Prepared by: Keri Norrie, Camosun College ACCOUNTING PRINCIPLES Third Canadian Edition Prepared by: Keri Norrie, Camosun College

ACCOUNTING FOR RECEIVABLES CHAPTER 8 ACCOUNTING FOR RECEIVABLES

RECEIVABLES The term receivables refers to amounts due from individuals and other companies; they are claims expected to be collected in cash. Three major classes of receivables are: 1. Accounts Receivable 2. Notes Receivable 3. Other Receivables

ACCOUNTS RECEIVABLE The three primary accounting problems associated with accounts receivable are: 1. Recognizing accounts receivable. 2. Valuing accounts receivable. 3. Disposing of accounts receivable.

RECOGNIZING ACCOUNTS RECEIVABLE Account Titles and Explanation GENERAL JOURNAL Date Account Titles and Explanation Debit Credit July 1 Accounts Receivable - Zellers Sales To record sales on account. 1,000 1,000 When a business sells merchandise to a customer on credit, Accounts Receivable is debited and Sales is credited.

RECOGNIZING ACCOUNTS RECEIVABLE Account Titles and Explanation GENERAL JOURNAL Date Account Titles and Explanation Debit Credit July 5 Sales Returns and Allowances 100 Accounts Receivable - Zellers 100 To record merchandise returned. When a business receives returned merchandise previously sold to a customer on credit, Sales Returns and Allowances is debited and Accounts Receivable is credited.

RECOGNIZING ACCOUNTS RECEIVABLE Account Titles and Explanation GENERAL JOURNAL Date Account Titles and Explanation Debit Credit July 31 Cash ($1,000 - $100) 900 Accounts Receivable- Zellers 900 To record collection of account. When a business collects cash from a customer for merchandise previously sold on credit, Cash is debited and Accounts Receivable is credited.

RECOGNIZING ACCOUNTS RECEIVABLE RELATIONSHIP OF GENERAL LEDGER AND SUBSIDIARY LEDGER General Ledger Customer B C Accounts Receivable The control account in the general ledger shows the total accounts receivable while the subsidiary ledger provides the detail by customer. Subsidiary Ledger Customer A

RECOGNIZING ACCOUNTS RECEIVABLE Account Titles and Explanation GENERAL JOURNAL Date Account Titles and Explanation Debit Credit July 31 Accounts Receivable - Zellers 13.50 Interest Revenue 13.50 To record interest on amount due. When financing charges are added to a balance owing, Accounts Receivable is debited and Interest Revenue is credited.

VALUING ACCOUNTS RECEIVABLE To ensure that receivables are not overstated on the balance sheet, they are stated at their net realizable value. Net realizable value is the net amount expected to be received in cash and excludes amounts that the company estimates it will not be able to collect.

VALUING ACCOUNTS RECEIVABLE Assets Liabilities Owner’s Equity = + At the end of each period, a company estimates the amount of credit losses using the allowance method. The allowance method reduces the accounts receivable asset to its net realizable value and reduces owner’s equity through recording bad debts expense. The recording of the bad debts expense in the same period as the related revenue results in better matching on the income statement.

THE ALLOWANCE METHOD How much of accounts receivable will not be collected? Which customers won’t pay? To reduce accounts receivable to its net realizable value, it is not feasible to credit the accounts receivable account directly for two reasons: 1. We don’t know which individual customers will not pay their receivable balance in the future. 2. The amount that will not be collected can only be estimated now. As a result, a contra asset account, Allowance for Doubtful Accounts, is credited for the estimated uncollectible amount.

THE ALLOWANCE METHOD GENERAL JOURNAL Date Account Title and Explanation Debit Credit Dec. 31 Bad Debts Expense 24,000 Allowance for Doubtful Accounts 24,000 To record estimate of uncollectible accounts. Estimated uncollectible amounts are debited to Bad Debts Expense and credited to Allowance for Doubtful Accounts (a contra asset account) at the end of each period.

