©CourseCollege.com 1 10 Receivables Learning Objectives 1.Utilize the Direct Method for Uncollectible Accounts Receivable 2.Utilize the Allowance Method for Uncollectible Accounts Receivable 3.Compute the Uncollectible Accounts Receivable Allowance 4.Describe accounting for Notes Receivable 5.Analysis: Compute and explain days’ sales and turnover in accounts receivable Examples are Accounts and Notes Receivable

©CourseCollege.com 2 Overview -Receivables Receivables -assets expected to be converted to cash over time. Accounts receivable - amounts due from customer purchases “on account” in the normal course of business Notes receivable - written promises to pay including interest. Receivables -assets expected to be converted to cash over time. Accounts receivable - amounts due from customer purchases “on account” in the normal course of business Notes receivable - written promises to pay including interest.

©CourseCollege.com 3 Overview -Receivables Accounts receivable are a primary source of operating cash flow. To increase cash flow receivables are often: Factored or sold to third parties for cash (less a factoring charge) to provide needed cash flow prior to the receivables scheduled collection. Pledged or offered as collateral to third party providers of business credit (i.e. banks) to facilitate lines of credit and loans to the firm. Accounts receivable are a primary source of operating cash flow. To increase cash flow receivables are often: Factored or sold to third parties for cash (less a factoring charge) to provide needed cash flow prior to the receivables scheduled collection. Pledged or offered as collateral to third party providers of business credit (i.e. banks) to facilitate lines of credit and loans to the firm.

©CourseCollege.com 4 Overview -Receivables A major issue in the study of accounts receivable is the accounting problem of dealing with credit losses due to uncollectible accounts.

©CourseCollege.com 5 Overview -Receivables Two methods are used to deal with uncollectible* accounts: Direct Write Off Allowance *also described as doubtful Two methods are used to deal with uncollectible* accounts: Direct Write Off Allowance *also described as doubtful Additional Concepts are needed to understand the treatment of Receivables

©CourseCollege.com 6 Materiality Concept Will the size of the accounting information misstatement or omission affect the judgment of third parties who are relying on the statements?

©CourseCollege.com 7 Materiality Concept Example: A business typically records office supplies expense in range of $50,000 per year. The physical count at year end includes a box of paper clips, for which, there is no available record of cost. Using one comparable brand, the cost is $5.25; using a second comparable brand the cost is $6.25. In a $50,000 budget, the $1 of uncertainty is not material. Either figure would be acceptable.

©CourseCollege.com 8 Conservatism Concept The desired practice in accounting of using the least optimistic estimate when two or more estimates are equally likely.

©CourseCollege.com 9 Conservatism Concept Example: One trade publication estimates the useful life of fabricated concrete forms to be 50 pours, while another estimates 35 pours. The conservatism concept would encourage use of the 35 pour estimate to determine the useful life as it is the least optimistic information as to the life of this material.

©CourseCollege.com 10 Materiality & Conservatism Accounting for Accounts Receivable involves the use of estimates. When using estimates it is important to remember these concepts. Use the least optimistic estimate when alternatives are equally likely. Omission of an item in an estimate is acceptable if it’s omission would not affect the judgment of third party users of the financial statements.

©CourseCollege.com 11 Uncollectible accounts result in Bad Debt* Expense An inescapable fact of granting credit to customers in the course of business is the hard reality that some customers will eventually be unable or unwilling to pay. * Also called Uncollectible Account expense

©CourseCollege.com 12 O10.1 Objective 10.1: Utilize the Direct Method for Uncollectible Accounts Receivable With the Direct Method, the account is expensed (written off) only when it is deemed to be uncollectible. Example: On January 18, Wilson Excavators determined that the entire account receivable of $6,750 owed by customer Oakwood Homes was not collectible due to a bankruptcy. The journal entry to record the write off follows...

©CourseCollege.com 13 Uncollectible account expense is also know as Bad debt expense. Journal entry – Direct write off

©CourseCollege.com 14 When was the $6,750 earned? The Oakwood Homes receivable was earned two months earlier in the previous fiscal year. Therefore, the Uncollectible account expense will not occur in the same fiscal period as the revenue from this transaction. This violates the Matching Concept.

