Receivables Chapter 8 The topic of Chapter 8 is receivables. 1 1

Define and explain common types of receivables Learning Objective 1 Define and explain common types of receivables The first learning objective is to define and explain common types of receivables.

Receivables Arise from selling goods and services on credit and lending money Right to receive cash in the future from a current transaction An asset Two major types Accounts receivable Notes receivable You have a receivable when you sell goods or services to another party on credit. The receivable is the seller’s claim for the amount of the transaction. You also have a receivable when you loan money to another party. So a receivable is really the right to receive cash in the future from a current transaction. It is something the business owns; therefore, it is an asset. The two major types of receivables are accounts receivable and notes receivable. Copyright (c) 2009 Prentice Hall. All rights reserved.

Accounts Receivable Amounts to be collected from customers for sales on credit Serves as a control account Summarizes total of all individual customer receivables Customer ledger Subsidiary ledger showing each customer’s balance Accounts receivable are amounts to be collected from customers from sales made on credit. Accounts receivable serves as a control account, because it summarizes the total of all customer receivables. A control account is an account in the general ledger that summarizes related subsidiary accounts. Companies also keep a ledger of each receivable from each customer. This customer ledger, called a subsidiary ledger, contains the details by individual customer that are summarized in the control account. Copyright (c) 2009 Prentice Hall. All rights reserved.

Notes Receivable More formal than accounts receivable Usually longer in term Debtor promises to pay by maturity date Charge interest to the borrower Promissory note Written document signed by both parties Notes receivable are more formal and usually longer in term than accounts receivable. Notes receivable represent the right to receive a certain amount of cash in the future from a customer or other party. Notes usually include a charge for interest. The debtor of a note promises to pay the creditor a definite sum at a future date—called the maturity date. A written document known as a promissory note serves as the evidence of the indebtedness and is signed by both the creditor and the debtor. Notes receivable due within one year or less are current assets. Notes due beyond one year are long-term. Copyright (c) 2009 Prentice Hall. All rights reserved.

Design internal controls for receivables Learning Objective 2 Design internal controls for receivables The second learning objective is to design internal controls for receivables.

Internal Controls and Receivables Credit department evaluates customers’ applications Separation of duties Credit department should not handle cash Cash handlers should not extend credit Most companies have a credit department to evaluate customers’ credit applications. The extension of credit requires a balancing act. The company doesn’t want to lose sales to good customers, but it also wants to avoid receivables that will never be collected. For good internal control over cash collections from receivables, the credit department should have no access to cash. Additionally, those who handle cash should not be in a position to grant credit to customers. For example, if a credit department employee also handles cash, the company would have no separation of duties. The employee could pocket money received from a customer. He could then label the customer’s account as uncollectible, and the company would write off the account receivable, as discussed in the next section. The company would stop billing that customer, and the employee would have covered his theft. For this reason, separation of duties is important. Copyright (c) 2009 Prentice Hall. All rights reserved.

Accounting for Uncollectibles Selling on credit: BENEFIT – Increase sales by selling to a wider range of customers COST – Some customers don’t pay Results in Uncollectible-account expense Two methods to account for uncollectible accounts Allowance method Direct write-off method Selling on credit brings both a benefit and a cost. The benefit: Increase revenues and profits by making sales to a wider range of customers. The cost: Some customers don’t pay, and that creates an expense called uncollectible-account expense, doubtful-account expense, or bad-debt expense. All three account names mean the same thing—a customer did not pay his or her account balance. There are two methods of accounting for uncollectible receivables: • The allowance method, or • In certain limited cases, the direct write-off method Copyright (c) 2009 Prentice Hall. All rights reserved.

Use the allowance method to account for uncollectibles Learning Objective 3 Use the allowance method to account for uncollectibles The third learning objective is to use the allowance method to account for uncollectibles.

Allowance Method Based on the matching principle Record uncollectible accounts expense in same period as sale Expense is estimated from past experience Offset to expense is Allowance for uncollectible accounts A contra asset, contra to Accounts receivable Most companies use the allowance method to measure bad debts. The allowance method is based on the matching principle; thus, the key concept is to record uncollectible-accounts expense in the same period as the sales revenue. The offset to the expense is to a contra account called Allowance for uncollectible accounts or the Allowance for doubtful accounts. The business doesn’t wait to see which customers will not pay. Instead, it records a bad-debt expense based on estimates developed from past experience and uses the allowance for uncollectible accounts to house the pool of “unknown” bad debtors. Copyright (c) 2009 Prentice Hall. All rights reserved.

