Chapter 8: Accounting for receivables

Losses from Accounts Receivable

-Businesses extend credit in order to increase their volume of sales relative to a cash-only policy. -Businesses understand, however, that they will likely not collect 100 percent of all of their outstanding accounts receivable. -Credit losses are considered an operating expense and are debited to bad debt expense.

Allowance Method

-GAAP requires an estimate be made of bad debt expenses at the time of the revenue recognition even though the actual accounts to be written off are unknown at this time; this is an example of the matching principle -this process is executed using the allowance method -the estimate results in an adjusting entry to the contra-asset account Allowance for Doubtful Accounts

Accounts Receivable Aging Method

-How do firms determine the amount of bad debt expenses to be written off during the year? -estimates the allowance for doubtful accounts as a percentage of the outstanding accounts receivable; this will give the desired ending balance in the Allowance for DD account -bad debts expense is then determined as the amount necessary to achieve the proper balance in the allowance account -the allowance for doubtful accounts balance is computed by computing an aging schedule on outstanding accounts receivable partitioned by age of the receivable

Writing Off Specific Receivables

-The company will write off a receivable when it is determined the amount will not be collected. -The write-off will not affect either expense or total assets, rather the entry simply cleans up the accounts receivable account (the expense occurred at the time of the estimate, not at the time of the write off).

Bad Debt Treatment

-bad debt is written off in the balance sheet once the firm determines that the debtor (typically the customer) will not pay up the amount owed, this is typically (but not always) when the customer declares bankruptcy -there are two ways to treat the bad debt expense in the income statement: A. Direct method: write off the bad debt expense in the IS once the bad debt occurs (i.e. the customer declares bankruptcy) B. Allowance method: estimate the probable bad debt expense associated with the sale, and write it off in the IS as soon as the sale is made

Interest Calculation

-interest is calculated according to following formula: interest = principal x interest rate x interest time -assume a 3 month note for $10,000 at an annual interest rate of 6 percent interest = $10,000 x 0.06 x 3/12 = $150

Recovery of Accounts Written Off

-occasionally an account written off will be later collected, assume the previous $200 write off was actually collected -2 entries will be recorded 1. reverse the original write-off 2. collect the cash

Notes Receivable

-promissory notes receivable are often used in sale transactions when the credit period is longer than the 30-60 day period common for accounts receivable -key characteristics include: > a fixed due date or on demand > a certain principal sum to be paid > an interest rate usually stated as an annual rate

Direct Write-Off Method

-under the direct write off method, bad debts are charged to bad debt expense in the period they are determined to be uncollectible -bad debt expense account is debited and accounts receivable is credited -no estimate is made for bad debts in the period of the revenue recognition, therefore no allowance for doubtful accounts is used -because this violates the matching principle, GAAP does not allow the direct write off method unless the amounts of bad debts are immaterial

Writing Off Specific Receivables: Impact on BS & IS

-writing off a specific bad debt should not have an impact on the IS (i.e., no impact on expenses or revenue) & no impact on BS (i.e., total assets & liabilities remain unchanged) -Net account Rec is what goes into determining total assets in the BS, since net account rec does not change after the write -off, total assets will not change either -similarly, none of the revenue or expense accounts are impacted by the write-off of the specific debt, therefore IS is not affected

Analyzing Receivables

A key measure of analyzing receivables is determining the speed of collection. Two ratios, the accounts receivable turnover and the average collection period are commonly calculated. -accounts receivable turnover = net sales/average accounts receivable -average collection period = 365/accounts receivable turnover

Accounts Receivable

accounts receivable is the current asset resulting from a sale or service executed on a credit basis

Debts to Assets Ratio

debt to assets ratio = total liabilities/total assets -example: firm has total assets of $5M & total stockholders equity of $2M DA ratio = (5-2)/5= 60% what happens to the DA ratio if the firm declares and pays dividends? Ans: total assets decline (since cash leaves the firm) total debt is not affected, thus, the DA ratio increases