The Most Common Ttransaction for Creating Receivables is

Learning Objectives        Obj.1Describe the common classes of receivables. Obj.2Describe the accounting for uncollectible receivables. Obj.3Describe the direct write-off method of accounting for uncollectible receivables. Obj.4Describe the allowance method of accounting for uncollectible receivables. Obj.5Compare the direct write-off and allowance methods of accounting for uncollectible accounts. Obj.6Describe the accounting for notes receivable. Obj.7Describe the reporting of receivables on the balance sheet. Analysis for Decision Making   Obj.8Describe and illustrate the use of the accounts receivable turnover and number of days’ sales in receivables to evaluate a company’s efficiency in collecting its receivables. 8-1Classification of Receivables The receivables that result from sales on account are normally accounts receivable or notes receivable o The term receivables includes all money claims against other entities, including people, companies, and other organizations. o Receivables are usually a significant portion of the total current assets. 8-1aAccounts Receivable The most common transaction creating a receivable is selling merchandise or services on account (on credit). o recorded as a debit to Accounts Receivable.  Such accounts receivable are normally collected within a short period, such as 30 or 60 days. o Classified on the balance sheet as a current asset.  8-1bNotes Receivable Notes receivable are amounts that customers owe for which a formal, written instrument of credit has been issued. o If notes receivable are expected to be collected within a year, they are classified on the balance sheet as a current asset.  Notes are often used for credit periods of more than 60 days. o For example, an automobile dealer may require a down payment at the time of sale and accept a note or a series of notes for the remainder.  usually provide for monthly payments.  Notes may also be used to settle a customer’s account receivable o Notes and accounts receivable that result from sales transactions are sometimes called trade receivables  In this chapter, all notes and accounts receivable are from sales transactions.  8-1cOther Receivables Other receivables include interest receivable, taxes receivable, and receivables from officers or employees. o normally reported separately on the balance sheet  If they are expected to be collected within one year, they are classified as current assets             If collection is expected beyond one year, they are classified as noncurrent assets and reported under the caption Investments. 8-2Uncollectible Receivables A major issue that has not yet been discussed is that some customers will not pay their accounts o That is, some accounts receivable will be uncollectible. Companies may shift the risk of uncollectible receivables to other companies o For example, some retailers do not accept sales on account but will only accept cash or credit cards.  Such policies shift the risk to the credit card companies. Companies may also sell their receivables. o This is often the case when a company issues its own credit card. Selling receivables is called factoring the receivables. o The buyer of the receivables is called a factor An advantage of factoring is that the company selling its receivables immediately receives cash for operating and other needs o depending on the factoring agreement, some of the risk of uncollectible accounts is shifted to the factor. Regardless of how careful a company is in granting credit, some credit sales will be uncollectible The operating expense recorded from uncollectible receivables is called bad debt expense, uncollectible accounts expense, or doubtful accounts expense. There is no general rule for when an account becomes uncollectible. o Some indications that an account may be uncollectible include the following:  The receivable is past due.  The customer does not respond to the company’s attempts to collect.  The customer files for bankruptcy.  The customer closes its business.  The company cannot locate the customer. If a customer doesn’t pay, a company may turn the account over to a collection agency. o After the collection agency attempts to collect payment, any remaining balance in the account is considered worthless The two methods of accounting for uncollectible receivables are as follows: o The direct write-off method records bad debt expense only when an account is determined to be worthless. o The allowance method records bad debt expense by estimating uncollectible accounts at the end of the accounting period. Warning Signs  A business must manage the risk of extending credit. o The following early warning signs can be used to signal the need to monitor future sales and accelerate collection efforts:  You’re only receiving partial payments.  