ACCT2001: Accounting Practice and Reporting Week 9: RECEIVABLES AND CURRENT LIABILITIES

Receivables and Current Liabilities

Receivables: Introduction

• A receivable arises when a business sells goods or services to another party on account (on credit).
• The receivable is the seller’s claim against the buyer for the amount of the transaction.
• Receivables also occur when a loan is made.
• The creditor sells goods or a service and obtains a receivable (an asset).
• The debtor takes on an obligation/payable (a liability) and will pay cash later.
• The chapter focuses on accounting for receivables by the seller (the creditor).

Types of Receivables

The three main types of receivables are:

• Accounts Receivable: Sometimes called trade receivables or trade debtors, are amounts to be collected from customers from sales made on credit, usually collected within a short period of time (therefore, are current assets).
• Bills (and Notes) Receivable: Usually have longer terms than accounts receivable.
  • They are current assets if due within 1 year or less, and non-current assets otherwise.
  • They may be collected in installments.
  • A promissory note is a special type of bill receivable and is a written promise to pay principal plus interest by a certain date.
• Other Receivables: Any other type of cash receivable in the future (e.g., dividends or interest receivable).

Internal Control Over Receivables

• Internal control over the collection of receivables must be applied similarly to that described in Chapter 8 for cash, e.g., separation of duties.
• Most large companies have a credit department to evaluate whether customers meet credit approval standards.
• A business does not want to lose sales to good customers who need time to pay but at the same time does not want to sell to customers who represent a poor credit risk.

Recording Sales on Credit

• To record revenue at the time of sale:

• The separate customer accounts receivable are called subsidiary accounts, whose balances sum to the balance in the control account Accounts receivable (i.e., $15,000$).

  Example:

  • Date: Mar 8

  • Account title: Accounts receivable—Brown (A+)

  • Dr: $5,000$

  • Cr: $5,000$

  • Account title: Service revenue (R+)

  • Performed service on account.

  • Date: Mar 8

  • Account title: Accounts receivable—Smith (A+)

  • Dr: $10,000$

  • Cr: $10,000$

  • Account title: Sales revenue (R+)

  • Sold goods on account.

Recording Collection of Cash

Example:

• Date: Mar 29
• Account title: Cash (A+)
• Dr: $12,000$
• Cr: Accounts receivable—Smith (A–) $8,000$
• Cr: Accounts receivable—Brown (A–) $4,000$
• Collected cash on account.

Recording Credit Card and Debit Card Sales

• Businesses that accept credit cards and debit cards can attract more customers.
  • Credit cards allow the customer to buy now and pay later.
  • Debit cards reduce the customer’s bank account immediately but allow electronic payment rather than cash or a cheque.
• The business benefits because it does not have to check credit ratings or collect from the customer, but there is almost always a fee to be paid to the card issuer to cover the processing costs.

Net Method

• Net—total sale less the processing fee equals the net amount of cash deposited by the processor, usually within a few days of the sale date

  Example:

  • Date: Aug 15
  • Account title: Cash (A+)
  • Dr: $2,940$
  • Account title: Card fee expense ($3,000 mes 0.02$) (E+)
  • Dr: $60$
  • Cr: Sales revenue (R+) $3,000$
  • Recorded credit card sales, net of fee (2%).

Gross Method

• Gross—total sale deposited, with processing fees deducted later, usually at the end of each month

  Example:

  • Date: Aug 15

  • Account title: Cash (A+)

  • Dr: $3,000$

  • Cr: Sales revenue (R+) $3,000$

  • Recorded credit card sales.

  • Date: Aug 31

  • Account title: Card fee expense ($3,000 mes 0.02$) (E+)

  • Dr: $60$

  • Cr: Cash/Bank (A–) $60$

  • Recorded fees charged by card processor (2%).

