Chapter 8 Receivables · Chapter 8 Receivables Chapter 8 Learning Objectives 1. Define and explain common ... Chapter 8 Learning Objectives 4. Account for notes receivable including

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Chapter 8Receivables

Chapter 8 Learning Objectives

1. Define and explain common types of receivables and journalize sales on credit

2. Apply the direct write-off method for uncollectibles

3. Apply the allowance method for uncollectibles and estimate bad debts expense based on the percent-of-sales, percent-of-receivables, and aging-of-receivables methods

8-2© 2018 Pearson Education, Inc.

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Chapter 8 Learning Objectives

4. Account for notes receivable including computing interest and recording honored and dishonored notes

5. Use the acid-test ratio, accounts receivable turnover ratio, and days’ sales in receivables to evaluate business performance


Learning Objective 1

Define and explain common types of receivables and journalize sales on credit


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WHAT ARE COMMON TYPES OF RECEIVABLES, AND HOW ARE CREDIT

SALES RECORDED?

• A receivable occurs when a business sells goods or services to another party on account (on credit).

• A receivable is a monetary claim against a business or an individual.– A receivable is a right to receive cash in the

future from a current transaction. – A creditor is the party who receives a

receivable.– A debtor is the party to a credit transaction

who is obligated to pay later.


Accounts Receivable

• Accounts receivable, also called trade receivables, represents the right to receive cash in the future from customers for goods or services performed. – Generally collected within 30 to 60 days– Reported as a current asset on the balance

sheet


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Notes Receivable

• Notes receivable usually have longer terms than accounts receivable. • Notes receivable are sometimes called

promissory notes.• A note receivable represents a promise to pay

a fixed amount of principle plus interest by a certain due date.

• The maturity date is the date on which a note receivable is due.


Other Receivables

• Any other type of receivable is considered other receivables.

• Receivables are classified as either current or long-term, depending on whether they will be received in one year or less.

• Examples include:• Dividends receivable• Interest receivable• Taxes receivable


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Exercising Internal Control Over Receivables

• Internal control over cash payments received by mail (usually checks) or online (EFTs) is important.

• A critical element of internal control is the separation of cash-handling and cash-accounting duties– Credit department should have no access

to cash – Those who handle cash should not be in a

position to grant credit to customers.


Recording Sales on Credit

Smart Touch Learning provides $5,000 in services to Brown on account and sells $10,000 (sales price) of merchandise inventory to Smith on account on August 8. Ignore Cost of Goods Sold.


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The control account, Accounts Receivable, shows a balance of $15,000. The individual customer accounts in the subsidiary ledger (Accounts Receivable—Brown $5,000 + Accounts Receivable—Smith $10,000) add up to $15,000.



When the business collects cash from both customers on August 29—$4,000 from Brown and $8,000 from Smith—Smart Touch Learning makes the following entry:


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After posting:


Decreasing Collection Time and Credit Risk

• Companies must wait to receive cash from sales on account.

• Some accounts are never collected.• Options to decrease collection time while

transferring the risk of noncollection to a third party include:– Credit Card and Debit Card Sales– Factoring and Pledging Receivables


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Apply the direct write-off method for uncollectibles


HOW ARE UNCOLLECTIBLES ACCOUNTED FOR WHEN USING THE DIRECT WRITE-

OFF METHOD?

• Bad debts expense arises from failure to collect from some customers who purchase on account.

• There are two methods of accounting for uncollectible receivables:– Direct write-off method– Allowance method (GAAP method)


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Recording and Writing Off Uncollectible Accounts—Direct Write-off Method

• The direct write-off method is a method of accounting for uncollectible receivables in which the company records bad debts expense when a customer’s account receivable is uncollectible. – Primarily used by small, nonpublic companies.– Accounts receivable are written off when the

business determines that it will never collect from a specific customer.

– Once an account receivable is written off, the company stops pursuing the collection.


Recording and Writing Off Uncollectible Accounts—Direct Write-off Method

On August 9, Smart Touch Learning determines that it will not be able to collect $200 from customer Dan King for a sale of merchandise inventory made on May 5.


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Recovery of Accounts Previously Written Off—Direct Write-off Method

On September 10, Smart Touch Learning unexpectedly receives $200 cash from Dan King.


Limitations of the Direct Write-off Method

• The direct write-off method violates the matching principle– Example: A company records sales revenue in

2017 and related bad debts expense in 2018. This results in:• Overstated net income in 2017• Understated net income in 2018• Overstated Accounts Receivable in 2017

• The direct write-off method is only acceptable for companies that have very few uncollectible receivables.


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Apply the allowance method for uncollectibles and estimate bad debts expense based on the percent-of-sales, percent-of-receivables, and aging-of-receivables methods


HOW ARE UNCOLLECTIBLES ACCOUNTED FOR WHEN USING THE ALLOWANCE

METHOD?