Methods for Estimating Uncollectibles Percent-of-Sales Income-Statement Approach Estimates uncollectible accounts as a percent of sales Aging-of-Accounts- Receivable Balance-Sheet Approach Determine target Allowance based on age of actual receivables Companies use their past experience as well as considering the economy, the industry they operate in, and other variables. In short, they make an educated guess, called an estimate. There are two basic ways to estimate uncollectibles: Percent-of-sales and Aging-of-accounts-receivable.   The percent-of-sales method computes uncollectible-account expense as a percentage of net credit sales. This method is also called the income-statement approach because it focuses on the amount of expense. The other approach for estimating uncollectible receivables is the aging-of-accounts-receivable method. This method is also called the balance-sheet approach because it focuses on the actual age of the accounts receivable and determines a target allowance balance from that age. Copyright (c) 2009 Prentice Hall. All rights reserved.

Allowance Method Operating expense Uncollectible accounts expense GENERAL JOURNAL DATE DESCRIPTION REF DEBIT CREDIT Uncollectible accounts expense Allowance for uncollectible accounts To estimate bad debts for period Contra-asset account The journal entry to record uncollectible accounts expense includes: a debit to the expense account and a credit to the allowance account. Copyright (c) 2009 Prentice Hall. All rights reserved.

Percent-of-Sales Method Credit sales % uncollectible The percent-of-sales method has one step–multiply credit sales by the estimated percent uncollectible. This will be the amount of Uncollectible account expense. Uncollectible account expense Copyright (c) 2009 Prentice Hall. All rights reserved.

Adjust Allowance for uncollectible accounts to Aging Method Adjust Allowance for uncollectible accounts to Aging schedule Uncollectible accounts expense is the difference between the target Allowance balance based on the aging schedule and the current Allowance account balance The aging method has two steps. First, the aging schedule is prepared. The total of the schedule is what the Allowance for uncollectible account balance should equal (the target balance). Second, this amount is compared to the current balance in the Allowance account. Uncollectible account expense will equal the difference between the Allowance account and the target balance based on the aging schedule. Copyright (c) 2009 Prentice Hall. All rights reserved.

Short Exercise 8-5 Aging Method GENERAL JOURNAL DATE DESCRIPTION REF DEBIT CREDIT Dec 31 Uncollectible account expense 210 Allowance for uncollectible accounts 0-60 Days Over 60 days Total $71,000 $6,000 $77,000 x 1% x 20% $710 $1,200 $1,910 Allowance for uncollectible accts $1,700 Adjustment needed $210 Short exercise 8-5 demonstrates the aging method. The percents are applied to the two aging groups of receivables. The aging schedule indicates the Allowance should equal $1,910. The current balance in the Allowance is $1,700. Therefore, a $210 increase is needed. Regardless of the method, the entry is the same. A debit to Uncollectible account expense and a credit to Allowance for uncollectible accounts. Copyright (c) 2009 Prentice Hall. All rights reserved.

Short Exercise 8-5 (continued) Allowance for uncollectible accounts $1,700 Adjusting entry $ 210 A T-account of the Allowance shows that after the entry is posted, the balance equals the aging schedule. Aging schedule $1,910 Copyright (c) 2009 Prentice Hall. All rights reserved.

Writing off Uncollectible Accounts When a specific customer account is identified as uncollectible, it is written off Entry: GENERAL JOURNAL DATE DESCRIPTION REF DEBIT CREDIT Allowance for uncollectible accounts Accounts receivable-name Suppose that, after repeated attempts, a company cannot collect an amount owed from a customer. At the time these bad debts are identified, the entry is made to write off the receivables from these customers. The entry debits the Allowance account, which reduces it. The entry credits Accounts receivable, which removes the customer’s account from the books. Copyright (c) 2009 Prentice Hall. All rights reserved.

Recovery of Account Sometimes a customer will pay the amount owed after the customer’s account is written off Two entries needed GENERAL JOURNAL DATE DESCRIPTION REF DEBIT CREDIT Accounts receivable-name Allowance for uncoll. accounts Cash When an account receivable is written off as uncollectible, the receivable does not die: The customer still owes the money. However, the company stops pursuing collection and writes off the account as uncollectible. Some companies turn delinquent receivables over to an attorney or other collection agency to recover some of the cash for them. If a company writes off a specific account receivable and then receives payment, two entries are needed. To account for this recovery, the company must reverse the effect of the earlier write-off to the Allowance account and record the cash collection. Reverses write off Records payment Copyright (c) 2009 Prentice Hall. All rights reserved.

