1. Accounting for Accruals – Advanced Topics: Receivables and Payables
Chapter Eight
Accounting for Accruals – Advanced Topics: Receivables and Payables
In Chapter Eight we will extend our study of receivables and payables to include bad debts, credit card sales, and liabilities for product warranties.

2. Credit Terms and Bad Debts
Some customers may be unwilling or unable to pay their accounts receivable. Because we do not want to overstate assets, we must show accounts receivable at its net realizable value on the balance sheet. The net realizable value is the gross amount of the receivables less some estimated allowance for doubtful accounts.
Whenever a company extends credit on the sale of merchandise or provides a service, there is the possibility that the customer may not be able to pay the amount due. Knowing this fact means that we do not want to run the risk of overstating our asset, accounts receivable. We believe that accounts receivable should be shown on the financial statements at net realizable value. Net realizable value is the gross amount of the receivable less any estimated amount for bad debts.
Let’s look at the revenue and doubtful account process.

3. Event 1 Revenue Recognition
During 2006, Matrix, Inc. a service company, renders services on account for customers in the amount of $375,000.
Part I
Matrix renders services to its clients during 2006 in the amount of three hundred seventy-five thousand dollars. Let’s look at the impact of these transactions on the financial statements of the company.
Part II
The asset account, accounts receivable, will increase by three hundred seventy-five thousand dollars. The company’s equity will increase by the same amount because income resulting from the transactions amount to three hundred seventy-five thousand dollars. Because the sales were on account, there is no cash flow impact.

4. Collection for Receivables
Event 2 Collection of Receivables
During the year, Matrix, Inc. collects cash of $325,000 on its accounts receivable.
Part I
During the year, Matrix collects cash of three hundred twenty-five thousand dollars on its accounts receivable. Let’s look at the impact of these transactions.
Part II The assets account, cash, will increase by three hundred twenty five thousand dollars and the asset, accounts receivable, will decrease by the same amount. There is no income impact of the collection of accounts receivable. The operating activities section of the Statement of Cash Flows will increase by the amount of cash collected.

5. Recognizing Bad Debts Expense
Event 3 Recognizing Bad Debts Expense
Based upon past experience, Matrix, Inc. estimates that $200 of its current accounts receivable balance will eventually prove to be uncollectible.
Part I Based on the company’s past experience, $200 of the current accounts receivable will eventually prove uncollectible.
Part II The contra asset account, Allowance for Doubtful Accounts, will increase by two hundred dollars and equity will decrease by the same amount because the expense associated with the estimate will reduce income. There is no cash flow impact.
Part III The current balance in our accounts receivable is fifty thousand dollars.
Part IV On the balance sheet, accounts receivable will be shown at net realizable value, or fifty thousand dollars less the allowance for doubtful accounts of two hundred dollars.

6. Real-World Reporting Practices
As you can see, most companies refer to their accounts receivable as either Accounts Receivable or just Receivables. Forty-four percent of all reporting companies refer to the allowance account as the Allowance for Doubtful Accounts.

7. General Ledger Accounts
Cash
Retained Earnings
325,000
374,800
Accounts Receivable
Service Revenue
375,000
325,000
375,000
375,000
50,000
0 Bal.
After we have posted the previous transactions, our general ledger looks like this. Notice that the Service Revenue and Bad Debts Expense are closed to Retained Earnings. The balance in the Allowance for Doubtful Accounts remains unchanged until one of our customers indicates an inability to pay the amount due.
Allowance for Doubtful Accounts
Bad Debts Expense
200
200
200
Bal. 0

8. Financial Statements
Part I We will report net income of three hundred seventy four thousand eight hundred dollars, Sales Revenue less Bad Debts Expense.
Part II You can see the balance sheet presentation of accounts receivable at net realizable value.
Part III The only cash flow impact of our transactions is the collection of cash from customers.

9. Event 1 Write-Off of an Uncollectible Account Receivable
Subsequent Period
Event 1 Write-Off of an Uncollectible Account Receivable
During 2007, Matrix, Inc. determines that an account receivable of $75 will not be collected. The company elects to write-off the account.
Part I During early 2007, Matrix has a customer that is just unable to pay its seventy- five dollar account receivable. We decide to write-off the account balance.
Part II The only impact of the transaction to writing off an account receivable is to reduce the asset, accounts receivable, and reduce the contra asset account, allowance for doubtful accounts.
Part III Notice that the net realizable value of the company’s accounts receivable are not affected by the write-off of the account. The net realizable value is the same before and after the write-off. After the write-off, accounts receivable are lower but so is the balance in the allowance for doubtful accounts.

