Chapter 7 Overview: Accounting for Receivables

ACCOUNTING FOR RECEIVABLES

Overview

  • Definition of Receivables

    • Amount due from another party.

  • Types of Receivables

    • Accounts Receivable: Amounts due from customers for credit sales.

    • Notes Receivable: Written promises to pay a certain amount, usually including interest.

Valuing Accounts Receivable

  • Credit Sales

    • Sales on credit result from extending credit directly to customers.

    • Each customer has a separate account in a subsidiary ledger;

    • Accounts Receivable account serves as a control account matching total from subsidiary ledger.

  • Types of Credit Sales

    • Store Credit: Credit extended through store credit systems.

    • Store Credit Cards: Used by major retailers; earn interest on past due balances.

    • Bank Credit Cards: Third-party cards for credit and debit transactions.

    • Installment Sales: Customers make periodic payments over time, including interest.

Cash Received Immediately on Deposit

  • Accounting Guidelines

    • Cash is received immediately on debit and some credit card transactions.

    • Treated as cash sales after deducting card fees.

  • Sample Entry Example:

    • Cash: xx,xxx

    • Credit Card Expense: xxx

    • Sales: xx,xxx

    • Cost of Goods Sold: x,xxx

    • Inventory: x,xxx

Installment Sales and Receivables

  • Amounts owed by customers who pay in installments.

  • Customers may incur interest charges.

  • Classified as current assets.

Accounting for Uncollectible Accounts

  • Companies anticipate some credit sales to be uncollectible, considered as an expense called Bad Debts.

  • Methods to Account for Uncollectible Accounts:

    • Direct Write-Off Method

    • Allowance Method

Direct Write-Off Method

  • Loss from an uncollectible account is recorded when identified.

  • Matching Principle: Direct write-off may not match sales and expenses accurately.

  • Materiality Constraint: Allowed if bad debts expense is negligible.

  • Entry Example:

    • Bad Debt Expense: xxx

    • Accounts Receivable: xxx

  • Recovering a Bad Debt:

    1. Reversal of Write-Off:

    • Accounts Receivable: xxx

    • Bad Debt Expense: xxx

    1. Normal Collection Entry:

    • Cash: xxx

    • Accounts Receivable: xxx

Allowance Method

  • Matches estimated losses from uncollectibles with associated sales.

  • Adjusting Entry: Recorded at period end estimating bad debts expense.

  • Advantages:

    • Records bad debts when related sales are recorded.

    • Balance sheet accurately reflects expected cash collection from receivables.

  • Adjusting Entry Example:

    • Bad Debts Expense: xxx

    • Allowance for Doubtful Accounts: xxx

    • Contra-asset account used for estimating uncollectibles.

    • Realizable Value: Expected cash from asset minus allowance for doubtful accounts.

  • Entry for Specific Write-Off:

    • Allowance for Doubtful Accounts: xxx

    • Accounts Receivable: xxx

    • Write-off does not change realizable value of accounts receivable.

  • Recovering a Bad Debt (Once Written-off):

    1. Reversal of Write-Off:

    • Accounts Receivable: xxx

    • Allowance for Doubtful Accounts: xxx

    1. Normal Collection Entry:

    • Cash: xxx

    • Accounts Receivable: xxx

Methods for Estimating Bad Debts

  • An estimate for bad debts expense is necessary for adjusting entries at period-end.

  • Three Estimation Methods:

    • Percent of Sales Method

    • Percent of Receivables Method

    • Aging of Receivables Method

Percent of Sales Method

  • Based on estimating a percentage of credit sales as uncollectible.

  • Often referred to as the income statement method.

  • Calculation: Multiply credit sales for the period by the estimated uncollectible percentage.

Percent of Receivables Method

  • Based on estimating a percentage of total receivables as uncollectible.

  • Also known as the balance sheet method.

  • Estimated uncollectible calculation: Dollar amount of accounts receivable times the uncollectible percentage.

  • Adjustments needed to balance allowance for doubtful accounts to estimated uncollectibles.

Aging of Accounts Receivable Method

  • Combines past and current receivable information for estimating allowance.

  • Receivables classified by age; respective percentages applied to each category.

Notes Receivable

  • Definition: Written promise to pay a fixed principal with interest at a future date.

  • May replace accounts receivable when customers require payment extensions.

  • Entry Example:

    • Notes Receivable: xx,xxx

    • Sales: xx,xxx

Maturity and Interest of Notes Receivable

  • Maturity Date: Due date for payment.

  • Interest Computation: Principal amounts multiplied by interest rate times time in years.

    • Banker’s rule for interest uses a 360-day year.

Recognizing Notes Receivable

  • Usually recorded in a singular Notes Receivable account for simplicity.

  • Common reasons for notes receivable:

    • Payment for products/services.

    • Lending money.

Valuing and Settling Notes

Recording Honored Notes

  • If the note is honored, record as:

    • Cash: xx,xxx

    • Interest Revenue: xxx

    • Notes Receivable: xx,xxx

Recording Dishonored Notes

  • If the note is not honored, transferred to an accounts receivable:

    • Accounts Receivable – Maker: xx,xxx

    • Interest Revenue: xxx

    • Notes Receivable: xx,xxx

End-of-Period Interest Adjustment

  • Compute any accrued interest at period-end for outstanding notes:

    • Interest Receivable: xx,xxx

    • Interest Revenue: xx,xxx

  • Entry for honoring a note with accrued interest:

    • Cash: xx,xxx

    • Interest Receivable: xx,xxx

    • Interest Revenue: xx,xxx

Disposal of Receivables

  • Companies may convert receivables into cash before due date for several reasons:

    • Cash need.

    • Desire to avoid collection efforts.

  • Methods for Conversion:

    • Selling Receivables: All or part of receivables sold to a bank or finance company.

    • Pledging Receivables: Receivables used as loan collateral, retaining ownership but requiring disclosure in financial statements.

Accounts Receivable Turnover Ratio

  • Definition: Measures quality and liquidity of receivables.

  • Indicates frequency of converting average receivables to cash annually.

  • Calculation:

    • Divide net sales by average accounts receivable:
      extAverageAccountsReceivable=racextBeginningAccountsReceivable+extEndingAccountsReceivable2ext{Average Accounts Receivable} = rac{ ext{Beginning Accounts Receivable} + ext{Ending Accounts Receivable}}{2}

  • Insights:

    • High turnover indicates liberal credit terms might improve sales.

    • Low turnover suggests stricter credit terms and aggressive collection may be necessary.