Accounting for Bad Debts (Uncollectable Accounts)

• Some customers do not pay, and that creates an expense called a bad debt expense, doubtful debt expense, or uncollectable account expense.
• These expenses must be written off from the books because the business does not expect to receive the cash in the future.
• There are two methods of accounting for uncollectable receivables:
  • Allowance method
  • Direct write-off method

The Allowance Method

• The allowance method allows companies to recognise impairment of receivables after initial recognition.
• The offset to the expense is a contra account called Allowance for doubtful debts (or Allowance for bad debts).
• The Allowance account shows the amount of the receivables that the business expects not to collect and reduces Accounts receivable to its net realisable value.
• Allowance for doubtful debts decreases Accounts receivable on the balance sheet; bad debts expense is included in operating expenses on the income statement.
• The more accurate the estimate of bad debts, the more reliable the information in the financial statements.
• Businesses use their past experience regarding bad debts as well as considering observable data about economic conditions and other indicators that defaults are probable.
• There are two basic ways to estimate bad debts:
  • Percentage of sales method
  • Ageing of accounts receivable method

Percentage of Sales Method

• The percentage of sales method calculates bad debts expense as a percentage of net credit sales.
• This is also called the income statement approach because it focuses on the amount of expense to be reported on the income statement.
• Bad debts expense is recorded as an adjusting entry at the end of the period (GST is shown here as an example). Example:
  • Date: Mar 31
  • Account title: Bad debts expense (E+)
  • Dr: $300$
  • Account title: GST clearing (10%) (A+/L–)
  • Dr: $30$
  • Cr: Allowance for doubtful debts (CA+) $330$
  • Allowing 2% doubtful debts expense for the period.

Ageing of Accounts Receivable Method

• The ageing of accounts receivable method is also called the balance sheet approach, as it focuses on the actual age of the accounts receivable and determines a target allowance balance from that age.

Comparing the Percentage of Sales and Ageing Methods

• In practice, businesses could use the two methods together: percentage of sales in the interim as indications of impairment appear, and the ageing method at the end of the accounting period.

Writing off a Bad Debt—Allowance Method

• Under the allowance method, when a specific customer account is identified as uncollectible, it is written off to the Allowance account.

• The write-off has no effect on total assets, liabilities, or equity as it affects no expense account.

  Example:

  • Date: Jul 15
  • Account title: Allowance for doubtful debts (CA–)
  • Dr: $200$
  • Cr: Accounts receivable—Andrews (A–) $80$
  • Cr: Accounts receivable—Jones (A–) $120$
  • Wrote off doubtful debts.

A Bad Debtor Pays Their Account—Allowance Method

• Sometimes, a customer will pay the amount owed after their account is written off.

• To account for this recovery, the business must reverse the effect of the earlier write-off to the Allowance account and record the cash collection.

  Example:

  • Date: Sep 4
  • Account title: Accounts receivable—Andrews (A+)
  • Dr: $80$
  • Cr: Allowance for doubtful debts (CA+) $80$
  • Account title: Cash (A+)
  • Dr: $80$
  • Cr: Accounts receivable—Andrews (A–) $80$

The Direct Write-Off Method

• Under the direct write-off method of accounting for bad debts, the business waits until it decides that a customer’s account receivable is uncollectable.

• The accountant then debits Bad debts expense and credits the customer’s Account receivable to write off the account.

  Example:

  • Date: Jul 15
  • Account title: Bad debts expense (E+)
  • Dr: $200$
  • Cr: Accounts receivable—Andrews (A–) $80$
  • Cr: Accounts receivable—Jones (A–) $120$
  • Wrote off bad debts.

• The method is deficient for two reasons:

  • It doesn’t set up an allowance for bad debts, so always reports the receivables at their full amount; assets are therefore overstated on the balance sheet.
  • It doesn’t recognise the bad debts expense in the same period in which the sale was made, and therefore overstates net profit in the current accounting period and overstates net profit in the following accounting period.

• In accrual accounting, expenses incurred must be identified with revenue earned during the period; thus, the direct write-off method is only acceptable when bad debts is so low that the difference between the methods is immaterial.

A Bad Debtor Pays Their Account—Direct Write-Off Method

• To account for this recovery, the business must reverse the effect of the earlier write-off to the Bad debts expense account and record the cash collection.

