Financial Accounting, Seventh Edition Chapter 8 Accounting for Receivables

Claims for which formal instruments of credit are issued Types of Receivables Amounts due from individuals and other companies that are expected to be collected in cash. Amounts owed by customers that result from the sale of goods and services. Claims for which formal instruments of credit are issued as proof of debt. “Nontrade” (interest, loans to officers, advances to employees, and income taxes refundable). Accounts Receivable Notes Receivable Other Receivables

Accounts Receivable Three accounting issues: Recognizing accounts receivable. Valuing accounts receivable. Disposing of accounts receivable.

Recognizing Accounts Receivable Illustration: Assume that on March 1, 2013, Terps Company sells merchandise on account to UVA Company for $1,000, with terms 1/10, n/30. The cost of the merchandise was $700. Prepare the journal entry/entries to record this transaction on the books of Terps Company.

Recognizing Accounts Receivable Illustration: On March 5, UVA Company returns defective merchandise worth $100 to Terps Company. Prepare the journal entry for Terps Company. Illustration: On Mar 10, Terps Company receives payment from UVA Company for the balance due. Prepare the journal entry for Terps Company.

Accounts Receivable Valuing Accounts Receivables Are reported as a current asset on the balance sheet. Are reported at the amount the company thinks they will be able to collect. Sales on account raise the possibility of accounts not being collected. Valuation can be difficult because an unknown amount of receivables will become uncollectible.

Valuing Accounts Receivable Some customers may not pay their account. Uncollectible amounts are referred to as bad debts. When an account receivable becomes uncollectible, a firm incurs a bad debt expense. There are two methods of dealing with bad debts expense: Direct Write-Off Method Allowance Method

Valuing Accounts Receivable Methods of Accounting for Uncollectible Accounts Direct Write-Off Theoretically undesirable: Violates matching principle. Receivable not stated at net realizable value. Not acceptable for financial reporting (violates GAAP). Allowance Method Losses are estimated: Follows matching principle. Receivable stated at net realizable value. Required by GAAP.

Direct Write-Off Method On March 1, Terps Company determines that they cannot collect $5,000 from Mr. Bad Guy, a credit customer. Method is objective because bad debt expense is written off at the time it proves to be uncollectible.

Direct Write-off versus Allowance Method The Direct Write-off Method is a violation of GAAP. WHY? Matching Principle requires expenses to be reported in the same accounting period as the revenue they help to generate.

There are two advantages to the allowance method: At the end of each period, a company estimates total bad debts expected to be realized from that period’s sales, based on industry averages or its past experience. This is done by using an Allowance for Doubtful Accounts - this is a contra-asset account that is offset against Accounts Receivable on the balance sheet. There are two advantages to the allowance method: It records estimated bad debts expense in the period when the related sales are recorded. It reports accounts receivable on the balance sheet at the estimated amount of cash to be collected.

Recording Estimated Uncollectibles At the end of its first year of operations, Terps Company estimates that $12,000 of it accounts receivable will prove uncollectible. The total accounts receivable balance at December 31, 2012, is $300,000.Prepare the appropriate journal entry.

Recording Estimated Uncollectibles At the end of its first year of operations, Terps Company estimates that $12,000 of it accounts receivable will prove uncollectible. The total accounts receivable balance at December 31, 2012, is $300,000.How would this be reported in the balance sheet of Terps Company?

Less: Allowance for Doubtful Accounts Net Accounts Receivable Let us do some financial analysis Compare the partial balance sheets of the following 2 companies and determine which company manages Accounts Receivables better Company A Company B Accounts Receivable 6,260 million 6,843 million Less: Allowance for Doubtful Accounts (323 million) (690 million) Net Accounts Receivable $5,937 million $6,153 million

Valuing Accounts Receivable Recording the Actual Write-Off of an Uncollectible Account: Assume that on March 1, 2013, Terps Company decided to write-off a $5,000 balance owed by Mr. Bad Guy. The entry to record the write-off is:

Valuing Accounts Receivable Recording the Write-Off of an Uncollectible Account: The write-off affects only balance sheet accounts.

Valuing Accounts Receivable Recovery of an Uncollectible Account: Assume that on July 1, Mr. Bad Guy pays the $5,000 amount that UMD Company had written off on March 1. Record the transaction: How often does a company recover previously written off bad debts?

Estimating Allowance for Doubtful Accounts Two Methods Percent of Sales Method Percent of Accounts Receivable Method

Valuing Accounts Receivable Bases Used for Allowance Method

Percentage of Sales Method Bad debts expense is computed as a straight percentage of the current year’s credit sales. The percentage is based on prior years’ experience, modified for changes in current year. Any existing balance in the Allowance for Doubtful Accounts is NOT considered in calculating Bad Debts Expense.

Percentage of Sales Method Terps company has net credit sales of $800,000 in 2012. Management estimates 1.0% of credit sales will eventually prove uncollectible. What is the journal entry to record Bad Debts Expense on Dec 31, 2012?

Percentage of sales Method Emphasizes the matching of expenses with revenues. When the company makes the adjusting entry, it disregards the existing balance in Allowance for Doubtful Accounts.

Percentage of Receivables Method Compute the estimate of the Allowance for Doubtful Accounts. Bad Debts Expense is computed as:

Aging of Receivables Method Year-end Accounts Receivable is broken down into age classifications. Each age grouping has a different likelihood of being uncollectible. Compute a separate allowance for each age grouping.

Aging of Receivables Method

Percentage of Receivables Method The unadjusted balance in the allowance account is $900. We estimated the proper balance to be $5,320. Occasionally the allowance account will have a debit balance prior to adjustment.

