Ch 6B: Receivables

Receivables

claims held against customers and others for money, goods, or services

Current vs Noncurrent Receivables

- current: collected within a year or during the current operating cycle

- noncurrent: all other receivables

Trade Receivables

- Trade Receivables: customers owe a company amounts for goods bought or services rendered

--- subclassified as A/R or N/R

Accounts Receivable

- oral promises of the purchaser to pay for goods and services received

- represent open accounts resulting from short term extensions of credit

- normally collected within 30 to 60 days

Notes Receivable

- written promises to pay a certain sum of money on a specified future date

- arise from sales, financing, or other transactions

- notes may be short term or long term and generally include an interest component

Nontrade Receivables

- arise from a variety of transactions outside the normal course of business

--- cash advances to officers, employees, and subsidiaries (companies that are majority owned by a parent company)

--- deposits paid to cover potential damages or losses, or as a guarantee of performance or payment

--- dividends and interest receivable

--- claims against insurance companies for casualties sustained, for tax refunds, or for damaged or lost goods

Recognition of Accounts Receivable

- Accounts receivable generally arise as part of a revenue arrangement

- The Revenue recognition principle indicates that a company should recognize revenue when it satisfies its performance obligation by transferring the good or service to the customer

Transaction Price

-the amount of consideration that a company expects to receive from a customer in exchange for transferring goods or services

Variable Consideration

- price of a good/service is dependent on future events

- future events like discounts, returns and allowances, rebates, and performance bonuses

- companies should record A/R and related revenue at the amount of consideration expected to be received from a customer

4 items that affect the transaction price and the A/R balance

1. trade discounts

2. cash discounts

3. Sales returns and allowances

4. time value of money

Trade Discounts

used to avoid frequent charges in catalogs, to alter prices for different quantities purchased, or to hide the true invoice price from customer

- commonly quoted in percentages

Cash Discounts (Sales Discounts)

- used to induce prompt payment

- presented in terms like 2/10, n/30 (2% discount if paid within 10 days, gross amount due in 30 days), or 2/10, E.O.M., net 30, E.O.M. (2% discount if paid any time by the 10th day of the following month, with full payment due by the 30th of the following month).

- customers take these unless their cash is very limited

- recorded with gross or net method

Sales Discount Gross Method

- company recognizes the receivable and related revenue at the invoice price

Sales Discount Net Method

- company recognizes the accounts receivable and related revenue at the invoice price less the cash discount

Sales Returns and Sales Allowances

- contra account to sales revenue

- deducted from sales rev to get net sales

- the returned inventory account is used to separate returned inventory from regular inventory

Time Value of Money

- a company should measure receivables in terms of their present value, that is, their discounted value of cash to be received in the future

- when expected cash receipts require a waiting period, the receivable face amount is not worth the amount the company ultimately receives

Two Methods used for uncollectable accounts

1. Direct Write Off Method

2. The Current Expected Credit Loss (CEPL)

Direct Write Off Method

- Non GAAP

- when a company determines a account to be uncollectable, it charges the loss to Credit Loss Expense

- shoes actual losses from uncollectable

- records facts, not estimates

- assumes that a good A/R resulted from each sale, and that later events revealed certain accounts to be uncollectible and worthless

- but it fails to record expenses in the same period as associated revenues and receivables are not stated at the net amount expected to be collected on the BS

- not appropriate, expect when the expected credit loss is immaterial

Current Expected Credit Loss Method (GAAP)

- GAAP

- estimating expected credit losses at the end of each period

- ensures that companies state receivables on the BS at the cash (net) realizable value or net accounts receivables. Which is gross accounts receivable less expected credit losses. The net A/R is the net amount expected to be collected

- companies estimate expected credit losses using info about past and current events as well as forecasts of future collectability

The Essential Features of CECL

1. companies estimate credit losses and compare the estimate to the current balance in the allowance accounts

2. companies debit estimated increases in credit losses to Credit Loss Expense and credit them to Allowance for Credit Losses, a contra asset account, through an adjusting entry at the end of each period

3. when companies write off a specific customer account, they debit actual uncollectibles to Allowance for Credit Losses and credit that amount to Accounts Receivable

Why use Allowance Account in CECL

- Allowance for Credit Losses shows the estimated amount of A/R that the company expects it will not collect in the future

- Uses it bc:

--- companies do not know which customer will not pay in the future, therefore, they cannot make a direct credit to A/R for the estimate. The credit goes to the allowance account which is a contra account to A/R

--- the credit balance in the allowance account will absorb the specific customer write offs when they occur in the future

- note: its a permanent account and not closed

Recording the write-off of an uncollectible account

- when companies have exhausted all means of collecting a past-due account and collection appears impossible, the company should write off the account

-- the company credits the customer's A/R balance since it wont be collected

- write off affects only BS accounts. Reduces AR and Allowance for credit losses so the net realizable value remains the same

Recovery of an Uncollectable Account

- occasionally, a company collects cash from a customer after it has written off the account as uncollectable.

