Financial Accounting - Receivables and Sales Study Guide
Financial Accounting - Receivables and Sales
Learning Objectives
LO5–1: Recognize accounts receivable.
LO5–2: Calculate net revenues using discounts, returns, and allowances.
LO5–3: Record an allowance for future uncollectible accounts.
LO5–4: Use the aging method to estimate future uncollectible accounts.
LO5–5: Apply the procedure to write off accounts receivable as uncollectible.
LO5–6: Contrast the allowance method and direct write-off method when accounting for uncollectible accounts.
LO5–7: Account for notes receivable and interest revenue.
LO5–8: Calculate key ratios investors use to monitor a company’s effectiveness in managing receivables.
LO5–9: Estimate uncollectible accounts using the percentage-of-credit-sales method.
Recognizing Accounts Receivable (LO5–1)
Credit Sales:
Definition: Transfer of products and services to a customer today, expecting cash collection in the future.
Also known as sales on account or services on account; common in business transactions.
Accounts Receivable:
Definition: Cash owed to the company by customers from sales or services on account.
Recorded at the time of the sale or service.
Also referred to as trade receivables.
Example: Recording of Credit Sales:
Scenario: Link’s Dental charges $500 for teeth whitening. Dee Kay promises to pay $500 by March 31 after receiving the service.
Journal Entry on March 1:
Debit Accounts Receivable: $500
Credit Service Revenue: $500 (Provide services on account)
Key Point: Companies recognize both an asset (accounts receivable) and revenue upon credit sales, expecting future payment.
Other Types of Receivables:
Nontrade Receivables: Originating from sources other than customers (e.g., tax refund claims, interest receivable, loans to employees).
Notes Receivable: Formal credit arrangements documented by written debt instruments.
Concept Check 5–1: Accounts receivable are sometimes termed trade receivables, while nontrade receivables include various claims and loans.
Calculating Net Revenues (LO5–2)
Trade Discounts:
Definition: Reduction in list price of a product/service to incentivize certain customers.
Accounting Treatment: Revenue recorded for the lower amount after discount.
Example: Link’s Dental typically charges $500 for teeth whitening; a 20% discount makes it $400.
Journal Entry on March 1:
Debit Accounts Receivable: $400
Credit Service Revenue: $400 (Credit sale with 20% trade discount)
Sales Returns and Allowances:
Customer returns a product; seller may issue cash refunds or reduce account balances based on sale terms.
Sales Returns: Customer returns products.
Treatment includes cash refunds or reductions in accounts receivable.
Sales Allowances: Price reductions for customer dissatisfaction.
Example: Dee informs Dr. Link about a competing offer; her account balance is reduced by $50:
Journal Entry on March 5:
Debit Sales Allowances: $50
Credit Accounts Receivable: $50 (Provide allowance for previous credit sale)
Common Mistake: Contra-revenue accounts (Sales Returns and Allowances) misclassified as expenses. They reduce revenues and decrease net income, but they are not expenses themselves.
Sales Discounts:
Definition: Reduction in price for prompt payment.
Example: Link’s Dental offers Dee a 2% discount for early payment. Dee pays on March 10:
Calculate discount: $7 on $350.
Journal Entry on March 10:
Debit Cash: $343
Debit Sales Discounts: $7
Credit Accounts Receivable: $350
Income Statement Reporting Revenues:
Examples of reporting service revenue net of allowances and discounts:
Service Revenue: $400
Less: Sales Allowances: $50
Less: Sales Discounts: $7
Net Service Revenue: $343
Concept Check 5–2: A sales allowance decreases net income and sales revenue.
Concept Check 5–3: Net Revenue = Total Revenue - Sales Discounts - Sales Allowances.
Valuing Accounts Receivable (LO5–3)
Key Point: Accounts receivable are recognized as assets and reported at their net realizable value, i.e., cash expected to be collected.
Allowance Method:
Definition: Accounting approach where companies estimate future uncollectible accounts and record these estimates in the current year, affecting both assets and expenses.
Estimated uncollectibles reduce assets and increase bad debt expense.
Key Point: Estimates of future uncollectible accounts are recorded in the current period, reflecting expected losses.
Estimating Uncollectible Accounts:
Percentage-of-Receivables Method:
Base estimate on the total accounts receivable.
Example: Kimzey estimates $6 million uncollectible from $20 million receivable ($20 million * 30%).
Journal Entry:
Debit Bad Debt Expense: $6 million
Credit Allowance for Uncollectible Accounts: $6 million
Bad Debt vs. Allowance for Uncollectible Accounts:
Bad Debt Expense is reported in the income statement while Allowance for Uncollectible Accounts is a contra-asset reducing total assets in the balance sheet.
