Download Accounting for Accounts Receivable and Bad Debts and more Exercises Accounting in PDF only on Docsity!
Sales and Accounts Receivable
Reporting and Analyzing Receivables
Study Objectives
- Identify the different types of receivables.
- Explain how accounts receivable are recognized in the accounts.
- Describe the methods used to account for bad debts.
- Compute the interest on notes receivable.
- Describe the entries to record the disposition of notes receivable.
- Explain the statement presentation of receivables.
- Describe the principles of sound accounts receivable management.
- Identify ratios to analyze a company's receivables.
- Describe methods to accelerate the receipt of cash from receivables.
Chapter Outline
Study Objective 1 - Identify the Different Types of Receivables
- Receivables refer to amounts due from individuals and companies. a. Receivables are generated by the functions for which a company is in business to perform b. Receivables are claims that are expected to be collected in cash. c. Receivables represent one of a company’s most liquid assets.
- Receivables are frequently classified as: a. Accounts receivable i. A/R are generated by the functions for which a company is in business to perform 1. Amounts owed by customers on account. 2. Result from the sale of goods and services (often called trade receivables ). 3. Expected to be collected within 30 to 60 days. 4. Usually the most significant type of claim held by a company. b. Notes receivable i. More formal debt that A/R involving a formal written promise to pay 1. Recorded at net present value which involves interest being stated or imputed on the amount owed (see ii and iii below) ii. Represent claims for which formal instruments of credit are issued as evidence of debt. iii. Credit instrument normally requires payment of interest and extends for time periods of 60-90 days or longer. iv. May result from sale of goods and services (often called trade receivables ).
c. Other receivables i. Nontrade receivables including interest receivable, loans to company officers, advances to employees, and income taxes refundable. ii. Generally classified and reported as separate items in the balance sheet.
Study Objective 2 - Explain how Accounts Receivable are Recognized in the Accounts
- For a service organization, a receivable is recorded when service is provided on account.
- Merchandisers record accounts receivable at the point of sale of merchandise on account.
- Entry is recorded to increase both Sales and Accounts Receivable.
- Receivable may be reduced by sales discount and/or sales return.
Study Objective 3 - Describe the Methods Used to Account for Bad Debts
- Recognition of bad debt expense is about matching the probable bad debt to the period in which the credit sale (that may result in a bad debt) is made. a. This involves estimating bad debts and charging bad debts expense in the period of sale as opposed to the period in which the bad debt becomes apparent due to failure of collection efforts. b. This process involves the use of a “contra” (aka valuation account) called Allowance for Bad Debts in conjunction with the traditional expense account Bad Debts Expense i. Estimated credit losses are debited to Bad Debt Expense (or Uncollectible Accounts Expense ) and credited to Allowance for Bad Debts in the period in which the sale occurs.
- The Allowance Method Illustrated: a. The allowance method of accounting for bad debts involves estimating uncollectible accounts at the end of each period. b. Provides for matching of expenses and revenues on the income statement and ensures that receivables are stated at their cash (net) realizable value on the balance sheet. c. Cash (net) realizable value is the net amount of cash expected to be received; it excludes amounts that the company estimates it will not collect. i. That is to say that cash realizable value is equal to A/R less Allowance for Bad Debts (i.e. the net amount of cash expected to be received based on best estimates. d. Receivables are therefore reduced by estimated uncollectible receivables on the balance sheet through use of the allowance method. e. The allowance method is required for financial reporting purposes when bad debts are material. It has three essential features: i. Uncollectible accounts receivable are estimated and matched against sales in the same accounting period in which the sales occurred. ii. Estimated uncollectibles are recorded as an increase to Bad Debts Expense and an increase to Allowance for Doubtful Accounts (a contra asset account) through an adjusting entry at the end of each period. iii. Actual uncollectibles are debited to Allowance for Doubtful Accounts and credited to Accounts Receivable at the time the specific account is written off as uncollectible. 3. Important characteristics to understand about the Allowance Method: a. Allowance for Doubtful Accounts shows the estimated amount of claims on customers that are expected to become uncollectible in the future. b. The credit balance in the allowance account will absorb the specific write-offs when they occur. c. Allowance for Doubtful Accounts is a “real (balance sheet) account” is not closed at the end of the fiscal year. d. Bad Debts Expense is reported in the income statement as an operating expense. e. Each write-off should be approved in writing by authorized management personnel.