10. Event 2 Investment in Note Receivable
Notes Receivable
Event 2 Investment in Note Receivable
During 2007, Matrix, Inc. decides to invest some idle cash. On November 1, 2007, the company loans $50,000 to another company. The note is due in one year and bears interest at an annual rate of 9%.
Part I Toward the end of 2007, Matrix has some idle cash that it wants to invest. On November 1, 2007, Matrix loans fifty thousand dollars to another company. The note is due in one year and bears interest at the annual rate of nine percent.
Part II The asset account, cash, decreases by fifty thousand dollars, and the asset account, notes receivable, increases by the same amount. There is no income statement impact of this transaction. However, the investing activities section of the Statement of Cash Flows shows an outflow of fifty thousand dollars.

11. Event 3 Revenue Recognition
During 2007, Matrix, Inc. renders services on account in the amount of $65,000.
Part I During 2007, Matrix renders sixty-five thousand dollars of services to customers on account.
Part II The asset account, accounts receivable, increases by sixty five thousand dollars and the equity section of the balance sheet increases by the same amount to recognize income of sixty-five thousand dollars. There is no cash flow impact of rendering services on account.

12. Collections on Account Receivable
Event 4 Collection on Accounts Receivable
During 2007, Matrix, Inc. collects $80,000 on its accounts receivable.
Part I
During 2007, Matrix collects eighty thousand dollars on its accounts receivable. Remember that the company had a beginning balance in its accounts receivable of forty nine thousand nine hundred twenty five dollars. We wrote off seventy five dollars of accounts receivable last year.
Part II The asset account, cash, increases by eighty thousand dollars and the asset account, accounts receivable, decreases by the same amount. There is no income impact of this transaction. However, the operating activities section of the Statement of Cash Flows shows an inflow from customers of eighty thousand dollars.

13. Reinstatement of Account
Event 5 Reinstatement of Account Written-Off
Of the $75 of accounts receivable previously written-off, it turns out that Matrix will be able to collect the full $75 amount owed.
Part I Matrix learns that the seventy-five dollar account receivable that was previously written-off will now be paid in full by the customer. The first thing we have to do is reinstate the account receivable.
Part II To reinstate the account written-off, we increase the accounts receivable by seventy-five dollars and increase the allowance for doubtful accounts by the same amount.

14. Event 6 Collection of Recovered Amount
Recovery on Account
Event 6 Collection of Recovered Amount
Of the $75 of accounts receivable previously written-off, it turns out that Matrix will be able to collect the full $75 amount owed.
After we reinstate the account receivable, we show the collection of the seventy-five dollars from the customer. The cash account is increased by seventy-five dollars and the accounts receivable is reduced by the same amount. While there is no income statement impact, the operating activities section of the Statement of Cash Flows shows an inflow from customers of seventy-five dollars.

15. Year-End Adjusting Entries
Event 7 Adjustment for Bad Debts Expense
At the end of 2007, Matrix estimates that its bad debts will amount to 1% of its gross sales.
Part I At the end of 2007, the company estimates that one percent of its gross sales will eventually prove to be uncollectible.
Part II Sales for 2007 were sixty-five thousand dollars, so it is estimated that six hundred fifty dollars will prove uncollectible.
Part III The allowance for doubtful accounts increases by six hundred fifty dollars and the bad debts expense, on the income statement, increases by the same amount. There is no cash flow impact of recording the estimated bad debts.

16. Interest Revenue Event 8 Recognition of Interest Revenue
At the end of 2007, Matrix must accrue interest on its note receivable.
$50,000 × 9% × 2/12 = $750 interest revenue
Part I
At the end of 2007, Matrix must also accrue interest on the loan it made on November 1st.
Part II
To calculate the interest we multiply the principal amount of fifty thousand dollars times the annual interest rate of nine percent and adjust the total for the time the note has been outstanding. The note was signed on November 1st, so two months have passed to December 31st. The interest revenue is seven hundred fifty dollars.
Part III The asset account, interest receivable, increases by seven hundred fifty dollars and the equity account increases by the same amount because net income increases by seven hundred fifty dollars. There is no cash flow impact of this accrual.

