Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD Chapter 10 Receivables

In this chapter… Balance Sheet Current Assets Cash Chapter Current Liabilities Accounts Payable5000 Accounts Receivable Wages Payable25000 Notes Receivable Utilities Payable2000 Marketable Securities25000Long-Term Debt Inventory Notes Payable20000 Capital Assets Bonds Payable Equipment250000Owner’s Equity Buildings Common Stock Goodwill60000 Retained Earnings48000 Total Assets Total Liabilities + OE Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Accounts Receivable A receivable is an amount due from another party, the 2 most common are: –Accounts Receivable – amounts due from customers for credit sales –Notes Receivable – amounts due from parties as a result of investment Accounts Receivable (AR) arises from credit sales to customers DateAccount Titles and explanationPRDebitCredit Jul 3Accounts Receivable20000 Sales20000 Jul 3COGS8000 Inventory8000 July 15Cash20000 Accounts Receivable20000 Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Accounts Receivable Subledger As is the case with AP, there is both an AR account in the General Ledger as well as several AR subledger accounts for each customer –Subledger accounts are required so that the firm can keep track of what is owned by individual customers Credit Sales can be created through the use of trade credit (sales on terms), or the use of credit cards –Credit Cards can be of 2 general types. Those issued by the firm itself (Sears, The Bay, Canadian Tire) Those issued by 3 rd party credit card companies (Enroute, Discovery) –Credit Cards issued by a 3 rd party usually come with expenses that the firm must pay Transaction fee (a per transaction fee) Monthly fee for equipment rental Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Credit Card Sales Transactions Initial credit card sale Cash received from CC Company DateAccount Titles and explanationPRDebitCredit July 5Accounts Receivable – CC Company20000 Sales20000 July 5COGS8000 Inventory8000 DateAccount Titles and explanationPRDebitCredit July 25Cash19600 Credit Card Expenses400 AR – CC Company20000 Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Valuing AR Not all customers will pay their debts. –Therefore companies need to make allowance for Bad Debt –Why do companies sell on credit then? Well, like everything, the benefits of selling on credit (more impulse sales) out weigh the costs (a few customers who don’t pay) How do we account for Bad Debt –First, we need to estimate the amount we should expect (based on historical patterns) We must estimate because we will need to apply an expense caused by bad debt in the current accounting period (remember, the matching principles says you need to match expenses in the same period as the revenues they helped to generate) –Once we have an amount, we will create an AR “contra-account” Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Estimating Bad Debt Two methods we can use –Based on percentage of Sales –Based on percentage of AR (as calculated as a % of AR or based on AR aging) AR aging refers to how old the outstanding invoice is (how long ago the sale was made) –We’ll cover these calculation methods in more detail later Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Recording Estimated Bad Debt As mentioned earlier, we will create a subledger account for each customer who buys on credit We’ll also create an AR “contra-account” where we can store allowances for doubtful accounts. This contra-account is not named to any one customer as we do not know yet which customer will default on their credit –The Bad Debt expense account is just like any other expense account –The “Allowance” account is the contra-account. It would be illustrated on the Balance Sheet as shown next… DateAccount Titles and explanationPRDebitCredit Dec 31Bad Debt Expense200 Allowance for Doubtful Accts200 Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Recording Estimated Bad Debt Notice how the AR account itself is untouched in the previous journal entry –The T-accounts look like this Accounts ReceivableSales Revenue Dec Dec 31 Bad Debt ExpenseAllowance for Doubtful Accts Dec Dec 31 Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Allowance for Doubtful Accounts The AFDA account is shown against the AR account –This contra-account reduces AR to an amount expected to be collected Balance Sheet Current Assets Cash10000 Current Liabilities32000 Accounts Receivable20000 Less: Allowance for Doubtful Accts Long Term Debt Other Assets970000Owner’s Equity Total Assets999800Total Liabilities + OE Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Allowance for Doubtful Accounts The Bad Debt Expense account is shown against the Revenue for the period –The Bad Debt Expense account reduces the revenue by the same amount that the contra-account reduces AR Income Statement Sales Revenue Expenses Bad Debt Expense Net Income Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Writing off Bad Debt So lets say our customer defaulted on the payment for a credit sale: –We would write down a specific accounts receivable subledger account –This will write down the overall AR account in the GL –And reduce the remaining Allowance for Doubtful Accounts The Balance Sheet now looks like… DateAccount Titles and