Accounting - Chapter 8

sale of receivables

1) their size 2) companies may sell receivables because they may be the only reasonable source of cash 3) billing and collection are often time‐consuming and costly

factor

A finance company or bank that buys receivables from businesses for a fee and then collects the payments directly from the customers

accounts receivable turnover

A measure of the liquidity of accounts receivable, computed by dividing net credit sales (net sales - cash sales) by average net accounts receivable during the year. - This ratio measures the number of times, on average, a company collects receivables during the period. - Unless seasonal factors are significant, average accounts receivable outstanding can be computed from the beginning and ending balances of the net receivables.

direct write-off method

A method of accounting for bad debts that involves charging receivable balances to Bad Debt Expense at the time receivables from a particular company are determined to be uncollectible. - Under this method, bad debt expense will show only ACTUAL losses from uncollectibles. - Under the direct write‐off method, companies often record bad debt expense in a period different from the period in which they recorded the revenue. Thus, no attempt is made to match bad debt expense to sales revenue in the income statement. - Nor does the company try to show accounts receivable in the balance sheet at the amount actually EXPECTED to be received. - Consequently, unless a company expects Bad Debt losses to be insignificant, the direct write‐off method is NOT acceptable for financial reporting purposes. - Debit "Bad Debt Expense" account - Credit "Accounts Receivable"

honor of notes receivable

A note is honored when its maker pays in full at its maturity date.

national credit card sales

A retailer's acceptance of a national credit card is another form of selling—factoring—the receivable by the retailer. - The use of national credit cards translates to more sales and zero bad debts for the retailer. - In exchange for these advantages, the retailer pays the credit card issuer a fee of 2% to 4% of the invoice price for its services - The retailer considers sales resulting from the use of Visa and MasterCard as CASH SALES. - As the seller: Debit "Cash" Debit "Service Charge Expense" Credit "Sales Revenue"

promissory note

A written promise to pay a specified amount of money on demand or at a definite time. - Promissory notes may be used (1) when individuals and companies lend or borrow money (2) when the amount of the transaction and the credit period exceed normal limits (3) in settlement of accounts receivable.

financial statement presentation of receivables

Companies should identify in the balance sheet or in the notes to the financial statements each of the major types of receivables. - Short‐term receivables are reported in the current assets section of the balance sheet, below short‐term investments. - Short‐term investments appear before short‐term receivables because these investments are nearer to cash. - Companies report both the gross amount of receivables and the allowance for doubtful accounts.

monitoring collections

Companies should prepare an accounts receivable aging schedule at least monthly. - It helps estimate the allowance for doubtful accounts - It helps managers estimate the timing of future cash inflows, which is very important to the treasurer's efforts to prepare a cash budget. - It provides information about the overall collection experience of the company and identifies problem accounts. - Monitoring the accounts receivable aging schedule helps users determine if the company's credit risk is increasing.

establishing a payment period

Companies that extend credit should determine a required payment period and communicate that policy to their customers. - It is important that the payment period is consistent with that of competitors so that you don't lose sales to them.

computing interest formula

Face Value of Note × Annual Interest Rate × Time in Terms of One Year = Interest - The interest rate specified on the note is an annual rate of interest. - Months/12 - Days/360

notes receivables

Notes receivable are a written promise (as evidenced by a formal instrument) for amounts to be received. - The note normally requires the collection of interest and extends for time periods of 60-90 days or longer. - Notes and accounts receivable that result from sales transactions are often called trade receivables.

notes receivable facts

Notes receivable give the holder a stronger legal claim to assets than do 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, the seller can transfer them to another party by endorsement. - Companies frequently accept notes receivable from customers who need to extend the payment of an outstanding account receivable. - Companies also often require notes from high‐risk customers. - The majority of notes originate from lending transactions.

other receivables

Other receivables include nontrade receivables such as interest receivable, loans to company officers, advances to employees, and income taxes refundable. - These do not generally result from the operations of the business. - Therefore, they are generally classified and reported as separate items in the balance sheet.

average collection period

The average amount of time that a receivable is outstanding, calculated by dividing 365 days by the accounts receivable turnover. - Companies use the average collection period to assess the effectiveness of a company's credit and collection policies. The average collection period should not greatly exceed the credit term period (i.e., the time allowed for payment). - The faster the turnover, the greater the reliability of the current ratio for assessing liquidity. - The accounts receivable turnover and the average collection period help users determine if a company's collections are being made in a timely fashion.

recovery of an uncollectible account

The company must make two entries to record the recovery of a bad debt: (1) It reverses the entry made in writing off the account. This reinstates the customer's account (2) It journalizes the collection in the usual manner. - Debit "Accounts Receivable" - Credit "Allowance for Doubtful Accounts" - Then Debit "Cash" - Then Credit "Accounts Receivable" - Note that the recovery of a bad debt, like the write‐off of a bad debt, affects only balance sheet accounts

entry for notes receivable

The company records the note receivable at its face value, the value shown on the face of the note. - No interest revenue is reported when the company accepts the note because the revenue recognition principle does not recognize revenue until the performance obligation is satisfied. - Interest is earned (accrued) as time passes.

determining the maturity date

The maturity date of a promissory note may be stated in one of three ways: (1) on demand, (2) on a stated date, and (3) at the end of a stated period of time - When the life of a note is expressed in terms of months, you find the date when it matures by counting the months from the date of issue. - When the due date is stated in terms of days, you need to count the exact number of days to determine the maturity date. - In counting, omit the date the note is issued but include the due date.

maker

The party in a promissory note who is making the promise to pay

payee

The party to whom payment of a promissory note is to be made

Writing off an uncollectible account

To prevent premature or unauthorized write‐offs, authorized management personnel should formally approve each write‐off. - To maintain segregation of duties, the employee authorized to write off accounts should not have daily responsibilities related to cash or receivables. - Debit "Allowance for Doubtful Accounts" and credit "Accounts Receivable" - Under the allowance method, a company debits every bad debt write‐off to the allowance account and NOT to Bad Debt Expense. - A write‐off affects only balance sheet accounts

captive finance companies

a sales finance company that is owned by the company selling the product - The purpose of captive finance companies is to encourage the sale of the company's products by assuring financing to buyers. - However, the parent companies involved do not necessarily want to hold large amounts of receivables, so they may sell them.

accelerating cash receipts

(1) "Time is money"—that is, waiting for the normal collection process costs money. (2) "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. - Therefore, in order to accelerate the receipt of cash from receivables, companies frequently sell their receivables to another company for cash, thereby shortening the cash‐to‐cash operating cycle.

disposal of notes receivable

- Debit "Cash" (the face value + interest paid) - Credit "Notes Receivable" (face value) - Credit "Interest Revenue" (interest amount)

extending credit

- If your credit policy is too tight, you will lose sales. - If it is too loose, you may sell to "deadbeats" who will pay either very late or not at all - It is important to check references of potential new customers as well as periodically to check the financial health of continuing customers.

allowance method

A method of accounting for bad debts that involves estimating uncollectible accounts at the end of each period. - Companies estimate uncollectible accounts receivable and match them against revenues in the same accounting period in which the revenues are recorded - It also ensures that receivables are stated at their cash (net) realizable value on the balance sheet - Companies record estimated uncollectibles as: Debit to "Bad Debt Expense" Credit to "Allowance for Doubtful Accounts" through an adjusting entry at the end of each period - "Allowance for Doubtful Accounts" is a contra account to Accounts Receivable - Companies DEBIT actual uncollectibles to "Allowance for Doubtful Accounts" and CREDIT them to "Accounts Receivable" at the time the specific account is written off as uncollectible - Companies do not close "Allowance for Doubtful Accounts" at the end of the fiscal year.

percentage‐of‐receivables basis

A method of estimating the amount of Bad Debt Expense whereby management establishes a percentage relationship between the amount of receivables and the expected losses from uncollectible accounts - Take the "Accounts Receivable" cost and apply the percentage estimate - Now, that value must be reported in "Allowance for Doubtful Accounts" - To increase the balance in "Allowance for Doubtful Accounts", DEBIT "Bad Debt Expense" and CREDIT "Allowance for Doubtful Accounts" by the difference/increase - The percentage‐of‐receivables basis provides an estimate of the cash realizable value of the receivables. - It also provides a reasonable matching of expenses to revenue

dishonor of notes receivable

A note that is not paid in full at maturity. - A dishonored note receivable is no longer negotiable. - However, the payee still has a claim against the maker of the note for both the note and the interest. - If the lender expects that it eventually will be able to collect, the two parties negotiate new terms to make it easier for the borrower to repay the debt - If there is no hope of collection, the payee should write off the face value of the note.

aging the accounts receivable

A schedule of customer balances classified by the length of time they have been unpaid. - After the company arranges the accounts by age, it determines the expected bad debt losses by applying percentages, based on past experience, to the totals of each category. - The longer a receivable is past due, the less likely it is to be collected. - As a result, the estimated percentage of uncollectible debts increases as the number of days past due increases. - Total estimated uncollectible accounts amount represent the existing customer claims expected to become uncollectible in the future. - Thus, this amount represents the required balance in "Allowance for Doubtful Accounts" at the balance sheet date. - Accordingly, the amount of bad debt expense that should be recorded in the adjusting entry is the DIFFERENCE between the required balance and the existing balance in the allowance account

trade receivables

Accounts receivable and notes receivable that result from sales transactions for a company's goods or services

accounts receivables

Accounts receivable are amounts customers owe on account. - They result from the sale of goods and services. - Companies generally expect to collect accounts receivable within 30 to 60 days. - They are usually the most significant type of claim held by a company.

receivables

Amounts due from individuals and companies that are expected to be collected in cash. - Receivables are claims that are expected to be collected in cash. - Receivables are important because they represent one of a company's most liquid assets. For many companies, receivables are also one of the largest assets.

bad debt expense

An expense account to record losses from extending credit - Although each customer must satisfy the credit requirements of the seller before the credit sale is approved, inevitably some accounts receivable become uncollectible - Also called "Uncollectible Accounts Expense"

maturity value

For each interest‐bearing note, the amount due at maturity is the face value of the note + interest for the length of time specified on the note

financial statement presentation of bad debt expense

In the income statement, companies report bad debt expense under "Selling expenses" in the operating expenses section. - They show interest revenue under "Other revenues and gains" in the nonoperating section of the income statement.

valuing notes receivable

Like accounts receivable, companies report short‐term notes receivable at their cash (net) realizable value. - The notes receivable allowance account is Allowance for Doubtful Accounts. - Valuing short‐term notes receivable is the same as valuing accounts receivable.

evaluating liquidity of receivables

Liquidity is measured by how quickly certain assets can be converted to cash.

accounting for uncollectible accounts

METHOD (1) the direct write‐off method METHOD (2) the allowance method

managing receivables

Managing accounts receivable involves five steps: 1. Determine to whom to extend credit. 2. Establish a payment period. 3. Monitor collections. 4. Evaluate the liquidity of receivables. 5. Accelerate cash receipts from receivables when necessary.

cash (net) realizable value

The net amount a company expects to receive in cash from receivables. - It excludes amounts that the company estimates it will NOT collect. - Estimated uncollectible receivables therefore reduce receivables on the balance sheet through use of the allowance method. - Companies MUST use the allowance method for financial reporting purposes when bad debts are material in amount

concentration of credit risk

The threat of nonpayment from a single large customer or class of customers that could adversely affect the financial health of the company. - If a company has significant concentrations of credit risk, it must discuss this risk in the notes to its financial statements. - Identifying risky credit customers helps users determine if the company has significant concentrations of credit risk.