17. General Ledger T-Accounts
Cash
Interest Receivable
Bal. 325,000
50,000
750
80,000 75
Service Revenue
65,000
65,000
Bal. 355,075
Accounts Receivable
0 Bal.
Bal. 49,925
80,000
Bad Debts Expense
65,000 75
650
650 75
34,925
Bal. 0
Here are the general ledger account balances updated for the transactions we recorded during Once again, Service Revenue, Bad Debts Expense and Interest Revenue have been closed to Retained Earnings. The current balance in the Allowance for Doubtful accounts is eight hundred fifty dollars.
Allowance for Doubtful Accounts
Interest Revenue
750
750
Bal. 125 75
Bal. 0
650
Retained Earnings
850
374,800 Bal.
Notes Receivable
65,100
50,000
439,900 Bal.

18. Financial Statements
Part I The first financial statement we prepare is the income statement. Bad Debts Expense is part of Net Operating Income, but Interest Revenue is not.
Part II After completing the income statement we can prepare the balance sheet. Notice our note receivable and interest receivable in the asset section of the balance sheet.
Part III Finally, we prepare the Statement of Cash Flows. During 2007, we had operating activity inflows from customers of eighty thousand seventy-five dollars and investing activities outflow of fifty thousand dollars.

19. Direct Write-Off Method
Event 1 Recognition of Revenue on Account
During 2008, Matrix, Inc. provides services to clients on account in the amount of $400,000.
Part I During 2008, Matrix provides services to customers on account in the amount of four hundred thousand dollars.
Part II The asset account, accounts receivable, increases by four hundred thousand dollars, and equities increases by the same amount because net income of four hundred thousand dollars is recognized.
Part III The journal entry to record the revenue is to debit accounts receivable and credit service revenue for four hundred thousand dollars.

20. Direct Write-Off Method
Event 2 Recognition of Bad Debt
During 2008, Matrix, Inc. determines that a customer who owes us $500 is unable to pay the amount due.
Part I An account receivable of five hundred dollars will not be paid by one of our customers. The account is to be written-off.
Part II The asset, accounts receivable, decreases by five hundred dollars, and equities decreases by the same amount because net income will reflect the bad debts expense of five hundred dollars.
Part II The proper journal entry to record the write-off is to debit Bad Debts Expense and credit Accounts Receivable for five hundred dollars.

21. Credit Card Sales
Rather than maintaining a credit granting department, many companies find it cost beneficial to accept credit cards. The credit card company deducts a fee, usually between 2% and 8%, from the gross amount of the sales, and pays the merchant the net balance (gross sales less credit card fee).
Not all companies can maintain a credit and collections department. For these companies, accepting credit cards is a viable alternative. Most credit card companies charge a fee of between two and eight percent of the gross sale to process the transaction and pay the seller. Receipts from credit card companies is usually very quick.

22. Event 1 Recording a Credit Card Sale
Credit Card Sales
Event 1 Recording a Credit Card Sale
Matrix, Inc. accepts a credit card in payment for services of $10,000. The credit card company charges a fee of 2%
of the gross sale.
Part I Matrix provides services to customers in the amount of ten thousand dollars. The customers elect to pay Matrix by using a credit card. The credit card company charges Matrix a fee of two percent on the amount of the gross sale.
Part II The processing fee is two hundred dollars, two percent of ten thousand dollars, so Matrix establishes a receivable from the credit card company for nine thousand eight hundred dollars. The income statement shows the gross sales of ten thousand dollars and the credit card fee of two hundred dollars, so net income is nine thousand eight hundred dollars. This amount increases the equity of Matrix. There is no cash flow impact at this stage in the process.
Part III The journal entry includes a debit to accounts receivable for nine thousand eight hundred dollars, a debit to credit card expense for the fee of two hundred dollars, and a credit to sales revenue for ten thousand dollars.

23. Event 2 Collection of a Credit Card Receivable
Credit Card Sales
Event 2 Collection of a Credit Card Receivable
Matrix, Inc. collects the full amount due from the credit card company.
Part I Two days after the sale, Matrix collects nine thousand eight hundred dollars from the credit card company.
Part II The asset account, cash, is increased by nine thousand eight hundred dollars and the receivable from the credit card company is decreased by the same amount. There is no income statement impact of the collection, but the operating activities section of the Statement of Cash Flows shows an inflow from customers of nine thousand eight hundred dollars.
Part III The journal entry to record the receipt is to debit cash and credit accounts receivable for nine thousand eight hundred dollars.

