Accounting for Receivables Chapter 7 Accounting for Receivables Up to this point in the course, we have unrealistically assumed that we would collect all of our Accounts Receivable. We all know that in reality we will not receive payment for some Accounts Receivable. In this chapter, we will learn how to account for the fact that we will not collect all Accounts Receivable owed to us. We will also learn about credit card sales and notes receivable.

Accounts Receivable Amounts due from customers for credit sales. Credit sales require: Maintaining a separate account receivable for each customer. Accounting for bad debts that result from credit sales. Earlier in the class, we talked about accrual accounting or the process of recognizing revenues and expenses when earned and incurred as opposed to when cash is paid. We determined that revenue is recognized on the books when the following occurs: The work has been substantially completed (the company has performed a service). There is a reasonable chance of collection (even though you have not collected cash, but feel that it is probable that you will collect the cash. E.g. you own a bar and your best customer Norm has been coming in every night for 10 years and has 6 drinks. Once a month you give him a bill and the next week he brings a check. Even though he has not given you the cash yet, you can be assured that you will be paid and recognize the revenue. In a situation like this, you’re recognizing revenue, so in your journal entry you must credit a revenue account. But what happens to the other side of the entry? Since cash has not been collected, cash cannot be debited, instead we must debit a receivable. What happens when customers purchase goods on credit, promise to pay, then don’t pay??

Recognizing Accounts Receivable $20.5 Mil. $5.785 Mil. $97.4 Mil. $92.9 Mil. As a percentage of total assets As this slide indicates, Accounts Receivable can be a major component of the total assets of a company. Proper valuation of Accounts Receivable is important. Receivables are a MAJOR part of the income of many businesses, especially those in the retail sector. The number of people who buy on credit is increasing at a rapid rate because of the efficiency of use thanks to technology.

C 1 Sales on Credit On July 16, Barton, Co. sells $950 of merchandise on credit to Webster, Co., and $1,000 of merchandise on account to Matrix, Inc. Part I Let’s prepare the entries to record these sales to Webster Company and Matrix Incorporated. Part II Both sales were sold on credit and include a debit to Accounts Receivable and a credit to Sales. Also notice that the specific customer is noted in the transaction so we can make the proper entry in the customer’s Accounts Receivable subsidiary ledger.

C 1 Sales on Credit On July 31, Barton, Co. collects $500 from Webster, Co., and $800 from Matrix, Inc. on account. Part I Let’s prepare the entries to record these two collections on account from Webster Company and Matrix Incorporated. Part II When cash is collected on accounts, we debit Cash and credit Accounts Receivable. Notice that the specific customer is noted in the transaction so we can make the proper entry in the customer’s Accounts Receivable subsidiary ledger.

Credit Card Sales C 1 Advantages of allowing customers to use credit cards: Customers’ credit is evaluated by the credit card issuer. Sales increase by providing purchase options to the customer. Most companies allow customers to use credit cards for sales on credit at their company. There are several advantages to this arrangement. First, the credit card company evaluates the customer’s credit worthiness for the company making the sale. Second, when customers can delay payment, they purchase more. Third, the credit card company carries the risk related to the customers’ bad debts. Fourth, cash collections are quicker because the selling company receives payment from the credit card company and does not have to wait for the customer to make a payment. Of course, in exchange for all of these advantages, companies pay a percentage of the sale to third party credit card companies as payment for using their services. In the case of credit cards, the place where you charge doesn’t have to wait for collection and have a receivable, but the BANK that owns your charge card waits for collection and has the receivable. Cash collections are speeded up. The risks of extending credit are transferred to the credit card issuer.

Valuing Accounts Receivable P1 Some customers may not pay their account. Uncollectible amounts are referred to as bad debts. There are two methods of dealing with bad debts: Direct Write-Off Method Allowance Method Companies must account for the fact that some customers may not be able to pay the amounts they owe. There are two basic methods used to account for bad debts: the direct write-off method and the allowance method. First, let’s look at the direct write-off method. Banks if dealing with credit cards, or any company that offers credit must deal with the probability and chance that not everyone will pay as promised, and make adjustments to their records for these people who do not pay. The direct write-off method and allowance method are the two methods used to deal with ‘writing off’ these debts, which is the removal from financial records.

