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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Chapter 8 1.

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1 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Chapter 8 1

2 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 2 Define and explain common types of receivables Account for notes receivable Use the allowance method to account for uncollectibles Understand the direct write-off method for uncollectibles

3 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 3 Report receivables on the balance sheet and evaluate a company using the acid- test ratio, days’ sales in receivables, and the accounts receivable turnover ratio

4 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Define and explain common types of receivables 4 1 1

5 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. An asset originating from selling goods or services to another party on credit Right to receive cash in the future from such a transaction Accounts receivable Repeating transactions, less formal Control account Subsidiary ledgers Notes receivable Individual signed instance Detailed terms Often long-term 5

6 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Control Account

7 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. What is the difference between accounts receivable and notes receivable? 7 Notes receivable include a charge for interest; accounts receivable do not. Accounts receivable are current assets; notes receivable are current or long-term assets. Notes receivable are more formal than accounts receivable. Notes receivable are evidenced by the debtor signing a promissory note; accounts receivable are not.

8 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Account for notes receivable 8 2 2

9 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. What happens when a customer fails to pay their bill on the due date? The phone call – in-house collection attempt The follow up – you said this then Place a hold on their account – no more product The negotiation – compromise? Collect Convert to a note Write off

10 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 10 Why would a selling firm convert past due Accounts Receivable to Notes Receivable? Builds commitment to actually pay Acknowledges that the amount is owed A big legal hammer to take to court! Why would a buyer submit to this? Pauses the collection calls Stalls payment until they have funds Note interest may be less than a past due rate They want to keep doing business with the supplier

11 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 11

12 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Maturity date can be: A specific date, such as March 13 Stated in terms of number of months A six-month note dated February 16, 2014, would mature on August 16, 2014 Stated in terms of number of days Must count days from issue date to maturity day How many days from Jan 11 th to March 15 th ? 12

13 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. A 180-day note dated February 16, 2014 matures on August 15,

14 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. By the year By the month By the day 14 1 year

15 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 15 Sept. 30, 2014: Note originated as a conversion from past due A/R. December 31, 2014: accrue interest earned Sept. 30, 2015: receive payment in full

16 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Sep. 1: Original sales entry. Dec. 1:Conversion of A/R to Notes Receivable Dec. 31:Year end accrual of Interest Receivable & Revenue (another adjusting entry!) Mar. 1:Collection of principal & interest

17 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Pre-work: Sept 1 st Gulf Corp. sold $1,500 of seashells to Glenn Holler, on terms 2/10, n/30. (Omit inventory/cogs effect) Journal Entry Steps 1)Identify account & type 2)Increase or decrease and apply debit and credit rules 3)Journalize & check

18 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Dec. 1: Conversion of A/R to Notes Receivable, 8%, due March 1 st the following year. Journal Entry Steps 1)Identify account & type 2)Increase or decrease and apply debit and credit rules 3)Journalize & check

19 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Dec. 31:Year end accrual of Interest Receivable & Revenue (an adjusting entry!) Journal Entry Steps 1)Identify account & type 2)Increase or decrease and apply debit and credit rules 3)Journalize & check

20 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Mar. 1:Collection of principal & interest Journal Entry Steps 1)Identify account & type 2)Increase or decrease and apply debit and credit rules 3)Journalize & check

21 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Mar. 1:Collection of principal & interest Journal Entry Steps 1)Identify account & type 2)Increase or decrease and apply debit and credit rules 3)Journalize & check

22 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. March 1 st: – if the maker fails to pay the Note receivable Move the note receivable into accounts receivable Any earned interest is added to the new accounts receivable 22 Journal Entry Steps 1)Identify account & type 2)Increase or decrease and apply debit and credit rules 3)Journalize & check

23 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. March 1 st: if the maker fails to pay the Note receivable Move the note receivable into accounts receivable Any earned interest is added to the new accounts receivable 23 Journal Entry Steps 1)Identify account & type 2)Increase or decrease and apply debit and credit rules 3)Journalize & check

24 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Use the allowance method to account for uncollectibles

25 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. That will be $25,000 cash please. Would you take it home today if I gave you 5 years to pay?

26 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Few customers No defaults Many high-risk customers Many defaults Many customers Moderate defaults Maximize profits where the expected cost of default from the worst acceptable credit risk = the profits gained from selling to that customer. (Marginal cost = Marginal revenue) Where is the sweet spot?

