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Accounting Principles I: Receivables Company Complete Study Guide, Study Guides, Projects, Research of Accounting

Accounting Principles I: Receivables Company Complete Study Guide Receivables Defined Accounts receivable are amounts that customers owe the company for normal credit purchases. Since accounts receivable are generally collected within two months of the sale, they are considered a current asset and usually appear on balance sheets below short‐term investments and above inventory. Notes receivable are amounts owed to the company by customers or others who have signed formal promissory notes in acknowledgment of their debts. Promissory notes strengthen a company's legal claim against those who fail to pay as promised. The maturity date of a note determines whether it is placed with current assets or long‐term assets on the balance sheet. Notes that are due in one year or less are considered current assets, and notes that are due in more than one year are considered long‐term assets.

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Accounting Principles I: Receivables
Company Complete Study Guide
Receivables Defined
Accounts receivableare amounts that customers owe the company for normal credit
purchases. Since accounts receivable are generally collected within two months of the
sale, they are considered a current asset and usually appear on balance sheets below
shortterm investments and above inventory.
Notes receivableare amounts owed to the company by customers or others who have
signed formal promissory notes in acknowledgment of their debts. Promissory notes
strengthen a company's legal claim against those who fail to pay as promised. The
maturity date of a note determines whether it is placed with current assets or longterm
assets on the balance sheet. Notes that are due in one year or less are considered
current assets, and notes that are due in more than one year are considered longterm
assets.
Accounts receivable and notes receivable that result from company sales are
calledtrade receivables, but there are other types of receivables as well. For example,
interest revenue from notes or other interestbearing assets is accrued at the end of
each accounting period and placed in an account namedinterest receivable. Wage
advances, formal loans to employees, or loans to other companies create other types of
receivables. If significant, these nontrade receivables are usually listed in separate
categories on the balance sheet because each type of nontrade receivable has distinct
risk factors and liquidity characteristics.
Receivables of all types are normally reported on the balance sheet at theirnet
realizable value, which is the amount the company expects to receive in cash.
Evaluating Accounts Receivable
Business owners know that some customers who receive credit will never pay their
account balances. These uncollectible accounts are also called bad debts. Companies
use two methods to account for bad debts: the direct writeoff method and the
allowance method.
Direct writeoff method. For tax purposes, companies must use the direct writeoff
method, under which bad debts are recognized only after the company is certain the
debt will not be paid. Before determining that an account balance is uncollectible, a
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Accounting Principles I: Receivables

Company Complete Study Guide

Receivables Defined

Accounts receivable are amounts that customers owe the company for normal credit purchases. Since accounts receivable are generally collected within two months of the sale, they are considered a current asset and usually appear on balance sheets below short‐term investments and above inventory. Notes receivable are amounts owed to the company by customers or others who have signed formal promissory notes in acknowledgment of their debts. Promissory notes strengthen a company's legal claim against those who fail to pay as promised. The maturity date of a note determines whether it is placed with current assets or long‐term assets on the balance sheet. Notes that are due in one year or less are considered current assets, and notes that are due in more than one year are considered long‐term assets. Accounts receivable and notes receivable that result from company sales are called trade receivables , but there are other types of receivables as well. For example, interest revenue from notes or other interest‐bearing assets is accrued at the end of each accounting period and placed in an account named interest receivable. Wage advances, formal loans to employees, or loans to other companies create other types of receivables. If significant, these nontrade receivables are usually listed in separate categories on the balance sheet because each type of nontrade receivable has distinct risk factors and liquidity characteristics. Receivables of all types are normally reported on the balance sheet at their net realizable value , which is the amount the company expects to receive in cash.

Evaluating Accounts Receivable

Business owners know that some customers who receive credit will never pay their account balances. These uncollectible accounts are also called bad debts. Companies use two methods to account for bad debts: the direct write‐off method and the allowance method. Direct writeoff method. For tax purposes, companies must use the direct write‐off method, under which bad debts are recognized only after the company is certain the debt will not be paid. Before determining that an account balance is uncollectible, a

