Accounting Chapter 5: Receivables and Sales

The direct write-off method is primarily used for

tax reporting. Companies do not report a tax deduction for bad debts until those bad debts are actually uncollectible.

net realizable value

the amount of cash the firm expects to collect

Two important ratios that help in understanding the company's effectiveness in managing receivables

the receivables turnover ratio and the average collection period.

-receivables turnover ratio -what does the "net" in net credit sales come from -The amount for net credit sales is obtained from where

-Number of times during a year that the average accounts receivable balance is collected (or "turns over"). It equals net credit sales divided by average accounts receivable. -The "net" in net credit sales refers to total credit sales net of discounts, returns, and allowances (similar to net revenues calculated earlier in the chapter) -The amount for net credit sales is obtained from the current period's income statement; average accounts receivable equals the average of accounts receivable reported in this period's and last period's balance sheets. Last period's ending accounts receivable are this period's beginning accounts receivable. The more frequently a business is able to "turn over" its average accounts receivable, the more quickly it is receiving cash from its customers.

-average collection period -Companies typically strive for what

-The average collection period is another way to express the same efficiency measure. This ratio shows the approximate number of days the average accounts receivable balance is outstanding. It is calculated as 365 days divided by the receivables turnover ratio. -a high receivables turnover ratio and a correspondingly low average collection period. As a company's sales increase, receivables also likely will increase. If the percentage increase in receivables is greater than the percentage increase in sales, the receivables turnover ratio will decline (and the average collection period will increase). This could indicate that customers are dissatisfied with the product or that the company's payment terms for attracting new customers are too generous, which, in turn, could increase sales returns and bad debts.

-what type of debit balance does notes receivable have -how we classify notes receivable

-a normal debit balance like assets -we classify notes receivable as either current or noncurrent, depending on the expected collection date. If the time to maturity is longer than one year, the note receivable is a long-term asset. -

COLLECTION OF NOTES RECEIVABLE -We record the collection of notes receivable the same way as collection of accounts receivable, except that -example: Continuing the previous example, suppose that on August 1, 2018, the maturity date, Justin repays the note and interest in full as promised. Kimzey will record the following.

-we also record interest earned as interest revenue in the income statement. Debit Cash 10600 credit notes receivable 10,000 credit interest revenue 600

The adjusting entries to record these estimated contra revenues at the end of the year can be somewhat complicated, so we leave them to a more advanced accounting course. For now, the important points to understand are:

1.Revenues are reported for the amount of cash a company expects to be entitled to receive from customers for providing goods and services. 2.Total revenues are reduced by sales discounts, sales returns, and sales allowances that occur during the year. 3.Total revenues are further reduced by an adjusting entry at the end of the year for the estimate of additional sales discounts, sales returns, and sales allowances expected to occur in the future but that relate to the current year.

interest calculation example: In the previous example, Kimzey accepted a six-month, 12% promissory note. The "12%" indicates the annual interest rate charged by the payee. The terms of the six-month note mean that Kimzey will charge Justin Payne one-half year of interest, or 6%, on the face value. Interest on Kimzey's note receivable is calculated as follows.

10,000 x 12% x 6/12=$600(interest)

contra revenue account

Both sales returns and sales allowances are classified as contra revenues. A contra revenue account is an account with a balance that is opposite, or "contra," to that of its related revenue account. The reason we use a contra revenue account is to keep a record of the total revenue earned separate from the reduction due to subsequent sales returns or sales allowances. Rather than analyze debits to the Service Revenue account, managers can more easily analyze debits to the Sales Returns or Sales Allowances accounts. Companies sometimes combine their sales returns and sales allowances in a single Sales Returns and Allowances account. For homework, use separate Sales Returns and Sales Allowances accounts.

allowance for uncollectible accounts (also called allowance for doubtful accounts)

Contra asset account representing the amount of accounts receivable that we do not expect to collect. we adjust for future bad debts by making this the allowance account provides a way to reduce accounts receivable indirectly, rather than decreasing the accounts receivable balance itself. We report the allowance for uncollectible accounts in the asset section of the balance sheet, but it represents a reduction in the balance of accounts receivable.