- How do companies determine the proper value for the “Allowance for Bad Debts ”? a. In “real life,” companies must estimate the amount of expected uncollectible accounts if they use the allowance method. There are two common methods employed for the estimation of uncollectible accounts (bad debts). i. The Balance Sheet approach: 1. The percentage of receivables basis : management establishes a percentage relationship between the amount of receivables and expected losses from uncollectible accounts. a. A schedule is prepared in which customer balances are classified by the length of time they have been unpaid. b. Because of its emphasis on time, this schedule is often called an aging schedule , and the analysis of it is often called aging the accounts receivable. i. After the accounts are arranged by age, the expected bad debt losses are determined by applying percentages, based on past experience, to the totals of each category. 1. For example: a. 0-30 days 95% b. 31-60 days 80% c. 60-90 days 70% d. Over 90 days 60% c. The estimated bad debts represent the existing customer claims expected to become uncollectible in the future. i. This amount represents the required balance in Allowance for Doubtful Accounts at the balance sheet date. ii. Accordingly , the amount of the bad debts adjusting entry is the difference between the required balance and the existing balance in the allowance account. iii. Occasionally the allowance account will have a debit balance prior to adjustment because write-offs during the year have exceeded previous provisions for bad debts.
- In such a case, the debit balance is added to the required balance when the adjusting entry is made.
- Direct write-off method (only GAAP when receivables are immaterial in amount) a. While the “Allowance Method” is the only GAAP method for businesses with material amounts of A/R, those businesses with only minor (immaterial) A/R can use the Direct Charge (aka Direct Write-Off) method. b. Application of the Direct Write-Off (Direct Charge) method i. When a specific account is determined to be uncollectible, the loss is charged to Bad Debt Expense. c. Direct Charge method illustrated:
Assume that Warden Co. writes off M. E. Doran’s $200 balance as uncollectible on December 12. The entry is:
Dec. 12 Bad Debts Expense 200 Accounts Receivable--M. E. Doran 200 (To record write-off of M. E. Duran account)
Note:
- Bad debts are written of only when the determination is made that they are uncollectible.
- There is no attempt to match the bad debt expense to the revenue that created it (the matching principal is violated).
d. Problems created by the Direct Charge method: i. Bad debts expense is often recorded in a period different from that in which the revenue was recorded (violation of matching principal). ii. No attempt is made to show accounts receivable in the balance sheet at the amount actually expected to be received (violation of full disclosure). iii. Use of the direct write-off method can reduce the usefulness of both the income statement and balance sheet. e. Why is the Direct Charge method allowed at all? i. Proponents argue that because receivables are immaterial, the Direct Charge method can cause no material differences in the values presented in the financial statements ii. Ease of use
Study Objective 4 - Compute the Interest on Notes Receivable
- Characteristics of promissory notes: a. A promissory note is a written promise to pay a specified amount of money on demand or at a definite time. b. In a promissory note, the party making the promise to pay is called the maker. c. The party to whom payment is to be made is called the payee. i. The payee may be specifically identified by name or may be designated simply as the bearer of the note. d. Notes receivable give the holder a stronger legal claim to assets than accounts receivable. e. Notes receivable are frequently accepted from customers who need to extend the payment of an outstanding account receivable, and they are often required from high-risk customers. f. Like accounts receivable, notes receivable can be readily sold to another party. g. Promissory notes are negotiable instruments.
- Accounting for notes receivable: a. Notes must have three components: i. Maker ii. Payee iii. Due date (or on demand) b. All notes must have an interest component but that interest component may be either stated or imputed. i. If there is no interest amount stated on the note, interest must be “imputed” and the rate applicable to the maker based on the makers’ credit worthiness.
