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Chapter 8

1. Chapter 8. 2. Receivables - amounts owed to company by others. Accounts Receivable Company just bills its customers/clients Result from rendering services or selling products to the public. 3. Notes Receivable Evidenced with promissory notes Formal written debt instruments

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Chapter 8

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  1. 1 Chapter 8

  2. 2 • Receivables - amounts owed to company by others. • Accounts Receivable • Company just bills its customers/clients • Result from rendering services or selling products to the public.

  3. 3 • Notes Receivable • Evidenced with promissory notes • Formal written debt instruments • Usually bear interest • Usually has fixed maturity date • Doesn’t have to – Demand Note • When customers pay A/R slowly • Make customers sign promissory note & pay interest

  4. 4 • Company should write off A/R where no hope of collecting the A/R • Conservatism – Don't show worthless A/R as an asset • This is misleading

  5. 5 • Two methods to write off bad A/R • Direct method • Not GAAP • Allowance method • GAAP

  6. 6 • Another GAAP principle is materiality • If amount is not material, you don’t need to follow GAAP. • Something is material if person's actions would be different if he or she knew the item in question. • If bad A/R not a material amount • You can use direct method • Otherwise must use allowance method.

  7. 7 • Direct method • Charge uncollectible accounts to an expense in the period of default • A selling expense • May not coincide with the period of the related sale • Violates Matching Principle

  8. 8 • If you write off A/R & customer eventually pays • First, reinstate A/R. • Reverse the prior journal entry.

  9. 9 • Second, you record that the A/R has been paid:

  10. 10 • Allowance Method • Matching Principle • Expense should be recorded in the same period as the related sale • Need to estimate bad debts each year • Company does not know which customer won’t pay. • So, you don’t write off any particular A/R • Instead you reduce A/R with a contra account • Allowance For Bad Debts

  11. 11 • Allowance for Uncollectible Accounts is contra account to A/R • Reduces A/R to amount estimated to be collectible. • Net number is the net realizable value of the A/R.

  12. 12 • Write off A/R when clear that it won’t be paid: • Note that there is no expense involved in the entry. • No Bad Debt Expense • Expense happened in year of sale

  13. 13 • After write-off • A/R net value does not change • Specific A/R was written off • Allowance for Uncollectible Accounts decrease by the same amount

  14. 14 • When customer pays after A/R written off • First, reinstate customer's A/R

  15. 15 • Second, record collection

  16. 16 • Most common methods for estimating uncollectible A/R • Percentage of net sales method and • Accounts receivable aging method.

  17. 17 • Percentage of sales method • Estimated percentage for uncollectible accounts is multiplied by net sales (or net credit sales) for the period. • The resulting figure is then used in adjusting entry.

  18. 18 • Previous balance in Allowance for Uncollectible Accounts • amounts from previous years - not yet been written off • irrelevant in making adjusting entry. • If: • You have net sales of $300,000 • You believe that 1% of your sales will not be collected • Place $3,000 into the allowance.

  19. 19 • Aging of accounts receivable method (Percentage of receivables basis) • Separate A/R by age categories • The total amounts in each category are multiplied by a different percentage (a different probability of default for each age category) • Add up products for estimate of total bad debts.

  20. 20 • Adjusting entry is for amount that brings Allowance for Uncollectible Accounts to the computed figure. • If you estimate a total of $3,000 of you’re A/R will not be paid, and • Your allowance has a credit balance of $1,000, • Credit the allowance (and debit bad debt expense) for $2,000.

  21. 21 • A promissory note has two parties • Maker (debtor) and • Payee (lender)

  22. 22 • Promissory note • Formal debt instrument • Usually bears interest • Interest on notes with terms of a year or less • Interest usually paid at maturity. • Usually has maturity date • Can be demand note. • Maturity value is the amount owed by maker at maturity.

  23. 23 • Promissory notes: • Loan to someone • Received in the sale of expensive merchandise or other assets • Extended payments • E.g., sales of automobiles • In exchange for delinquent A/R

  24. 24 • When promissory note replaces A/R • Maker is customer who can’t pay A/R on time. • Company gives more time, but wants interest. • Company converts A/R into interest bearing promissory note.  

  25. 25 • Assume a $6,000, 10%, six-month promissory note is issued in place of A/R:

  26. 26 • When the note matures, the maker pays the principle and the accrued interest:

  27. 27 • If the note is dishonored: • Company just has A/R again. • No more interest will accrue thereafter

  28. 28 • Supposed to accrue interest revenue in the period earned even though not yet paid (Adjusting Entry). • Assume 3-month promissory note is issued in December:

  29. 29

  30. 30 • A promissory note is honored when it is paid in full at its maturity date.

  31. 31 • Managing Accounts Receivable • Company with A/R needs to watch the following steps carefully:

  32. 32 • Extending Credit • Who should get credit? • E.g., look at credit reports, ask for guarantees or letters of credit • Your credit policies have to be competitive • But, you still want to make sure you will get paid.

  33. 33 • Establishing a Payment Period • You have to be competitive. • Consider offering incentives for customers to pay early (e.g., sales discounts).

  34. 34 • Monitoring Collections • Make sure customers are paying you. • Look at Credit Risk Ratio: Allowance for Doubtful Accounts --------------------------------------------- Accounts Receivable • A disproportionate increase in this ratio • Warning more customers are not paying A/R

  35. 35 • Accelerating Cash Receipts • Company needs cash faster than customers are paying A/R • A company can sell it’s A/R to a factor. • Factor charges a fee to purchase the A/R. • Treated as an expense • operating expense or • other expense

  36. 36

  37. 37 • Similar to treatment of VISA or MasterCard credit card sale • Credit card company is agreeing to issue credit to your customers • so that you don’t have to

  38. 38

  39. 39 • Evaluating the Receivable Balance • When evaluating company’s credit policies management looks at two measures: • (i) Receivables Turnover Ratio, and • (ii) Average Collection Period.

  40. 40 • Receivables Turnover Ratio • tells you how many times you give and collect credit (A/R) during the year, on average: Net Credit Sales ----------------------------------------------------- Average Net Accounts Receivable

  41. 41 • Average Collection Period • Reflects the number of days it takes to collect a firm’s A/R: 365 --------------------------------------------- Receivables Turnover Ratio

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