Assume Link's Dental wants Dee to pay quickly on her teeth-whitening bill and offers her terms of 2/10, n/30. This means that if Dee pays within 10 days, the amount due ($350 after the $100 trade discount and the $50 sales allowance) will be reduced by 2% (or $7 = $350 × 2%). Collection During the Discount Period.Let's see what happens when Dee pays within 10 days: Assume that Dee pays on March 10, which is within the 10-day discount period. Link's Dental records the following entry when it receives payment. Collection After the Discount Period: For our second scenario, assume that Dee waits until March 31 to pay, which is not within the 10-day discount period. Link's Dental records the following transaction at the time it collects cash from Dee.

Debit Cash 343 debit sales discounts 7 credit accounts receivable 350 Debit cash 350 credit accounts receivable 350

ESTIMATING UNCOLLECTIBLE ACCOUNTS IN THE FOLLOWING YEAR At the end of 2019, Kimzey must once again estimate uncollectible accounts and make a year-end adjustment. Recall that Kimzey estimated bad debts in 2019 to be $5 million but only $4 million was actually written off. This means the balance of the allowance account at the end of 2019 prior to any year-end adjustment is $1 million. Suppose that in 2019 Kimzey bills customers for services totaling $80 million, and $30 million are still receivable at the end of the year. Of the $30 million still receivable, let's say Kimzey again uses the aging method and estimates $8 million will not be collected. For what amount would Kimzey record the year-end adjusting entry for bad debts in 2019? Before answering, let's first examine the current balance of the allowance account, as shown in Illustration 5-8. Notice that the balance before the year-end adjustment in this example is a $1 million credit. A credit balance before adjustment indicates that the estimate of uncollectible accounts at the beginning of the year (or end of last year) may have been too high. However, it's possible that some of the estimated uncollectible accounts have not proven bad yet. A debit balance before adjustment indicates that the estimate at the beginning of the year was too low. Based on all available information at the end of 2019, Kimzey estimates that the allowance for uncollectible accounts should be $8 million. This means the allowance account needs to increase from its current balance of $1 million credit to the estimated ending balance of $8 million credit. Kimzey can accomplish this by adjusting the account for $7 million as follows:

Debit bad debt expense 7 Credit allowance for uncollectible accounts 7

Another example of the use of notes receivable is to replace existing accounts receivable. For example, suppose that Justin received $10,000 of services on account, but Kimzey originally recorded the amount due as Accounts Receivable. Over time, it became apparent that Justin would not be able to pay quickly, so Kimzey required Justin to sign a six-month, 12% promissory note on February 1, 2018. When Justin signs the note, Kimzey records the following transaction to reclassify the existing account receivable as a note receivable.

Debit notes receivable 10,000 Credit Accounts Receivable 10,000 Recognize that the transaction has no impact on the accounting equation; it is simply a matter of reclassifying assets. One asset (notes receivable) increases, while another asset (accounts receivable) decreases.

Calculating Interest Revenue over Time for Kimzey Medical Clinic: Because Kimzey earns two months of interest in 2018, it must accrue that interest as revenue on December 31, 2018 (even though no cash has been collected). The adjustment to accrue interest revenue follows. On May 1, 2019, the maturity date, Kimzey records the collection of the note receivable of $10,000 and interest of $600. Notice that the cash collected for interest includes $200 receivable from 2018, as well as $400 of additional interest revenue related to four months in 2019.

December 31, 2018: Debit interest receivable 200 credit interest revenue 200 interest revenue=10000 x 12% x 2/12 May 1, 2019: debit cash 10600 credit notes receivable 10000 credit interest receivable(from 2018) 200 credit interest revenue (from 2019) 400 interest revenue=10000 x 12% x 4/12 (The entry on May 1, 2019, eliminates the balances of the note receivable and interest receivable recorded in 2018.)

discount terms

Discount terms, such as 2/10, n/30, are a shorthand way to communicate the amount of the discount and the time period within which it's available. The term "2/10," pronounced "two ten," for example, indicates the customer will receive a 2% discount if the amount owed is paid within 10 days. The term "n/30," pronounced "net thirty," means that if the customer does not take the discount, full payment net of any returns or allowances is due within 30 days.