• Most companies use the allowance method to measure bad debts.– The allowance method is based

on the matching principle. – It records bad debts in the same

period as the sales revenue.• A contra asset account called

Allowance for Bad Debts reduces the Accounts Receivable to the net realizable value.


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Recording Bad Debts Expense—Allowance Method

As of December 31, 2019, Smart Touch Learning estimates that $80 of its $4,400 accounts receivable are uncollectible.


Recording Bad Debts Expense—Allowance Method


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Writing Off Uncollectible Accounts—Allowance Method

• An allowance is established for the estimated uncollectible accounts.

• Instead of recording a debit to Bad Debts Expense, the company records a debit to Allowance for Bad Debts.

• The entry to write off an account under the allowance method has no effect on net income at the time of entry.



On January 10, 2020, Smart Touch Learning determines that it cannot collect a total of $25 from its customer Shawn Clark.


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The entry to write off a receivable reduces the amount of the Allowance for Bad Debts account and also the Accounts Receivable account, but it does not affect the net realizable value shown on the balance sheet.


Recovery of Accounts Previously Written Off—Allowance Method

Recall that Smart Touch Learning wrote off the $25 receivable from Shawn Clark on January 10, 2020. It is now March 4, 2020, and Smart Touch Learning unexpectedly receives $25 cash from Clark.


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Estimating and Recording Bad Debts Expense—Allowance Method

• Companies estimate bad debts expense based upon:• Past experience• The industry in which they operate• Other variables

• There are three methods to estimate uncollectibles using the allowance method:– Percent-of-sales– Percent-of-receivables– Aging-of-receivables


• The percent-of-sales method computes bad debts expense as a percentage of net credit sales.

• Some companies use all sales, not just credit sales.

• This method is also called the income-statement approach.


Percent-of-Sales Method

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Smart Touch Learning uses the percent-of-sales method to account for uncollectibles. Past experience suggests that 0.5% of credit sales will be uncollectible, which amounted to $60,000.



At December 31, Smart Touch Learning records the following adjusting entry to recognize bad debts expense for the year:



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After posting the adjusting entry, Smart Touch Learning has the following balances in its accounts. Ignore the previously recorded reversal of the write-off and assume collections on account during the year are $58,000:



Percent-of-Receivables Method

• The percent-of-receivables method computes bad debts expense as a percentage of accounts receivable.


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On December 31, 2020, Smart Touch Learning’s unadjusted Accounts Receivable balance is $6,375, and 4% of accounts receivable is estimated to be uncollectible. The Allowance for Bad Debts account has a credit balance of $55, so the adjustment is $200.



Smart Touch Learning records the following adjusting entry on December 31 to recognize bad debts expense for the year:


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After posting the adjusting entry, Smart Touch Learning has the following balances:



Martin’s Music has a debit balance in its Allowance for Bad Debts account of $150. It estimates uncollectible accounts will be 2% of $40,000 of Accounts Receivable.


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Aging-of-Receivables Method

• The aging-of-receivables method is similar to the percent-of-receivables method.

• In the aging method, businesses group individual accounts based on how long the receivable has been outstanding.

• Different percentages are applied to each category.




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The procedure for recording the year-end adjusting entry under the aging-of-receivables method is similar to the percent-of-receivables method.



Smart Touch Learning knows the target balance of the Allowance for Bad Debts account is $185.

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After posting the adjusting entry, Smart Touch Learning has the following balances in its balance sheet and income statement accounts:


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Comparison of Accounting for Uncollectibles



Account for notes receivable including computing interest and recording honored and dishonored notes


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HOW ARE NOTES RECEIVABLE ACCOUNTED FOR?

• Promissory note—A written promise to pay a specified amount of money at a particular future date, usually with interest.

• Maker of the note (debtor)—The entity that signs the note and promises to pay the required amount.– The maker of the note is the debtor.

• Payee of the note (creditor)—The entity to whom the maker promises future payment; the payee of the note is the creditor. – The creditor is the company that loans the money.



• Principal—The amount loaned by the payee and borrowed by the maker of the note.

• Interest—The revenue to the payee for loaning money. – Interest is an expense to the debtor and revenue

to the creditor.• Interest period—The period of time during

which interest is computed. – It extends from the original date of the note to the

maturity date. – Also called the note term.


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• Interest rate—The percentage rate of interest specified by the note. – Interest rates are almost always stated for a period

of one year.• Maturity date—As stated earlier, this is the

date when final payment of the note is due.– Also called the due date.

• Maturity value—The sum of the principal plus interest due at maturity. – Maturity value is the total amount that will be paid

back.




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Smart Touch Learning lends Lauren Holland $1,000 on September 30, 2019, for one year, at an annual rate of 6%.


Identifying Maturity Date

• Some notes specify the maturity date. • Other notes state the period of the note in

days or months. – When the period is given in months, the note’s

maturity date falls on the same day of the month as the date the note was issued.

