Needles Powers Crosson Principles of Accounting 12e Receivables 9 C H A P T E R © human/iStockphoto

LEARNING OBJECTIVES  LO1: Define receivables, and explain the allowance method for valuation of receivables as an application of accrual accounting.  LO2: Apply the allowance method of accounting for uncollectible accounts.  LO3: Make common calculations for notes receivable.  LO4: Show how to evaluate the level of receivables, and identify alternative means of financing receivables. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

SECTION 1: CONCEPTS  Accrual accounting (matching principle): recording transactions in the periods in which they occur, rather than in the periods in which cash is received or paid  Valuation: the process of assigning a monetary value to a business transaction and the resulting assets and liabilities  Disclosure: the convention requiring that a company’s financial statements and the accompanying notes present all information relevant to the users’ understanding of the statements ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Accounts Receivable  Accounts receivable are short-term financial assets that arise from sales on credit and are often called trade credit. –In setting credit terms, a company must keep in mind the credit terms of its competitors and the needs of its customers. –Companies that are too lenient in granting credit can run into difficulties when customers don’t pay. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Accounts Receivable as a Percentage of Total Assets for Selected Industries ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Accounts Receivable  The accounts of customers who cannot or will not pay are called uncollectible accounts (or bad debts). –There are two methods of accounting for uncollectible accounts:  Direct charge-off method: recognize a loss when an account is determined to be uncollectible. (This is not in accordance with accrual accounting.)  Allowance method: recognize a loss at the time credit sales are made. (This is in accordance with accrual accounting.) ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Notes Receivable  Notes receivable are short-term financial assets supported by written agreements called promissory notes. –A promissory note is an unconditional promise to pay a definite sum of money on demand or at a future date.  The person or entity that signs the note and promises to pay is the maker of the note.  The entity to whom payment is to be made is the payee. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

A Promissory Note ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

The Allowance Method: Using Accrual Accounting to Value Receivables  The allowance method is an application of accrual accounting, which requires losses from bad debts to be matched with the revenue they help to produce. –It serves to value accounts receivable on the balance sheet. –Because management cannot identify at the time of sale which customers will not pay or how much the company will lose, losses from uncollectible accounts must be estimated. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Uncollectible Accounts: The Allowance Method (slide 1 of 2) ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Uncollectible Accounts: The Allowance Method (slide 2 of 2) ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Disclosure of Receivables (slide 1 of 3)  A payee includes all the promissory notes it holds that are due in less than one year as notes receivable in the current assets section of the balance sheet.  Any interest accrued on these notes is also included in the current assets section—as interest receivable.  Uncollectible Accounts Expense appears on the income statement as an operating expense. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Disclosure of Receivables (slide 2 of 3)  Allowance for Uncollectible Accounts appears on the balance sheet as a contra account, deducted from accounts receivable in the current assets section. –It reduces the accounts receivable to the amount expected to be collectible (net realizable value), as shown on the next slide. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Disclosure of Receivables (slide 3 of 3) ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