Subsidiary Ledgers

In practice, all companies maintain records for individual customer accounts to help in tracking amounts receivable and in estimating amounts uncollectible. This idea was demonstrated in Illustration 5-6. A subsidiary ledger contains a group of individual accounts associated with a particular general ledger control account. For example, the subsidiary ledger for accounts receivable keeps track of all increases and decreases to individual customers' accounts. The balances of all individual accounts then sum to the balance of total accounts receivable in the general ledger and reported in the balance sheet. Subsidiary ledgers are also used for accounts payable, property and equipment, investments, and other accounts.

sales return

In some cases, customers may not be satisfied with a product or service purchased. If a customer returns a product, we call that a sales return. After a sales return, (a) we reduce the customer's account balance if the sale was on account or (b) we issue a cash refund if the sale was for cash.

percentage-of-credit-sales method or the income statement method

In the chapter, we estimated uncollectible accounts based on a percentage of accounts receivable at the end of the period. You learned that this method is the percentage-of-receivables method or the balance sheet method, because we base the estimate of bad debts on a balance sheet amount—accounts receivable. The estimated percentage could be a single percentage applied to the entire balance of accounts receivable, or it could vary based on the age of individual accounts receivable (the aging method). As an alternative, we can estimate uncollectible accounts based on the percentage of credit sales for the year, aptly referred to as the percentage-of-credit-sales method or the income statement method, because we base the estimate of bad debts on an income statement amount—credit sales. In this appendix, we consider the percentage-of-credit-sales method.

Accrued Interest (using same example as above)

It frequently happens that a note is issued in one year and the maturity date occurs in the following year. For example, what if Justin Payne issued the previous six-month note to Kimzey on November 1, 2018, instead of February 1, 2018? In that case, the $10,000 face value (principal) and $600 interest on the six-month note are not due until May 1, 2019. The length of the note (six months) and interest rate (12%) remain the same, and so the total interest of $600 charged to Justin remains the same. However, Kimzey will earn interest revenue in two separate accounting periods (assuming Kimzey uses a calendar year): for two months of the six-month note in 2018 (November and December), and for four months in the next year (January through April). Illustration 5-14 demonstrates the calculation of interest revenue over time. Interest receivable from Kimzey's six-month, $10,000, 12% note is $100 per month (= $10,000 × 12% × 1/12).

PERCENTAGE-OF-CREDIT-SALES METHOD example

Let's rework the example in the chapter for Kimzey Medical Clinic (see Illustrations 5-8 to Illustrations 5-10 and their discussion). During 2019, Kimzey bills customers $80 million for services, with $30 million in accounts receivable remaining at the end of the year. The balance of the allowance account, before adjustment, is a $1 million credit. For the percentage-of-receivables method, we'll use the estimate for uncollectible accounts used in the chapter—$8 million based on the age of accounts receivable. For the percentage-of-credit-sales method, let's assume Kimzey expects 12.5% of credit sales to be uncollectible. Kimzey bases the 12.5% estimate on a number of factors, including current economic conditions and the average percentage of uncollectibles in the previous year, its first year of operations. Illustration 5-16 demonstrates the differences in the two methods when adjusting for estimates of uncollectible accounts. Notice that the two methods for estimating uncollectible accounts result in different adjustments. Because the amounts of the adjustments differ, the effects on the financial statements differ. Recall that the balance of the allowance account before adjustment is a $1 million credit. After adjustment, the balance of the allowance account will differ between the two methods, as will the amount of bad debt expense. Illustration 5-17 summarizes the differences in financial statement effects. From an income statement perspective, some argue that the percentage-of-credit-sales method provides a better method for estimating bad debts because expenses (bad debts) are better matched with revenues (credit sales). A better matching of expenses and revenues results in a more accurate measure of net income for the period. From a balance sheet perspective, though, the percentage-of-receivables method is preferable because assets (net accounts receivable) are reported closer to their net realizable value. The current emphasis on better measurement of assets (balance sheet focus) outweighs the emphasis on better measurement of net income (income statement focus). This is why the percentage-of-receivables method (balance sheet method) is the preferable method, while the percentage-of-credit-sales method (income statement method) is allowed only if amounts do not differ significantly from estimates using the percentage-of-receivables method.

percentage-of-receivables method

Method of estimating uncollectible accounts based on the percentage of accounts receivable expected not to be collected. also referred to as the balance sheet method

Why is the direct write off method of accounting for uncollectible accounts not permitted for financial reporting purposes except in limited circumstances

Notice that bad debt expense is recorded in the year of the write-off (2019) instead of the year of the service revenue (2018). Total assets are also reduced by crediting Accounts Receivable at the time of the actual write-off (2019). Compared to the allowance method, the direct write-off method causes assets to be overstated and operating expenses to be understated in 2018.

