1. Chapter 05 Receivables and Sales McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc.

2. Part A Recognition of Accounts Receivable 5-2

3. Credit sales oCommon for large business transactions in which buyers don’t have sufficient cash available or where credit cards cannot be used because the transaction amount exceeds typical credit card limits. oRevenue is recognized at the time of a credit sale. oAn asset (accounts receivable) is recognized at the time of a credit sale. 5-3

4. LO1 Recognize Accounts Receivable oCredit sales transfer products and services to a customer today while bearing the risk of collecting payment from that customer in the future. oEven though the seller does not receive cash at the time of the credit sale, the firm records revenue immediately, as long as future collection from the customer is reasonably certain. oAlong with the recognized revenue, at the time of sale the seller also obtains a legal right to receive cash from the buyer. The legal right to receive cash is valuable and represents an asset of the company. 5-4

5. LO2 Calculate net revenues using discounts, returns, and allowances oRepresents a reduction, not in the selling price of a product or service, but in the amount to be paid by a credit customer if payment is made within a specified period of time. oIt’s a discount intended to provide incentive for quick payment. oThe amount of the discount and the time period within which it’s available usually are communicated in short-hand terms such as 2/10, n/30. oThe term “2/10,” indicates the customer will receive a 2% discount if the amount owed is paid within 10 days. oThe term “n/30,” means that if the customer does not take the discount, full payment is due within 30 days. Sales Discount 5-5

6. Sales Return and Allowances Sales Allowances If a customer does not return a product, but the seller reduces the customer’s balance owed or provides at least a partial refund because of some deficiency in the company’s product or service, we call that a sales allowance Sales Return If a customer returns a product it is sales return. After a sales return, owe reduce the customer’s account balance if the sale was on account or owe issue a cash refund if the sale was for cash. 5-6

7. Part B Valuation of Accounts Receivable 5-7

8. LO3 Record an allowance for future uncollectible accounts oThe right to receive cash from a customer is a valuable resource for the company. This is why accounts receivable is an asset, reported in the company’s balance sheet. oTo be useful to decision makers, accounts receivable should be reported at the amount of cash the firm expects to collect, an amount known as net realizable value. Should companies sell goods and services to their customers on account, or should they accept only cash payment at the time of purchase? The downside of extending credit to customers is that not all customers will pay fully on their accounts The downside of extending credit to customers is that not all customers will pay fully on their accounts The upside, allowing customers the ability to purchase on account and pay cash later boosts sales. The upside, allowing customers the ability to purchase on account and pay cash later boosts sales. 5-8

9. Allowance Method Involves allowing for the possibility that some accounts will be uncollectible at some point in future. Uncollectible accounts have the effect of : oreducing assets (accounts receivable) by an estimate of the amount we don’t expect to collect and oincreasing expenses (bad debt expense) to reflect the cost of offering credit to customers. 5-9

10. Estimating Uncollectible Accounts Kimzey specializes in emergency outpatient care. It doesn’t verify the patient’s health insurance, It knows that a high proportion of fees for emergency care provided will not be collected. In 2012, it bills customers $50 million. By the end of the year, $20 million remains due from customers. Of this amount, it estimates that 30% is likely to be uncollected. Assuming Kimzey uses Percentage-of- receivables method; the year-end adjusting entry to allow for these future uncollectible accounts is as follows: 5-10

11. LO4 Apply the procedure to write off accounts receivable as uncollectible On February 23, 2013, Kimzey receives notice that one of its former patients, Bruce, has filed for bankruptcy. He believes it is unlikely Bruce will pay his account of $4,000. Remember, Kimzey previously allowed for the likelihood that some of its customers would not pay. Now it knows a specific customer will not pay, it can adjust the allowance and reduce the accounts receivable. Kimzey makes the following entry. 5-11

12. LO5 Use the aging method to estimate future uncollectible accounts oManagement can estimate this percentage using historical averages, current economic conditions, industry comparisons, or other analytical techniques. oA more accurate method than assuming a single percentage uncollectible for all accounts is to consider the age of various accounts receivable, and use a higher percentage for “old” accounts than for “new” accounts. This is known as the aging method. oFor instance, accounts that are 60 days past due are older than accounts that are 30 days past due. The older the account, the less likely it is to be collected 5-12

13. LO6 Contrast the allowance method and direct write- off method when accounting for uncollectible accounts Suppose a company provides services for $10,000 on account in 2012, but makes no allowance for uncollectible accounts at the end of the year. On September 17, 2013, $2,000 is considered uncollectible. The company records the write-off as follows. oRecording bad debt expense at the time we know the account to be uncollectible. oThe direct write-off method is used for tax purposes but is generally not permitted for financial reporting. Direct Write-Off Method 5-13

14. Part C Notes Receivable 5-14

15. LO7 Apply the procedure to account for notes receivable, including interest calculation oNotes receivable are similar to accounts receivable but are more formal credit arrangements evidenced by a written debt instrument, or note. oNotes receivables are classified as either Current or Noncurrent depending on the expected collection date. oIf the time to maturity is longer than one year, the note receivable is a long-term asset. 5-15

16. LO8 Calculate key ratios investors use to monitor a company’s effectiveness in managing receivables oThe amount of a company’s accounts receivable is influenced by a variety of factors, including the level of sales, the nature of the product or service sold, and credit and collection policies. oMore liberal credit policies—allowing customers a longer time to pay or offering cash discounts for early payment—often are initiated with the specific objective of increasing sales volume. oManagement’s choice of credit and collection policies results in trade-offs. oInvestors, creditors, and financial analysts can gain important insights by monitoring a company’s investment in receivables. oTwo important ratios that help in understanding the company’s effectiveness in managing receivables are the oreceivables turnover ratio and othe average collection period. 5-16

17. Appendix Percentage-of-Credit Sales Method 5-17

18. LO9 Estimate uncollectible accounts using the percentage-of-credit sales method Percentage-of- receivables method Based on the estimate of bad debts on a balance sheet amount—accounts receivable Percentage-of-Credit sales method Based on the estimate of bad debts on an income statement amount—credit sales Income statement methodBalance sheet method 5-18

19. End of chapter 05 5-19