company generally makes several attempts to collect the debt from the customer. Recognizing the bad debt requires a journal entry that increases a bad debts expense account and decreases accounts receivable. If a customer named J. Smith fails to pay a $225 balance, for example, the company records the write‐off by debiting bad debts expense and crediting accounts receivable from J. Smith. The Internal Revenue Service permits companies to take a tax deduction for bad debts only after specific uncollectible accounts have been identified. Unless a company's uncollectible accounts represent an insignificant percentage of their sales, however, they may not use the direct write‐off method for financial reporting purposes. Since several months may pass between the time that a sale occurs and the time that a company realizes that a customer's account is uncollectible, the matching principle, which requires that revenues and related expenses be matched in the same accounting period, would often be violated if the direct write‐off method were used. Therefore, most companies use the direct write‐off method on their tax returns but use the allowance method on financial statements. Allowance method. Under the allowance method, an adjustment is made at the end of each accounting period to estimate bad debts based on the business activity from that accounting period. Established companies rely on past experience to estimate unrealized bad debts, but new companies must rely on published industry averages until they have sufficient experience to make their own estimates. The adjusting entry to estimate the expected value of bad debts does not reduce accounts receivable directly. Accounts receivable is a control account that must have the same balance as the combined balance of every individual account in the accounts receivable subsidiary ledger. Since the specific customer accounts that will become uncollectible are not yet known when the adjusting entry is made, a contra‐asset account named allowance for bad debts , which is sometimes called allowance for doubtful accounts , is subtracted from accounts receivable to show the net realizable value of accounts receivable on the balance sheet. If at the end of its first accounting period a company estimates that $5,000 in accounts receivable will become uncollectible, the necessary adjusting entry debits bad debts expense for $5,000 and credits allowance for bad debts for $5,000.

Under the allowance method, a write‐off does not change the net realizable value of accounts receivable. It simply reduces accounts receivable and allowance for bad debts by equivalent amounts. | | | Before writing off J. Smith's account | After writing off J. Smith's account | Accounts Receivable | $100,000 | $99, | Less: Allowance for Bad Debts | (5.000) | (4.775) | Net Realizable Value | $95,000 | $95, Customers whose accounts have already been written off as uncollectible will sometimes pay their debts. When this happens, two entries are needed to correct the company's accounting records and show that the customer paid the outstanding balance. The first entry reinstates the customer's accounts receivable balance by debiting accounts receivable and crediting allowance for bad debts. As in the previous example, the debit to accounts receivable must be posted to the general ledger control account and to the appropriate subsidiary ledger account. The second entry records the customer's payment by debiting cash and crediting accounts receivable. Most companies record cash receipts in a cash receipts journal. Since a special journal's column totals are posted to the general ledger at the end of

each accounting period, the posting to J. Smith's account is the only one shown with the cash receipts journal entry in the illustration below. In the future when management looks at J. Smith's payment history, the account's activity will show the eventual collection of the amount owed. If you use the general journal for the entry shown in the immediately previous cash receipts journal, you post the entry directly to cash and accounts receivable in the general ledger and also to J. Smith's account in the accounts receivable subsidiary ledger.

If the allowance for bad debts account had a $300 credit balance instead of a $ debit balance, a $4,700 adjusting entry would be needed to give the account a credit balance of $5,000. Aging method. In general, the longer an account balance is overdue, the less likely the debt is to be paid. Therefore, many companies maintain an accounts receivable aging schedule , which categorizes each customer's credit purchases by the length of time they have been outstanding. Each category's overall balance is multiplied by an estimated percentage of uncollectibility for that category, and the total of all such calculations serves as the estimate of bad debts. The accounts receivable aging schedule shown below includes five categories for classifying the age of unpaid credit purchases.

In this example, estimated bad debts are $5,000. If the account has an existing credit balance of $400, the adjusting entry includes a $4,600 debit to bad debts expense and a $4,600 credit to allowance for bad debts. Percentage of credit sales method. Some companies estimate bad debts as a percentage of credit sales. If a company has $500,000 in credit sales during an accounting period and company records indicate that, on average, 1% of credit sales become uncollectible, the adjusting entry at the end of the accounting period debits bad debts expense for $5,000 and credits allowance for bad debts for $5,000. Companies that use the percentage of credit sales method base the adjusting entry solely on total credit sales and ignore any existing balance in the allowance for bad debts account. If estimates fail to match actual bad debts, the percentage rate used to estimate bad debts is adjusted on future estimates.

Factoring Receivables

Companies sometimes need cash before customers pay their account balances. In such situations, the company may choose to sell accounts receivable to another company that specializes in collections. This process is called factoring, and the company that purchases accounts receivable is often called a factor. The factor usually charges between one and fifteen percent of the account balances. The reason for such a wide range in fees is that the receivables may be factored with or without recourse. Recourse means the company factoring the receivables agrees to reimburse the factor for uncollectible accounts. Low percentage rates are usually offered only when recourse is provided. Suppose a company factors $500,000 in accounts receivable at a rate of 3%. The company records this sale of accounts receivable by debiting cash for $485,000,

