Acounting Chapter 8

Analysis of Receivables Method

• The analysis of receivables method is based on the assumption that the longer an account receivable is outstanding, the less likely it is that it will be collected.

Accounts Receivable

• The most common transaction creating a receivable is selling merchandise or services on account (on credit). • The receivable is recorded as a debit to Accounts Receivable. • Such accounts receivable are normally collected within a short period, such as 30 or 60 days. • They are classified on the balance sheet as a current asset.

Number of Days Sales in Receivables

• The number of days' sales in receivables is an estimate of the length of time the accounts receivable have been outstanding. • Number of Days Sales in Receivables = Average Accounts Receivable / Average Daily Sales

Analysis of Receivables Method Part 3

• The preceding steps are then summarized in an aging schedule, and this overall process is called aging the receivables. • The sum of the estimated uncollectible accounts for each aged class is the estimated uncollectible accounts on December 31. • This is the desired adjusted balance for Allowance for Doubtful Accounts. • Comparing the sum of the estimated uncollectible accounts in the aging schedule with the unadjusted balance of the allowance account determines the amount of the adjustment for Bad Debt Expense.

Classification of Receivables

• The receivables that result from sales on account are normally accounts receivable or notes receivable. • The term receivables includes all money claims against other entities, including people, companies, and other organizations. • Notes and accounts receivable that result from sales transactions are sometimes called trade receivables.

Write Offs to the Allowance Account

• When a customer's account is identified as uncollectible, it is written off against the allowance account. • This requires the company to remove the specific accounts receivable and an equal amount from the allowance account.

Write-Offs to the Allowance Account

• Because Allowance for Doubtful Accounts is based on an estimate, it will normally have a balance at the end of a period. As a result, the total write-offs to the allowance account during the period will rarely equal the balance of the account at the beginning of the period. • The allowance account will have a credit balance at the end of the period if the write-offs during the period are less than the beginning balance. • The allowance account will have a debit balance at the end of the period if the write-offs during the period exceed the beginning balance. • An account receivable that has been written off against the allowance account may be collected later.

Notes Receivables

• Notes receivable are amounts that customers owe for which a formal, written instrument of credit has been issued. • If notes receivable are expected to be collected within a year, they are classified on the balance sheet as a current asset. • Notes are often used for credit periods of more than 60 days. • Notes may also be used to settle a customer's accounts receivable.

Other Receivables

• Other receivables include • interest receivable • taxes receivable • receivables from officers or employees • Other receivables are normally reported separately on the balance sheet. • If they are expected to be collected within one year, they are classified as current assets. • If collection is expected beyond one year, these receivables are classified as noncurrent assets and reported under the caption Investments.

Uncollectible Receivables

• Regardless of how careful a company is in granting credit, some credit sales will be uncollectible. • The operating expense recorded from uncollectible receivables is called bad debt expense, uncollectible accounts expense, or doubtful accounts expense. • The two methods of accounting for uncollectible receivables are as follows: • The direct write-off method records bad debt expense only when an account is determined to be worthless. • The direct write-off method is often used by small companies and companies with few receivables. • The allowance method records bad debt expense by estimating uncollectible accounts at the end of the accounting period. • Generally accepted accounting principles (GAAP) require companies with a large amount of receivables to use the allowance method.

Percent of Sales Method

• Since accounts receivable are created by credit sales, uncollectible accounts can be estimated as a percent of credit sales.

Accounts Receivable Turnover

• The accounts receivable turnover measures how frequently during the year the accounts receivable are being converted to cash. • Accounts Receivable Turnover = Sales / Average Accounts Receivable

Estimating Uncollectibles

• The allowance method requires an estimate of uncollectible accounts at the end of the period. • This estimate is normally based on past experience, industry averages, and forecasts of the future. • The two methods used to estimate uncollectible accounts are as follows: • Percent of sales method • Analysis of receivables method

Uncollectible Receivables

• A major issue of selling merchandise or services on account (on credit) is that some customers will not pay their accounts. That is, some accounts receivable will be uncollectible. • Companies may shift the risk of uncollectible receivables to other companies by not accepting sales on account and only accepting cash or credit cards. • Companies may also sell their receivables. • Selling receivables is called factoring the receivables. • The buyer of the receivables is called a factor. • An advantage of factoring is that the company selling its receivables immediately receives cash for operating and other needs.

Notes Receivable Perks

• A note receivable has some advantages over an account receivable. • By signing a note, the debtor recognizes the debt and agrees to pay it according to its terms. Thus, a note is a stronger legal claim.

Accounting for Notes Receivable

• A promissory note may be received by a company from a customer to replace an account receivable. In such cases, the promissory note is recorded as a note receivable. • If the maker of the note fails to pay the note on the due date, it is considered a dishonored note receivable. • A company that holds a dishonored note transfers the face amount of the note plus any interest due back to an accounts receivable account. • A company receiving a note should record an adjusting entry for any accrued interest at the end of the period.

Analysis of Receivables Method Part 2

• The analysis of receivables method is applied as follows: 1. The due date of each account receivable is determined. 2. The number of days each account is past due is determined. This is the number of days between the due date of the account and the date of the analysis. 3. Each account is placed in an aged class according to its days past due (1-30 days past due, 31-60 days past due, 61-90 days past due, and so on). 4. The totals for each aged class are determined. 5. The total for each aged class is multiplied by an estimated percentage of uncollectible accounts for that class. 6. The estimated total of uncollectible accounts is determined as the sum of the uncollectible accounts for each aged class.