Needles Powers Crosson Principles of Accounting 12e Receivables 9 C H A P T E R ©...

NeedlesPowersCrosson

Principles of Accounting

12e

Receivables9C H A P T E R

© human/iStockphoto

LEARNING OBJECTIVES

LO1: Define receivables, and explain the allowance method for valuation of receivables as an application of accrual accounting.

LO2: Apply the allowance method of accounting for uncollectible accounts.

LO3: Make common calculations for notes receivable.

LO4: Show how to evaluate the level of receivables, and identify alternative means of financing receivables.

©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

SECTION 1: CONCEPTS

Accrual accounting (matching principle): recording transactions in the periods in which they occur, rather than in the periods in which cash is received or paid

Valuation: the process of assigning a monetary value to a business transaction and the resulting assets and liabilities

Disclosure: the convention requiring that a company’s financial statements and the accompanying notes present all information relevant to the users’ understanding of the statements


Accounts Receivable

Accounts receivable are short-term financial assets that arise from sales on credit and are often called trade credit.– In setting credit terms, a company must

keep in mind the credit terms of its competitors and the needs of its customers.

– Companies that are too lenient in granting credit can run into difficulties when customers don’t pay.


Accounts Receivable as a Percentage of Total Assets for Selected Industries


Accounts Receivable

The accounts of customers who cannot or will not pay are called uncollectible accounts (or bad debts).– There are two methods of accounting for

uncollectible accounts: Direct charge-off method: recognize a loss

when an account is determined to be uncollectible. (This is not in accordance with accrual accounting.)

Allowance method: recognize a loss at the time credit sales are made. (This is in accordance with accrual accounting.)


Notes Receivable

Notes receivable are short-term financial assets supported by written agreements called promissory notes. – A promissory note is an unconditional

promise to pay a definite sum of money on demand or at a future date. The person or entity that signs the note and

promises to pay is the maker of the note. The entity to whom payment is to be made is the

payee.


A Promissory Note


The Allowance Method: Using Accrual Accounting to Value Receivables

The allowance method is an application of accrual accounting, which requires losses from bad debts to be matched with the revenue they help to produce.– It serves to value accounts receivable on

the balance sheet.– Because management cannot identify at

the time of sale which customers will not pay or how much the company will lose, losses from uncollectible accounts must be estimated.


Uncollectible Accounts: The Allowance Method (slide 1 of 2)


Uncollectible Accounts: The Allowance Method (slide 2 of 2)


Disclosure of Receivables(slide 1 of 3)

A payee includes all the promissory notes it holds that are due in less than one year as notes receivable in the current assets section of the balance sheet.

Any interest accrued on these notes is also included in the current assets section—as interest receivable.

Uncollectible Accounts Expense appears on the income statement as an operating expense.



Allowance for Uncollectible Accounts appears on the balance sheet as a contra account, deducted from accounts receivable in the current assets section. – It reduces the accounts receivable to the

amount expected to be collectible (net realizable value), as shown on the next slide.





SECTION 2: ACCOUNTING APPLICATIONS

Estimate uncollectible accounts and uncollectible accounts expense using– Percentage of net sales method– Accounts receivable aging method

Write off uncollectible accounts Make common calculations for notes

receivable


Uncollectible Accounts

The allowance account is necessary because the specific uncollectible accounts will not be identified until later.– The company’s accountant makes an

estimate based on past experience and current economic conditions. The estimated losses from uncollectible accounts should be realistic.

– Two common methods of estimating uncollectible accounts expense are: the percentage of net sales method the accounts receivable aging method


Percentage of Net Sales Method

The basis for the percentage of net sales method is the amount of this year’s net sales that will not be collected. The answer determines the amount of uncollectible accounts expense for the year.


Uncollectible Accounts: The Percentage of Net Sales Method (slide 1 of 3)






Accounts Receivable Aging Method(slide 1 of 3)

The basis for the accounts receivable aging method is the amount of the ending balance of accounts receivable that will not be collected.– The ending balance of Allowance for

Uncollectible Accounts is determined directly through an analysis of accounts receivable.

– The difference between this amount and the actual balance of Allowance for Uncollectible Accounts is the expense for the period.