Accounts receivable Increases (debits) Sales on credit Decreases (credits) Customer payments Write-offs To summarize, Accounts receivable are increased when customers buy goods and services on credit. The account decreases when customers make payments. It also decreases when a specific customer account is identified as uncollectible. Copyright (c) 2009 Prentice Hall. All rights reserved.

Allowance for uncollectible accounts Decreases (debits) Write-offs Increases (credits) Uncollectible-account expense entry Recoveries of accounts previously written off The Allowance for uncollectible account increases at the end of each period when uncollectible-account expense is estimated. It is decreased when specific accounts are written off. It increases if there is a recovery of an account previously written off. Copyright (c) 2009 Prentice Hall. All rights reserved.

Understand the direct write-off method for uncollectibles Learning Objective 4 Understand the direct write-off method for uncollectibles The fourth learning objective is to understand the direct write-off method for uncollectibles.

Direct Write-Off Method Used by small businesses No Allowance for uncollectible accounts Records Uncollectible-accounts expense when specific account is written off GENERAL JOURNAL DATE DESCRIPTION REF DEBIT CREDIT Uncollectible account expense Accounts receivable-name Write off account using direct write off method There is another way to account for uncollectible receivables that is primarily used by small, non-public companies. It is called the direct write-off method. Under the direct write-off method, the Allowance for uncollectible accounts doesn’t exist. Instead, you wait until you identify a specific customer from which you’ll never collect. Then you write off the customer’s Account receivable by debiting Uncollectible account expense and crediting the customer’s Account receivable. Copyright (c) 2009 Prentice Hall. All rights reserved.

Problems with Direct Write-Off Method Overstates Accounts receivable on the balance sheet No Allowance account Violates matching principle Uncollectible-account expense often not in same period as sale The direct write-off method is defective for two reasons: 1. It does not set up an allowance for uncollectible account. As a result, the direct write-off method always reports Accounts receivables at their full amount. Thus, assets are overstated on the balance sheet. 2. It does not match Uncollectible account expense against revenue very well. Many times, accounts aren’t deemed uncollectible until the following period. Therefore, the expense is not recorded in the same period as the revenue. Copyright (c) 2009 Prentice Hall. All rights reserved.

Report receivables on the balance sheet Learning Objective 5 Report receivables on the balance sheet The fifth learning objective is to report receivables on the balance sheet.

Accounts receivable on the Balance Sheet Current asset Shown net of Allowance for uncollectible accounts Two presentation styles: Accounts receivable appear in the current assets section of the Balance Sheet. There are two ways to show Accounts receivable on that financial statement. The first shows the detail of the Accounts receivable and Allowance accounts and the resulting net value. The second shows the net value as a single line item. Balance Sheet (Partial) December 31, 2012 Assets Current assets:   Accounts receivable, net of allowance for doubtful accounts of $$$ $$$$$ Copyright (c) 2009 Prentice Hall. All rights reserved.

Journalize credit-card, bankcard, and debit-card sales Learning Objective 6 Journalize credit-card, bankcard, and debit-card sales The sixth learning objective is to journalize credit-card, bankcard, and debit-card sales.

Credit Card Sales Credit card companies (American Express and Discover) pay the retailer and bill the customer Credit card company charges a fee to the retailer 1 – 5% GENERAL JOURNAL DATE DESCRIPTION REF DEBIT CREDIT Accounts receivable – Discover Credit-card discount expense Sales revenue Credit-card sales are common in retailing. Customers present credit cards like American Express or Discover to pay for purchases. The credit-card company pays the seller and then bills the customer. Credit cards offer the convenience of buying without having to pay cash immediately. A Discover customer receives a monthly statement from Discover, detailing each transaction. The card holder can then write just one check to cover many purchases. Retailers also benefit. They don’t have to check each customer’s credit rating. The credit-card company has already done so. Retailers don’t have to keep accounts receivable records or pursue collection from customers. The benefits do not come free. The seller receives less than 100% of the face value of the sale. The credit-card company takes a fee of 1% to 5% on the sale. To record a credit-card sale, Accounts receivable is debited for the sale amount less the fee. Credit-card discount expense is debited for the fee and Sales is credited for the full amount. Copyright (c) 2009 Prentice Hall. All rights reserved.