SECTION 2: ACCOUNTING APPLICATIONS  Estimate uncollectible accounts and uncollectible accounts expense using –Percentage of net sales method –Accounts receivable aging method  Write off uncollectible accounts  Make common calculations for notes receivable ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Uncollectible Accounts  The allowance account is necessary because the specific uncollectible accounts will not be identified until later. –The company’s accountant makes an estimate based on past experience and current economic conditions. The estimated losses from uncollectible accounts should be realistic. –Two common methods of estimating uncollectible accounts expense are:  the percentage of net sales method  the accounts receivable aging method ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Percentage of Net Sales Method  The basis for the percentage of net sales method is the amount of this year’s net sales that will not be collected. The answer determines the amount of uncollectible accounts expense for the year. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Uncollectible Accounts: The Percentage of Net Sales Method (slide 1 of 3) ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Uncollectible Accounts: The Percentage of Net Sales Method (slide 2 of 3) ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Uncollectible Accounts: The Percentage of Net Sales Method (slide 3 of 3) ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Accounts Receivable Aging Method (slide 1 of 3)  The basis for the accounts receivable aging method is the amount of the ending balance of accounts receivable that will not be collected. –The ending balance of Allowance for Uncollectible Accounts is determined directly through an analysis of accounts receivable. –The difference between this amount and the actual balance of Allowance for Uncollectible Accounts is the expense for the period. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Accounts Receivable Aging Method (slide 2 of 3)  The aging of accounts receivable is the process of listing each customer’s receivable account according to the due date of the account. –If the customer’s account is past due, there is a possibility that the account will not be paid. –That possibility increases as the account extends further beyond the due date. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Accounts Receivable Aging Method (slide 3 of 3)  To illustrate the accounts receivable aging method, we will use Radko Company, whose aging of accounts receivable is shown on the next slide. –Each account receivable is classified as being not yet due or as being 1-30 days, days, days, or over 90 days past due. –Based on past experience, the estimated percentage for each category is determined and multiplied by the amount in each category to determine the estimated, or target, balance of Allowance for Uncollectible Accounts. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Analysis of Accounts Receivable by Age ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Adjusting the Allowance Account: Credit Balance (slide 1 of 2) ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Adjusting the Allowance Account: Credit Balance (slide 2 of 2) ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Adjusting the Allowance Account: Debit Balance (slide 1 of 2) ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Adjusting the Allowance Account: Debit Balance (slide 2 of 2) ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Comparison of the Two Methods  Both the percentage of net sales method and the accounts receivable aging method estimate the uncollectible accounts expense in accordance with accrual accounting, but they do so in different ways. –The percentage of net sales method is an income statement approach. –The accounts receivable aging method is a balance sheet approach. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Two Methods of Estimating Uncollectible Accounts ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Writing Off Uncollectible Accounts  The total of accounts receivable written off in a period will rarely equal the estimated uncollectible amount.  When it becomes clear that a specific account receivable will not be collected, the amount should be written off to Allowance for Uncollectible Accounts. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Writing Off Uncollectible Accounts (slide 1 of 3) ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Writing Off Uncollectible Accounts (slide 2 of 3) ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Writing Off Uncollectible Accounts (slide 3 of 3) ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Common Calculations for Notes Receivable  Several calculations are common to promissory notes: –Maturity date –Duration of a note –Interest –Maturity value –Accrued interest ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Maturity Date  The maturity date is the date on which a promissory note must be paid. This date must be stated on the note or be determinable from the facts on the note. –When the maturity date is a specific number of days from the date of the note, the exact maturity date must be determined. In computing this date, it is important to exclude the date of the note. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Maturity Date  A note dated May 20 and due in 90 days would be due on August 18, determined as follows. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Duration of a Note  The duration of a note is the time between a promissory note’s issue date and its maturity date. Interest is calculated on the basis of the duration of a note. –When the maturity date is stated as a specific date, the exact number of days must be determined. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Duration of a Note  If a note issued on May 10 matures on August 10, the duration of the note is 92 days. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Interest  Interest is the cost of borrowing money or the return on lending money, depending on whether one is the borrower or the lender. The amount of interest is based on three factors: –Principal (the amount of money borrowed or lent) –Rate of interest –Length of the loan ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Interest  The formula used in computing interest is: Principal X Rate of Interest X Time = Interest –The interest on a one-year, 8 percent, $1,000 note would be: $1,000 X 8/100 X 1 = $80 –If the term of the note is three months instead of a year, the interest would be: $1,000 X 8/100 X 3/12 = $20 –If the term of the note is 45 days, the interest would be: $1,000 X 8/100 X 45/365 = $9.86 ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Maturity Value  The maturity value is the total proceeds of a promissory note—face value plus interest—at the maturity date.  The maturity value of a 90-day, 8 percent, $1,000 note is computed as follows: Maturity Value = Principal + Interest = $1,000 + ($1,000 X 8/100 X 90/365) = $1,000 + $19.73 = $1, ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Accrued Interest (slide 1 of 2)  Accrued interest must be apportioned to the periods in which it belongs.  Assume that a $1,000, 90-day, 8 percent note was received on August 31 and that the fiscal year ends September 30. Interest for 30 days is calculated as follows: Principal X Rate of Interest X Time = Interest $1,000 X 8/100 X 30/365 = $6.58 ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Accrued Interest (slide 2 of 2)  The remainder of the interest income would be calculated as follows: Principal X Rate of Interest X Time = Interest $1,000 X 8/100 X 60/365 = $ $6.58 of the interest would be recorded as income in the fiscal year ending September 30, and the interest receivable ($6.58) would be shown as received when the note is paid. - The remainder of the interest, $13.15, would be recorded as income in the next fiscal year. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Dishonored Note  A note not paid at maturity is called a dishonored note. –The holder, or payee, of a dishonored note should transfer the total amount due (including interest income) from Notes Receivable to an individual account receivable for the debtor. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Receivables and the Financial Statements  Accounts receivable on the balance sheet is closely related to sales on the income statement. –The estimation of uncollectible credit sales affects the amount of net accounts receivable and operating expenses. –Interest income on notes receivable affects the amount of assets and revenues. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Valuation of Accounts Receivable on the Balance Sheet Impacts Net Sales on the Income Statement ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