Common Mistake: Students may misclassify Allowance for Uncollectible Accounts as a liability due to its credit balance. It indicates a reduction in an asset, not a liability.
Concept Check 5–4: Allowance for Uncollectible Accounts is subtracted from Accounts Receivable on the balance sheet.
Estimating Uncollectible Accounts Using Aging Method (LO5–4)
Aging Method: Considers the age of receivables; older accounts are more likely uncollectible, providing a more accurate estimate than a single percentage.
Example of Aging Schedule:
Kimzey’s accounts receivable aging schedule results in an estimated uncollectible amount of $5 million.
Journal Entry:
Debit Bad Debt Expense: $5 million
Credit Allowance for Uncollectible Accounts: $5 million
Concept Check 5–5: The aging method recognizes that as accounts age, they are less likely to be collected.
Excerpt from Tenet Healthcare Corporation's Annual Report:
They establish allowances for potentially uncollectible accounts based on their aging, historical collection experience, and external factors like economic changes.
Writing Off Accounts Receivable as Uncollectible (LO5–5)
Definition: When a customer is determined unlikely to pay, the company writes off the account balance.
Results in a decrease to both Accounts Receivable and Allowance for Uncollectible Accounts but has no immediate impact on total assets or expenses since the bad debt was previously estimated.
Example: Kimzey writes off the account of a bankrupt customer for $4,000:
Journal Entry on February 23, 2019:
Debit Allowance for Uncollectible Accounts: $4,000
Credit Accounts Receivable: $4,000
Common Mistake: Recording bad debt expense at the time of writing off an account instead of in the prior period during estimation.
Collections on Written-Off Accounts:
If Bruce later pays $1,000 (25% of the amount owed), the reestablishment and collection entries are as follows:
Reestablishing the Account:
Debit Accounts Receivable: $1,000
Credit Allowance for Uncollectible Accounts: $1,000
Collecting Cash:
Debit Cash: $1,000
Credit Accounts Receivable: $1,000
Concept Check 5–6: Writing off does not decrease total amounts on the balance sheet or income statement; it does not affect net income or total assets.
Allowance Method & Direct Write-Off Method (LO5–6)
Direct Write-Off Method: Bad debts written off only when determined to be uncollectible, mainly used when accounts are immaterial or for tax reporting.
Comparison with Allowance Method:
The key difference lies in the timing of expense recognition and the adjustments made to the allowance account.
Example Comparison (2018 vs. 2019): If the estimated bad debts were adjusted in the prior year and actual write-offs matched this estimation.
Concept Check 5–8: A credit balance indicates that the prior estimate of bad debts was too low.
Notes Receivable and Interest Revenue (LO5–7)
Definition: Notes receivable represent formal credit arrangements backed by written agreements; classified as current or noncurrent based on maturity.
Recording Notes Receivable:
Example: Kimzey provided $10,000 of services to Justin Payne, who signs a promissory note for payment plus interest:
Journal Entry:
Debit Notes Receivable: $10,000
Credit Service Revenue: $10,000
Interest Revenue Calculation:
Interest on Note:=
Formula: $10,000 × 12% × 6/12 = $600
Entry When Collecting Note::
Debit Cash: $10,600
Credit Notes Receivable: $10,000
Credit Interest Revenue: $600
Accrual of Interest:
Entry on December 31, 2018:
Debit Interest Receivable: $200
Credit Interest Revenue: $200
Key Ratios for Monitoring Receivables (LO5–8)
Receivables Turnover Ratio: Measures how many times average accounts receivable balance is collected during a period.
Average Collection Period: Indicates the average number of days accounts receivable remain outstanding.
Example Analysis: Comparison between Tenet Healthcare and LifePoint Hospitals based on receivables ratios.
Tenet Receivables Turnover Ratio: 6.2 times, Avg. Collection Period: 58.9 days.
LifePoint Hospitals: 3.8 times, Avg. Collection Period: 96.1 days.
Key Point: High turnover indicates efficient collection of cash from customers.
Estimating Uncollectible Accounts: Percentage-of-Credit-Sales Method (LO5–9)
Definition: Estimates bad debts based directly on the percentage of credit sales.
Adjusts the allowance account based on current year's credit sales not expected to be collected.
Example for Kimzey:
Credit sales of $80 million and an estimate of 12.5% bad debts results in:
Journal Entry:
Debit Bad Debt Expense: $10 million
Credit Allowance for Uncollectible Accounts: $10 million
Financial Statement Effects: Comparison on net income and accounts receivable balance across both percentage methodologies.
Concept Check 5–12: An adjustment reflects the total estimated bad debts based on credit sales percentage.