The aging of accounts receivable is the process of listing each customer’s receivable account according to the due date of the account.– If the customer’s account is past due, there

is a possibility that the account will not be paid.

– That possibility increases as the account extends further beyond the due date.



To illustrate the accounts receivable aging method, we will use Radko Company, whose aging of accounts receivable is shown on the next slide.– Each account receivable is classified as being

not yet due or as being 1-30 days, 31-60 days, 61-90 days, or over 90 days past due.

– Based on past experience, the estimated percentage for each category is determined and multiplied by the amount in each category to determine the estimated, or target, balance of Allowance for Uncollectible Accounts.


Analysis of Accounts Receivable by Age


Adjusting the Allowance Account: Credit Balance (slide 1 of 2)


Adjusting the Allowance Account: Credit Balance (slide 2 of 2)


Adjusting the Allowance Account: Debit Balance (slide 1 of 2)


Adjusting the Allowance Account: Debit Balance (slide 2 of 2)


Comparison of the Two Methods

Both the percentage of net sales method and the accounts receivable aging method estimate the uncollectible accounts expense in accordance with accrual accounting, but they do so in different ways.– The percentage of net sales method is an

income statement approach.– The accounts receivable aging method is a

balance sheet approach.


Two Methods of Estimating Uncollectible Accounts


Writing Off Uncollectible Accounts

The total of accounts receivable written off in a period will rarely equal the estimated uncollectible amount.

When it becomes clear that a specific account receivable will not be collected, the amount should be written off to Allowance for Uncollectible Accounts.


Writing Off Uncollectible Accounts (slide 1 of 3)







Common Calculations for Notes Receivable

Several calculations are common to promissory notes:– Maturity date– Duration of a note– Interest– Maturity value– Accrued interest


Maturity Date

The maturity date is the date on which a promissory note must be paid. This date must be stated on the note or be determinable from the facts on the note.– When the maturity date is a specific

number of days from the date of the note, the exact maturity date must be determined. In computing this date, it is important to exclude the date of the note.


Maturity Date

A note dated May 20 and due in 90 days would be due on August 18, determined as follows.


Duration of a Note

The duration of a note is the time between a promissory note’s issue date and its maturity date. Interest is calculated on the basis of the duration of a note.– When the maturity date is stated as a

specific date, the exact number of days must be determined.


Duration of a Note

If a note issued on May 10 matures on August 10, the duration of the note is 92 days.


Interest

Interest is the cost of borrowing money or the return on lending money, depending on whether one is the borrower or the lender. The amount of interest is based on three factors:– Principal (the amount of money borrowed or

lent)– Rate of interest– Length of the loan


Interest

The formula used in computing interest is:

Principal X Rate of Interest X Time = Interest–The interest on a one-year, 8 percent, $1,000 note would be:

$1,000 X 8/100 X 1 = $80–If the term of the note is three months instead of a year, the interest would be:

$1,000 X 8/100 X 3/12 = $20–If the term of the note is 45 days, the interest would be:

$1,000 X 8/100 X 45/365 = $9.86©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Maturity Value

The maturity value is the total proceeds of a promissory note—face value plus interest—at the maturity date.

The maturity value of a 90-day, 8 percent, $1,000 note is computed as follows:

Maturity Value = Principal + Interest = $1,000 + ($1,000 X 8/100 X

90/365) = $1,000 + $19.73 = $1,019.73


Accrued Interest(slide 1 of 2)

Accrued interest must be apportioned to the periods in which it belongs.

Assume that a $1,000, 90-day, 8 percent note was received on August 31 and that the fiscal year ends September 30. Interest for 30 days is calculated as follows:

Principal X Rate of Interest X Time = Interest

$1,000 X 8/100 X 30/365 = $6.58


Accrued Interest(slide 2 of 2)

The remainder of the interest income would be calculated as follows:

Principal X Rate of Interest X Time = Interest$1,000 X 8/100 X 60/365 = $13.15

- $6.58 of the interest would be recorded as income in the fiscal year ending September 30, and the interest receivable ($6.58) would be shown as received when the note is paid.

- The remainder of the interest, $13.15, would be recorded as income in the next fiscal year.