27 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Two methods to account for uncollectible accounts: Allowance method – GAAP approved Matches default expense with sales revenue Direct write-off method – Rarely GAAP legal Disregards the matching principle The risk of default is taken when the sale is made. This is what ultimately causes the default An estimated expense should be entered even before accounts actually default 27

28 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Companies use their history, and industry information to estimate uncollectibles Percent-of-sales approach Aka: Income-statement approach Estimates uncollectible accounts as a percent of sales Aging-of-accounts Aka: Balance-sheet approach Determine target allowance based on detailed receivables balances 28

29 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. All hail the matching principle Expense amount based on percentage of sales Cares little about balance sheet accuracy Estimate future default by multiplying a default rate times sales revenue. Prepare an adjusting entry to: Record the default expense Dump the credit into an allowance account for future write off use 29

30 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

31 Hollywood hangout estimates that 1% of the sales will be uncollectable. Perform their period end adjusting entry. Hollywood hangout estimates that 1% of the sales will be uncollectable. Perform their period end adjusting entry.

32 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

33 During its first year of operations, Spring Garden Plans earned revenue of $322,000. Industry experience suggests that bad debts will amount to 2% of revenues. At December 31, 2012, accounts receivable total $36,000. The company uses the allowance method to account for uncollectibles Journalize Spring’s uncollectible account expense adjustment using the percent-of sales method. 2

34 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Journal Entry DATEACCOUNTS AND EXPLANATIONSDEBITCREDIT Dec 31 Accounts receivable322,000 Sales revenue322, Uncollectible account expense (322,000 x.02)6,440 Allowance for uncollectible accounts6,440 1.Journalize Spring’s sales and uncollectible account expense using the percent-of sales method. 34

35 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 2. How much should you report as Net Accounts Receivable on the balance sheet after that adjusting entry? 35 Balance sheet (Partial): Accounts receivable$36,000 Less: Allowance for uncollectible accounts$ 6,440 Accounts receivable, net$29,560

36 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Calculates default expectations based on the amount of unpaid customer accounts still on then books That’s Accounts receivable The resulting calculation belongs on the balance sheet That’s the ending balance for the allowance account Use whatever expense amount it takes to get the balance sheet correct Note, this is a new step! 36

37 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

38 Based on the aging of their receivables, Hollywood hangout estimates that $750 of their A/R balance will be uncollectable. Perform their period end adjusting entry. Based on the aging of their receivables, Hollywood hangout estimates that $750 of their A/R balance will be uncollectable. Perform their period end adjusting entry.

39 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Total A/R Expect not to collect

40 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

41 Perform the adjusting entry to arrive at the desired balance in the allowance account

42 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Focuses on actual age of the accounts receivable Determines a target allowance balance 42 AR Total Expected not to collect

43 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. The amount not expected to be collected becomes the allowance account target balance Journal entry $150 credit balance plus/minus adjustment = $400 43

44 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Summer and Sandcastles Resort had the following balances at December 31, 2012, before the year-end adjustments: The aging of accounts receivable yields the following data: 44 Accounts receivable Allowance for uncollectible accounts 78,000 Beg Bal 1,900 Age of Accounts Receivable 0-60 daysOver 60 DaysTotal Receivables Amount receivable $75,000$3,000$78,000 % uncollectible × 4% × 24% Amount uncollectible $3,000+ $720= $ 3,720

45 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 1.Journalize Summer’s entry to adjust the allowance account to its correct balance at December 31, Prepare a T-account to compute the ending balance of Allowance for uncollectible accounts. 45 Accounts receivable Allowance for uncollectible accounts 78,000 Beg Bal 1,900 Adj 1,820 _ __________________________________________ End Bal 3,720 Journal Entry DATEACCOUNTS AND EXPLANATIONSDEBITCREDIT 2012 Dec31Uncollectible account expense ($3,720 − $1,900)1,820 Allowance for uncollectible accounts1,820

46 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. When we know we aren’t going to collect from a particular customer, we have to take their accounts receivable off of our books The A/R is now worthless Our books should reflect this reality Issues: We already expensed this as an estimate We are storing the expense in the allowance account Mechanics: Reduce A/R amount Use the allowance account to offset it 46

47 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Surprise! On February 14 th Paris Hilton answers our collection call. She refuses to pay her $500 bar tab because she doesn’t even remember being there. We know we don’t have a prayer of collecting, so we write if off. Journalize that.