Direct Write-Off Method P1 On August 4, Barton determines it cannot collect $350 from Martin, Inc., a credit customer. Part I The Direct write-off method records the actual losses from an uncollectible account during the period when the account is actually deemed uncollectible. In this transaction, Barton determines that Martin Incorporated can’t pay the three hundred fifty dollars it owes. Its written off as shown above on the slide. Part II Barton would debit Bad Debts Expense and credit Accounts Receivable for three hundred fifty dollars. Notice that the specific customer is noted in the transaction so we can make the proper entry in the customer’s Accounts Receivable subsidiary ledger.

Direct Write-Off Method P1 On September 9, Martin decides to pay $200. Part I Now assume that Martin sends Barton a partial payment of two hundred dollars after Barton made the write off entry. Should Barton return the two hundred dollars since they have written off Martin’s account receivable? Of course not. Part II Since Barton had written off Martin’s account receivable, the first entry is required to reverse the write off and re-establish part of Martin’s account receivable. This entry includes a debit to Accounts Receivable an a credit to Bad Debts Expense. The second entry is a debit to Cash and a credit to Accounts Receivable for the amount of cash received.

Matching vs. Materiality P1 Matching vs. Materiality Materiality states that an amount can be ignored if its effect on the financial statements is unimportant to users’ business decisions. Matching requires expenses to be reported in the same accounting period as the sales they help produce. The direct write-off method does not attempt to match bad debts expense in the period that the sale occurred. As a result, this method cannot be used when preparing financial statements using generally accepted accounting principles unless there is an immaterial impact on the financial statements. As a result, most companies preparing financial statements using generally accepted accounting principles use the allowance method to account for bad debts. For example, I sell goods on 12/31/2007 on credit, on that date I debit my accounts receivable and credit sales, hence I have revenue in 2007. If this client decides to go bankrupt and not pay me, I most likely will not learn of this until 2008, the next accounting period after the revenue is recognized. In 2008, when I learn I’m not getting paid, I would debit my bad debt expense and credit my A/R. As you can see, I have revenue in one period, and my related expense in the following period, a direct violation of the matching principle.

P1 Allowance Method At the end of each period, estimate total bad debts expected to be realized from that period’s sales. There are two advantages to the allowance method: It records estimated bad debts expense in the period when the related sales are recorded. It reports accounts receivable on the balance sheet at the estimated amount of cash to be collected. The allowance method does attempt to match Bad Debts Expense in the period with the related revenue. This method requires that an estimate of bad debts be made and recorded at the end of each period. At the end of the year, we look at our financial statements and make a ‘GUESS’ as to what we think we won’t collect, and make an adjusting entry to write off our guess. This method has two advantages: First, it adheres to the matching principle because the Bad Debts Expense is recorded in the period of the sale, and Second, it reports accounts receivable on the balance sheet at the estimated amount of cash to be collected. Let’s see how the allowance method works.

Recording Bad Debts Expense At the end of its first year of operations, Barton Co. estimates that $3,000 of it accounts receivable will prove uncollectible. The total accounts receivable balance at December 31, 2007, is $278,000. Part I At the end of the period, a company estimates how much of its accounts receivable will not be collected. This estimate is based on past collection history and current economic information. Remember that when we make this estimate, we do not know specifically WHO will not pay us. If we knew WHO would not pay us, we would never have sold to them on credit in the first place—right? At the end of the period, Barton Company estimates that three thousand dollars of its accounts receivable will not be collected. The total balance in accounts receivable is two hundred seventy-eight thousand dollars. Let’s prepare the entry to record this estimate of bad debts. Part II The entry requires a debit to Bad Debt Expense and a credit to Allowance for Doubtful Accounts for the estimated amount. Why can’t we just credit Accounts Receivable in this entry? Remember, we are recording an estimate of uncollectible accounts and we do not know WHO specifically will not pay us. If we tried to credit Accounts Receivable, which customer’s subsidiary account would we use? The answer is we would not know which one to use. As a result, we credit the Allowance for Doubtful Accounts account. Part III Allowance for Doubtful Accounts is a contra-asset account. It has a normal credit balance. It is reported on the balance sheet as a subtraction from the Accounts Receivable balance to arrive at the amount of accounts receivable we actually think we will collect. Contra asset account

Recording Bad Debts Expense At the end of its first year of operations, Barton Co. estimates that $3,000 of it accounts receivable will prove uncollectible. The total accounts receivable balance at December 31, 2007, is $278,000. On the balance sheet, the Allowance for Doubtful Accounts is subtracted from the Accounts Receivable balance. The reported value of two hundred seventy-five thousand dollars is called net realizable value. It is the amount of Accounts Receivable that we actually think we will collect.