– When the period is given in days, the maturity date is determined by counting the actual days from the date of issue.• Count the maturity date• Omit the issue date


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Identifying Maturity Date

A 180-day note dated February 16, 2019, matures on August 15, 2019, as shown here:


Computing Interest on a Note

The formula for computing the interest is as follows:

• In the formula, time represents the portion of a year that interest has accrued on the note. – It may be expressed as a fraction of a year in months

(number of months/12)– Or a fraction of a year in days (number of days/365)


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Using the data in Exhibit 8-4, Smart Touch Learning computes interest revenue for one year as follows:

• The maturity value of the note is $1,060 ($1,000 principal + $60 interest).

• The time element is 12/12 or 1 because the note’s term is one year.



Interest on a $2,000 note at 10% for nine months is computed as follows:

The interest on a $5,000 note at 12% for 60 days can be computed as follows:


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Accruing Interest Revenue and Recording Honored Notes Receivable

Refer back to Exhibit 8-4: Smart Touch Learning lending Lauren Holland $1,000 on September 30, 2019, for one year at an annual interest rate of 6%. On December 31, interest should be accrued.



For 2020, Smart Touch Learning earns nine months of interest:


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On the maturity date of the note, Smart Touch Learning will receive cash for the principal amount plus interest. The company considers the note honored and makes thefollowing entry:



On July 1, 2019, Rosa Electric sells household appliances for $2,000 to Dorman Builders. Dorman signs a nine-month promissory note at 10% annual interest. Rosa’s entries:


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Sports Club cannot pay Blanding Services the amount due on accounts receivable of $5,000. Blanding accepts a 60-day, $5,000 note receivable, with 12% interest, on Nov. 19, 2019.


Recording Dishonored Notes Receivable

• When a maker dishonors a note, the dishonored note and the unpaid interest are transferred to Accounts Receivable.

• Later, the Accounts Receivable can be written off under the direct write-off method or the allowance method.


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Suppose Rubinstein Jewelers has a six-month, 10% note receivable for $1,200 from Mark Adair that was signed on March 3, 2019, and Adair defaults. Rubinstein Jewelers will record the default on September 3, 2019, as follows:


Recording Dishonored Notes Receivable


Use the acid-test ratio, accounts receivable turnover ratio, and days’ sales in receivables to evaluate business performance


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HOW DO WE USE THE ACID-TEST RATIO, ACCOUNTS RECEIVABLE TURNOVER RATIO,

AND DAYS’ SALES IN RECEIVABLES TO EVALUATE BUSINESS PERFORMANCE?

• Balance-sheet data are useful because they show the relationships among assets, liabilities, and revenues.

• Ratios for analysis:– Acid-test ratio– Accounts receivable turnover ratio– Days’ sales in receivables


HOW DO WE USE THE ACID-TEST RATIO, ACCOUNTS RECEIVABLE TURNOVER RATIO,

AND DAYS’ SALES IN RECEIVABLES TO EVALUATE BUSINESS PERFORMANCE?


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The following is a summary of financial information for Sears Holdings Corporation (with all amounts shown in millions):

Acid-Test (or Quick) Ratio

• The acid-test ratio is used to measure a company’s ability to pay its current liabilities.

• It is more stringent than the current ratio. • Quick assets are cash, cash equivalents,

short-term investments, and net current receivables.

• The higher the acid-test ratio, the more able the business is to pay its current liabilities.

• In general, an acid-test ratio of 1.00 or higher is considered safe.– Acceptability of the ratio depends on industry


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Acid-Test (or Quick) Ratio

Sears Holdings Corporation’s acid-test ratio January 30, 2016:

The business has $0.12 of quick assets to pay each $1.00 of current liabilities.


Accounts Receivable Turnover Ratio

• The accounts receivable turnover ratiomeasures the number of times the company collects the average accounts receivable balance in a year.

• The higher the ratio, the faster the cash collections.


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Accounts Receivable Turnover Ratio

Sears Holdings Corporation’s accounts receivable turnover ratio January 30, 2016:

The business turns over its receivables 59.31 times a year.

Note: Net sales is used instead of net credit sales. This is because most companies don’t report the level of detail needed to determine net credit sales.


Days’ Sales in Receivables

• Days’ sales in receivables indicates how many days it takes to collect the average level of accounts receivable. – It is also called the collection period.

• The number of days’ sales in receivables should be close to the number of days customers are allowed to make payment when credit is extended.

• The shorter the collection period, the more quickly the organization can use its cash.


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Days’ Sales in Receivables

Sears Holdings Corporation’s days’ sales in receivables can be computed as follows:

On average, it takes Sears Holdings Corporation 6 days to collect its accounts receivable.

– Note: We used net sales rather than net credit sales when calculating the accounts receivable turnover. Therefore, the calculation includes both cash and credit sales.



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Chapter 8 Receivables · Chapter 8 Receivables Chapter 8 Learning Objectives 1. Define and explain common ... Chapter 8 Learning Objectives 4. Account for notes receivable including

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