1 Financial Accounting: Tools for Business Decision Making, 4th Edition Kimmel, Weygandt, Kieso CHAPTER 8 Prepared by Ellen L. Sweatt Georgia Perimeter College and Barbara Muller Arizona State University West

2 Chapter 8 REPORTING AND ANALYZING RECEIVABLES

3 Chapter 8 Reporting and Analyzing Receivables After studying Chapter 8, you should be able to : Identify the different types of receivables. Explain how accounts receivable are recognized in the accounts. Describe the methods used to account for bad debts. Compute the interest on notes receivable. Describe the entries to record the disposition of notes receivable.

4 Explain the statement presentation of receivables. Describe the principles of sound accounts receivable management. Identify ratios to analyze a company's receivables. Describe methods to accelerate the receipt of cash from receivables. Chapter 8 Reporting and Analyzing Receivables

5 Amounts due from individuals and other companies-expected to be collected in cash Three major classes of receivables Accounts Receivable - amounts owed by customers on account, expected to be collected within days Notes Receivable - claims for which formal instruments of credit are issued Other Receivables - non-trade receivables, for example, interest receivable and advances to employees TYPES OF RECEIVABLES 11 1

6 Receivables Differ Depending On... Industry Time of year Whether the company extends long-term financing Credit policies

7 Accounts Receivable... Amounts owed by customers on account. Result from the sale of goods/services. Expected to be collected within days. Most significant type of claim held by company. Often called trade receivables.

8 Two accounting issues associated with accounts receivable:  Recognizing accounts receivable.  Valuing accounts receivable. ACCOUNTS RECEIVABLE 11 2

9 RECOGNIZING ACCOUNTS RECEIVABLE When a business sells merchandise to a customer on credit, Accounts Receivable is debited (increased) and Sales is credited (increased). July 1 Accounts Receivable – Polo Company 1,000 Sales 1,000

10 RECOGNIZING ACCOUNTS RECEIVABLE When a business sells merchandise to a customer on credit, Accounts Receivable is debited and Sales is credited. When a business receives returned merchandise previously sold to a customer on credit, Sales Returns and Allowances is debited and Accounts Receivable is credited (decreased). July 5 Sales Returns and Allowances 100 Accounts Receivable – Polo Company 100

11 Review Accounts receivable include a. Interest receivable. b. Advances to employees. c. Amounts customers owe from purchasing goods and/or services. d. Income taxes receivable.

12 Review Accounts receivable include a. Interest receivable. b. Advances to employees. c. Amounts customers owe from purchasing goods and/or services. d. Income taxes receivable.

13 Receivables are valued at the net amount expected to be received in cash Excludes amounts that the company estimates it will not be able to collect (net realizable value) Credit losses Recorded as Bad Debts Expense Considered a normal and necessary risk of doing business ACCOUNTING FOR BAD DEBTS 11 3

14 Bad Debts Expense... Is an expense to record estimated uncollectible receivables. Keeps expenses from being understated on the income statement and accounts receivables from being overstated on the balance sheet.

15 2 Methods for Accounting for Uncollectible Accounts The Direct Write-off Method The Allowance Method

16 Direct Write-Off Method Bad debt losses are not estimated. No allowance account is used. Accounts are written off when determined uncollectible as follows: Bad Debts Expense 200 Accounts Receivable--M. E. Doran 200 Bad debt expense will show only actual losses. Accounts receivable will be reported at gross amount.

17  Direct write-off method An entry is made for bad debts expense when an account is determined to be uncollectible at which time the loss is charged to Bad Debts Expense  No matching of bad debts expense with the sales revenue  Accounts receivable are reported at their gross amount on the balance sheet.  Not acceptable for financial reporting purposes. DIRECT WRITE-OFF METHOD

EFFECTS OF DIRECT WRITE- OFF METHOD

19  Allowance method Required when bad debts are deemed to be material in amount  Uncollectible accounts are estimated At the end of each period  Expense for the uncollectible accounts is Matched against sales in the same accounting period in which the sales occurred  Results in Receivables being stated at cash (net) realizable value THE ALLOWANCE METHOD

20 Estimated uncollectibles are debited to Bad Debts Expense and credited to Allowance for Doubtful Accounts at the end of each period. THE ALLOWANCE METHOD Dec. 31 Bad Debts Expense12,000 Allowance for Doubtful Accounts 12,000

Presentation of Allowance for Doubtful Accounts

Actual uncollectibles are debited to Allowance for Doubtful Accounts and credited to Accounts Receivable at the time the specific account is written off. THE ALLOWANCE METHOD Mar. 1 Allowance for Doubtful Accounts 500 Accounts Receivable - R. A. Ware 500 General Ledger Balances after Write-off

Illustration 8-5 Cash Realizable Value Remains the Same!

When there is recovery of an account that has been written off: reverse the entry made to write off the account and... Recovery of Uncollectible Accounts July 1 Accounts Receivable – R. A. Ware 500 Allowance for Doubtful Accounts 500 Record the collection in the usual manner. July 1 Cash 500 Accounts Receivable 500

25 Allowance Method  Allowance for doubtful accounts is not closed at the end of the year  Bad debt expense is NOT recorded when an actual write-off occurs It has been previously estimated and recorded  A write-off of accounts receivable affects only balance sheet accounts  A recovery of accounts receivable affects only balance sheet accounts

26 Review The Allowance for Doubtful Accounts represents? a. Cash set aside to make up for anticipated credit losses. b. The total uncollectible accounts that arose during the period. c. The total uncollectible accounts for the period plus estimated losses for the next period. d. A contra-asset account designed to reduce accounts receivable to net realizable value.

27 Review The Allowance for Doubtful Accounts represents? a. Cash set aside to make up for anticipated credit losses. b. The total uncollectible accounts that arose during the period. c. The total uncollectible accounts for the period plus estimated losses for the next period. d. A contra-asset account designed to reduce accounts receivable to net realizable value.

28 Review The collection of a previously written off account receivable a. Results in bad debt expense being reduced for the period. b. Will impact both the income statement and balance sheet. c. Requires reversal of the entry originally made to record the write off. d. Results in bad debt expense being increased during the period.

29 Review The collection of a previously written off account receivable a. Results in bad debt expense being reduced for the period. b. Will impact both the income statement and balance sheet. c. Requires reversal of the entry originally made to record the write off. d. Results in bad debt expense being increased during the period.

Percentage of Receivables... Management establishes a percentage relationship between the amount of receivables and the expected losses from uncollectible accounts. 2% of $600,000(credit sales) = $12,000

31 Aging of Accounts Receivable The analysis of customer balances by the length of time they have been unpaid. The longer a debt is outstanding the less likely it is to be paid.

AGING SCHEDULE The older the accounts, the less likely to be paid

33 PERCENTAGE OF RECEIVABLES BASIS If the trial balance shows Allowance for Doubtful Accounts with a credit balance of $528, an adjusting entry for $1,700 ($2,228 - $528) is necessary.

PERCENTAGE OF RECEIVABLES BASIS If the trial balance shows Allowance for Doubtful Accounts with a credit balance of $528, an adjusting entry for $1,700 ($2,228 - $528) is necessary. Dec. 1 Bad Debts Expense 1,700 Allowance for Doubtful Accounts 1,700

Notes Receivable... Credit which is extended by use of a formal instrument.

Promissory note Written promise to pay a specified amount of money on demand or at a definite time Maker The party making the promise. Payee The party to whom payment is made. NOTES RECEIVABLE

37 Credit instrument normally requires: payment of interest extends for time periods of days or longer. Give the holder a stronger legal claim than the other receivables. Can be sold to another party. Notes Receivable...

38 Notes Receivable... Are often accepted from customers who need to extend payment of an account receivable. Are often required from high-risk customers.

The basic formula for computing interest on an interest-bearing note is: The interest rate specified on the note is an annual rate of interest. FORMULA FOR COMPUTING INTEREST Face Value of Note Annual Interest Rate Time in Terms of One Year Interest X X = 11 4 Illustration 8-11 COMPUTATION OF INTEREST

40 Notes Receivable... are recorded at face value. are reported at cash (net) realizable value. are honored when paid in full at maturity. are dishonored when not paid in full at maturity.

RECOGNIZING NOTES RECEIVABLE Wilma Company receives a $1,000, 2-month, 12% promissory note from Brent Company to settle an open account. May 1 Notes Receivable 1,000 Accounts Receivable – Brent Company 1,000

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

43 Review On 1/1/07, Oscar Co. gave a $10,000, four month, 9% note payable to Dina Inc. At the maturity date, how much will Dina Inc. collect from Oscar Co.? a. $10,000. b. $10,900. c. $10,225. d. $10,300. $10,000 x.09 x 120/360

44 Review On 1/1/07, Oscar Co. gave a $10,000, four month, 9% note payable to Dina Inc. At the maturity date, how much will Dina Inc. collect from Oscar Co.? a. $10,000. b. $10,900. c. $10,225. d. $10,300. $10,000 x.09 x 120/360