- The company makes two entries to record the recovery of a credit loss

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

Estimating the Expected Credit Loss

- companies must estimate the amount of credit loss when they use the CECL method

- common method: Aging Schedule: applies a different credit loss percentage to various age categories based on past experience

--- it serves as a control device by identifying which accounts require special attention based on how long they have been past due

Promissory Note

- a notes receivable is supported by a formal promissory note, a written promise to pay a certain sum of money at a specific future date

- its a negotiable instrument that a maker signs in favor or a designated payee who may legally and readily sell or otherwise transfer the note to others

- can be interest or zero interest bearing

- fairly liquid and can easily be converted to cash

Interest-bearing vs Zero-interest-bearing notes

- Interest-bearing notes: have a stated rate of interest

- Zero-interest-bearing notes: include interest as part of their face amount

The basis issues in accounting for notes receivable are the same as those for A/R: (three)

- recognition

- valuation

- disposition

Recognition of Notes Receivable

- companies record and report long term N/R at the present value of the cash they expect to collect

- stated (nominal/face) interest rate: the interest rate that is written into the N/R contract. The stated rate represents the cash rate of interest paid by the borrower

- effective-interest rate (market rate of effective yield): the interest rate used in the market to determine the value of the note, also referred to as the discount rate used to determine present value

- when stated interest rate equals effective interest rate, the note sells at face value

- when they are not equal, the present value of the note will be different from the face value of the note(recorded at discount/ premium then amortized over useful life)

Note not issued at face value: Zero-interest bearing note

- interest is associated with the note, but there are no regular, cash interest payments made on the note

- instead, the cash is received by the borrower when the note is first executed is less than the face value, but the borrower must pay back the full face value on the maturity date of the note

- in this kind of note, the present value is the cash paid to the borrower

Discount on Notes Receivable

- valuation account

- contra asset account to N/R

Effective-Interest Method

- the carrying value of the note is multiplied by the implied interest rate to determine the amount of interest revenue for the period

- the different btwn cash interest payments and interest revenue is the amount of discount that will be amortizes each period

Premium

When the present value exceeds the face value, which means the stated rate is greater than the effective rate, the note is exchanged at a premium

- its a debit and

- the recorded interest revenue will be less than the cash interest received

Note Received for Property, Goods, or Services

- the stated interest rate is presumed to be fair unless:

--- no interest rate is stated or

--- the stated interest rate is unreasonable, or

--- the face amount of the note is materially different from the current cash sales price for the same or similar items or from the current fair value of the debt instrument

- in these circumstances, the company measures the present value of the note by the fair value of the property, goods or services by an amount that reasonable approximates the fair value of the note

If a company cannot determine that fair value and if the note has no ready market, determining the present value of the note is more difficult. To estimate the present value of a note under such circumstances, the company must:

- approximate an applicable interest rate that may differ from the stated interest rate. This process of interest rate approximation is called imputation and results in an imputed rate

- determine the imputed interest rate when it receives the note. the company ignores any subsequent changes in prevailing interest rates

Valuation of Notes Receivable

- record short term notes at the net amount expected to be collected (face amnt-allowances) (allowance for credit losses)

- the estimations involved in valuing short term notes receivable and in recording credit loss expense and the related allowance exactly parallel that for trade accounts receivable

- companies estimate the amount of expected credit losses by an analysis of the receivable

Two additional special issues for accounting and reporting of receivables ralate to:

1. Disposition of receivables

2. Presentation and analysis

1. Disposition of receivables: Sale of Receivables

- factors: companies that buy receivables for a fee and then collect the payments directly from customers

- A sale of receivables can be arranged in two ways:

1. Sale without recourse

2. Sale with recourse

Sale without recourse

- the factor assumes the credit risk of some customers not paying their A/R balance

- a factor will charge you more without recourse bc the factor is taking on more risk by being responsible for any bad debts

- the seller of the receivables assumes no responsibility for any credit losses associated with the transferred receivables

- the transfer of A/R here is an outright sale of the receivables in both form (transfer of title) and substance (transfer of control)

--- the seller DR cash for the proceeds and CR A/R for the face value of the receivables

--- the seller recognizes the difference reduced by any provision for probable adjustments (disc, returns and allow...) as Loss on Sale of Receivables

-- the seller uses a receivable from factor account (reported as a receivable) to account for the proceeds retained by the factor to cover probable sales discounts, sales returns, and sales allowances

Sale with recourse

- if a receivable becomes uncollectable, you will be responsible

- financial component approach: company assigns values to the components, such as recourse provision, servicing rights, and agreement to reacquire. In this approach, each party to the sale only recognizes the assets controlled and the liabilities incurred after the sale

Loan

- to borrow funds, you generally have to pledge or assign your A/R as collateral for the loan

--- under a pledge, the assigned receivables remain under the control of the borrower

--- if the loan is not paid when due, the lender can convert the collateral to cash

Accounting for transfer of receivables

Transfer of Receivables

Does it meet the three conditions?:

- 1. Transferred assets isolated from transferor

- 2. Transferee has right to pledge or sell assets

- 3. Transferor does not maintain control through repurchase agreement

Yes!

- Is there Continuing Involved?

-- Yes: Record as a Sale: 1) Reduce Receivables 2) Recognize assets obtained and liabilities incurred 3) Record gain or loss

-- No: Record as a sale: 1) Reduce Receivables 2) Record gain or loss

No!

- Record as secured borrowing:

- 1. Record Liability

- 2. Record interest expense

Presentation of Receivables

Rules for classifying receivables:

1. Separate the different types of receivables that a company possesses, if material

2. Appropriately offset the valuation accounts against the proper receivable accounts

3. Determine that receivables classified in the current assets section will be converted into cash within the year or the operating cycle, whichever is longer

4. Disclose any loss contingencies that exist on the receivables

5. Disclose any receivables designated or pledged as collateral

6. Disclose the nature of credit risk inherent in the receivables, how that risk is analyzed and assessed in arriving at the allowance for credit losses, and the changes and reasons for those changes in the allowance for credit losses

Accounts Receivable Turnover

- Net Sales/Average Net Accounts Receivable

- assess liquidity of receivables

- measures the number of times a company collects receivables during the period

Average Days to Collect Receivables

- 365/accounts receivable turnover