Knowledge Check Question 1: The two methods of accounting for bad debts are the direct write-off method and the allowance method. When comparing the two, which of the following is true? The direct write-off method is exact and also better illustrates the matching principle. The allowance method is less exact, but it better illustrates the matching principle. The direct write-off method is theoretically superior. The direct write-off method requires two separate entries to write off an uncollectible account.

Comprehensive Example: Terps Company On Dec 31, 2012, the Accounts Receivable balance of Terps Company is $42,300. Also, the Allowance for Doubtful Accounts has a balance of $2,300 on December 31, 2011. Historically, 10 percent of the accounts receivable balance is not collected. During the year 2012, Terps Company wrote off $2,700 of uncollectible accounts. What is the adjusting journal entry on December 31, 2012?

Comprehensive Example: Terps Company

Valuing Accounts Receivable Summary Percentage of Sales approach: Focus on “Bad debt expense” estimate, existing balance in the allowance account is ignored. Method achieves a matching of expense and revenues. Percentage of Receivables approach: Accurate valuation of receivables on the balance sheet. Method may also be applied using an aging schedule. Existing balance in allowance account considered.

Knowledge Check Question 2: A company used the percent of sales method to determine its bad debts expense. At the end of the current year, the company's unadjusted trial balance reported the following selected amounts: Accounts receivable $ 245,000 debit Allowance for doubtful accounts $ 300 credit Net Sales $ 900,000 credit All sales are made on credit. Based on past experience, the company estimates 0.5% of credit sales to be uncollectible. What amount should be debited to Bad Debts Expense when the year-end adjusting entry is prepared? $4,200 $1,225 $45,000 $4,500

Knowledge Check Question 3: On December 31 of the current year, a company's unadjusted trial balance included the following: Accounts Receivable, debit balance of $97,250; Allowance for Doubtful Accounts, credit balance of $951. What amount should be debited to Bad Debts Expense, assuming 6% of outstanding accounts receivable at the end of the current year will be uncollectible? $3,992. $4,884. $5,835. $6,786.

Accounts Receivable Disposing of Accounts Receivable Companies sell receivables for two major reasons. Receivables may be the only reasonable source of cash. Billing and collection are often time-consuming and costly.

Disposing of Accounts Receivable Sale of Receivables A factor buys receivables from businesses and then collects the payments directly from the customers. Typically the factor charges a commission to the company that is selling the receivables. The fee depends on the ‘credit quality’ of the receivables purchased. CREDIT QUALITY OF RECEIVABLES FICO Score 700 and above $2,819 FICO Score of 600 to 699 2,737 FICO SCORE below 600 868 Total Nondelinquent accounts $6,424 Delinquent accounts (30 days past due) 419 Period end gross credit card receivables $6,843

Disposing of Accounts Receivable Illustration: Assume that Terps Company factors $600,000 of receivables to Federal Factors. Federal Factors assesses a service charge of 10% of the amount of receivables sold. Record the journal entry to record the sale by Terps Company.

Bank Credit Card Sales Retailer considers bank credit card (such as VISA/Mastercard/Discover) sales the same as cash sales. Retailer must pay card issuer a fee of 2 to 4% for processing the transactions. Retailer records the sale in a similar manner as checks deposited from cash sale. Terps Company has a bank credit card sale of $500 to a customer. The bank charges a processing fee of 3%. Record the transaction.

Knowledge Check: On October 18 of the current year, a company concluded that a customer's $4,400 account receivable was uncollectible and that the account should be written off. What effect will this write-off have on this company's net income and total assets assuming the allowance method is used to account for bad debts? Decrease in net income; decrease in total assets. Increase in net income; no effect on total assets. No effect on net income; no effect on total assets. No effect on net income; decrease in total assets.

Statement Presentation and Analysis Accounts Receivable Turnover measures the number of times on average the company collects accounts receivables during the period. Accounts Receivable Turnover Net Credit Sales = Average Net Accounts Receivable Average Collection Period in Days measures the average number of days the company takes to collect its accounts receivable Days in Year (365) Average Collection Period in Days = Accounts Receivable Turnover

Statement Presentation and Analysis Illustration: In its Balance Sheet, Target Corporation reported a beginning balance of credit card receivables of $5,927 million, and ending balance of $6,153 million. Target’s net sales revenue for the year was $68,466 million. Determine the accounts receivable turnover for Target Corporation.

Let us analyze Target Corporation’s Bad Debts Expense (in millions $) 2011 2010 2009 Allowance for Doubtful Accounts at the beginning of period 690 1,016 1,010 Allowance for Doubtful Accounts at the end of period 430 Write offs of delinquent accounts 572 1,007 1,287 Recoveries of previously written off accounts 152 153 108 Bad Debts Expense ?

Let us analyze Target Corporation’s Bad Debts Expense (in millions $) 2011 2010 2009 Allowance for Doubtful Accounts at the beginning of period 690 1,016 1,010 Allowance for Doubtful Accounts at the end of period 430 Write offs of delinquent accounts 572 1,007 1,287 Recoveries of previously written off accounts 158 153 108 Bad Debts Expense 154 528 1,185

Shifting Income Allowance account sometimes used by managers to shift income from one year into another Cookie jar reserve is created 2011 2012 Bad debt expense overestimated in 2011 creating a bigger expense Less bad debt expense required during 2012 to show higher profits

The following data was reported by WALMART, VERIZON and Johnson & Johnson. Sales Revenue $ 446,950 $110,875 $65,030 Accounts Receivable, Ending Balance $ 5,089 $11,776 $ 10,581 Accounts Receivable, Beg. Balance $ 5,937 $ 11,781 $ 9,774 Accounts Receivable Turnover 81.07 9.41 6.39 Average Collection Period 4.5 days 38.79 days 57.12 days

"We make a living by what we get. We make a life by what we give." End Chapter 8 "We make a living by what we get. We make a life by what we give." Winston Churchill