Estimating Bad Debts Expense Two Methods Percent of Sales Method Accounts Receivable Methods Percent of Accounts Receivable Aging of Accounts Receivable Method How does a company come up with the estimate for the entry at the end of the year? Well, there are two methods from which to choose: The Percent of Sales Method and the Accounts Receivable Method. Under the Accounts Receivable Method, there are actually two separate methods a company can use: percent of accounts receivable and aging of accounts receivable. Let’s look at the Percent of Sales Method first.

Percent of Sales Method Bad debts expense is computed as follows: When using the Percent of Sales Method, the estimate at the end of the period is determined by taking current period sales and multiplying by an established bad debt percentage. The bad debt percentage is determined based on past history of the company and current economic trends. Also, the sales transactions included in this computation are typically only the credit sales. There are not any collection issues to consider for cash sales transactions. Let’s look at an example.

Percent of Sales Method Barton has credit sales of $1,400,000 in 2007. Management estimates 0.5% of credit sales will eventually prove uncollectible. What is Bad Debts Expense for 2007? Barton has credit sales of one million four hundred thousand dollars in the year 2007. Management estimates that point five percent of credit sales will eventually prove to be uncollectible. What is Barton’s Bad Debts Expense for the year 2007?

Percent of Sales Method Barton’s accountant computes estimated Bad Debts Expense of $7,000. Part I Barton’s Bad Debt Expense would be seven thousand dollars. This is determined by multiplying the credit sales of one million four hundred thousand dollars by point five percent. What would be the entry Barton would prepare to record Bad Debts Expense? Part II Barton would debit Bad Debts Expense and credit Allowance for Doubtful Accounts for seven thousand dollars. Though this might sound funny at the moment, always remember bad debt expense in the following way: “bad debt expense is the amount in which the allowance account is increased for a period.” in other words, when dealing with the allowance method, the only account that you will EVER see with bad debt expense is the allowance for doubtful accounts!!

Percent of Accounts Receivable Method Compute the estimate of the Allowance for Doubtful Accounts. Bad Debts Expense is computed as: Now, let’s switch our focus to the Percent of Accounts Receivable Method. Let’s first look at the method that uses a percent of the accounts receivable balance to arrive at bad debts expense. First, when using the Percent of Accounts Receivable Method, the estimate at the end of the period is determined by taking the Accounts Receivable balance and multiplying by an established bad debt percentage. The bad debt percentage is determined based on past history of the company and current economic trends. This computation provides the company with the balance desired in the Allowance for Doubtful Accounts. Second, because the Allowance for Doubtful Accounts is a permanent account (receivables are permanent, and we’re adjusting based on receivables), it will always have a balance in it. As a result, when we determine the desired balance in step one, we have to then look and see what balance is already in the Allowance for Doubtful Accounts and make the entry for the amount needed to arrive at the desired balance. Let’s look at an example to see how this works.

Percent of Accounts Receivable Barton has $100,000 in accounts receivable and a $900 credit balance in Allowance for Doubtful Accounts on December 31, 2007. Past experience suggests that 4% of receivables are uncollectible. What is Barton’s Bad Debts Expense for 2007? At the end of 2007, Barton has one hundred thousand dollars in Accounts Receivable and a nine hundred dollar credit balance in Allowance for Doubtful Accounts. Barton’s past experience indicates that four percent of the receivables are uncollectible. What is Barton’s Bad Debt Expense for 2007?