- Interest on Notes Receivable: a. The formula for computing interest is (PxRxT): i. Face Value of Note ( principle ) x Annual Interest Rate x Time (in terms of one year) ii. Interest is normally stated on a per annum basis and therefore the formula must be applied on a per annum basis (i.e. 3 months = ¼ year)
- The interest rate specified on the note is an annual rate of interest. The time factor in the computation expresses the fraction of a year that the note is outstanding. iii. Determining the Maturity date: When the maturity date is stated in days, the time factor is frequently the number of days divided by 360. For example, the maturity date of a 60-day note dated July 17 is determined as follows: Term of note 60 days July 31 days Date of note 17 Remaining days in July: 14 August 31 45 Maturity date, September 15
- A dishonored note is a note that is not paid in full at maturity. a. If the maker of the note defaults or if the note is not paid in full at the maturity date (or on demand in the case of a demand note) the note is considered dishonored , two options are possible: i. If the lender expects that it will eventually be able to collect, the Notes Receivable account is transferred to an Account Receivable for both the face value of the note and the interest due. ii. If there is no hope of collection, the face value of the note should be written off. Study Objective 6 - Explain the Balance Sheet Presentation of Receivables
- Receivables are “Real Accounts” presented on the balance sheet in order of liquidity.
- Each of the major types of receivables should be identified in the balance sheet or in the notes to the financial statements. a. Short-term receivables (other than Accounts Receivable) are reported in the current asset section of the balance sheet below short-term investments. b. Both the gross amount of receivables and the allowance for doubtful accounts should be reported. c. Notes receivable are listed before accounts receivable because notes are more easily converted to cash. d. Bad Debts Expense is reported under “Selling expenses” in the income statement. e. Interest Revenue is shown under “Other Revenues and Gains” in the non-operating section of the income statement.
Study Objective 7 - Describe the Principles of Sound Accounts Receivable Management
- Managing accounts receivable involves five steps: a. Determine to whom to extend credit. i. Risky customers might be required to provide letters of credit or bank guarantees. ii. Risky customers might be required to pay cash on delivery. iii. Ask potential customers for references from banks and suppliers and check the references. iv. Periodically check financial health of continuing customers. b. Establish a payment period. i. Determine a required payment period and communicate that policy to customers. ii. Make sure company's payment period is consistent with that of competitors. c. Monitor collections. i. Prepare accounts receivable aging schedule at least monthly. ii. Pursue problem accounts with phone calls, letters, and legal action if necessary. d. Evaluate the receivables balance. i. If a company has significant concentrations of credit risk, it is required to discuss this risk in the notes to its financial statements. 1. A concentration of credit risk is a threat of nonpayment from a single customer or class of customers that could adversely affect the financial health of the company. e. Accelerate cash receipts from receivables when necessary. (see study objective 9 below) i. Many companies offer terms (2/10 net 30 etc) to accelerate payment by creditors.
♦ Note: If a company has significant risk of uncollectible accounts or other problems with receivables, it is required to discuss this possibility in the notes to the financial statements.
The advantages of having a note receivable rather than an account receivable are that:
- Notes earn interest.
- Notes receivable give the holder a stronger legal claim to assets than accounts receivable.
- A note is a negotiable instrument and may be transferred to another party by endorsement
All these steps are superfluous if the credit/collections department is not staffed with competent personnel
Study Objective 8 - Identify Ratios to Analyze a Company's Receivables
- Liquidity is measured by how quickly certain assets can be converted into cash. a. The ratio used to assess the liquidity of the receivables is the receivables turnover ratio. i. The ratio measures the number of times, on average; receivables are collected during the period. ii. The receivables turnover ratio is computed by dividing net credit sales (net sales less cash sales) by the average gross accounts receivables during the year. b. A popular variant of the receivables turnover ratio is to convert it into an average collection period in terms of days. This is computed by dividing the receivables turnover ratio into 365 days.
