ACCT 2301 CH 8 Receivables

Accounts receivable that are uncollectible must be

written off, which means they must be removed from the books, because the company does not expect to receive cash in the future.

Businesses that sell goods or services on account receive cash by

mail, usually in the form of a check, or online payments via electronic funds transfer (EFT)

Estimating and Recording Bad Debts Expense—Allowance Method

Companies use their past experience as well as consider the economy, the industry they operate in, and other variables. In short, they make an educated guess, called an estimate. There are three basic ways to estimate uncollectibles: Percent-of-sales Percent-of-receivables Aging-of-receivables

By accepting credit cards and debit cards, businesses are able to attract more customers.

Credit cards offer the customer the convenience of buying something without having to pay cash immediately. Debit cards, on the other hand, reduce the customer's bank account immediately but allow the customer to pay electronically instead of with currency or by writing a check.

Promissory Note

Example with journal entry

Principal

The amount loaned by the payee and borrowed by the maker of the note.

Pledging receivables

business uses its receivables as security for a loan. The business borrows money from a bank and offers its receivables as collateral. The business is still responsible for collecting on the receivables, but it uses this money to pay off the loan along with interest. In pledging, if the loan is not paid, the bank can collect on the receivables. In both situations, the business has managed to receive cash immediately for the receivables instead of having to wait for collection.

Credit increases the sales of the department store, but

but it also has its disadvantages the department store has to wait to receive cash customers don't pay

Businesses must maintain a separate accounts receivable account for

for each customer in order to account for payments received from the customer and amounts still owed.

When using the allowance method, companies estimate bad debts expense at the end of the period and then

record an adjusting entry. Journalize Accounts: Bad Debts Expense Allowance for Bad Debts Note: Recorded bad debts expense for the period.

The business does not wait to see which customers will not pay. Instead, it

records a bad debts expense based on estimates developed from past experience and uses the Allowance for Bad Debts to hold the pool of "unknown" uncollectible accounts.

write-off

(business) to cancel a debt; to recognize that something is a failure, has no value, etc.

Converting an Accounts Receivable (no interest) to a promissory note with interest

A company may accept a note receivable from a credit customer who fails to pay an account receivable. 1. Open a notes receivable and close accounts receivable. 2. Create Interest Receivable and credit interest revenue (if the interest period crosses into another year) 3. Close Note Receivable by documenting Cash (D) Notes Receivable (CR) orig amount Interest Receivable (accrued from prior year period) Interest Revenue (from current yr period)

Receivable

A monetary claim against a business or an individual.

The three major types of receivables are:

Accounts receivable Notes receivable Other receivables

Computing Interest on a Note - Month

Amount of interest= Principal × Interest rate × Time In the formula, time (period) represents the portion of a year that interest has accrued on the note. It may be expressed as a fraction of a year in months (number of months/12) or a fraction of a year in days (number of days/365). Amount of interest= Principal × Interest rate × Time =$1,000×0.06×12/12 =$60

Recording Dishonored Notes Receivable

Because the note has expired, it is no longer in force. Convert from promissory note back to accounts receivable. But the debtor still owes the payee. The payee can transfer the note receivable amount to Accounts Receivable. Suppose Rubinstein Jewelers has a six-month, 10% note receivable for $1,200 from Mark Adair that was signed on March 3, 2019, and Adair defaults. Rubinstein Jewelers will record the default on September 3, 2019, as follows: Include the amount owed as interest revenue.

Dishonor a Note

Failure of a note's maker to pay a note receivable at maturity. also called defaulting on a note

subsidiary account

For billing and collection purposes, companies keep a separate accounts receivable account for each customer The sum of all balances in subsidiary accounts receivable equals a control account balance

The length of the collection period depends on the credit terms of the sale.

For example, sales on net 30 terms should be collected within approximately 30 days. When there is a discount, such as 2/10, net 30, the collection period may be shorter than 30 days. Credit terms of net 45 result in a longer collection period than 30 days.

The interest revenue earned on the note up to year-end is part of that year's earnings.

Journal Interest Receivable Interest Revenue Note: Accrued interest revenue Because of the revenue recognition principle, we want to record the earnings from the note in the year in which they were earned.

The percent-of-receivables and aging-of-receivables methods are based on the balance of accounts receivable.

These approaches are also called balance-sheet approaches because they focus on Accounts Receivable (a balance sheet account) and determine a target allowance balance based on a percentage of the receivable balance.