The customer’s ordering pattern has declined dramatically, or the customer has stopped buying from you.  The customer requests frequent changes in the payment schedule.  You are repeatedly told that late payments are in the mail.  The customer refuses to make payment, claiming dissatisfaction with the product.  You can’t reach your customer, or the customer refuses to acknowledge you.  The direct write-off method is often used by small companies and companies with few receivables           Generally accepted accounting principles (GAAP), however, require companies with a large amount of receivables to use the allowance method o Most well-known companies such as General Electric (GE), PepsiCo (PEP), Intel (INTC), and FedEx (FDX) use the allowance method. 8-3Direct Write-Off Method for Uncollectible Account Bad Debt Expense is not recorded until the customer’s account is determined to be worthless o At that time, the customer’s account receivable is written off. To illustrate, assume that a $4,200 account receivable from D. L. Ross has been determined to be uncollectible. o The entry to write off the account is as follows: An account receivable that has been written off may be collected later. o In such cases, the account is reinstated by an entry that reverses the write-off entry. o The cash received in payment is then recorded as a receipt on account. To illustrate, assume that the D. L. Ross account of $4,200 written off on May 10 is later collected on November 21 o The reinstatement and receipt of cash is journalized as follows: The direct write-off method is used by businesses that sell most of their goods or services for cash or through the acceptance of MasterCard (MA) or VISA (V), which are recorded as cash sales o In such cases, receivables are a small part of the current assets and any bad debt expense is small.  Examples of such businesses are a restaurant, a convenience store, and a small retail store. 8-4Allowance Method for Uncollectible Accounts The allowance method estimates the uncollectible accounts receivable at the end of the accounting period. o Based on this estimate, Bad Debt Expense is recorded by an adjusting entry. To illustrate, assume that ExTone Company began operations August 1, 20Y1 o As of the end of its accounting period on December 31, ExTone has an accounts receivable balance of $200,000 o This balance includes some past due accounts  Based on industry averages, ExTone estimates that $30,000 of the December 31, 20Y1, accounts receivable will be uncollectible. o However, on December 31, 20Y1, ExTone doesn’t know which customer accounts will be uncollectible o Thus, specific customer accounts cannot be decreased or credited. a contra asset account, Allowance for Doubtful Accounts, is credited for the estimated bad debts. o Using the $30,000 estimate, the following adjusting entry is made on December 31, 20Y1: The preceding adjusting entry affects the income statement and balance sheet     On the income statement, the $30,000 of Bad Debt Expense will be matched against the related revenues of the period. On the balance sheet, the value of the receivables is reduced to the amount that is expected to be collected or realized. o This amount, $170,000 ($200,000 – $30,000), is called the net realizable value of the receivables. After the preceding adjusting entry is recorded, Accounts Receivable still has a debit balance of $200,000. o This balance is the total amount owed by customers on account on December 31, 20Y1, as supported by the accounts receivable subsidiary ledger. The accounts receivable contra account, Allowance for Doubtful Accounts, has a credit balance of $30,000. 8-4aWrite-Offs to the Allowance Account When a customer’s account is identified as uncollectible, it is written off against the allowance account. o This requires the company to remove the specific accounts receivable and an equal amount from the allowance account.  To illustrate, on January 21, 20Y2, John Parker’s account of $6,000 with ExTone Company is written off as follows: o At the end of a period, Allowance for Doubtful Accounts will normally have a balance.  This is because Allowance for Doubtful Accounts is based on an estimate.  As a result, the total write-offs to the allowance account during the period will rarely equal the balance of the account at the beginning of the period. o The allowance account will have a credit balance at the end of the period if the write-offs during the period are less than the beginning balance.  It will have a debit balance if the write-offs exceed the beginning balance.  Exhibit 1 illustrates the allowance method where the adjusting entry increases the Allowance for Doubtful Accounts (fills the bucket) while writing off accounts decreases the Allowance for Doubtful Accounts (empties the bucket).  