Consider the following computations of Mckesson's receivables turnover ratio for 2000 and 2001:
2001 2000
Net Credit Sales Net Credit Sales Average Gross Receivables Average Gross Receivables
$42,010 = 11.7 $36,687 = 12. ($3,863.1+$3,309.4)/2 ($3,309.4+$2,732.6)/
365/11.7 = 31.2 days 365/12.1 = 30.2 days
Study Objective 9 - Describe Methods to Accelerate the Receipt of Cash from Receivables
- Two common expressions apply to the collection of receivables: a. Time is money—that is, waiting for the normal collection process costs money. b. A bird in the hand is worth two in the bush—that is, getting the cash now is better than getting it later or not at all.
- Methods to Accelerate payment of receivables by creditors: a. Offer Terms (Sales discounts)for quick payment of goods (2/10, net 30) i. Known as sales discounts, these terms allow the creditor to take a 2% discount if the receivable is paid in the first 10 days of the month. Failure to take the discount costs the purchaser 36% on an annualized basis and is often an effective stimulus to generate rapid payment by creditors. ii. There are three reasons for the sale of receivables. b. Sell receivables: In recent years, for competitive reasons, sellers (retailers, wholesalers, and manufacturers) often have provided financing to purchasers of their goods. This process has generated increased sales but retarded the collection of cash. i. Receivables may be sold because they may be the only reasonable source of cash. When credit is tight, companies may not be able to borrow money in the usual credit markets. ii. Another reason for selling receivables is that billing and collection are often time- consuming and costly. As a result, it is often easier for a retailer to sell the receivables to another party that has expertise in billing and collection matters.
- A common way to accelerate receivables collection is a sale to a factor. a. A factor is a finance company or a bank that buys receivables from businesses for a fee and then collects the payments directly from the customers.
Sales and Accounts Receivable Review
9 What are the different types of receivables? Why is it necessary to have them in different categories?
9 Explain how accounts receivable are recognized in the accounts.
9 What are the two methods used to account for bad debts? Which method is required by GAAP if bad debts are material?
9 How is bad debt estimated when using the allowance method?
9 What is the formula for computing interest on notes receivable?
9 Describe the entries to record the disposition of notes receivable.
9 Explain the statement presentation of receivables.
9 What are the five steps in managing accounts receivable?
9 Identify and compute ratios to analyze a company's receivables.
9 What methods are used to accelerate the receipt of cash from receivables?
Reading Comprehension Check I Name _______________
Sales and Accounts Receivable
The term _______________ refers to amounts due from individuals and companies. _______________ are
claims that are expected to be collected in cash. The management of _ ______________ is a very important activity
for any company that sells goods on _______________. Receivables are important because they represent one of a
company's most _______________ _______________. For many companies receivables are also one of the largest
_______________.
The relative significance of a company's _______________ as a percentage of its _______________ differs
depending on its industry, the time of year, whether it extends long-term financing, and its _______________
_______________. To reflect important differences among receivables, they are frequently classified as (1)
_______________ , (2) _______________ , and (3) _______________.
_______________ ______________ are amounts owed by customers on account. They result from the
_______________ of _______________ and _______________. These receivables generally are expected to be
collected within _______________ to _______________ days. They are the most significant type of claim held by
the company.
_______________ _______________ represent claims for which formal instruments of credit are issued
as evidence of the _______________. The credit instrument normally requires the debtor to pay _______________
and extends for time periods of _______________ to _______________ days or longer. Notes and accounts
receivable that result from sales transactions are often called _______________ _______________.
Reading Comprehension Check II Name _______________
Sales and Accounts Receivable
Credit may also be granted in exchange for a formal credit instrument known as a _______________
_______________. A promissory note is a written promise to pay a specified amount of money on _______________
or at a _______________ _______________. Promissory notes may be used when (1) individuals and
companies _______________ or _______________ money, (2) when the amount of the transaction and the credit
period exceed _______________ _______________ , and (3) in settlement of _______________
_______________.
In a promissory note, the party making the promise to pay is called the _______________ ; the party to whom
payment is to be made is called the _______________. The payee may be specifically identified by name or may be
designated simply as the _______________ of the _______________.