There are two methods of accounting for uncollectible receivables and recording the related bad debts expense:

• Direct write-off method • Allowance method Once an account receivable is written off, the company stops pursuing the collection. Some companies might turn delinquent receivables over to an attorney or other collection agency to recover some of the cash for the company, but generally companies do not expect to receive any future payment.

Quick assets are defined as

•cash •including cash equivalents •short-term investments, •net current receivables

Allowance for Bad Debts

A contra asset account, related to accounts receivable, that holds the estimated amount of uncollectible accounts. Also known as Allowance for Doubtful Accounts or Allowance for Uncollectible Accounts The allowance account is subtracted from the asset Accounts Receivable.

Allowance Method

A method of accounting for uncollectible receivables in which the company estimates bad debts expense instead of waiting to see which customers the company will not collect from.

Direct Write-off Method

A method of accounting for uncollectible receivables in which the company records bad debts expense when a customer's account receivable is uncollectible. primarily used by small, nonpublic companies

Percent-of-Receivables Method

A method of estimating uncollectible receivables by determining the balance of the Allowance for Bad Debts account based on a percentage of accounts receivable. In the percent-of-receivables method, the business once again determines a percentage of uncollectible accounts based on past experience. This method is different than the percent-of-sales method because it multiplies the percentage by the ending unadjusted balance in the Accounts Receivable account instead of by net credit sales.

Aging-of-Receivables Method

A method of estimating uncollectible receivables by determining the balance of the Allowance for Bad Debts account based on the age of individual accounts receivable. Target balance is calculated by age of accounts x % uncollectable added together (see screenshot) The formula for Bad Expense Debts is the same as % of Receivables

Percent-of-Sales Method

A method of estimating uncollectible receivables that calculates bad debts expense based on a percentage of net credit sales. also called the income-statement approach because it focuses on the amount of expense that is reported on the income statement

Accounts Receivable Turnover Ratio

A ratio that measures the number of times the company collects the average accounts receivable balance in a year. The higher the ratio, the faster the cash collections. = Net credit sales / Average net accounts receivable ex. =$25,146 / [($419+$429)/2] =59.31 times Most companies don't report the level of detail needed to determine net CREDIT sales. In this example we used all sales (including cash)

Notes Receivable

A written promise that a customer will pay a fixed amount of principal plus interest by a certain date in the future. sometimes called promissory notes Notes receivable due within 12 months or within the normal operating cycle if the cycle is longer than a year are considered current assets. Notes receivable due beyond one year are long-term assets.

Recovery of Accounts Previously Written Off—Allowance Method : Journal

Accounts: Accounts Receivable Allowance for Bad Debts Notes: Reinstated previously written off account With payment: Cash Accounts Receivable Notes: Collected cash on account

Example Quick Ratio from book

Acid-test ratio = (Cash including cash equivalents + Short-term investments + Net current receivables) / Total Current Liabilities =($238 cash + $419 a/r ) / $5,4380 =.12 (rounded)

Recovery of Accounts Previously Written Off—Allowance Method

After a company has previously written off an account, the company stops attempting to collect on the receivable. Customers will occasionally make payment on receivables that have already been written off. A business will need to reverse the write-off to the Allowance for Bad Debts account and then record the receipt of cash. In reversing the write-off, the business is reestablishing the receivable account and reversing the write-off from the Allowance for Bad Debts account.

percent of sales method formula

Bad Debts Expense = Net credit sales × % + amount in Allowance for bad debts ex. During the​ year, Horace Company had net credit sales of $ 41k. At the end of the​ year, before adjusting​ entries, the balance in Accounts Receivable was $14k​(debit) and the balance in allowance for Bad Debts was $ 640 (credit). If the company uses an income statement approach to estimate bad debts at 7%, what is the ending balance in the Allowance for Bad Debts​ account? =41k * 7% + 640 =3510

Journal Entries - Comparison of Accounting for Uncollectibles

Direct Write-off vs. Allowances Methods

Some companies sell merchandise in exchange for notes receivable.

In this instance, a product was "sold" so we have to account for Sales Revenue. Ex. July 1, 2019, Rosa Electric sells household appliances for $2,000 to Dorman Builders. Dorman signs a nine-month promissory note at 10% annual interest. Breakdown: On maturity date Cash = 2,150 (that's the full amount on 9 mo. agreement) Separated out: • 2,000 to close A/R • 100 to close Int A/R • 50 to new yr interest revenue earned

Should the uncollectible accounts be underestimated?

In understating the amount of uncollectible accounts, Norah would be misleading the bank on the amount of cash that Happy Kennels expects to collect in the future. Norah would also understate Bad Debts Expense and overstate net income on the income statement.

