1 Chapter 8

2 Receivables - amounts owed to company by others. Accounts Receivable –Company just bills its customers/clients –Result from rendering services or selling products to the public.

3 Notes Receivable –Evidenced with promissory notes Formal written debt instruments Usually bear interest Usually has fixed maturity date –Doesn’t have to – Demand Note When customers pay A/R slowly –Make customers sign promissory note & pay interest

4 Company should write off A/R where no hope of collecting the A/R –Conservatism – Don't show worthless A/R as an asset This is misleading

5 Two methods to write off bad A/R –Direct method Not GAAP –Allowance method GAAP

6 Another GAAP principle is materiality –If amount is not material, you don’t need to follow GAAP. –Something is material if person's actions would be different if he or she knew the item in question. –If bad A/R not a material amount You can use direct method –Otherwise must use allowance method.

7 D.Uncollectible Accounts Expense$100 Cr.Accounts Receivable$100 Direct method –Charge uncollectible accounts to an expense in the period of default A selling expense May not coincide with the period of the related sale –Violates Matching Principle

8 D.Accounts Receivable$100 Cr.Uncollectible Accounts Expense$100 If you write off A/R & customer eventually pays –First, reinstate A/R. Reverse the prior journal entry.

9 D.Cash$100 Cr.Accounts Receivable$100 Second, you record that the A/R has been paid:

10 D.Uncollectible Accounts Expense$12,000 Cr.Allowance for Uncollectible Accounts $12,000 Allowance Method –Matching Principle Expense should be recorded in the same period as the related sale Need to estimate bad debts each year Company does not know which customer won’t pay. –So, you don’t write off any particular A/R –Instead you reduce A/R with a contra account »Allowance For Bad Debts

11 Accounts Receivable$200,000 Less: Allowance for Uncollectible Accounts12, $188,000 Allowance for Uncollectible Accounts is contra account to A/R –Reduces A/R to amount estimated to be collectible. –Net number is the net realizable value of the A/R.

12 D.Allowance for Uncollectible Accounts$100 Cr.Accounts Receivable$100 Write off A/R when clear that it won’t be paid: –Note that there is no expense involved in the entry. No Bad Debt Expense Expense happened in year of sale

13 After write-off –A/R net value does not change Specific A/R was written off Allowance for Uncollectible Accounts decrease by the same amount

14 D.Accounts Receivable$100 Cr.Allowance for Uncollectible Accounts $100 When customer pays after A/R written off –First, reinstate customer's A/R

15 D.Cash$100 Cr.Accounts Receivable$100  Second, record collection

16 Most common methods for estimating uncollectible A/R –Percentage of net sales method and –Accounts receivable aging method.

17 Percentage of sales method –Estimated percentage for uncollectible accounts is multiplied by net sales (or net credit sales) for the period. –The resulting figure is then used in adjusting entry.

18 Previous balance in Allowance for Uncollectible Accounts –amounts from previous years - not yet been written off –irrelevant in making adjusting entry. If: –You have net sales of $300,000 –You believe that 1% of your sales will not be collected –Place $3,000 into the allowance.

19 Aging of accounts receivable method (Percentage of receivables basis) –Separate A/R by age categories –The total amounts in each category are multiplied by a different percentage (a different probability of default for each age category) –Add up products for estimate of total bad debts.

20 Adjusting entry is for amount that brings Allowance for Uncollectible Accounts to the computed figure. –If you estimate a total of $3,000 of you’re A/R will not be paid, and –Your allowance has a credit balance of $1,000, –Credit the allowance (and debit bad debt expense) for $2,000.

21 A promissory note has two parties –Maker (debtor) and –Payee (lender)

22 Promissory note –Formal debt instrument –Usually bears interest Interest on notes with terms of a year or less –Interest usually paid at maturity. –Usually has maturity date Can be demand note. Maturity value is the amount owed by maker at maturity.

23 Promissory notes: –Loan to someone –Received in the sale of expensive merchandise or other assets Extended payments E.g., sales of automobiles –In exchange for delinquent A/R

24 When promissory note replaces A/R –Maker is customer who can’t pay A/R on time. –Company gives more time, but wants interest. –Company converts A/R into interest bearing promissory note.

25 D.Notes Receivable$6,000 Cr.Accounts Receivable$6,000 Assume a $6,000, 10%, six-month promissory note is issued in place of A/R:

26 D.Cash$6,300 Cr.Notes Receivable$6,000 Interest Revenue300 When the note matures, the maker pays the principle and the accrued interest:

27 D.Account Receivable$6,300 Cr.Notes Receivable$6,000 Interest Revenue300 If the note is dishonored: –Company just has A/R again. –No more interest will accrue thereafter

28 Dec. 1 D.Notes Receivable$6,000 Cr.Accounts Receivable $6,000 Supposed to accrue interest revenue in the period earned even though not yet paid (Adjusting Entry). Assume 3-month promissory note is issued in December:

29 Dec.31D.Interest Receivable$50 Cr.Interest Revenue$50

30 March 1D.Cash$6,150 Cr.Notes Receivable$6,000 Interest Receivable50 Interest Revenue100 A promissory note is honored when it is paid in full at its maturity date.

31 Managing Accounts Receivable –Company with A/R needs to watch the following steps carefully:

32 Extending Credit –Who should get credit? E.g., look at credit reports, ask for guarantees or letters of credit –Your credit policies have to be competitive But, you still want to make sure you will get paid.

33 Establishing a Payment Period –You have to be competitive. –Consider offering incentives for customers to pay early (e.g., sales discounts).

34 Monitoring Collections –Make sure customers are paying you. –Look at Credit Risk Ratio: Allowance for Doubtful Accounts Accounts Receivable –A disproportionate increase in this ratio Warning more customers are not paying A/R

35 Accelerating Cash Receipts –Company needs cash faster than customers are paying A/R –A company can sell it’s A/R to a factor. –Factor charges a fee to purchase the A/R. Treated as an expense –operating expense or –other expense

36 D.Cash$588,000 Service Charge Expense12,000 Cr.Accounts Receivable$600,000

37 Similar to treatment of VISA or MasterCard credit card sale Credit card company is agreeing to issue credit to your customers –so that you don’t have to

38 D.Cash$970 Service Charge Expense30 Cr.Sales$1,000

39 Evaluating the Receivable Balance –When evaluating company’s credit policies management looks at two measures: –(i) Receivables Turnover Ratio, and –(ii) Average Collection Period.

40 Receivables Turnover Ratio –tells you how many times you give and collect credit (A/R) during the year, on average: Net Credit Sales Average Net Accounts Receivable

41 Average Collection Period Reflects the number of days it takes to collect a firm’s A/R: Receivables Turnover Ratio