Notes receivable give the holder a stronger _______________ _______________ to _______________
than _______________ _______________. Like accounts receivable, _______________ _______________
can be readily sold to another party. Promissory notes are _______________ _______________ (as are checks)
which means that, when sold, they can be _______________ to another party by _______________.
Notes receivable are frequently accepted from customers who need to extend the payment of an outstanding
_______________ _______________ and are often required from high-risk customers.
Solutions to Reading Comprehension Check II
Sales and Accounts Receivable
Credit may also be granted in exchange for a formal credit instrument known as a promissory
note. A promissory note is a written promise to pay a specified amount of money on ____ demand
or at a definite time. Promissory notes may be used when (1) individuals and companies
lend or borrow money, (2) when the amount of the transaction and the credit period exceed
normal limits , and (3) in settlement of _____ accounts receivable.
In a promissory note, the party making the promise to pay is called the maker ; the party to whom
payment is to be made is called the payee. The payee may be specifically identified by name or may be
designated simply as the bearer of the note.
Notes receivable give the holder a stronger legal claim to
_______ assets than accounts receivable. Like accounts receivable, notes
receivable can be readily sold to another party. Promissory notes are negotiable
instruments (as are checks) which means that, when sold, they can be transferred to another party by
endorsement.
Notes receivable are frequently accepted from customers who need to extend the payment of an outstanding
accounts receivable and are often required from high-risk customers.
Solutions to Vocabulary Quiz
Sales and Accounts Receivable
- Dishonored note
- Accounts receivable
- Maker
- Direct write-off method
- Receivables turnover ratio
- Average collection period
- Promissory note
- Allowance method
- Factor
- Aging the accounts receivable
Multiple Choice Quiz Name _______________
Sales and Accounts Receivable
- To ensure receivables are not overstated on the balance sheet, they are reported: a. at gross realizable value. b. at their cash (net) realizable value. c. less estimated uncollectible receivables. d. both b and c above.
- Which of the following is the most liquid asset? a. Unearned revenue. b. Long-lived assets. c. Receivables. d. Intangibles.
- Receivables are often classified as: a. accounts, notes, long-lived. b. accounts, notes, other. c. accounts, notes, inventory. d. none of the above.
- All of the following are "other receivables" except: a. petty cash. b. interest receivable. c. income taxes refundable. d. advances to employees.
- The method of accounting for bad debt expense, which conforms to GAAP is: a. direct write-off method. b. allowance method. c. both a and b. d. none of the above.
- An aging of accounts receivable is used if bad debts are accounted for using: a. direct write-off method. b. allowance method with uncollectibles based on percentage of sales. c. allowance method with uncollectibles based on percentage of accounts receivable basis. d. none of the above.
- When the allowance method is used and an account is subsequently written off as uncollectible, the following account is debited: a. bad debt expense. b. allowance for doubtful accounts. c. accounts receivable. d. both b and c.
Solutions to Multiple Choice Quiz
Sales and Accounts Receivable
- d
- c
- b
- a
- b
- c
- b
- c
- d
- b
Exercise 1 - World Wide Web Research and Financial Statement Presentation Activity
Sales and Accounts Receivable
American Express launched The Travelers Cheque in 1891. Since that time, the company significantly expanded its range of products. Go to www.americanexpress.com to find the information needed to answer the following questions.
- What are some of the benefits to businesses of accepting the American Express card?
- Is Card Member Receivables of American Express increasing or decreasing?
- What was the amount of the Reserve for Card Member Receivables for the two most current years?
- Is the Bad Debt Expense of American Express increasing or decreasing?
Solutions: Information available on Wiley student website.
Note: The Wiley student website is constantly being updated. Please check to see that the information requested in this exercise is available.