Bank Cards Retailers receive cash at time of sale VISA and MasterCard most common bank cards Charge retailer a fee GENERAL JOURNAL DATE DESCRIPTION REF DEBIT CREDIT Cash Bankcard discount expense Sales revenue Most banks issue their own cards, known as bankcards, which operate much like credit cards. VISA and MasterCard are the two main bankcards. When a company makes a sale and accepts a VISA card as payment, the company receives cash at the point of sale. The cash received is less than the full amount of the sale because the bank deducts its fee. The entry is similar to that for a credit-card sale, with one exception. Instead of Accounts receivable being debited, Cash is debited. Copyright (c) 2009 Prentice Hall. All rights reserved.

Point! A business that accepts Bank cards (VISA and Mastercard) will have a relationship/account with a “merchant bank” When the card is run up and submitted to the bank, the bank is automatically adding the amount to the cardholders loan amount and advancing cash into the merchant’s account with the bank. Can be done now automatically through phone lines and Internet Copyright (c) 2009 Prentice Hall. All rights reserved.

Debit Cards Different than credit and bankcards Same as cash Amount subtracted from buyer’s bank account Amount added to retailer’s bank account Debit cards are fundamentally different from credit cards and bankcards. Using a debit card is like paying with cash, except that you don’t have to carry cash or write a check at the retailer. The buyer swipes the card through a special terminal to pay for purchases, and the buyer’s bank balance is automatically decreased. The retailer’s Cash account is increased immediately. Copyright (c) 2009 Prentice Hall. All rights reserved.

Point! The fundamental difference isn’t so different The merchant has to go through a “merchant” bank. The merchant does not have to pay a “fee” for this service because the bank is happy to have the cardholder’s money sitting in its bank. Copyright (c) 2009 Prentice Hall. All rights reserved.

Account for notes receivable Learning Objective 7 Account for notes receivable The seventh learning objective is to account for notes receivable.

Notes receivable More formal than Accounts receivable Debtor signs promissory note A written promise to pay a specified amount of money at a particular future date Notes receivable are more formal than Accounts receivable. The debtor signs a promissory note as evidence of the transaction. A promissory note is a written promise to pay a specified amount of money at a particular future date. Copyright (c) 2009 Prentice Hall. All rights reserved.

Notes Receivable Interest Starts Principal Payee Maker Maturity Date PROMISSORY NOTE ______________ _____________ Amount Date For value received, I promise to pay to the order of First National Bank __________________________________ Dollars on ______________________________ plus interest at the annual rate of 12%. ________________________ Principal $10,000.00 Oct. 4, 2010 Payee Ten thousand and no/100--------------------- January 2, 2011 Maturity Date Maker Here are the terms related to promissory notes along with a diagram. Maker of the note (debtor): The entity that signs the note and promises to pay the required amount; the maker of the note is the debtor. In this diagram, the maker is Jeanette Sims. Payee of the note (creditor): The entity to whom the maker promises future payment; the payee of the note is the creditor. In this note, the payee is First National Bank. Principal: The amount loaned out by the payee and borrowed by the maker of the note. Here the principal is $10,000. Interest: The revenue to the payee for loaning money. Interest is an expense to the debtor and income to the creditor. Interest period: The period of time during which interest is computed. It extends from the original date of the note to the maturity date, also called the note term. In this case, the interest period is from October 4, 2010, to January 2, 2011, or 90 days. Interest rate: The percentage rate of interest specified by the note. Interest rates are almost always stated for a period of one year. A 12% note means that the amount of interest for one year is 12% of the note’s principal. Maturity date: As stated earlier, this is the date when final payment of the note is due, also called the due date. In this note, the due date is January 2, 2011. Maturity value: The sum of the principal plus interest due at maturity. Interest Rate Jeanette Sims Copyright (c) 2009 Prentice Hall. All rights reserved.

Identifying Maturity Date Maturity date can be: A specific date, such as March 13 Stated in terms of number of months A three month note signed on March 13 would be due on June 13 Stated in terms of number of days Must count days from issue date to maturity day Example on following slide Some notes specify the maturity date. For example, June 13, 2012 could be a maturity date. Other notes state the period of the note in days or months. When the period is given in months, the note’s maturity date falls on the same day of the month as the date the note was issued. For example, a three-month note dated March 13, 2012 would mature on June 13, 2012. When the period is given in days, the maturity date is determined by counting the actual days from the date of issue. Copyright (c) 2009 Prentice Hall. All rights reserved.