To illustrate, assume that during 20Y2, ExTone Company writes off $26,750 of uncollectible accounts, including the $6,000 account of John Parker recorded on January 21, 20Y2. o Allowance for Doubtful Accounts will have a credit balance of $3,250 ($30,000 – $26,750), computed as follows:     o If ExTone had written off $32,100 in accounts receivable during the second year, Allowance for Doubtful Accounts would have a debit balance of $2,100, computed as follows: The allowance account balances (credit balance of $3,250 and debit balance of $2,100) in the preceding illustrations are before the end-of-period adjusting entry. o After the end-of-period adjusting entry is recorded, Allowance for Doubtful Accounts should always have a credit balance. An account receivable that has been written off against the allowance account may be collected later. o Like the direct write-off method, the account is reinstated by an entry that reverses the writeoff entry  The cash received in payment is then recorded as a receipt on account. To illustrate, assume that Nancy Smith’s account of $5,000, which was written off on April 2, 20Y2, is collected later on June 10. o ExTone Company journalizes the reinstatement and the collection as follows: 8-4bEstimating Uncollectibles The allowance method requires an estimate of uncollectible accounts at the end of the period o This estimate is normally based on past experience, industry averages, and forecasts of the future.  The two methods used to estimate uncollectible accounts are as follows: o Percent of sales method. o Analysis of receivables method.     Percent of Sales Method Since accounts receivable are created by credit sales, uncollectible accounts can be estimated as a percent of credit sales o If the portion of credit sales to sales is relatively constant, the percent may be applied to total sales. To illustrate, assume the following data for ExTone Company on December 31, 20Y2, before any adjustments: o Bad Debt Expense of $22,500 is estimated as follows: The adjusting entry for uncollectible accounts on December 31, 20Y2, is as follows:    o After the adjusting entry is posted to the ledger, Bad Debt Expense will have an adjusted balance of $22,500. o Allowance for Doubtful Accounts will have an adjusted balance of $25,750 ($3,250 + $22,500).  Both T accounts follow: Under the percent of sales method, the amount of the adjusting entry is the amount estimated for Bad Debt Expense o This estimate is credited to whatever the unadjusted balance is for Allowance for Doubtful Accounts. To illustrate, assume that in the preceding example the unadjusted balance of Allowance for Doubtful Accounts on December 31, 20Y2, had been a $2,100 debit balance instead of a $3,250 credit balance. o The adjustment would still have been $22,500. o However, the December 31, 20Y2, ending adjusted balance of Allowance for Doubtful Accounts would have been $20,400 ($22,500 – $2,100). Analysis of Receivables Method The analysis of receivables method is based on the assumption that the longer an account receivable is outstanding, the less likely that it will be collected. o The analysis of receivables method is applied as follows: 1. Step 1The due date of each account receivable is determined. 2. Step 2 The number of days each account is past due is determined. This is the number of days between the due date of the account and the date of the analysis. 3. Step Each account is placed in an aged class according to its days past due. Typical aged classes include the following: 4. Step 5The total for each aged class is multiplied by an estimated percentage of uncollectible accounts for that class. 5. Step 6The estimated total of uncollectible accounts is determined as the sum of the uncollectible accounts for each aged class.    The preceding steps are summarized in an aging schedule, and this overall process is called aging the receivables.5 To illustrate, assume that ExTone Company uses the analysis of receivables method instead of the percent of sales method o ExTone prepared an aging schedule for its accounts receivable of $240,000 as of December 31, 20Y2, as shown in Exhibit 2. Assume that ExTone sold merchandise to Saxon Woods Co. on August 29, 20Y2, with terms 2/10, n/30 Thus, the due date (Step 1) of Saxon Woods’ account is September 28, 20Y2, computed as follows: o As of December 31, 20Y2, Saxon Woods’ account is 94 days past due (Step 2), computed as follows:  Exhibit 2 shows that the $600 account receivable for Saxon Woods Co. was placed in the 91–180 days past due class (Step 3).  The total for each of the aged classes is determined (Step 4).  Exhibit 2 shows that $125,000 of the accounts receivable are not past due, while $64,000 are 1–30 days past due  ExTone applies a different estimated percentage of uncollectible accounts to the totals of each of the aged classes (Step 5).  