Recording Honored Notes Receivable

Journal Cash Notes Receivable Interest Receivable Interest Revenue Notes Collected noted receivable plus interest On the maturity date of the note, Smart Touch Learning will receive cash for the principal amount plus interest. The company considers the note honored and makes the following entry:

Other Receivables

Other receivables make up a miscellaneous category that includes any other type of receivable where there is a right to receive cash in the future. Common examples include: • dividends receivable • interest receivable • taxes receivable These other receivables may be either current or long-term assets, depending on whether they will be received within one year or the normal operating cycle if the cycle is longer than a year (current asset) or received more than a year in the future (long-term asset).

A receivable occurs when a business sells goods or services to another party on account (on credit).

Receivables also occur when a business loans money to another party. A receivable is the right to receive cash in the future from a current transaction. It is something the business owns; therefore, it is an asset

Identifying Maturity Date

Some notes specify the maturity date. For example, September 30, 2020, is the maturity date of the note shown in Exhibit 8-4. Other notes state the period of the note in days or months.

Most companies use the allowance method to measure bad debts.

The allowance method is based on the matching principle; thus, the key concept is to record bad debts expense in the same period as the sales revenue.

Under IFRS, receivables are recognized and reported similarly to what is required by GAAP. Accounts Receivable must be reported at net realizable value.

The allowance method is used to accomplish the matching of bad debt expense to the sales of the period and to report receivables at net realizable value. Under IFRS, the Allowance for Bad Debts may be called the Provision for Bad Debts. IFRS provides more detailed criteria than GAAP for determining when an account is uncollectible.

Accounts Receivable will be reported on the balance sheet, but it will now be shown at the net realizable value.

The balance sheet now reports the amount of accounts receivable that Smart Touch Learning expects to collect, $4,320. The contra account, Allowance for Bad Debts, is subtracted from Accounts Receivable showing that although $4,400 is owed to Smart Touch Learning, the company estimates that $80 of accounts receivable will be uncollectible.

Selling on account brings both a benefit and a cost:

The benefit to a business is the potential increased revenues and profits by making sales to a wider range of customers. The cost, however, is that some customers do not pay, creating uncollectible receivables.

Percent-of-Receivables Method : Formula

The calculation for bad debts expense under the percent-of-receivables method is a two-step process. First, the company determines the target balance of Allowance for Bad Debts. Step 1: Determine the target balance of Allowance for Bad Debts. Target balance = Ending balance of accounts receivable × % Step 2. Then, it uses the target balance to determine the amount of the bad debts expense. Bad Debt Expense = Target balance (- if credit / + if debit) unadjusted Allowance for Bad Debts

Instead, the company must record an expense associated with the cost of the uncollectible account. This expense is called bad debts expense.

The cost to the seller of extending credit. It arises from the failure to collect from some credit customers. sometimes called: • doubtful accounts expense • uncollectible accounts expense.

For good internal control over cash collections from receivables, separation of duties must be maintained.

The credit department should have no access to cash, and those who handle cash should not be in a position to grant credit to customers. If a credit department employee also handles cash, he or she could pocket money received from a customer.

Each receivable transaction involves two parties:

The creditor, who receives a receivable (an asset). The creditor will collect cash from the customer or borrower. Payee of the note (creditor)—The entity to whom the maker promises future payment; the payee of the note is the creditor. The creditor is the company that loans the money. ----------------------- The debtor, the party to a credit transaction who takes on an obligation/payable (a liability). The debtor will pay cash later.

Maturity Date

The date when a note is due. A written document known as a promissory note serves as evidence of the debt and is signed by the debtor. the date when final payment of the note is due. Also called the due date.

Notes receivable are more formal than accounts receivable.

The debtor signs a promissory note as evidence of the transaction.

Net Realizable Value

The net value a company expects to collect from its accounts receivable. Accounts Receivable less Allowance for Bad Debts.

Debtor

The party to a credit transaction who takes on an obligation/payable. Maker of the note (debtor)—The entity that signs the note and promises to pay the required amount; the maker of the note is the debtor.

Interest rate

The percentage rate of interest specified by the note. Interest rates are almost always stated for a period of one year. Keep in mind that interest rates are stated as an annual rate. Therefore, the time in the interest formula should also be expressed in terms of a fraction of one year.

Interest period

The period of time during which interest is computed. It extends from the original date of the note to the maturity date. Also called the note term.