Percent of Accounts Receivable Desired balance in Allowance for Doubtful Accounts. Part I First, we must determine the desired balance in the Allowance for Doubtful Accounts. To do this, Barton multiplies the Accounts Receivable balance of one hundred thousand dollars by the four percent that is expected to be uncollectible. Four thousand dollars is the desired balance in Allowance for Doubtful Accounts. Part II Remember that Allowance for Doubtful Accounts is a permanent account and already has a nine hundred dollar credit balance. So, if we want the balance to be four thousand, we only need to credit this account for three thousand one hundred dollars. The entry would be to debit Bad Debts Expense and credit Allowance for Doubtful Accounts for three thousand one hundred dollars.

Aging of Accounts Receivable Method P2 Year-end Accounts Receivable is broken down into age classifications. Each age grouping has a different likelihood of being uncollectible. A second method classified as Percent of Accounts Receivable is the Aging of Accounts Receivable Method. When using this method, first we classify the Accounts Receivable by age. Second, for each age group we determine the likelihood of being uncollectible. Third, for each age group we calculate a separate allowance amount. Then, we add up all the allowance amounts and that gives us the desired balance in the Allowance for Doubtful Accounts. Let’s see an example of how the aging of accounts receivable works. Compute a separate allowance for each age grouping.

Aging of Accounts Receivable P2 First, we broke Barton’s accounts receivable up into aged categories such as current, 1 to 30 days past due, 31 to 60 days past due, and so on. Then, for each of these age groups, we determined how much we thought would be uncollectible. So, for the current age group, one percent is expected to be uncollectible. For the 1 to 30 days past due age group, three percent is expected to be uncollectible, and so on. Notice that the older the age group the higher the uncollectible percentage. Next, we multiplied the balance of each age group by its uncollectible percentage. Then, we added all the uncollectible amounts up to five thousand, three hundred twenty dollars. This is the balance we want in the Allowance for Doubtful Accounts.

Barton determines that Martin’s $300 account is uncollectible. P2 Writing Off a Bad Debt With the allowance method, when an account is determined to be uncollectible, the debit goes to Allowance for Doubtful Accounts. Barton determines that Martin’s $300 account is uncollectible. Part I Now, let’s see what happens when we determine that a specific customer will not be able to pay the amounts owed. When using the allowance method, we write off an uncollectible account to Allowance for Doubtful Accounts. Assume that Barton determines that Martin’s three hundred dollar account receivable is uncollectible. What entry would Barton make? Part II Barton would debit Allowance for Doubtful Accounts and credit Accounts Receivable. Now that we know the specific customer involved, the customer is noted in the transaction, so we can make the proper entry in the customer’s Accounts Receivable subsidiary ledger. In the previous entries, we were ADJUSTING for our guess as to what will not be collected. Here, we’re now actually writing off an account when we’re positive we won’t collect. The allowance is our guess account, so we’re decreasing our ‘guess’ account, and at the same time decreasing our actual receivable for what we know we won’t collect!

P2 Recovery of a Bad Debt Subsequent collections on accounts written-off require that the original write-off entry be reversed before the cash collection is recorded. Part I Now assume that Martin sends Barton payment of three hundred dollars after Barton made the write-off entry. Should Barton return the three hundred dollars since they have written off Martin’s account receivable? Of course not. Part II Since Barton had written off Martin’s account receivable, the first entry is required to reverse the write off and re-establish Martin’s account receivable. This entry includes a debit to Accounts Receivable and a credit to Allowance for Doubtful Accounts. The second entry is a debit to Cash and a credit to Accounts Receivable for the amount of cash received.

Emphasis on Realizable Value Emphasis on Realizable Value Summary % of Sales Emphasis on Matching Sales Bad Debts Exp. % of Receivables Emphasis on Realizable Value Accts. Rec. All. for Doubtful Accts. Aging of Receivables Emphasis on Realizable Value Accts. Rec. All. for Doubtful Accts. Here is a summary of the allowance methods we just discussed. The focus of the Percent of Sales Method is on matching Bad Debts Expense with the related revenues. The focus of the two Percent of Accounts Receivable Methods is on valuing accounts receivable at net realizable value on the balance sheet. Both methods do a better job than the Direct Method of matching and reporting accounts receivable at net realizable value on the balance sheet. Income Statement Focus Balance Sheet Focus Balance Sheet Focus