©CourseCollege.com 15 Direct Write Off Method Because it violates the Matching Concept, the Direct write off Method is not a generally accepted accounting principle. It is the method permitted by the Internal Revenue Service

©CourseCollege.com 16 O10.2 The Allowance method estimates Uncollectible accounts expense to follow the Matching Concept. Objective 10.2: Utilize the Allowance method for Uncollectible Accounts Receivable

©CourseCollege.com 17 O10.2 The Allowance account is: A contra asset account Used to reduce Accounts Receivable by the estimate of future uncollectible accounts. We don’t know which Accounts Receivable will become uncollectible, so we use a contra account.

©CourseCollege.com 18 Allowance for Uncollectible Accounts (1) Net realizable value6 The net effect or “weight” on the balance sheet is called the net realizable value of accounts receivable. Accounts Receivable 7 O10.2 The Allowance account

©CourseCollege.com 19 Adjusting entry for AR Allowance O10.2

©CourseCollege.com 20 When is a specific AR removed because it cannot be collected? When the firm receives information that the specific AR will not be collected. It is then written off O10.2

©CourseCollege.com 21 O10.2 The Dog here just informed me that he is bankrupt and can’t pay his $1000 espresso bill. Don’t you have something in your Allowance account for my unfortunate circumstance?

©CourseCollege.com 22 Write off using the Allowance method Notice the Allowance is being used up with the Write off. O10.2

©CourseCollege.com 23 Write offs using the Allowance method do not involve an expense The expense was recorded when the allowance was adjusted O10.2

©CourseCollege.com 24 O10.2 Adjust – Write off The specific accounts which will eventually be uncollectible are not know when the estimate is made. It is a best guess.

©CourseCollege.com 25 O10.3 Objective 10.3: Compute the Uncollectible Accounts Receivable Allowance

©CourseCollege.com 26 How is Uncollectible account expense estimated? Using the firm’s historical expense information Two approaches are used... O10.3 How is the amount of the Allowance estimated?

©CourseCollege.com 27 1.Balance Sheet Focus 2. Income Statement Focus At the end of the fiscal period, both approaches estimate and record the expense for uncollectible accounts. Two Approaches O10.3

©CourseCollege.com Balance Sheet Focus –What portion of the existing Accounts Receivable are estimated to be uncollectible? 2.2. Income Statement Focus-What portion of Sales on account are estimated to be uncollectible? O10.3 Two Approaches

©CourseCollege.com Balance Sheet Focus –net realizable value is the greater concern 2.2. Income Statement Focus-matching concept is the greater concern O10.3 Which approach should be used?

©CourseCollege.com 30 % of Accounts Receivable Firms using the % of Accounts Receivable believe that a percentage of AR is the best estimate of uncollectible account expense. Based on historical uncollectible account expense, the firm determines the percentage of end of fiscal period Accounts Receivable that are expected to result in uncollectible account (bad debt) expense. O10.3

©CourseCollege.com 31 % of Accounts Receivable (example) Marsh Cabinets estimates that 2.5% of the end of period AR result in uncollectible account expense. AR at year end total $88,000. Marsh will select the adjusting entry for Uncollectible account expense that results in the net realizable value of AR equal to $88,000 less 2.5% as follows... O10.3 $88,000 X.025 = $2,200

©CourseCollege.com 32 % of Accounts Receivable (example) O10.3

©CourseCollege.com 33 % of Accounts Receivable (example) What if there had been a balance in the Allowance account? O10.3

©CourseCollege.com 34 % of Accounts Receivable (example) With the % of AR method the balance (if any) in the Allowance account must be considered when calculating the adjusting entry. O10.3

©CourseCollege.com 35 % of Accounts Receivable (example) The adjusting entry is calculated to force the ending balance to equal the % of AR desired. O10.3

©CourseCollege.com 36 % of Accounts Receivable (example) This would result in a different amount of Uncollectible account expense. O10.3

