Chapter 7 Cash and Receivables
Receivable = a right to receive cash in the future from a current transaction. It's the money that customers owe to the company for products/services they have received but have not yet paid for.
Accounts receivable = usually recorded as a current asset on the balance sheet, this is because the collection period is rather short. It's an oral promise.
Notes receivable = written promises that a customer will pay the principle + additional interest payments. The collection period is relatively longer compared to accounts receivable.
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.
A revenue should be recognizeed as soon as a change in control occurs, and so an accounts receivable arises
Key indicators of change in control:
Right to payment from the customer
Passing of legal title to the customer
Transfer of physical possession of the goods
The seller no longer has significant risk and rewards of the ownership
There is an acceptance of the assets by the customer
Two methods to account for uncollectible accounts
Direct write-off method:
Remove the unpaid amount from the company's accounts receivable balance and recognizing it as a loss. By writing off the account, the company reduces its amounts receivable and recognizes the loss as an expense on the income statement. The bad debt expense is recorded as soon as the accounts receivable is deemed uncollectible.
“Bad debt expense" as a debit and “Accounts receivable” as a credit
Theoreticaaly dificient:
Fails to record expenses as incurred
Receivable not stated at cash realizable value
Not appropriate when amount uncollectible is material
Allowance method:
As soon as a feeling arises that a company is not going to pay or is going to default, you estimate the future collectible money as a percentage and create an allowance for bad debt account.
Rule of thumb: the older the account, the less likely it will be collected.
Make two bookings:
“Bad debt expense" as debit and “Allowance for bad debt" as a credit
“Allowance for bad debt" as debit and “Account receivable” as credit
Losses are estimated:
Percentage-of-sales
Percentage-of-receivables
IFRS requires when bad debts are material in amount
Three methods for the allowance method
Percentage-of-sales
Bad debt expense = net credit sales x bad debt percentage
Percentage-of-receivables
Determine the target balance for allowance: Target balance = Ending accounts receivables x Bad debt percentage
Determine the bad debt expense by evaluating the allowance account: Bad debt expense = Target balance - Existing credit balance
Aging of receivables method
Determine the target balance for allowance of bad debt based on the account age: Target = sigma (Each group x Bad debt percentage)
Account for the existing credit/debit balance: Bad debt expense = Target balance - Existing balance of allowance for bad debt expenses
What if customers pay after is has been written off?
Reverse the journey entry
Direct write-off method (two bookings):
“Account receivable” as debit and “Bad debt expense" as credit
“Cash” as debit and “Accounts receivable" as credit
Allowance method (two bookings):
“Allowance receivable" as debit and “Allowance for bad debt" as credit
“Cash” as debit and “Accounts receivable” as credit
Recognition of notes receivables
Short-term notes (< 1 year) → on the balance at face value
Allowance for potential losses is deducted from the face value to reflect the estimated amount that may not be collected
Long-term notes (> 1 year) → recorded at the present value of cash flows expected to be collected over the life of the note
This present value calcuation takes into account the stated interest rate of the note and the prevailing market interest rate
Stated rate = market rate → Note issued at face value
Stated rate > market rate → Note issued at premium
Stated rate < market rate → Note issued at discount
Definitive periods: Interest payment (PV) = (CF)/(1+r)^t
Indefinite periods: Interest payment (PV) = (CF)/r)
Journal entries for notes receivable
Initial recognition: The note receivable is recognized as present value → the amount of cash expected to be received in the future discounted at the precailing market interest rate
Subsequent measurement: Interest revenue is recognized over the life of note using the effective interest → the rate that exactly discounts the estimated future cash payments/receipts through the expected life of the financial instrument to the net carrying amount of the rate at the time
Amortization: When a cond or note is issued at a discount (below its face value), the difference between the face value and the cash receivable represents the discount. This discount is considered additional interest expense for the borrower/additional interest revenue for the lender → the discount is amortized over the life of the bond or note. Each period, a portion of the discount is added to the carrying value of the bord or note, which is used to calculate the interest expense/revenue for that period.
Effective-interest method = a mechanism used to account for and allocate the discount on a bond/note receivable over its life → Interest expense (or income) = Effective interest rate x Carrying amount at beginning of period
Accounts receivable turnover ratio = measure the number of times, on average, a company collects its accounts receivable during a specific period. It helps assess the liquidity of the receivables, which means how quickly the company can convert its receivables into cashh.
Also measures the number of times, on average, a company collects its accounts receivable during a specific period
= Net credit sales/Average accounts receivable