As shown in Exhibit 2, the percent is 2% for accounts not past due, while the percent is 80% for accounts over 365 days past due.  The sum of the estimated uncollectible accounts for each aged class (Step 6) is the estimated uncollectible accounts on December 31, 20Y2.  This is the desired adjusted balance for Allowance for Doubtful Accounts.  . For ExTone, this amount is $26,490, as shown in Exhibit 2.  Comparing the estimate of $26,490 with the unadjusted balance of the allowance account determines the amount of the adjustment for Bad Debt Expense. o For ExTone, the unadjusted balance of the allowance account is a credit balance of $3,250. o The amount to be added to this balance is therefore $23,240 ($26,490 – $3,250).  The adjusting entry is as follows:  After the preceding adjusting entry is posted to the ledger, Bad Debt Expense will have an adjusted balance of $23,240  Allowance for Doubtful Accounts will have an adjusted balance of $26,490, and the net realizable value of the receivables is $213,510 ($240,000 – $26,490) o Both T accounts follow:  Under the analysis of receivables method, the amount of the adjusting entry is the amount that will yield an adjusted balance for Allowance for Doubtful Accounts equal to that estimated by the aging schedule. o To illustrate, if the unadjusted balance of the allowance account had been a debit balance of $2,100, the amount of the adjustment would have been $28,590 ($26,490 + $2,100). o In this case, Bad Debt Expense would have an adjusted balance of $28,590.  However, the adjusted balance of Allowance for Doubtful Accounts would still have been $26,490 After the adjusting entry is posted, both T accounts follow: Comparing Estimation Methods o       Both the percent of sales and analysis of receivables methods estimate uncollectible accounts. o each method has a slightly different focus and financial statement emphasis. Under the percent of sales method, Bad Debt Expense is the focus of the estimation process. o places more emphasis on matching revenues and expenses and, thus, emphasizes the income statement.  the amount of the adjusting entry is based on the estimate of Bad Debt Expense for the period  Allowance for Doubtful Accounts is then credited for this amount. Under the analysis of receivables method, Allowance for Doubtful Accounts is the focus of the estimation process o places more emphasis on the net realizable value of the receivables and, thus, emphasizes the balance sheet. o the amount of the adjusting entry is the amount that will yield an adjusted balance for Allowance for Doubtful Accounts equal to that estimated by the aging schedule.  . Bad Debt Expense is then debited for this amount. Exhibit 3 summarizes these differences between the percent of sales and the analysis of receivables methods o Exhibit 3 also shows the results of the ExTone Company illustration for the percent of sales and analysis of receivables methods o The amounts shown in Exhibit 3 assume an unadjusted credit balance of $3,250 for Allowance for Doubtful Accounts. o While the methods normally yield different amounts for any one period, over several periods the amounts should be similar. 8-5Comparing Direct Write-Off and Allowance Methods As a basis for illustration, the following transactions, taken from the records of Hobbs Company for the year ending December 31, 20Y6, are used: o Mar. 1. Wrote off account of C. York, $3,650. o Apr. 12. Received $2,250 as partial payment on the $5,500 account of Cary Bradshaw. Wrote off the remaining balance as uncollectible. o June 22. Received the $3,650 from C. York, which had been written off on March 1. Reinstated the account and recorded the cash receipt. o Sept. 7. Wrote off the following accounts as uncollectible (record as one journal entry): o Dec. 31. Hobbs Company uses the percent of credit sales method of estimating uncollectible expenses. Based on past history and industry averages, 1.25% of credit sales are expected to be uncollectible.   o Hobbs recorded $3,400,000 of credit sales during the year. Exhibit 4 illustrates the journal entries for Hobbs using the direct write-off and allowance methods o Using the direct write-off method, there is no adjusting entry on December 31 for uncollectible accounts o In contrast, the allowance method records an adjusting entry for estimated uncollectible accounts of $42,500. The primary differences between the direct write-off and allowance methods are summarized in Exhibit 5. Bad debt expense is recorded Direct Write-Off Method When the specific customer accounts are determined to be uncollectible. Allowance Method Using an estimate based on:  (1) a percent of sales or  (2) an analysis of receivables. Allowance account Primary users     1. 2. 3. 