ADORABLE JUNIOR GARMET Balance Sheet (Partial) Current assets Cash $ 14,800 Accounts receivable $200,000 Less: Allowance for doubtful accounts 25,000 175,000 Net Realizable Value

BASES USED FOR THE ALLOWANCE METHOD Companies use either of two methods in the estimation of uncollectible accounts: 1. Percentage of sales 2. Percentage of receivables Both bases are GAAP; the choice is a management decision.

COMPARISON OF BASES OF ESTIMATING UNCOLLECTIBLES (Illustration 8-4) Percentage of Receivables Percentage of Sales Net Realizable Value Accounts Allowance for Doubtful Accounts Receivable Emphasis on Income Statement Relationships Emphasis on Balance Sheet Relationships

PERCENTAGE OF SALES BASIS In the percentage of sales basis, management establishes a percentage relationship between the amount of credit sales and expected losses from uncollectible accounts. Expected bad debt losses are determined by applying the percentage to the sales base of the current period. This basis better matches expenses with revenues.

PERCENTAGE OF RECEIVABLES BASIS Under the percentage of receivables basis, management establishes a percentage relationship between the amount of accounts receivable and the required balance in the allowance account. This percentage can be applied to the total accounts receivable balance, or to individual accounts receivable balances stratified by age.

PERCENTAGE OF RECEIVABLES BASIS The required balance in the allowance account is determined by applying the percentage to the accounts receivable balance at the end of the current period. The amount of the adjusting entry to record expected bad debt losses for the current period is the difference between the required balance and the existing balance in the allowance account. This basis produces the better estimate of net realizable value of receivables.

THE ALLOWANCE METHOD GENERAL JOURNAL Date Account Titles and Explanation Debit Credit Mar. 1 Allowance for Doubtful Accounts 4,500 Accounts Receivable — Kids Online 4,500 Write-off of Kids Online account. Actual uncollectible accounts are debited to Allowance for Doubtful Accounts and credited to Accounts Receivable at the time the specific account is written off.

Account Titles and Explanation Allowance for Doubtful Accounts THE ALLOWANCE METHOD GENERAL JOURNAL Date Account Titles and Explanation Debit Credit July 1 Accounts Receivable — Kids Online 4,500 Allowance for Doubtful Accounts 4,500 To reverse write-off of Kids Online account. When there is recovery of an account that has been written off: 1. reverse the entry made to write off the account and ...

Account Titles and Explanation Accounts Receivable — Kids Online THE ALLOWANCE METHOD GENERAL JOURNAL Date Account Titles and Explanation Debit Credit July 1 Cash 4,500 Accounts Receivable — Kids Online 4,500 To record collection from Kids Online 2. Record the collection in the usual manner.

DISPOSING OF ACCOUNTS RECEIVABLE To accelerate the receipt of cash from receivables, owners frequently: 1. sell to a factor, such as a finance company or a bank, and 2. make credit card sales.

DISPOSING OF ACCOUNTS RECEIVABLE A factor buys receivables from businesses for a fee and collects the payments directly from customers. Credit cards are frequently used by retailers who wish to avoid the paperwork of issuing credit. Retailers can receive cash more quickly from the credit card issuer.

CREDIT CARD SALES Three parties are involved when credit cards are used in making retail sales: 1. the credit card issuer, 2. the retailer, and 3. the customer. The retailer pays the credit card issuer a percentage fee of the invoice price for its services. From an accounting standpoint, sales from bank cards (e.g., Visa and MasterCard) are treated differently than sales from non-bank cars (e.g., American Express).

BANK CARD SALES Sales resulting from the use of VISA and MasterCard are considered cash sales by the retailer. These cards are issued by banks. Upon receipt of credit card sales slips from a retailer, the bank immediately adds the amount to the seller’s bank balance.

Account Titles and Explanation To record VISA credit card sales. BANK CARD SALES GENERAL JOURNAL Date Account Titles and Explanation Debit Credit Oct 21 Cash 965 Credit Card Expense ($1,000 x 3.5%) 35 Sales 1,000 To record VISA credit card sales. Anita Ferreri purchases a number of compact discs for her restaurant from Kerr Music Co. for $1,000 using her Royal Bank VISA card. The service fee that the Royal charges is 3.5 percent.