24. Warranty Obligations
Generally within the warranty period, the seller promises to replace or repair defective products without charge to the customer.
Event 1 Sale of Merchandise Matrix, Inc. sells $100,000 of merchandise for cash. The merchandise has a cost to Matrix of $60,000.
Part I You have probably purchased merchandise with a product warranty. Most warranties agree to replace or repair defective merchandise within a specified period of time.
Part II Matrix sells one hundred thousand dollars of merchandise that has a cost basis to the company of sixty thousand dollars. The merchandise is subject to a warranty.
Part III
The asset account, cash, increases by one hundred thousand dollars and income of one hundred thousand dollars increases equity. The operating activities section of the statement of cash flows shows an inflow of one hundred thousand dollars. In addition, the asset inventory decreases by sixty thousand dollars and cost of goods sold increases by the same amount.

25. Warranty Obligations
Event 2 Recognition of Warranty Expense Matrix, Inc. estimates that warranty expense associated with the current sale will be $5,000.
Part I Matrix estimates that warranty expense associated with the one hundred thousand dollar sale will be five thousand dollars.
Part II The liability account, warranties payable, increases by five thousand dollars and an expense account, warranty expense, increases by the same amount. We are matching cost with the revenues generated in the accounting period.

26. Warranty Obligations
Event 3 Settlement of Warranty Obligation Matrix, Inc. pays $1,000 cash to repair defective merchandise returned by several customers.
Part I It cost Matrix one thousand dollars cash to pay for repairs to defective merchandise included in the one hundred thousand dollar sale.
Part II The asset, cash, is reduced by one thousand dollars, and the liability, warranty payable, is reduced by the same amount. The one thousand dollars paid will eventually appear in the operating activities section of the statement of cash flows as an outflow.

27. General Ledger T-Accounts
Cash
Service Revenue
Bal. 355,075
1,000
100,000
100,000
100,000
0 Bal.
Bal. 454,075
Cost of Goods Sold
60,000
60,000
Inventory
160,000
60,000
Bal. 0
Bal. 100,000
Warranty Expense
5,000
5,000
Here are our general ledger account balances after posting the transactions. Once again, all revenue and expense accounts are closed to retained earnings. Let’s look at the financial statements.
Warranties Payable
Bal. 0
1,000
5,000
Retained Earnings
4,000 Bal.
439,900 Bal.
35,000
Common Stock
474,900 Bal.
75,175

28. Financial Statements
Part I Revenue less cost of goods sold is equal to gross margin. We subtract the warranty expense to arrive at net income of thirty-five thousand dollars. Now we can prepare the balance sheet.
Part II Notice the warranties payable in the liability section of the balance sheet.
Part III
In the statement of cash flows we have the one hundred thousand dollar inflow from customers and the outflow for warranty payments.

29. Accounts Receivable Turnover
Accounts Receivable Turnover Ratio
Sales Accounts Receivable =
The longer it takes to collect accounts receivable, the greater the opportunity cost of lost income.
The accounts receivable turnover ratio is a measure of how long it takes to collect our accounts receivable. A short collection period is better than a longer period.

30. Days to Collect Receivable
Average Number of Days to Collect Accounts Receivable =
365 Accounts Receivable Turnover Ratio
This ratio often helps simplify the issues surrounding the collections of accounts receivable.
The average number of days to collect accounts receivable tells managers exactly how many days are required to collect our receivables. Some managers prefer this measure because it provides very specific information.

31. Operating Cycle
The operating cycle is the average time it takes a business to convert inventory to accounts receivable plus the time it takes to convert accounts receivable back into cash.
Exhibit eight dash nine is interesting because you can see that even in the same industry there can be wide diversity in the days it takes to collect receivables and the length of the company’s operating cycle. Notice that OfficeMax excels at collecting its receivables but has the longest operating cycle of similar companies in its industry. As you would expect, wine producers have a very long operating cycle.

32. End of Chapter Eight
In this chapter we looked at some advanced transactions involving accounts and notes receivable. In addition, we examined bad debts expense and obligations for product warranties.