explanationPRDebitCredit Dec 31Allowance for Doubtful Accts20 AR – Dave Ludwick20 Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Writing off Bad Debt After writing down the Dave Ludwick AR subledger account, we notice that the Net AR account (AR less Allowance for Doubtful Accts) is not changed –That’s because we already allowed for the doubtful account Balance Sheet Current Assets Cash10000 Current Liabilities32000 Accounts Receivable19980 Less: Allowance for Doubtful Accts Long Term Debt Other Assets970000Owner’s Equity Total Assets999800Total Liabilities + OE Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Recovering Bad Debt So we assumed a customer would not pay, so we wrote down his account But now he has come back and paid, at least partly. The transactions are simply the reverse of the write down: –First, restore the Allowance and the AR subledger –Then take the cash and run DateAccount Titles and explanationPRDebitCredit Aug 31AR – Dave Ludwick20 Allowance for Doubtful Accts20 Aug 31Cash20 AR – Dave Ludwick20 Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Estimating Bad Debt Expense Earlier we said there were 2 ways to calculate Bad Debt allowance –Based on percentage of Sales –Based on percentage of AR Percent of Sales Approach –This approach applies a percent (based on historical experience) to the total credit sales to estimate what is expected to be uncollectible So if last year you saw that 2% of credit sales remained uncollectible, unless you had info to indicate it would be different this year, you would apply a 2% factor the sales in the reporting period to estimate Bad Debt Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Estimating Bad Debt Expense Percent of Accounts Receivable –This approach implies that some portion of end of period AR balance is uncollectable A bad debt adjusting entry is made to bring the Allowance for Doubtful Accounts balance to the proportion of AR outstanding This requires an adjustment that considers the opening balance to the required outcome (We’ll see this by example in a minute) Aging Accounts Receivable –The older a receivable is, generally the less likely it will be collected. –An Aging Analysis groups receivables by age (1-30 days, days, 60+ days, as an example), then applies different %ages to different groups to estimate Bad Debt (see Exh 10.14) Again, we make the adjustment considering the opening balance and the required outcome (We’ll see this by example in a minute) Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Estimating Bad Debt Expense Direct Write-Off Method –This method does not use an advance estimate for Bad Debt Expense –It only expenses Bad Debt as it happens –So only once a credit sales has been determined as uncollectible does the AR subledger for that customer get written down. –Like…. DateAccount Titles and explanationPRDebitCredit Aug 31Bad Debt Expense20 AR – Dave Ludwick20 Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Mid Chapter Demo Problem Lets try the Mid Chapter Demo Problem Lets calculate the Bad Debt Expense and Allowance for Doubtful Accounts using –Estimate of total credit sales –Estimate of outstanding AR –Aging analysis Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Short Term Notes Receivable Promissory Note: is a written promise to pay some amount on demand or by some specific date –A Short-term Note Receivable is a promissory note due within the business’s accounting period –Usually a note is for non-operational receivables (like shareholder loans) Characteristics of a Note: –Principal – the amount owed to the business –Interest – usually expressed as an annual interest rate –Time – the amount of time to the required pay date Interest calculation –Interest = (Principal) x (Annual Interest rate) x (Time [years]) –As an example… Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Short Term Notes Receivable Someone promises to pay for a $1000 purchase within 6 months (assuming a 12% interest rate) –Principal = 1000 –Annual Interest Rate = 12% –Time [years] = 6/12 =.5 –Interest owed = (1000)x(.12)x(.5) = 60 Ok, so what! Big deal! How do we use this in accounting Well, we make a loan and eventually receive payment of principal and interest. Here is what it looks like….. Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Short Term Notes Receivable The loan… The payment… DateAccount Titles and explanationPRDebitCredit June 5Notes Receivable1000 Cash1000 DateAccount Titles and explanationPRDebitCredit Dec 5Cash1060 Notes Receivable1000 Interest Revenue60 Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

End of Period Adjustment If Notes are outstanding at the end of the period, but not yet “collectable”, we need to make an entry to account for that portion of the interest earned during the period Then once payment is made in the new period: DateAccount Titles and explanationPRDebitCredit Dec 31Interest Receivable30 Interest Revenue30 DateAccount Titles and explanationPRDebitCredit Mar 31Cash1060 Interest Receivable30 Interest Revenue30 Notes Receivable1000 Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Sample Problems Try the following –Exercise 10-1 –Exercise 10-4 –Exercise 10-7 –Exercise 10-8 –Problem 10-4A –Problem 10-10A Chapter 11 Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD