Chapter 5

Chapter 5: Receivables and Sales

Part A: Recognizing Accounts Receivable

Learning Objective 1 - Recognizing Accounts Receivable

• Credit Sales Definition: Transfer goods/services today while expecting payment in the future.

• Recording at Credit Sale Time:

  • Debit: Accounts Receivable (amount owed by customers).

  • Credit: Revenue (immediate recognition upon providing goods/services).

  • Increasing assets (debits), increasing revenue (credit)

Example of Recording a Credit Sale

• Date: March 1

• Transaction: Services delivered for $500 (credit sale).

  • Entry:

    • Debit Accounts Receivable $500

    • Credit Service Revenue $500

Recording Subsequent Receipt

• Date: March 31

• Cash Collection for Previous Service:

  • Entry:

    • Debit Cash $500

    • Credit Accounts Receivable $500

Key Point

• Companies record accounts receivable and revenue at the time of sale, reducing receivables upon collection.

Part B: Estimating Uncollectible Accounts

Learning Objective 3 - Establishing an Allowance

• Uncollectible Accounts: Accounts that are not expected to be collected (bad debts).

• Allowance Method (GAAP):

  • Estimate uncollectible amounts and report them as a contra asset to receivables.

  • How do companies know how much accounts receivable they’re not going to collect?

    • Look at historical how much of your receivables didn’t get paid back, and you assign a percentage aligning with that

    • Aging method

    • Since 2023, there was a standard credit model that requires you to use a econometric model considering future economic events to consider what your future losses will be

Example of Estimating Bad Debts

• Estimate: Kimzey owes $20 million customers and expects 30% uncollectible:

  • Company records:

    • Debit Bad Debt Expense (increases expenses $6 million)

    • Credit Allowance for Uncollectible Accounts (increases allowance account $6 million) — this is a contra account, so we’re decreasing the accounts receivable

      • Accounts receivable - Uncollected accounts = net revenue

Key Point

• Under the allowance method, receivables are reported net of expected uncollectibles.

Writing Off Accounts Receivable

• When a customer is deemed uncollectible, the account is written off:

  • Entry:

    • Debit Allowance for Uncollectible Accounts (reduces contra asset)

    • Credit Accounts Receivable (reduces asset)

  • Total assets and net income remain unchanged.

Part C: Notes Receivable and Interest

Learning Objective 7: Notes Receivable

• Definition: Formal credit arrangements backed by a written instrument.

  • If the asset has a maturity date or liquidation date of less than a year, it’s a current asset

  • If greater than a year, non-current.

    • Exceptions: operating cycles like airplane, luxury cars

• Recording a Note Receivable: Same as recording accounts receivable. For example, providing a service worth $10,000 results in:

  • Entry:

    • Debit Notes Receivable $10,000

    • Credit Service Revenue $10,000

Interest Calculation

• Interest for Notes: Calculated by:

  • Formula: Interest = Principal x Rate x Time

• Example Calculation: $10,000 at 12% for 6 months:

  • Interest = $10,000 x 12% x 6/12 = $600

  • Collection Entry:

    • Debit Cash for total amount received (Principal + Interest)

Accruing Interest

• Interest earned but not collected by year-end should be accrued:

  • Entry:

    • Debit Interest Receivable

    • Credit Interest Revenue

Analysis and Calculation of Ratios

Learning Objective 8: Monitoring Receivables

• Receivables Turnover Ratio: Measures how often accounts receivable are collected within a period.

• Average Collection Period: Indicates how long it takes to collect receivables.

  • Interpretation: Comparison of Tenet vs. CVS Health:

    • Tenet has lower collection days vs CVS; indicates management efficiency.

Key Point

• Ratios help analyze the effectiveness of managing receivables and cash collection methods.

APPENDIX: Percentage-of-Credit-Sales Method

• Used to estimate uncollectible accounts as a percentage of credit sales.

• Adjusting entries recognize bad debt expense as credit sales rise and predict future risks.

Common Mistakes

• Misclassification of contra revenue accounts (sales returns/allowances) as expenses.

• Failing to correctly implement the allowance method vs direct write-off methods, leading to potential asset misstatements.