©CourseCollege.com 37 Aging Accounts Receivable A more accurate % of AR approach is to employ an aging analysis of AR. Aging analysis separates AR into groups according to their due date. Typically, the older the group of AR, the higher the % expected to become uncollectible. Using historical experience, the firm applies different percentages to the aging groups as follows... O10.3

©CourseCollege.com 38 Aging Accounts Receivable O10.3 After adjusting entry, this should be the balance in the Allowance account

©CourseCollege.com 39 Allowance for Uncollectible Accounts (7,340) Net realizable value 130,760 Accounts Receivable 138,100 O10.3 Net value of AR

©CourseCollege.com 40 % of Sales (on account) Firms using the % of Sales believe that some percentage of credit Sales is the best estimate of uncollectible account expense. Based on historical uncollectible account expense, the firm determines the percentage of total credit sales that are expected to result in uncollectible account (bad debt) expense. O10.3

©CourseCollege.com 41 % of Sales (example) Lie Photography estimates that 1.2% of sales on account have resulted in uncollectible account expense. For the year just ended, total sales on account were $365,000. O10.3 Lie will expense 1.2% of sales or $4,380 with an adjusting entry at year end as follows... $365,000 X.012 = $4,380

©CourseCollege.com 42 % of Sales (example) O10.3

©CourseCollege.com 43 % of Sales (example) O10.3 Any balance remaining in the Allowance account is ignored when using the % of Sales method.

©CourseCollege.com 44 % of Sales (example) O10.3 Over several fiscal periods, a build up or shortage in the Allowance account should be addressed by reviewing the estimate used.

©CourseCollege.com 45 Objective 10.4: Describe accounting for Notes Receivable O10.4

©CourseCollege.com 46 Promissory Note $5,000 May 14, 2007 Amount Date Sixty days after date I promise to pay to the order of Western Supply Seattle, WA Five Thousand and no/100 ————————————-Dollars For value received with interest at the annual rate of 10% John Kowalsky. Kowalsky Construction Promissory Note $5,000 May 14, 2007 Amount Date Sixty days after date I promise to pay to the order of Western Supply Seattle, WA Five Thousand and no/100 ————————————-Dollars For value received with interest at the annual rate of 10% John Kowalsky. Kowalsky Construction Notes Receivable The Maker is the entity who promises to pay. O10.4

©CourseCollege.com 47 Conversion of Accounts Receivable Conversion of Accounts Receivable Financing a Sale Lending Cash directly Notes Receivable Examples O10.4

©CourseCollege.com 48 Principal amount Annual Interest rate Time Period in years Interest XX = Example: Principal = $50,000; Interest (annual) 8%; Maturity 180 days; The note was received Feb. 1; end of fiscal period Dec. 31, no adjusting entry is required. Notes Receivable $50,000 x.08 x (180/360) = $2000 O10.4

©CourseCollege.com 49 O10.4 At Maturity Remember that Interest Income is usually reported on the Income Statement with “Other (Income)/ Expense”

©CourseCollege.com 50 Principal amount Annual Interest rate Time Period in years Interest XX = Example: Principal = $24,000; Interest (annual) 10%; Maturity 90 days; The note was received Nov. 1; end of fiscal period Dec. 31 adjustment entry is required. Notes Receivable $24,000 x.10 x (60/360) = $400 O10.4

©CourseCollege.com 51 Adjusting Entry O10.4

©CourseCollege.com 52 At Maturity The receipt of principal and interest at maturity requires this journal entry that recognizes the new interest income for the current fiscal period. O10.4

©CourseCollege.com 53 Objective 10.5: Analysis: Compute and explain days’ sales and turnover in accounts receivable O10.5

©CourseCollege.com 54 The days’ sales uncollected answers the following question: On average, how many days will it take to collect the current AR total? Days’ Sales Uncollected AR Sales Days’ Sales Uncollected O10.5 The AR balance is the end of year total. Sales is for the year. X 365

©CourseCollege.com 55 The AR turnover ratio answers the following question: How many times did the firm sell its’ average Accounts Receivable. AR Turnover Sales AR Turnover O6.4 Average AR is often calculated as: (Beg AR +End AR)/2 Average Accounts Receivable

©CourseCollege.com 56 Example

©CourseCollege.com 57 End Unit 10