SECTION 3: BUSINESS APPLICATIONS  Receivables turnover  Days’ sales uncollected  Financing receivables –Factoring of accounts receivable –Securitization of accounts receivable –Discounting of accounts receivable  Ethics ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Evaluating the Level of Accounts Receivable and Ethical Ramifications  It is critical for a company to manage the level of its receivables.  Two common measures of the effect of a company’s credit policies are receivables turnover and days’ sales uncollected.  Many companies manage their receivables by using various means to finance them.  The judgments in estimating uncollectible accounts are a temptation for unethical behavior. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Receivables Turnover (slide 1 of 2)  The receivables turnover shows how many times, on average, a company turned its receivables into cash during a period. –It is computed by dividing net sales by the average accounts receivable (net of allowances). –Nike’s receivables turnover in 2011 is computed on the next slide. –To interpret a company’s ratios, we must take into consideration the norms of the industry in which it operates, also shown on the next slide. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Receivables Turnover (slide 2 of 2) ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Days’ Sales Uncollected (slide 1 of 2)  Day’s sales uncollected shows, on average, how long it takes to collect accounts receivable. –To determine the days’ sales uncollected, the number of days in a year is divided by the receivables turnover. –For Nike, it is computed on the next slide. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Days’ Sales Uncollected (slide 2 of 2) ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Financing Receivables  Companies can finance their receivables by selling or transferring accounts receivable to another entity.  Three methods of financing receivables in this way are: –Factoring –Securitization –Discounting ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Factoring  Factoring is the sale or transfer of accounts receivable to an entity, called a factor. Factoring can be done with or without recourse. –With recourse means that the seller of the receivables is liable to the factor if a receivable cannot be collected. –Without recourse means that the factor bears any losses from unpaid accounts. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

How Factoring Works ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Factoring  In accounting terminology, a seller of receivables with recourse is said to be contingently liable. –A contingent liability is a potential liability that can develop into a real liability if a particular event occurs—in this case, a customer’s nonpayment of a receivable. –A contingent liability generally requires disclosure in the notes to the financial statements. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Securitization  Securitization is a process in which a company groups its receivables in batches and sells them at a discount to other companies or investors. –When the receivables are paid, the buyers get the full amount. –Their profit depends on the amount of the discount. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Discounting (slide 1 of 2)  Discounting is a method of financing receivables by selling promissory notes held as notes receivable to a financial lender, usually a bank. –The bank derives its profit by deducting the interest from the maturity value of the note. –The holder of the note endorses the note and turns it over to the bank. –The bank expects to collect the maturity value of the note (principal plus interest), but it also has recourse against the note’s endorser. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Discounting (slide 2 of 2)  Assume that Company X holds a $20,000 note from Company Z, and the note will pay $1,200 in interest. A bank is willing to buy the note for $19,200. –If Company Z pays, the bank will receive $21,200 at maturity and realize a $2,000 profit. –If Company Z fails to pay, Company X is liable to the bank for payment. In the meantime, Company X has a contingent liability for the amount of the discounted note plus interest that it must disclose in its financial statements. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Ethics and Estimates in Accounting for Receivables  Because the amount of uncollectible accounts can only be estimated and the exact amount will not be known until later, a company’s earnings can be easily manipulated. –Earnings can be overstated by underestimating the amount of losses from uncollectible accounts. –Earnings can be understated by overestimating the amount of the losses. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Ethics and Estimates in Accounting for Receivables  Misstatements of earnings can occur simply because of a bad estimate.  They can also be deliberately made to meet analysts’ estimates of earnings, reduce income taxes, or meet benchmarks for bonuses.  Companies will high ethical standards try to be accurate in their estimates of uncollectible accounts, and they disclose the basis of their estimates. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.