What is the effect in Kimzey's financial statements when writing off Bruce's account receivable?

Overall, the write-off of the account receivable has no effect on total amounts reported in the balance sheet or in the income statement. Notice that there is no decrease in total assets and no decrease in net income with the write-off. Here's why: We have already recorded the negative effects of the bad news. Kimzey recorded those effects when it estimated future bad debts at the end of 2018 by recording a debit to bad debt expense and a credit to the allowance account. So, when Bruce declares bankruptcy in the following year, 2019, we had already established the allowance for this bad debt. The write-off on February 23, 2019, reduces both an asset account (Accounts Receivable) and its contra asset account (Allowance for Uncollectible Accounts), leaving the net receivable unaffected. Thus, the entry to record the actual write-off results in no change to total assets and no change to net income.

allowance method

Recording an adjustment at the end of each period to allow for the possibility of future uncollectible accounts. The adjustment has the effects of reducing assets and increasing expenses. Generally Accepted Accounting Principles (GAAP) require that we account for uncollectible accounts using what's called the allowance method. This method involves allowing for the possibility that some accounts will be uncollectible at some point in the future.3 Be sure to understand this key point. Using the allowance method, we account for events (customers' bad debts) that have not yet occurred but that are likely to occur. This is different from other transactions you've learned about to this point. Those earlier transactions involved recording events that have already occurred, such as purchasing supplies, paying employees, and providing services to customers. Under the allowance method, companies are required to estimate future uncollectible accounts and record those estimates in the current year. An account receivable we do not expect to collect has no value. Thus, we need to (1) reduce assets (accounts receivable) by an estimate of the amount we don't expect to collect. At the same time, failure to collect a customer's cash represents a cost inherent in using credit sales, so we also need to (2) increase expenses (bad debt expense) to reflect the cost of offering credit to customers. The bad debt expense will decrease net income. In the next section, we'll see how to use the allowance method to record estimated bad debts.

sales allowance

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.

bad debt expense

The amount of the adjustment to the allowance for uncollectible accounts, representing the cost of estimated future bad debts charged to the current period.

net accounts receivable or net realizable value

The difference between total accounts receivable and the allowance for uncollectible accounts.

END-OF-PERIOD ADJUSTMENT FOR CONTRA REVENUES

The discussion above deals with how companies record contra revenues—sales discounts, sales returns, and sales allowances—during the year. However, companies also must adjust for these amounts at the end of the year using adjusting entries. The revenue recognition standard (ASU No. 2014-09) issued in 2014 requires a company to report revenues equal to the amount of cash the company "expects to be entitled to receive." Those expectations could change as new information becomes available.1

END-OF-PERIOD ADJUSTMENT FOR CONTRA REVENUES We can see how this works with a simple example. Suppose General Health sells medical parts and consultation services of $400,000 on account during 2018. Also during 2018, some customers receive sales discounts totaling $6,000 for quick payment, while others return unused parts of $10,000 and others receive allowances of $14,000.

These contra revenue transactions reduce the amount of cash to be received from customers, so at the time they occur we need to reduce revenues. To reduce revenues, we debit Sales Discounts for $6,000, Sales Returns for $10,000, and Sales Allowances for $14,000. The procedure for recording these amounts was discussed earlier. In addition, at the end of 2018 the company must estimate any additional discounts, returns, and allowances that will occur in 2019 as a result of sales transactions in 2018. The reason is that some activities associated with sales transactions in 2018 will not occur until 2019 but will affect the final amount of cash received from customers. Continuing our example, suppose the company estimates an additional $1,000 in sales discounts, $2,000 in sales returns, and $3,000 in sales allowances in 2019 associated with sales in 2018. These estimates represent the expectation of less cash to be received, so according to the revenue recognition standard, we need to reduce revenue in 2018 for their amounts as well