4. No allowance account is used. The allowance account is used. Small companies and companies with Large companies and those with a few receivables. large amount of receivables. 8-6Notes Receivable A note has some advantages over an account receivable o By signing a note, the debtor recognizes the debt and agrees to pay it according to its terms Thus, a note is a stronger legal claim. 8-6aCharacteristics of Notes Receivable A promissory note is a written promise to pay the face amount, usually with interest, on demand or at a date in the future Characteristics of a promissory note are as follows: The maker is the party making the promise to pay. The payee is the party to whom the note is payable. The face amount is the amount for which the note is written on its face. The issuance date is the date a note is issued. 5. The due date or maturity date is the date the note is to be paid. 6. The term of a note is the amount of time between the issuance and due dates. 7. The interest rate is that rate of interest that must be paid on the face amount for the term of the note.  Exhibit 6 illustrates a promissory note.  The maker of the note is Selig Company, and the payee is Pearland Company. o The face value of the note is $2,000, the interest rate is 10%, and the issuance date is March 16, 20Y8. o The term of the note is 90 days, which results in a due date of June 14, 20Y8, computed as follows and shown in Exhibit 7:        The interest on a note is computed as follows: o The interest rate is stated on an annual (yearly) basis, while the term is expressed as days. Thus, the interest on the note in Exhibit 6 is computed as follows: To simplify, 360 days per year will be used. In practice, companies such as banks and mortgage companies use the exact number of days in a year, 365. The maturity value is the amount that must be paid at the due date of the note, which is the sum of the face amount and the interest. o The maturity value of the note in Exhibit 6 is $2,050 ($2,000 + $50). 8-6bAccounting for Notes Receivable A promissory note may be received by a company from a customer to replace an account receivable.           o . In such cases, the promissory note is recorded as a note receivable To illustrate, assume that a company accepts a 30-day, 12% note dated November 21 in settlement of the account of W. A. Bunn Co., which is past due and has a balance of $6,000. o The company journalizes the receipt of the note as follows: At the due date, the company journalizes the receipt of $6,060 ($6,000 face amount plus $60 interest) as follows: If the maker of a note fails to pay the note on the due date, the note is a dishonored note receivable. A company that holds a dishonored note transfers the face amount of the note plus any interest due back to an accounts receivable account. o For example, assume that the $6,000, 30-day, 12% note received from W. A. Bunn Co. and recorded on November 21 is dishonored. . The company holding the note transfers the note and interest back to the customer’s account as follows: o The company has earned the interest of $60, even though the note is dishonored. If the account receivable is uncollectible, the company will write off $6,060 against Allowance for Doubtful Accounts. A company receiving a note should record an adjusting entry for any accrued interest at the end of the period o For example, assume that Crawford Company issues a $4,000, 90-day, 12% note dated December 1, 20Y3, to settle its account receivable. o If the accounting period ends on December 31, the company receiving the note would journalize the following entries: The receipt of the maturity value of the note on its due date of March 1, 20Y4, is recorded as follows: The interest revenue account is closed at the end of each accounting period o The amount of interest revenue is normally reported in the “Other revenue and expense” section of the income statement. 8-7Reporting Receivables on the Balance Sheet All receivables that are expected to be realized in cash within a year are reported in the “Current assets” section of the balance sheet. Current assets are normally reported in the order of their liquidity, beginning with cash and cash equivalents. The balance sheet presentation for receivables for Under Armour (UAA) follows: In Under Armour’s financial statements, accounts receivable is reported at the net realizable value on the balance sheet with a note showing the amount of the allowance for doubtful accounts. o A company may choose to subtract the allowance for doubtful accounts from accounts receivable on the balance sheet to report the net realizable value of receivables. Other disclosures, such as unusual credit risks within the receivables, are reported in the financial statement notes. o For example, if the majority of the receivables are due from one customer or are due from customers located in one area of the country or one industry, these facts are disclosed. o    Accounts Receivable Turnover and Number of Days’ Sales in Receivables  Two financial measures that are useful in evaluating efficiency in collecting receivables are the following: o Accounts recievable turnover o Number of days’ sales in receivables  The accounts receivable turnover measures how frequently during the year the accounts receivable are being converted to cash. o For example, with credit terms of n/30, the accounts receivable should turn over about 12 times per year.  