Dishonored Note

A note not paid at maturity is called a dishonored note. – The holder, or payee, of a dishonored note

should transfer the total amount due (including interest income) from Notes Receivable to an individual account receivable for the debtor.


Receivables and the Financial Statements

Accounts receivable on the balance sheet is closely related to sales on the income statement.– The estimation of uncollectible credit sales

affects the amount of net accounts receivable and operating expenses.

– Interest income on notes receivable affects the amount of assets and revenues.


Valuation of Accounts Receivable on the Balance Sheet Impacts Net Sales on the Income Statement



SECTION 3: BUSINESS APPLICATIONS

Receivables turnover Days’ sales uncollected Financing receivables

– Factoring of accounts receivable– Securitization of accounts receivable– Discounting of accounts receivable

Ethics


Evaluating the Level of Accounts Receivable and Ethical Ramifications

It is critical for a company to manage the level of its receivables.

Two common measures of the effect of a company’s credit policies are receivables turnover and days’ sales uncollected.

Many companies manage their receivables by using various means to finance them.

The judgments in estimating uncollectible accounts are a temptation for unethical behavior.


Receivables Turnover(slide 1 of 2)

The receivables turnover shows how many times, on average, a company turned its receivables into cash during a period.– It is computed by dividing net sales by the

average accounts receivable (net of allowances).

– Nike’s receivables turnover in 2011 is computed on the next slide.

– To interpret a company’s ratios, we must take into consideration the norms of the industry in which it operates, also shown on the next slide.


Receivables Turnover(slide 2 of 2)


Days’ Sales Uncollected(slide 1 of 2)

Day’s sales uncollected shows, on average, how long it takes to collect accounts receivable.– To determine the days’ sales uncollected,

the number of days in a year is divided by the receivables turnover.

– For Nike, it is computed on the next slide.


Days’ Sales Uncollected(slide 2 of 2)


Financing Receivables

Companies can finance their receivables by selling or transferring accounts receivable to another entity.

Three methods of financing receivables in this way are:– Factoring– Securitization– Discounting


Factoring

Factoring is the sale or transfer of accounts receivable to an entity, called a factor. Factoring can be done with or without recourse.– With recourse means that the seller of the

receivables is liable to the factor if a receivable cannot be collected.

– Without recourse means that the factor bears any losses from unpaid accounts.


How Factoring Works


Factoring

In accounting terminology, a seller of receivables with recourse is said to be contingently liable.– A contingent liability is a potential

liability that can develop into a real liability if a particular event occurs—in this case, a customer’s nonpayment of a receivable.

– A contingent liability generally requires disclosure in the notes to the financial statements.


Securitization

Securitization is a process in which a company groups its receivables in batches and sells them at a discount to other companies or investors.– When the receivables are paid, the buyers

get the full amount.– Their profit depends on the amount of the

discount.


Discounting(slide 1 of 2)

Discounting is a method of financing receivables by selling promissory notes held as notes receivable to a financial lender, usually a bank.– The bank derives its profit by deducting the

interest from the maturity value of the note.

– The holder of the note endorses the note and turns it over to the bank.

– The bank expects to collect the maturity value of the note (principal plus interest), but it also has recourse against the note’s endorser.


Discounting (slide 2 of 2)

Assume that Company X holds a $20,000 note from Company Z, and the note will pay $1,200 in interest. A bank is willing to buy the note for $19,200.– If Company Z pays, the bank will receive

$21,200 at maturity and realize a $2,000 profit.– If Company Z fails to pay, Company X is liable

to the bank for payment. In the meantime, Company X has a contingent liability for the amount of the discounted note plus interest that it must disclose in its financial statements.


Ethics and Estimates in Accounting for Receivables

Because the amount of uncollectible accounts can only be estimated and the exact amount will not be known until later, a company’s earnings can be easily manipulated.– Earnings can be overstated by

underestimating the amount of losses from uncollectible accounts.

– Earnings can be understated by overestimating the amount of the losses.


Ethics and Estimates in Accounting for Receivables

Misstatements of earnings can occur simply because of a bad estimate.

They can also be deliberately made to meet analysts’ estimates of earnings, reduce income taxes, or meet benchmarks for bonuses.

Companies will high ethical standards try to be accurate in their estimates of uncollectible accounts, and they disclose the basis of their estimates.



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