allowance method vs direct-write-off method

Under the allowance method, future bad debts are estimated and recorded as an expense and a reduction in assets in 2018. Bad debt expense is recorded in the same period (2018) as the revenue it helps to create (also in 2018). Under the direct write-off method, though, we make no attempt to estimate future bad debts. We record bad debt expense in the period the account proves uncollectible. In this case, we report the bad debt expense and reduction in assets in 2019. The direct write-off method violates GAAP, since sales are recorded in one period (2018) and the related bad debt expense is recorded in the following period (2019). Notice that, either way, the ultimate effect is a $2,000 debit to Bad Debt Expense and a $2,000 credit to Accounts Receivable. The balance of Allowance for Uncollectible Accounts cancels out; it initially increases with a credit for the estimate of bad debts and then decreases with a debit for actual bad debts. The difference between the two methods is in the timing. The direct write-off method reduces accounts receivable and records bad debt expense at the time the account receivable proves uncollectible. If the credit sale occurs in a prior reporting period, bad debt expense is not properly matched with revenues (credit sales). Also, accounts receivable will be overstated in the prior period. The direct write-off method typically is not acceptable for financial reporting.

Direct write off method

We've just seen how the allowance method for uncollectible accounts works. This is the method required for financial reporting by Generally Accepted Accounting Principles (GAAP). However, for tax reporting, companies use an alternative method commonly referred to as the direct write-off method. Under the the direct write-off method, we write off bad debts only at the time they actually become uncollectible, unlike the allowance method which requires estimation of uncollectible accounts before they even occur.

notes receivable

When receivables are accompanied by formal credit arrangements made with written debt instruments (or notes), we refer to them as notes receivable.

disadvantage of the allowance method

While the allowance method is conceptually superior to the direct write-off method and more accurately reports assets and matches revenues and expenses, it does have one disadvantage. This disadvantage arises from the fact that reported amounts under the allowance method represent management estimates. If so inclined, management could use these estimates to manipulate reported earnings. For example, if management wants to boost earnings in the current year, it can intentionally underestimate future uncollectible accounts. Similarly, if a company is having an especially good year and management wants to "reserve" earnings for the future, it can intentionally overestimate future uncollectible accounts. Having a large expense in the current year means there is less of a charge to bad debt expense in a future year, increasing future earnings. Other expenses, such as rent expense, are much more difficult to manipulate because their reported amounts don't rely on management estimates. These expenses are evidenced by past transactions, and their amounts are verifiable to the penny using a receipt or an invoice.

notes receivable

are similar to accounts receivable but are more formal credit arrangements evidenced by a written debt instrument, or note. Notes receivable typically arise from loans to other entities (including affiliated companies); loans to stockholders and employees; and occasionally the sale of merchandise, other assets, or services.

How would the patient, Justin Payne, record the previous transaction? By signing the note, Justin has an account payable that becomes reclassified as a note payable. He records the issuance of the note payable on February 1 as follows.

debit accounts payable 10000 credit notes payable 10,000 Just as one company's account payable is another company's account receivable, there is also a note payable for every note receivable. For every dollar a company earns in interest revenue, another company incurs a dollar of interest expense. We address notes payable in Chapter 8, but if you have a good understanding of notes receivable, then you have a head start with its flip side—notes payable.

To see how companies record credit sales, consider an example. Suppose Link's Dental charges $500 for teeth whitening. Dee Kay decides to have her teeth whitened on March 1 but doesn't pay cash at the time of service. She promises to pay the $500 whitening fee to Link by March 31. Link's Dental records the following at the time of the whitening.

debit accounts receivable credit service revenue

COLLECTION OF ACCOUNTS PREVIOUSLY WRITTEN OFF Later in 2019, on September 8, Bruce's bankruptcy proceedings are complete. Kimzey had expected to receive none of the $4,000 Bruce owed. However, after liquidating all assets, Bruce is able to pay each of his creditors 25% of the amount due them. So, when Kimzey receives payment of $1,000 (= $4,000 × 25%), it makes the following two entries.