45 Notes may be held to their maturity (honored)  Face amount plus interest is received Notes may be sold  To speed up the collection of cash Maker of the note may default  Note is dishonored DISPOSING OF NOTES RECEIVABLE 11 5

HONOR OF NOTES RECEIVABLE A note is honored when it is paid in full at its maturity date. For an interest-bearing note, the amount due at maturity is the face value of the note plus interest for the length of time specified on the note. Wolder Co. lends Higley Inc. $10,000 on June 1, accepting a 5-month, 9% interest-bearing note. Wolder Co. collects the maturity value of the note from Higley on November 1. 10,375 10,

HONOR OF NOTES RECEIVABLE If Wolder Co. prepares prepares financial statements as of September 30, interest for 4 months, or $300, would be accrued. 300

DISHONOR OF NOTES RECEIVABLE A dishonored note is a note that is not paid in full at maturity. A dishonored 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. Nov 1 Accounts Receivable10, 375 Notes Receivable Interest Receivable Interest Revenue 10,

49 BALANCE SHEET PRESENTATION OF RECEIVABLES  In the balance sheet, short-term receivables are reported in the current assets section below short-term investments.  Report both the gross amount of receivables and the allowance for doubtful accounts.  The income statement will show Bad debts expense Interest revenue 11 6

50 BALANCE SHEET PRESENTATION OF RECEIVABLES

MANAGING RECEIVABLES 11 7

52 Concentration of Credit Risk Is a threat of nonpayment from a single customer or class of customers that could adversely affect the financial health of the company.

53 EVALUTING LIQUIDITY OF RECEIVABLES  Ratios are computed to evaluate the liquidity of a company’s accounts receivable.  How quickly the asset can be converted to cash  Accounts receivables turnover ratio is used to assess the liquidity of the receivables.  Average collection period is also used to assess liquidity  A rule of thumb is that the average collection period should not exceed the credit term period. 11 8

54 EVALUTING LIQUIDITY OF RECEIVABLES

55 Receivables Turnover Ratio= Net Credit Sales Average Net Receivables Is a measure of the liquidity of receivables.

56 Average Collection Period= 365 days Receivables Turnover Ratio Is the average amount of time that a receivable is outstanding

57 Review When a note receivable is dishonored by the maker, the payee should? a. Record a loss. b. Establish an account receivable from the maker. c. Increase the Notes Receivable- Dishonored account. d. Record bad debt expense.

58 Review When a note receivable is dishonored by the maker, the payee should? a. Record a loss. b. Establish an account receivable from the maker. c. Increase the Notes Receivable- Dishonored account. d. Record bad debt expense.

59  Companies frequently sell their receivables to another company to shorten their cash-to-cash cycle  Reasons for selling receivables Size of receivables, large amounts of cash are tied up Receivables may be the only reasonable source of cash Billing and collecting are time consuming and costly ACCELERATING CASH RECEIPTS 11 9

60 Credit cards  Used by retailers who wish to avoid the paperwork of issuing credit  Cash is received quickly from the credit card issuer National credit cards  Visa, MasterCard, Discover, and American Express CREDIT CARD SALES

CREDIT CARDS ADVANTAGES TO THE RETAILER

VISA, MASTERCARD, AND DISCOVER SALES Morgan Marie purchases a number of compact discs for her restaurant from Sondgeroth Music Co. for $1,000 using her VISA First Bank Card. The service fee that First Bank charges is 3%. Cash 970 Service Charge Expense 30 Sales 1,000

SALE OF RECEIVABLES TO A FACTOR Hendrendon Furniture factors $600,000 of receivables to Federal Factors, Inc. Federal Factors assesses a service charge of 2% of the amount of receivables sold. Cash 588,000 Service Charge Expense (2% x $600,000) 12,000 Accounts Receivable 600,000

64 Review Madeline Company’s Accounts Receivable balance was $400,000 and the balance in the Allowance for Doubtful Accounts was $48,000 before writing off an uncollectible account of $60,000. What was the net realizable value of accounts receivable after the write-off? a. $352,000. b. $400,000. c. $292,000. d. $340,000.

65 Review Madeline Company’s Accounts Receivable balance was $400,000 and the balance in the Allowance for Doubtful Accounts was $48,000 before writing off an uncollectible account of $60,000. What was the net realizable value of accounts receivable after the write-off? a. $352,000. b. $400,000. c. $292,000. d. $340,000.

66 Evaluating the Receivables Balance Liquidity is measured by how quickly certain assets can be converted into cash. The receivables turnover ratio measures the number of times, on average, receivables are collected during the period.

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