Chapter 7: Accounting for Receivables
Accounting for Receivables
Chapter 7 Learning Objectives
Conceptual Learning Objectives
C1: Describe accounts receivable and how they occur and are recorded.
C2: Describe a note receivable, the computation of its maturity date, and the recording of its existence.
C3: Explain how receivables can be converted to cash before maturity.
Analytical Learning Objective
A1: Compute accounts receivable turnover and use it to help assess financial condition.
Procedural Learning Objectives
P1: Apply the direct write-off method to accounts receivable.
P2: Apply the allowance method to accounts receivable.
P3: Estimate uncollectibles based on sales and accounts receivable.
P4: Record the honoring and dishonoring of a note and adjustments for interest.
Learning Objective C1: Accounts Receivable
Description of Accounts Receivable
A receivable is defined as an amount due from another party.
Companies must maintain a separate account for each customer to track:
Purchases made by the customer.
Payments already made.
Outstanding balances owed by the customer.
Valuation of Accounts Receivable
A company must keep accurate records of the dollar amounts of receivables.
These amounts are often expressed as percentages of total assets for comparative analysis.
Sales on Credit: Journal Entries
Example from TechCom:
On July 1, there was a credit sale of $950 to CompStore.
A collection of $720 was received from RDA Electronics for a previous sale.
Sales on Bank Credit Cards
On July 15, TechCom recorded $100 of credit card sales with a 4% fee, resulting in a cash collection of $96 immediately deposited.
Learning Objective P1: Direct Write-Off Method
Bad Debts and Accounting Methods
There are two primary methods for accounting for bad debts:
Direct Write-Off Method
Allowance Method
Uncollectible amounts that may not be paid are referred to as bad debts.
Recording the Direct Write-Off Method
Example:
On January 23, TechCom determined it cannot collect $520 from customer J. Kent, hence necessitating a write-off registered in the customer's Accounts Receivable ledger.
Recovering a Bad Debt
On March 11, J. Kent made a full payment of $520 for the previously written-off amount.
Implications of the Direct Write-Off Method
The direct write-off method generally does not match sales with expenses well.
The Expense recognition principle states that expenses must be reported during the same period as the sales they help generate.
Under the materiality constraint, using the direct write-off method is permissible if the financial results closely approximate those produced by the allowance method.
Learning Objective P2: Allowance Method
Overview of the Allowance Method
Advantages:
Records estimated bad debts expense in the same period as the associated sales.
Reports accounts receivable on the balance sheet at estimated collectible cash amounts.
At the end of each period, total expected bad debts are estimated based on current period sales.
Recording Bad Debts Expense
Case Scenario:
TechCom had credit sales of $300,000 in its first year. By year-end, $20,000 remained uncollected. Based on experience from similar businesses, $1,500 was estimated to be uncollectible.
Balance Sheet Presentation
The balance sheet will reflect the estimated collectible amount, maintaining a clear portrayal of TechCom’s financial position.
Writing Off a Bad Debt
TechCom identified J. Kent's $520 account as uncollectible, requiring proper accounting action.
Recovering a Bad Debt
On March 11, payment was received on the previously uncollectible write-off, restoring the account.
Learning Objective P3: Estimating Uncollectibles
Methods for Estimating Bad Debts Expense
Percent of Sales Method
Balance Sheet Methods
Percent of Accounts Receivable
Aging of Accounts Receivable
Percent of Sales Method
The calculation is given by: ( ext{Current Period Sales}) imes ( ext{Bad Debt ext{%}}) = ext{Estimated Bad Debts Expense}
For example, if Musicland had credit sales of $400,000:
(400,000 imes 0.6 ext{ ext{%}}) = 2,400 (Estimated Bad Debts Expense).
Percent of Receivables Method
Estimation formula for Allowance for Doubtful Accounts:
Calculation: ( ext{Year-end Accounts Receivable}) imes ( ext{Bad Debt ext{%}})
Continuing example:
If Musicland has $50,000 in accounts receivable and $200 credit balance in Allowance, then calculation would be:
(50,000 imes 5 ext{ ext{%}} = 2,500) (allowance balance).
Aging of Accounts Receivable
Method involves classifying receivables based on how overdue they are, calculating estimated bad debts percentage for each classification.
Aging of Receivables is typically presented in a summary table.
Learning Objective C2: Notes Receivable
Definition of Notes Receivable
A promissory note is a formal written vow to pay a designated amount either on demand or on a specific future date, generally inclusive of an interest rate.
Computing Maturity Date
Upon receiving a $1,000, 90-day, 12% note, the maturity date is calculated as due and repayable.
According to the 'banker's rule', a year is computed based on 360 days regardless of the actual number of days in a year.
Recording Notes Receivable
Notes are logged under a singular Notes Receivable account to maintain straightforward recordkeeping.
Acceptance of Past-Due Accounts Receivable
A note may also substitute for an outstanding account receivable.
Example: Accepting a $232 cash component plus a $600, 60-day, 15% note to cover a $832 overdue account from a customer is prevalent practice.
Learning Objective P4: Recording Notes
Recording an Honored Note
Obligations related to the principal and interest of a note must be fulfilled by the maturity date.
Recording a Dishonored Note
Even if the note becomes dishonored, the maker remains liable for repaying the principal and accrued interest.
End-of-Period Interest Adjustments
When recording accrued interest adjustments, interest is calculated based on the number of days until the accounting period's end from the note's date.
Calculation example: For a $3,000, 12% note, with 15 days accrued, interest will equal:
3,000 imes 0.12 imes rac{15}{360} = 15.
Learning Objective C3: Converting Receivables to Cash
Disposal of Receivables
Companies have the option to convert receivables into cash before their maturity.
This can involve selling or pledging receivables.
Learning Objective A1: Accounts Receivable Turnover
Accounts Receivable Turnover Ratio
This ratio is pivotal for evaluating managerial efficiency in extending credit to generate revenue.