The accounts receivable turnover is computed as follows  The average accounts receivable can be determined by adding the beginning and ending accounts receivable balances and dividing by 2. o For example, consider the following financial data (in millions) for Under Armour, Inc. (UAA):  The accounts receivable turnover for Years 1 and 2 can be computed as follows (rounding to one decimal place):  The accounts receivable turnover has declined in Year 2 o This suggests that Under Armour is allowing customers to take longer to pay their accounts.      The number of days’ sales in receivables is an estimate of the length of time the accounts receivable have been outstanding. o With credit terms of n/30, the number of days’ sales in receivables should be about 30 days. o It is computed as follows: Average daily sales are determined by dividing sales by 365 days. o For example, using the preceding data for Under Armour, the number of days’ sales in receivables for Years 1 and 2 is computed as follows (rounding all calculations to one decimal place): The number of days’ sales in receivables confirms that Under Armour’s efficiency in collecting accounts receivable declined from Year 1 to Year 2 o Lengthening the credit terms or selling in markets where longer credit terms are standard could cause this decline. o The efficiency in collecting accounts receivable has declined when the accounts receivable turnover decreases or the number of days’ sales in receivables increases. The efficiency in collecting accounts receivable can be compared across companies in similar industries. o For example, the accounts receivable turnover and number of days’ sales in receivables for Under Armour can be compared to a competitor, such as Columbia Sportswear Company (COLM), as shown in Exhibit 8.  In this analysis, Under Armour is more efficient in collecting accounts receivable than is Columbia Sportswear. Chapter Review 8-8aLet’s Review Chapter Summary 1. Receivables include all money claims against other entities. Receivables are normally classified as accounts receivable, notes receivable, or other receivables. 2. The operating expense recorded from uncollectible receivables is called bad debt expense. The two methods of accounting for uncollectible receivables are the direct write-off method and the allowance method. 3. Under the direct write-off method, the entry to write off an account debits Bad Debt Expense and credits Accounts Receivable. Neither an allowance account nor an adjusting entry is needed at the end of the period. 4. Under the allowance method, an adjusting entry is made for uncollectible accounts. When an account is determined to be uncollectible, it is written off against the allowance account. The allowance account is a contra asset account that normally has a credit balance after the adjusting entry has been posted. The estimate of uncollectibles may be based on a percent of sales or an analysis of receivables. Exhibit 3 compares and contrasts these two methods. 5. Exhibit 4 illustrates the differences between the direct write-off and allowance methods of accounting for uncollectible accounts. 6. A note received to settle an account receivable is journalized as a debit to Notes Receivable and a credit to Accounts Receivable. When a note is paid at maturity, Cash is debited, Notes Receivable is credited, and Interest Revenue is credited. If the maker of a note fails to pay, the dishonored note is journalized by debiting an account receivable for the amount due from the maker of the note. 7. All receivables that are expected to be realized in cash within a year are reported in the “Current assets” section of the balance sheet. In addition to the allowance for doubtful accounts, additional receivable disclosures include the market (fair) value and unusual credit risks. 8. Accounts receivable turnover measures how frequently during the year the accounts receivable are being converted to cash. It is computed as sales divided by average accounts receivable. The number of days’ sales in receivables is an estimate of the length of time the accounts receivable have been outstanding. It is computed by dividing average accounts receivable by average daily sales.