debit accounts receivable 1000 credit allowance for uncollectible accounts 1000 debit cash 1000 credit accounts receivable 1000 The first entry simply reverses a portion of the previous entry that Kimzey made on February 23 to write off the account. The second entry records the collection of the account receivable. Notice that in both entries the debit entry increases total assets by the same amount that the credit entry decreases total assets. Therefore, collecting cash on an account previously written off also has no effect on total assets and no effect on net income. Of course, the two entries above could have been recorded as a single entry by debiting Cash and crediting Allowance for Uncollectible Accounts. The debit to Accounts Receivable in the first entry and the credit to Accounts Receivable in the second entry exactly offset one another. Two entries are used here to help emphasize (1) the reversal of the prior write off and (2) the cash collection on account. Continuing our example, suppose that by the end of 2019 total accounts written off by Kimzey equal $4 million. Because Kimzey allowed for bad debts by setting up the Allowance for Uncollectible Accounts for $5 million at the end of 2018, the write-offs in 2019 will have no effect on total assets or net income. But what about the remaining $1 million left in the balance of Allowance for Uncollectible Accounts? As we'll see next, the remaining balance of $1 million will affect our new adjustment in the following year. Writing off a customer's account as uncollectible reduces the balance of accounts receivable but also reduces the contra asset—allowance for uncollectible accounts. The net effect is that there is no change in the net receivable (accounts receivable less the allowance) or in total assets. We recorded the decrease to assets as a result of the bad debt when we established the allowance for uncollectible accounts in a prior year.

When recording a transaction, companies don't recognize trade discounts directly. Instead, they recognize trade discounts indirectly by recording the sale at the discounted price. For example, let's go back to Link's Dental, which typically charges $500 for teeth whitening. Assume that in order to entice more customers, Dr. Link offers a 20% discount on teeth whitening to any of his regular patients. Since Dee Kay is one of Dr. Link's regular patients, she can take advantage of the special discount and have her teeth whitened for only $400.

debit accounts receivable 400 credit service revenue 400

WRITING OFF ACCOUNTS RECEIVABLE: To continue with our example of Kimzey Medical Clinic, let's suppose that on February 23, 2019 (the following year), Kimzey receives notice that one of its former patients, Bruce Easley, has filed for bankruptcy protection against all creditors. Based on this information, Kimzey 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, though it didn't know which ones. Now that it knows a specific customer will not pay, it can adjust the allowance and reduce the accounts receivable balance itself. Upon receiving news of this actual bad debt, Kimzey records the following.

debit allowance for uncollectible accounts 4000 credit accounts receivable 4000

To see how the direct write-off method works, suppose a company provides services on account for $100,000 in 2018, but makes no allowance for uncollectible accounts at the end of the year. Then, in the following year on September 17, 2019, an account of $2,000 becomes uncollectible. The company records the actual write-off as follows.

debit bad debt expense 2000 credit accounts receivable 2000

The adjusting entry at the end of 2018 to allow for future bad debts would instead be $5 million using the aging method.

debit bad debt expense 5 credit allowance for uncollectible accounts 5

ESTIMATING UNCOLLECTIBLE ACCOUNTS: To use the allowance method, a company first estimates at the end of the current year how much in uncollectible accounts will occur in the following year. Consider an example of future uncollectible accounts for Kimzey Medical Clinic, which specializes in emergency outpatient care. Because it doesn't verify the patient's health insurance before administering care, Kimzey knows that a high proportion of fees for emergency care provided will not be collected. Page 224 In 2018, its first year of operations, Kimzey bills customers $50 million for emergency care services provided. By the end of the year, $20 million remains due from customers. Those receivables are assets of the company. But how much of the $20 million does Kimzey expect not to collect in the following year? The receivables not expected to be collected should not be counted as assets. The credit manager at Kimzey estimates that approximately 30% of accounts receivable will not be collected. Estimating uncollectible accounts based on the percentage of accounts receivable expected not to be collected is known as the percentage-of-receivables method. This method sometimes is referred to as the balance sheet method, because we base the estimate of bad debts on a balance sheet amount—accounts receivable.4 Using the 30% estimate, Kimzey expects that $6 million of its accounts receivable (or 30% of $20 million) likely will never be collected. It makes the following year-end adjustment to allow for these future uncollectible accounts.