48 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

49 Sometimes a customer will pay the amount owed after the customer’s account is written off Two entries needed to collect Paris reconsidered $500 payment: Reinstate her Accounts receivable. Record the payment. 49

50 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Make sales on account Establish a pool (allowance) for future potential uncollectibility Collect cash on account from most customers Possibly convert some A/R to Notes receivables Identify bad debts and write them off Reinstate & collect some written off accounts 50

51 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Understand the direct write-off method for uncollectibles

52 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Used by small businesses Used by large all-cash-sales businesses No Allowance for uncollectible accounts Record uncollectible accounts expense when specific account is written off

53 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Overstates Accounts receivable on the balance sheet No contra asset allowance account Incents forestalling of write offs. Violates matching principle Uncollectible account expense often not in same period as sale All hail materiality! 53

54 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Direct write-off of debt recovery process is different from the allowance method The debt was written off the books To recover: Reverse the write-off journal entry Record the cash payment 54

55 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Gate City Cycles had trouble collecting its account receivable from Sue Ann Noel. On June 19, 2012, Gate City finally wrote off Noel’s $700 account receivable. Gate City turned the account over to an attorney, who hounded Noel for the rest of the year. On December 31, Noel sent a $700 check to Gate City Cycles with a note that said, “Here’s your money. Please call off your bloodhound!” 1. Journalize the entries required for Gate City Cycles, assuming Gate City uses the direct write-off method. 55

56 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 56 Journal Entry DATEACCOUNTS AND EXPLANATIONSDEBITCREDIT Jun19Uncollectable account expense700 Accounts receivable—Sue Ann Noel700 Dec31Accounts receivable—Sue Ann Noel700 Uncollectable account expense700 Dec31Cash700 Accounts receivable—Sue Ann Noel700 Collected on account.

57 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Journalize credit-card and debit-card sales

58 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Credit-card sales are an alternative form for receiving payments Two types: Issued by a financial institution Visa Mastercard Issued by a credit card company American Express Discover 58

59 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Different than credit and bankcards Same as cash Amount subtracted from buyer’s bank account Amount added to retailer’s bank account 59

60 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Retailers receive cash at time of sale Visa and MasterCard most common bank cards Retailer accepting the credit cards pays a fee Two types of fee transactions: NET: The total sale less the processing fee assessed equals the net amount of cash deposited Gross: The total sale is deposited and the fee is deducted at the end of the month Journal entry similar to cash sales 60

61 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Restaurants do a large volume of business by credit and debit cards. Suppose Chocolate Passion restaurant had these transactions on January 28, 2012: National Express credit-card sales..... $ 9,300 ValueCard debit-card sales ,000 Suppose Chocolate Passion’s processor charges a 3% fee and deposits sales net of the fee. Requirement: 1. Journalize these sale transactions for the restaurant. 61

62 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 62 Journal Entry DATEACCOUNTS AND EXPLANATIONS POST. REF.DEBITCREDIT Jan28Cash$9,021 Card discount expense ($9,300 ×.03)279 Sales revenue$9,300 Recorded credit-card sales, net of fee. 28Cash8,730 Card discount expense ($9,000 ×.03)270 Sales revenue9,000 Recorded bank card sales, net of fee. National Express credit-card sales..... $ 9,300 ValueCard debit-card sales ,000

63 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Evaluate accounts receivable performance

64 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Also called the “quick ratio” Stringent measure of liquidity Measures entity’s ability to pay its current liabilities immediately 64

65 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Measures the number of times the company sells and collects the average receivables Higher the ratio, the faster the cash collections occur How well a company is managing its customer credit policies 65

66 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Also called “collection period” It is number of days it takes to collect the average balance of receivables The shorter the collection period, the more quickly cash is available Options to calculate: Complex pathway involving too much math Calculate turns first, then divide 365 by turns 66

67 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Who collects faster Budweiser or Coors? BUD - Budweiser TAP – Coors Get the numbers Do the math Read the story days normal Lots of other normals 67 Net Sales Average A/R =A/R Turns 365 A/R Turns = Days’ sales in receivables

68 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Add inventory information to measure the whole business cycle Who turns inventory into cash more quickly? days of inventory is norm days of A/R is normal is a normal business cycle range 68