  Example:

  • Date: Sep 4
  • Account title: Accounts receivable—Andrews (A+)
  • Dr: $80$
  • Cr: Bad debts expense (E–) $80$
  • Account title: Cash (A+)
  • Dr: $80$
  • Cr: Accounts receivable—Andrews (A–) $80$

Summary: Chapter 9

• A receivable arises when a business sells goods or services to a second business on credit.
• The two main types of receivables are accounts receivable and bills receivable.
• There are two methods of accounting for uncollectable receivables—the allowance method and the direct write-off method.
• The allowance method records a bad debt expense based on observable data indicating impairment and uses the Allowance for doubtful debts to house the pool of ‘unknown’ bad debtors.
• Under the direct write-off method, the business waits until it decides that a customer’s account receivable is uncollectable and then debits Bad debts expense.

Learning Objectives: Chapter 11

• Account for current liabilities of known amount.
• Account for current liabilities that must be estimated.

Current Liabilities of Known Amount

• The amounts of most liabilities are known, while a few must be estimated.
• Current liabilities of known amount include:
  • Accounts payable
  • Short-term bills payable
  • Good and services tax payable
  • Current portion of non-current (long-term) debt
  • Accrued expenses (accrued liabilities)
  • Unearned revenues

Accounts Payable

• Amounts owed for products or services purchased on account are accounts payable.

• Since these are due on average in 30 days, they are current liabilities.

  Example:

  • To record $700$ of inventory purchased on credit (including GST at 10%):
    • Date: Jul 3
    • Account title: Inventory ($770/1.1$) (A+)
    • Dr: $700$
    • Account title: GST clearing ($770/11$) (A+)
    • Dr: $70$
    • Cr: Accounts payable (L+) $770$
    • Purchased inventory on credit.

• Example:*

• To record payment of the liability, including taking advantage of the purchase discount of 3%:

  • Date: Jul 15
  • Account title: Accounts payable (L–)
  • Dr: $770.00$
  • Account title: Cash ($770 mes 0.97$) (A–)
  • Cr: $746.90$
  • Account title: Inventory ($770 mes 0.03 mes 1/11$) (A–)
  • Cr: $21.00$
  • Account title: GST clearing ($770 mes 0.03 mes 1/11$) (A–/L+)
  • Cr: $2.10$
  • Paid within discount period.

Accrued Expenses (Accrued Liabilities)

• An accrued expense is an expense that has not yet been paid.
• When an expense is accrued (debited), it always has a related unpaid bill, or an accrued liability (credited).
  Example: interest expense accrued over 6 months on a $20,000$ loan:
• Payroll (covered later) creates accrued expenses and is the major expense for a service organisation.
  Date: Dec 31
  *Account title: Interest expense ($20,000 mes 6\% mes 6/12$) (E+)
  *Dr: $600$
  *Account title: Interest payable (L+)
  *Cr: $600$

Unearned Revenues

• Unearned revenue arises when a business receives cash in advance and therefore has an obligation to provide goods or services to the customer in the future; it is a current liability until the revenue is earned.

  Example: $600 cash received in advance for a month’s work, with one-third of the work done during June:
  Date: Jun 20
  *Account title: Cash (A+)
  *Dr: $600$
  *Account title: Unearned service revenue (L+)
  *Cr: $600$
  Date: Jun 30
  *Account title: Unearned service revenue (L–)
  *Dr: $200$
  *Account title: Service revenue (R+)
  *Cr: $200$

Current Liabilities That Must Be Estimated

• A business may know that a liability exists but may not know the exact amount.
• This liability must be estimated and reported on the balance sheet.
• Warranties are a prime example of this type of liability.
• Contingent liabilities where the loss can be reasonably estimated must also be estimated.

Contingent Liabilities

• A contingent liability is not an actual liability—it is a potential liability that depends on a future event happening.
• How to disclose this liability depends on the likelihood of an actual loss.

Summary: Chapter 11

• A current liability must be paid in a year or less.
• For some current liabilities, the exact amount is known or can easily be calculated.
• For some, the current liability is known based on a contract, such as with the current portion of long-term loans payable.
• Others must be accrued and are known based on a bill received or hours worked.
• An estimated expense (e.g., a warranty) and liability are journalised at the time of sale to recognise the expense when the revenue is earned.