Days' Sales in Receivables

The ratio of average net accounts receivable to one day's sales. also called the collection period The ratio tells how many days it takes to collect the average level of accounts receivable. = 365 days / Accounts receivable turnover ratio. The number of days' sales in receivables should be close to the number of days customers are allowed to make payment when credit is extended. The shorter the collection period, the more quickly the organization can use its cash. The longer the collection period, the less cash is available for operations.

Interest

The revenue to the payee for loaning money. Interest is an expense to the debtor and revenue to the creditor.

Accounts Receivable

The right to receive cash in the future from customers for goods sold or for services performed. also called trade receivables usually collected within a short period of time, such as 30 or 60 days, and are therefore reported as a current asset on the balance sheet.

Maturity value

The sum of the principal plus interest due at maturity. Maturity value is the total amount that will be paid back.

The entry to write off a receivable reduces the amount of the Allowance for Bad Debts account and also the Accounts Receivable account, but it does not affect the net realizable value shown on the balance sheet.

This is because both Allowance for Bad Debts (contra asset) and Accounts Receivable (asset) were reduced by the amount of the write-off. In addition, the write-off of a receivable does not affect net income because the entry does not involve revenue or expenses.

Under the allowance method of accounting for uncollectibles, businesses must estimate the amount of the bad debts expense at the end of the accounting period.

This is done using one of three methods: percent-of-sales, percent-of-receivables, or aging-of-receivables.

Occasionally after a company writes off an account, the customer will decide to make payment

To account for this recovery, the company must reverse the earlier write-off.

Computing Interest on a Note - days

When the interest period is stated in days, we sometimes compute interest based on a 360-day year rather than on a 365-day year. A 360-day year eliminates some rounding and was used frequently in the past. However, with the use of computers to calculate interest, a 365-day year is much more common now. The interest on a $5,000 note at 12% for 60 days can be computed as follows: Amount of interest = Principal × Interest rate × Time =$5,000×0.12×60/365 =$98.63 (rounded)

Identifying Maturity Date - days

When the period is given in days, the maturity date is determined by counting the actual days from the date of issue. A 180-day note dated February 16, 2019, matures on August 15, 2019, as shown here: In counting the number of days in a note term, remember to: Count the maturity date. Omit the date the note was issued.

Identifying Maturity Date - months

When the period is given in months, the note's maturity date falls on the same day of the month as the date the note was issued. For example, a six-month note dated February 16, 2019, would mature on August 16, 2019.

Writing Off Uncollectible Accounts—Allowance Method

When using the allowance method, companies still write off accounts receivable that are uncollectible. However, instead of recording a debit to Bad Debts Expense (as done when using the direct write-off method), the company will record a debit to Allowance for Bad Debts.

Acid-test (quick) ratio

also called the quick ratio, used to measure a company's ability to pay its current liabilities. The acid-test ratio reveals whether the entity could pay all its current liabilities if they were to become due immediately. The acid-test ratio is a more stringent measure than the current ratio but it is not as stringent as the cash ratio. The acid test is a ratio of the sum of a company's quick assets to total current liabilities. Acid-test ratio = (Cash including cash equivalents + Short-term investments + Net current receivables) / Total Current Liabilities

Businesses also benefit from accepting payment by credit and debit cards. They do not have to

check each customer's credit rating or worry about keeping accounts receivable records or even collecting from the customer because the card issuer has the responsibility of collecting from the customer. Thus, instead of collecting cash from the customer, the seller will receive cash from the card issuer.

factoring receivables

sells its receivables to a finance company or bank (often called a factor) The business immediately receives cash less an applicable fee from the factor for the receivables The factor, instead of the business, now collects the cash on the receivables. The business no longer has to deal with the collection of the receivable from the customer. The business receives cash associated with the receivable from the factor instead of the customer. In both situations, the business has managed to receive cash immediately for the receivables instead of having to wait for collection.

Bad Debts Expense is not debited when a company writes off an account receivable when using the allowance method because

the company has already recorded the Bad Debts Expense as an adjusting entry The entry to write off an account under the allowance method has no effect on net income at the time of entry.

Limitations of the Direct Write-off Method

the direct write-off method violates the matching principle. The matching principle requires that the expense of uncollectible accounts be matched with the related revenue For example, when using the direct write-off method, a company might record sales revenue in 2017 but not record the bad debts expense until 2018. By recording the bad debts expense in a different year than when the revenue was recorded, the company is overstating net income in 2017 and understating net income in 2018. This method is only acceptable for companies that have very few uncollectible receivables.

Receivables represent

the right to receive cash in the future from a current transaction