debit bad debt expense 6 credit for uncollectible accounts 6

Accounting for Notes Receivable: As an example, let's say that, on February 1, 2018, Kimzey Medical Clinic provides services of $10,000 to a patient, Justin Payne, who is not able to pay immediately. In place of payment, Justin offers Kimzey a six-month, 12% promissory note. Because of the large amount of the receivable, Kimzey agrees to accept the promissory note as a way to increase the likelihood of eventually receiving payment. In addition, because of the delay in payment, Kimzey would like to charge interest on the outstanding balance. A formal promissory note provides an explicit statement of the interest charges.

debit notes receivable credit service revenue

Suppose on March 5, after she gets her teeth whitened but before she pays, Dee notices that another local dentist is offering the same procedure for $350, which is $50 less than Link's discounted price of $400. Dee brings this to Dr. Link's attention and because his policy is to match any competitor's pricing, he offers to reduce Dee's account balance by $50. Link's Dental records the following sales allowance.

debit sales allowance 50 accounts receivable 50

It is important to emphasize that the direct write-off method is not allowed for

financial reporting under GAAP It is only used in financial reporting if uncollectible accounts are not anticipated or are expected to be very small.

The one issue that usually applies to notes receivable but not to accounts receivable is

interest

interest calculation

interest = face value x annual interest rate x fraction of the year

the upside of extending credit to customers by allowing them to purchase on account?

it boosts sales by allowing customers the ability to purchase on account and pay cash later. Just think of how many times you wanted to buy food, clothes, electronics, or other items, but you didn't have cash with you. You're not alone. Many customers may not have cash readily available to make a purchase or, for other reasons, simply prefer to buy on credit.

aging method

n our example for Kimzey Medical Clinic, we estimated future uncollectible accounts by applying a single estimated percentage to total accounts receivable (30%). Management can estimate this percentage using historical averages, current economic conditions, industry comparisons, or other analytical techniques. A more accurate method than assuming a single percentage uncollectible for all accounts is to consider the various ages of individual accounts receivable, using a higher percentage for "old" accounts than for "new" accounts. This is known as the aging method. For instance, accounts that are 120 days past due are older than accounts that are 60 days past due. The older the account, the less likely it is to be collected Using the aging method to estimate uncollectible accounts is more accurate than applying a single percentage to all accounts receivable. The aging method recognizes that the longer accounts are past due, the less likely they are to be collected.

We recognize accounts receivable as assets in the balance sheet and report them at their....

net realizable value, that is, the amount of cash we expect to collect.

The downside of extending credit to customers

not all customers will pay fully on their accounts. Even the most well-meaning customers may find themselves in difficult financial circumstances beyond their control, limiting their ability to repay debt. Customers' accounts that we no longer consider collectible are uncollectible accounts, or bad debts.

nontrade receivables

receivables that originate from sources other than customers. They include tax refund claims, interest receivable, and loans by the company to other entities, including stockholders and employees.

Even though the seller does not receive cash at the time of the credit sale, the firm

records revenue immediately once goods or services are provided to the customer and future collection from the customer is probable.

Net revenues (or net sales)

refer to a company's total revenues less any amounts for discounts, returns, and allowances. We discuss these items next.

trade discounts

represent a reduction in the listed price of a product or service. Companies typically use trade discounts to provide incentives to larger customers or consumer groups to purchase from the company. Trade discounts also can be a way to change prices without publishing a new price list or to disguise real prices from competitors.

accounts receivable

represent the amount of cash owed to a company by its customers from the sale of products or services on account. To understand accounts receivable, we need to start with credit sales, from which accounts receivable originate.

sales discount

represents 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. It's a discount intended to provide incentive for quick payment.

Credit sales

transfer products and services to a customer today while bearing the risk of collecting payment from that customer in the future. Credit sales transactions are also known as sales on account. Similarly, credit service transactions are also called services on account. Companies often combine total sales revenues with total service revenues in reporting total revenues on the income statement. As we saw in the opening story, Tenet Healthcare provides a considerable amount of healthcare-related sales and services on credit, but many of its credit customers never pay. In this chapter, we focus on recording sales or services on credit and dealing with the likelihood that some customers will not pay as promised.

Customers' accounts that we no longer consider collectible

uncollectible accounts, or bad debts.

Along 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. This asset is referred to as accounts receivable (sometimes called trade receivables), and the firm records it at the time of a credit sale.