Accounting for Receivables

1. Accounting for Receivables Chapter 8

2. Receivables • Includes all money claims against other entities, including people, business firms, and other organization. • Are usually a significant portion of the total current assets.

3. Types of Receivables • Accounts receivable • Results from the sale of merchandise on credit and expected to be collected within a relatively short period, such as 30 or 60 days.

4. Types of Receivable • Notes receivable: • Are amounts that customer owe, for which a formal written instrument of credit has been issued. • Are usually used for credit periods of more than sixty days. • May be used to settle a customer’s accounts receivable

5. Uncollectible receivables • When allowing customers to purchase on credit, we run the risk of nonpayment. • Many retail businesses may shift the risk of uncollectible to other companies. Allow only VISA or Mastercard. • Companies may also sell their receivables to other companies. Usually companies issue their own credit cards. • Regardless of the care used in granting credit and the collection procedures used, a part of the credit sales will not be collectible. • Bad debts expenses – operating expense recorded from the uncollectible receivables.

6. Two methods • Allowance method • Required by generally accepted accounting principles (GAAP) • Estimates the accounts receivable that will not be collected and records bad debt expense for this estimate at the end of each accounting period. • Direct write off method • No estimate of uncollectible • Write off as deemed uncollectible

7. Allowance Method • We create a CONTRA ASSET ACCOUNT called Allowance for Bad Debts. It increases with a credit. • Record the total estimate that has not been written off. • Entry is considered an adjusting entry.

8. Allowance method • Allowance account • Records the estimate uncollectible • Credit to increase • Bad Debts Expense • Records the annual estimated uncollectible • Uncollectible account expense

9. Adjusting Entry Suppose that accounts receivable have a Balance of $105,000 and it is estimated that $4,000 will go bad. Record the adjusting entry under the allowance method.

10. Net Realizable Value Net Realizable Value = Accounts receivable balance – Allowance for bad debts What is really expected to be collected!

11. Write offs to the Allowance Account • Once that we determine that a particular customer will be not collectible, we write off the account. • The write off consists of reducing the allowance account by the amount of the write off and removing the uncollectible account from accounts receivable.

12. Example 2 • Suppose that J Mays account with a balance of $1,200 is uncollectible.

13. Estimating Uncollectibles • The allowance method estimates bad debts expense at the end of the period. • Estimate of uncollectibles at the end of a fiscal period is based on past experience and forecasts of the future. • Two methods are used: • Estimated based on percentage of sales • Analysis of accounts receivable.

14. Estimated Based on Sales • We assume that a percentage of credit sales will go bad and record that as the adjusting entry.

15. Example 3: • Suppose that credit sales for the period were $800,000 of which 1% is expected to be uncollectible. Record the entry. • $800,000 x 1% = $ 8,000

16. Example 4 • Suppose that the company expects 3% of credit sales to go uncollected. A review of the trial balance shows: • Sales $1,000,000 of which 45% are cash sales. • Accounts receivable has a balance of $70,000. • Allowance for bad debts has credit balance of $2,000.

17. Example 4 Credit sales are $1,000,000 x 55% = $550,000 Estimate is $550,000 x 3% = $16,500 Allowance for Bad Debts Debit Credit $2,000 balance $16,500 should be balance

18. Example 4 • As a result of the credit balance in the Allowance account, • We will record the entry not for $16,500 but $14,500 • ( $16,500 - $2,000).

19. Example 5 • Suppose that the company expects 3% of credit sales to go uncollected. A review of the trial balance shows: • Sales $1,000,000 of which 45% are cash sales. Accounts receivable has a balance of $70,000. • Allowance for bad debts has debit balance of $2,000.

20. Example 5 Credit sales are $1,000,000 x 55% = $550,000 Estimate is $550,000 x 3% = $16,500 Allowance for Bad Debts Debit Credit $2,000 balance $16,500 should be balance

21. Example 4 • As a result of the credit balance in the Allowance account, • We will record the entry not for $16,500 but $18,500 • ( $16,500 + $2,000).

22. Rule • When the Allowance Account at the end of the year: • Has a debit balance  we underestimated the bad debts last period. • Has a credit balance  we overestimated the bad debts last period.

23. Notes on Allowance method • If allowance account has prior balance then at end of year should equal estimated uncollectible

24. Analysis of Receivables • Actually looking at each individual account and determining probability of collect ability • Aging of receivables

25. Aging Schedule

26. Entry

27. Direct write off Method • There is no estimated uncollectible • No allowance account • Only when specific customer goes bad will it be written off to the expense account

28. Direct Write off • Example 5: Suppose that Haby’s account goes bad with a balance of $8,000

29. Reinstatement of write offs • Allowance method • Example 6: Suppose Habys pays the amount due.

30. Reinstatement of write offs • Direct Write off method

31. Notes Receivable Characteristics • Promissory note – is a written promise to pay a sum of money on demand or at a definite time. • Payee – the person to whom the note is payable to • Maker – one making the note and owing the money • Due date – when the note is due • Maturity value = principal + interest

32. Sample Note I, Chris owe Odalys $10,000 payable in 60 days plus 12% interest. Signed Chris May 1, 2007 Principal Time Maker Payee Interest rate

33. The length of time that the note is open is usually stated in days or months. Use 360 day year for easy of computation in class but in real life we use 365 day year. Computation of Due Date Before calculators easier to use 360 days to make calculations

34. Example 7 • Suppose that a note is issued on May 1st for 60 days when is the note due. Days in note 60 days Days in month note is issued 31 days Day note is issued 1 Days available in month 30 Days for next month 30 Days in next month June 30 Note due on June 30th

35. Example 8 • Use information in the sample note

36. Computation of Interest Principal X Rate X Time = Interest Amount due Interest rate on note Amount due on note Days in note 360 days

37. Computation of Interest • Example: Suppose that face or principal of note is $30,000, interest rate is 10% for 60 days. • Principal X Rate X Time = Interest • $30,000 X 10% X 60/360 = $500 • Maturity value = Principal + Interest • = $30,000 + $500 • = $30, 500

38. Example 8 • Suppose that a note for $20,000 with 12% is issued on June 5 for 90 days. Compute the due date, interest, and maturity value of the note.

39. Accounting for Notes Receivables • A customer may use a note to replace an account receivable. • This causes the creation of a note receivable and the removal of the outstanding accounts receivable.

40. Example 9 • Suppose that the account for Mister is past due. Mister converts the receivable to a note for 60 days at 10%. The balance is $6,000.

41. Example 9 • Mister pays amount due on the date. Note that is paid on due date is said to be HONORED

42. Dishonored Notes • When the maker does not pay the maturity value on the due date, the note is said to be DISHONORED • At this time, the note ceases to exist, the maturity value of the note is reported again as an Accounts Receivable. • We include the interest computed as income earned but not yet received.

43. Example 9 • Suppose that the account for Mister is past due. Mister converts the receivable to a note for 60 days at 10%. The balance is $6,000. On the due date, the note becomes dishonored Notice that the difference is that we debit accounts receivables instead of cash.