Determine the Maturity Date A 90-day note issued March 13 Days in note 90 Days in March 31 Date of issue -13 Days outstanding in March -18 Days remaining 72 Days in April 30 Days in May -61 Due date in June 11 Let’s use an example of how to compute the maturity date when the note term is expressed in days. In this example, a 90-day note is issued March 13. First, subtract the issue date (13) from the total days in March (31). Subtract this amount (18) from the days in the note (90). That leaves 72 more days, which is more than two months. Add together the days in the next two months (April and May). Subtract that from the remaining days. In this example, the note would be due June 11th. Copyright (c) 2009 Prentice Hall. All rights reserved.

Principal Rate time Computing Interest Amount of note Annual interest rate The formula for computing the interest is: Principal x Rate x Time. In the formula, time period represents the portion of a year that interest has accrued on the note. It may be expressed as a fraction of a year in months (#/12) or a fraction of a year in days (#/360). Keep in mind that interest rates are stated as an annual rate. Therefore, the time in the interest formula should also be expressed in terms of a fraction of the year. time # of months 12 # of days 360 OR Copyright (c) 2009 Prentice Hall. All rights reserved.

Accruing Interest Revenue If any notes receivable are outstanding at the end of the period, interest must be accrued Interest is earned over time Revenue must be recorded in the period earned A note receivable may be outstanding at the end of an accounting period. The interest revenue earned on the note up to the last day of the year is part of that year’s earnings. Recall that interest revenue is earned over time, not just when cash is received. Because of the matching principle, we want to record the earnings from the note in the year in which they were earned. Copyright (c) 2009 Prentice Hall. All rights reserved.

Accruing Interest Revenue Note term = 9 months 4 months 5 months Date of Note, Aug 1, 2011 End of Fiscal Year, Dec 31, 2011 Maturity Date, May 1, 2012 This time line shows how interest revenue must be split into two different accounting periods. Let’s say a company had a nine-month note receivable that was signed on August 1, 2011. The note would be due on May 1, 2012 – which is in the next accounting period. At December 31, five months of interest must be accrued on the note. In 2012, the other four months of interest would be recorded. Copyright (c) 2009 Prentice Hall. All rights reserved.

Exercise 8-19 GENERAL JOURNAL 2011 Jan 3 Cash 101,920 DATE DESCRIPTION REF DEBIT CREDIT 2011 Jan 3 Cash 101,920 Bankcard discount expense 2,080 Sales revenue 104,000 Oct 1 Notes receivable 24,000 Dec 31 Interest receivable 600 Interest revenue (24,000 x 10% x 3/12) Exercise 8-19 provides practice on bankcard sales and notes receivable. In the first transaction, the company had $104,000 of bankcard sales with a 2% fee. Sales revenue is credited for the full amount. Bankcard discount expense is debited for 2% of the sales and Cash is debited for the difference. On October 1, the company loaned $24,000 to one of its executives, who signed a note. Notes receivable is debited for the principal. On December 31, interest must be accrued on the note. Interest receivable is debited, and Interest revenue is credited for $600. This amount is computed using the interest formula – principal of $24,000 multiplied by the interest rate of 10% multiplied by time 3/12. It has been three months since the note was issued to the end of the year. Copyright (c) 2009 Prentice Hall. All rights reserved.

Exercise 8-19 (continued) GENERAL JOURNAL DATE DESCRIPTION REF DEBIT CREDIT 2012 Oct 1 Cash 26,400 Interest receivable 600 Interest revenue 1,800 Notes receivable 24,000 On October 1 of the following year, the note is due. Cash is debited for the maturity value. Interest receivable is credited for the amount from the adjusting entry. Interest revenue is recognized for the remaining nine months on the note. Notes receivable is credited for the principal. Interest revenue = 24,000 x .10 x 9/12 Copyright (c) 2009 Prentice Hall. All rights reserved.

Dishonored Notes Receivable If the maker does not pay the note on the due date, the note is dishonored The note is expired, but the maker still owes the company for the maturity value An entry is made to convert the note into an account receivable GENERAL JOURNAL DATE DESCRIPTION REF DEBIT CREDIT Accounts receivable-name Notes receivable-name Interest revenue If the maker of a note doesn’t pay at maturity, the maker dishonors (defaults on) the note. Because the note has expired, it is no longer in force. But the debtor still owes the payee. The payee can transfer the note receivable amount to Accounts receivable. Copyright (c) 2009 Prentice Hall. All rights reserved.