NON-BANK CARD SALES Sales using American Express and other non-bank cards are reported as credit sales, not cash sales. Conversion into cash does not occur until American Express remits the net amount to the seller.

Account Titles and Explanation NON-BANK CARD SALES GENERAL JOURNAL Date Account Titles and Explanation Debit Credit Oct 24 Accounts Receivable 475 Credit Card Expense ($500 x 5%) 25 Sales To record American Express credit card sales. 500 Kerr Music Co. accepts an AMERICAN EXPRESS card for a $500 sale. The service fee that AMERICAN EXPRESS charges is 5 percent.

NOTES RECEIVABLE A promissory note is a written promise to pay a specified amount of money on demand or at a definite time. The party making the promise is the maker. The party to whom payment is made is called the payee.

RECOGNIZING NOTES RECEIVABLE GENERAL JOURNAL Date Account Titles and Explanation Debit Credit Notes Receivable - Higly 10,000 May 31 Accounts Receivable — Higly 10,000 To record acceptance of Higly note. Wolder Company receives a $10,000, 4.5% promissory note, due in four months (Sept 30) from Higly Inc. to settle an open account.

FORMULA FOR CALCULATING INTEREST Illustration 8-7 The basic formula for calculating interest on an interest-bearing note is: The interest rate specified on the note is an annual rate of interest. Principal of Note Annual Interest Rate Time in Terms of One Year Interest X X =

RECOGNIZING NOTES RECEIVABLE GENERAL JOURNAL Date Account Titles and Explanation Debit Credit 37.50 37.50 June 30 Interest Receivable Interest Revenue ($10,000 x 4.5% x 1/12) To accrue interest on Higly note receivable. An adjusting entry is recorded at the June 30 year end to accrue one month of interest on the Highly note receivable.

VALUING NOTES RECEIVABLE Like accounts receivable, short-term notes receivable are reported at their net realizable value. The notes receivable allowance account is Allowance for Doubtful Notes.

HONOUR OF NOTES RECEIVABLE GENERAL JOURNAL Date Account Title and Explanation Debit Credit Sept. 30 Cash 10,150 Notes Receivable - Higly 10,000.00 Interest Revenue 112.50 Interest Receivable 37.50 To record collection of Higly note. A note is honoured when it is paid in full at its maturity date. Wolder Co. collects the principal amount of $10,000, the one month of interest accrued already at June 30, and three months additional interest revenue ($10,000 x 4.5% x 3/12) for the loan period of July 1 – September 30.

DISHONOUR OF NOTES RECEIVABLE GENERAL JOURNAL Date Account Title and Explanation Debit Credit Sept. 30 Accounts Receivable - Higly 10,150 Notes Receivable - Higly 10,000.00 Interest Revenue 112.50 Interest Receivable 37.50 To record the dishonouring of Higly note. A dishonoured note is a note that is not paid in full at maturity. A dishonoured note receivable is no longer negotiable. Since the payee still has a claim against the maker of the note, the balance in Notes Receivable is usually transferred to Accounts Receivable.

BALANCE SHEET PRESENTATION OF RECEIVABLES Each of the major types of receivables should be identified in the balance sheet or in the notes to the financial statements. In the balance sheet, short-term receivables are reported within the current assets section below cash and temporary investments. Both the gross amount of receivables and the allowance for doubtful accounts should be reported.

USING THE INFORMATION IN THE FINANCIAL STATEMENTS Financial ratios are calculated to evaluate the short-term liquidity of a company. These ratios include the receivables turnover ratio and the collection period ratio.

ACCOUNTS RECEIVABLE TURNOVER RATIO The ratio used to assess the liquidity of the receivables is the receivables turnover ratio. Net Credit Average Net Receivables Sales Receivables Turnover  =

Days in Year Receivables Collection (365) Turnover Period in Days COLLECTION PERIOD The collection period in days is a variant of the receivables turnover ratio and makes liquidity even more evident. The general rule is that the collection period should not exceed the credit term period. Days in Year Receivables Collection (365) Turnover Period in Days  =

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