Calculating interest. Notes generally specify an interest rate, which is used to determine how much interest the maker of the note must pay in addition to the principal. Interest on short‐term notes is calculated according to the following formula: For example, interest on a four-month, 9%, $1,000 note equals $30. When a note's due date is expressed in days, the specified number of days is divided by 360 or 365 in the interest calculation. You may see either of these figures because accountants used a 360‐day year to simplify their calculations before computers and calculators became widely available, and many textbooks still follow this convention. In current practice, however, financial institutions and other companies generally use a 365 ‐day year to calculate interest. Therefore, you should be prepared to calculate interest either way. The interest on a 90‐day, 12%, $10,000 note equals $300 if a 360‐day year is used to calculate interest, and the interest equals $295.89 if a 365‐day year is used. Even when a note's due date is not expressed in days, adjusting entries that recognize accrued interest are often calculated in terms of days. Suppose a company holds a four‐ month, 10%, $10,000 note dated October 19, 20X2. If the company uses an annual accounting period that ends on December 31, an adjusting entry that recognizes 73 days of accrued interest revenue must be made on December 31, 20X2. To determine the number of days in this situation, subtract the date of issue from the number of days in October and then add the result to the number of days in November and December (31 ‐ 19 = 12; 12 + 30 + 31 = 73). Notice that when you count days, you omit the note's issue date but include the note's due date or, in this situation, the date that the adjusting entry is made. Assuming the interest calculation uses a 365‐day year, the accrued interest revenue equals $200. The adjusting entry debits interest receivable and credits interest revenue.

Interest on long‐term notes is calculated using the same formula that is used with short‐ term notes, but unpaid interest is usually added to the principal to determine interest in subsequent years. For example, a two‐year, 10%, $10,000 note accrues $1,000 in interest during the first year. The principal and first year's interest equal $11,000 when compounded, so $1,100 in interest accrues during the second year.

Recording Notes Receivable Transactions

Customers frequently sign promissory notes to settle overdue accounts receivable balances. For example, if a customer named D. Brown signs a six‐month, 10%, $2, promissory note after falling 90 days past due on her account, the business records the event by debiting notes receivable for $2,500 and crediting accounts receivable from D. Brown for $2,500. Notice that the entry does not include interest revenue, which is not recorded until it is earned. If a customer signs a promissory note in exchange for merchandise, the entry is recorded by debiting notes receivable and crediting sales.

If D. Brown dishonors the note and the company believes the note is a bad debt, allowance for bad debts is debited for $2,500 and notes receivable is credited for $2,500. No interest revenue is recognized because none will ever be received. If interest on a bad debt had previously been accrued, then a correcting entry is needed to remove the accrued interest from interest revenue and interest receivable (by debiting interest revenue and crediting interest receivable). Although interest revenue would have been overstated in the accounting periods when the interest was accrued and would be understated in the period when the correcting entry occurs, efforts to amend prior statements or recognize the error in footnotes on forthcoming statements are not necessary except in rare situations where the bad debt changes reported revenue so much that the judgment of those who use financial statements is materially affected by the disclosure.

Discounting Notes Receivable

Just as accounts receivable can be factored, notes can be converted into cash by selling them to a financial institution at a discount. Notes are usually sold (discounted) with recourse, which means the company discounting the note agrees to pay the financial institution if the maker dishonors the note. When notes receivable are sold with recourse, the company has a contingent liability that must be disclosed ni the notes accompanying the financial statements. A contingent liability is an obligation to pay an amount in the future, if and when an uncertain event occurs. The discount rate is the annual percentage rate that the financial institution charges for buying a note and collecting the debt. The discount period is the length of time between a note's sale and its due date. The discount , which is the fee that the financial institution charges, is found by multiplying the note's maturity value by the discount rate and the discount period. Suppose a company accepts a 90‐day, 9%, $5,000 note, which has a maturity value (principal + interest) of $5,110.96. In this example, precise calculations are made by using a 365‐day year and by rounding results to the nearest penny.

If the company immediately discounts with recourse the note to a bank that offers a 15% discount rate, the bank's discount is $189. The bank subtracts the discount from the note's maturity value and pays the company $4,921.92 for the note. | Maturity Value | $5,110. | Discount | (189.04) | Discounted Value of Note | $4,921. The company determines the interest expense associated with this transaction by subtracting the discounted value of the note from the note's face value plus any interest revenue the company has earned from the note. Since the company discounts the note before earning any interest revenue, interest expense is $78.08 ($5000.00 ‐ $4,921.92). The company records this transaction by debiting cash for $4,921.92, debiting interest expense for $78.08, and crediting notes receivable for $5,000.00. Suppose the company holds the note for 60 days before discounting it. After 60 days, the company has earned interest revenue of $73.97. Since the note's due date is 30 days away, the bank's discount is $63.01. The bank subtracts the discount from the note's maturity value and pays the company $5,047. for the note.