69 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 69 Net Sales Average A/R =A/R turns 365 A/R Turns = Days’ sales in receivables COGS Average Inv. =Inventory turns 365 Inventory. turns = Days’ inventory on hand Faster collections is less risk taking Faster inventory means better product management Faster business cycle means more times making money each year normal normal 3-4 normal normal = Days’ inventory on hand normal Days’ sales in receivables + Days in the business cycle

70 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Step 1: One day’s sales is calculated Net sales (Total revenues) divided by 365 days per year 70

71 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Step 2: Day’s sales in inventory Average net receivables divided by one days sales 71

72 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Northend Medical Center included the following items in its financial statements: 1.How much net income did Northend earn for the month? 72 Service revenue …………$14,700 Less: Cost of services sold and other expenses… 12,400 Net income …………………$ 2,300

73 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 2. Show two ways Northend can report receivables on its classified balance sheet: 73 Current assets: Accounts receivable …………... $2,590 Less: Allowance for doubtful accounts ___150 Accounts receivable, net …...$ 2,440 or Accounts receivable, net of allowance for uncollectible accounts of $150…………...$2,440

74 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Southside Clothiers reported the following items at September 30, 2012 (last year’s—2011—amounts also given as needed): Compute Southside’s (a) acid-test ratio, (b) days’ sales in average receivables for 2012, and (c) accounts receivable turnover ratio. Evaluate each ratio value as strong or weak. Southside sells on terms of net

75 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. = $260,000 + $140,000 + $270,000 $500,000 = $670,000 $500,000 = 1.34 Southside’s position is strong. 75 (a)Acid-test ratio = Cash + Short-term investments + Net current receivables Total current liabilities

76 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. (b) Days’ sales in average receivables = * Average net accounts receivable ** One day’s sales *Average net accounts receivable = $170, ,000/2 = *$220,000 **One day’s sale=(Net sales/365 days) = $2,920,000/365 days = **$8,000 The days’ sales in average receivables are strong relative to credit terms of net = 28 days *$220,000 **$8,000

77 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 77 (c) Accounts receivable Turnover Ratio = Net sales revenue Average net accounts receivable = $2,920,000 $220,000 =13.3 Southside’s accounts receivable turnover ratio is strong relative to credit terms of net 30.

78 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Discount a note receivable (see Appendix 8A)

79 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. The payee needs cash before the maturity date Payee sells the receivables Amount is determined by present-value concepts 79

80 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Compute the original amount of interest on the note receivable Maturity value of the note = Principal + Interest Determine the period (number of days, months, or years) the bank will hold the note (the discount period) Compute the bank’s discount on the note This is the bank’s interest revenue from holding the note Seller’s proceeds from discounting the note receivable = Maturity value of the note – Bank’s discount on the note 80

81 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. $1,000 note is received on September 30, 2015 Maturity date is one year Note is discounted on November 30, 2014 Interest applied is 12%, and is higher than notes Amounts received is called proceeds 81

82 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. If proceeds are less than principle amount, the payee debits Interest expense If proceeds are greater than principle amount, the payee debits Interest revenue 82

83 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. The two main differences between accounts receivable and notes receivable are that : 1) accounts receivable are usually collected in a short time, such as within 30 days; and 2) notes receivable are usually longer in term and have a signed, interest-bearing document to support the note. The allowance method records Uncollectible account expense based on estimating the future potential that the company won’t collect. This estimate is based on experience, economy, and other factors. So the company knows that–historically–some percentage of customers will not pay. 83

84 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. There is no allowance for uncollectible accounts account or estimates used for the direct write-off method. The expense is journalized at the time the company determines a customer cannot pay. Most companies accept debit and/or credit cards as payment for sales. Companies can likely increase sales by offering customers the option to pay with debit/credit cards. This also allows the company to get its cash sooner, but a small fee is paid for that convenience. 84

85 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Notes receivable are another form of receivable that also earn interest. Interest, whether earned or incurred, is calculated as principal x rate x time. The passage of time is what creates the interest. Accounts receivable, net of allowance, is listed in the Current asset section of the balance sheet. Notes receivable is listed as current only if the note will be collected in one year or less. Ratios serve as benchmarks to see how well a company is managing its receivables. 85

86 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 86

87 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Copyright All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America. 87


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