under 2/10, n/30 terms.

Accounts Receivable Discounts Example: Jan 1 st, sell $10,000 of product under 2/10, n/30 terms. Recorded as if discount won’t be taken Gross Method Jan 1Accts Rec10,000 Sales10,000

Accounts Receivable Discounts Example: Jan 1 st, sell $10,000 of product under 2/10, n/30 terms. Gross Method Jan 1Accts Rec10,000 Sales10,000 Net Method Jan 1Accts Rec9,800 Sales9,800

Accounts Receivable Discounts Example: Jan 1 st, sell $10,000 of product under 2/10, n/30 terms. Gross Method Jan 1Accts Rec10,000 Sales10,000 Net Method Jan 1Accts Rec9,800 Sales9,800 Recorded as if discount will be taken

Gross Method Jan 9Cash9,800 Sales Discs200 Accts Rec10,000 Accounts Receivable Discounts Example: Jan 9th, receive payment within discount period

Accounts Receivable Discounts Example: Jan 9th, receive payment within discount period Gross Method Jan 9Cash9,800 Sales Discs200 Accts Rec10,000 If the discount is actually realized, it is recorded upon receipt of the cash payment. Sales Discounts is a contra-revenue account.

Accounts Receivable Discounts Example: Jan 9th, receive payment within discount period Gross Method Jan 9Cash9,800 Sales Discs200 Accts Rec10,000 Net Method Jan 9Cash9,800 Accts Rec9,800

Accounts Receivable Discounts Example: Jan 9th, receive payment within discount period Gross Method Jan 9Cash9,800 Sales Discs200 Accts Rec10,000 Net Method Jan 9Cash9,800 Accts Rec9,800 Discount has already been recorded on sales date.

Accounts Receivable Discounts Example: Jan 29th, receive payment outside discount period Now assume instead that the payment was sent after the discount period expired.

Accounts Receivable Discounts Example: Jan 29th, receive payment outside discount period Gross Method Jan 29Cash10,000 Accts Rec10,000 No correction needed, since we already assumed the discount would not be taken.

Accounts Receivable Discounts Example: Jan 29th, receive payment outside discount period Gross Method Jan 29Cash10,000 Accts Rec10,000 Net Method Jan 29Cash10,000 Accts Rec9,800 Forfeited Discount200

Accounts Receivable Discounts Example: Jan 29th, receive payment outside discount period Gross Method Jan 29Cash10,000 Accts Rec10,000 Net Method Jan 29Cash10,000 Accts Rec9,800 Forfeited Discount200 Record the forfeited discount (a revenue account).

Accounts Receivable Doubtful Receipts One method of recording default is to record a loss when actual default occurs. This is called the direct write-off method. All receivables have some probability of default. The default on payment needs to be recorded appropriately. Not considered an acceptable method because it does not match revenues with costs effectively.

Accounts Receivable Doubtful Receipts The accepted method is called the Allowance Method. An Allowance for Doubtful Accounts is set up as a contra-receivable account (contra-asset). It holds management’s best estimate for the amount of receivables that will default.

Accounts Receivable Doubtful Receipts To determine management’s best estimate for default, use one of two methods: Percentage of Sales Method: a fixed percentage of sales will be considered doubtful This is also called the balance sheet approach, since the estimate is based on a percentage of a balance sheet receivable account. This is also called the income statement approach, since the estimate is based on a percentage of sales revenue. Percentage of Receivables Method: a fixed percentage of the receivables balance will be considered doubtful

Accounts Receivable Example: Assume Paterno Corp. has $200,000 in sales during Of these sales, 30% are in cash and 70% are on credit. They estimate that 4% of their credit sales will not be collected Credit Sales: 0.70 x $200,000 = $140,000 Estimate of doubtful collections: 0.04 x $140,000 = $5,600 Doubtful Receipts: Percentage of Sales Method

Accounts Receivable Example: Assume Paterno Corp. has $200,000 in sales during Of these sales, 30% are in cash and 70% are on credit. They estimate that 4% of their credit sales will not be collected. Journal entry: Bad Debt Expense$5,600 Allowance for Doubtful Accts$5,600 Doubtful Receipts: Percentage of Sales Method

Accounts Receivable Doubtful Receipts-Percentage of Receivables Method Most firms know that the probability of default is based on the staleness of accounts. For example, credit card companies recognize that the probability of default increases in the length of the time a credit card account remains past due. Firms facing this scenario usually set up aging schedules that outline their estimates for default, based on the age of balances in receivable accounts.

Accounts Receivable Doubtful Receipts-Percentage of Receivables Method Aging Schedule Based on historical data, MBNA estimates the following default rates on its outstanding credit card receivables: AgeEstimated Default Rate < 60 days old5% days old10% > 90 days old20%

Accounts Receivable Doubtful Receipts-Percentage of Receivables Method Aging Schedule Assume MBNA has the following outstanding receivables balances: AgeA/R Balance < 60 days old$2,500, days old$1,200,000 > 90 days old$1,000,000

Accounts Receivable Doubtful Receipts-Percentage of Receivables Method Aging Schedule MBNA would compute its ending balance for Allowance for Doubtful Accounts as follows: AgeA/R BalanceEstimated Default Rate AFDA < 60 days old$2,500,0005% days old$1,200,00010% > 90 days old$1,000,00020% Totals

Accounts Receivable Doubtful Receipts-Percentage of Receivables Method Aging Schedule MBNA would compute its ending balance for Allowance for Doubtful Accounts as follows: AgeA/R BalanceEstimated Default Rate AFDA < 60 days old$2,500,0005%$125, days old$1,200,00010%$120,000 > 90 days old$1,000,00020%$200,000 Totals$445,000

Accounts Receivable Doubtful Receipts-Percentage of Receivables Method Aging Schedule Note that the aging schedule computes the Allowance for Doubtful Accounts ending balance.

Accounts Receivable Doubtful Receipts-Percentage of Receivables Method Aging Schedule Note that the aging schedule computes the Allowance for Doubtful Accounts ending balance. The journal entry to record bad debt expense is for the difference between the AFDA beginning balance and this new ending balance.

Accounts Receivable Doubtful Receipts-Percentage of Receivables Method Aging Schedule AFDA Beg Bal$375,000

Accounts Receivable Doubtful Receipts-Percentage of Receivables Method Aging Schedule AFDA Beg Bal$375,000 End Bal$445,000

Accounts Receivable Doubtful Receipts-Percentage of Receivables Method Aging Schedule AFDA Beg Bal$375,000 End Bal$445,000 $70,000 Bad-Debt Expense

Accounts Receivable Doubtful Receipts-Percentage of Receivables Method Aging Schedule AFDA Beg Bal$375,000 End Bal$445,000 $70,000 Bad Debt Expense$70,000 Allowance for Doubtful Accts$70,000

Accounts Receivable Sales Returns and Allowances Returns and allowances are handled in the same manner as doubtful collection. An account called Allowance for Sales Returns is set up based on management’s best estimate for returns.