Accounts and Bills Receivable Chapter 8 HORNGREN ♦ HARRISON ♦ BAMBER ♦ BEST ♦ FRASER ♦ WILLETT

8 - 2 Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Objectives 1.Design internal controls for receivables 2.Use the provision method to account for bad debts by the percentage of sales and aging of accounts method 3.Use the direct write off method to account for bad debts 4.Accounts for bills receivable 5.Report receivables on the financial statements 6.Use the acid-test ratio and days’ sales in receivables to evaluate a firms financial position

8 - 3 Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Accounts receivable (Trade receivables) Receivables Bills receivable (Notes receivable)

8 - 4 Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Design internal controls for receivables. Objective 1

8 - 5 Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Establishing Internal Control l What are some controls over accounts receivable? Separation of duties Separation of duties Approval for write-off Approval for write-off Control over mail receipts Control over mail receipts

8 - 6 Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia The Credit Department l Companies grant credit to customers in order to increase sales. l The credit department evaluates customers who apply for credit cards.

8 - 7 Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Accounting for Bad Debts Provision method Direct write-off method

8 - 8 Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Use the provision method to account for bad debts by the percent of sales and aging of accounts method. Objective 2

8 - 9 Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Methods for Estimating Bad Debts Percentage of Sales Aging of Accounts Receivable

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Percentage of Sales l This is also called the statement of financial performance approach. l It is based on prior experience of the business. l It is calculated as a percentage of credit sales. l It ignores the current balance of the provision account. l The percentage used is adjusted as needed to reflect collection experience.

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Percentage of Sales Example l The credit department of Anna’s Boutique estimates (based on prior experience) that 1% of net credit sales are uncollectible. l Net credit sales for the year just ended were $500,000. l What is the adjusting entry? l $500,000 × 1% = $5,000

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Percentage of Sales Example June 30, 2004 Bad Debts Expense 5,000 Provision for Bad debts 5,000 Recorded bad debts expense for the year June 30, 2004 Bad Debts Expense 5,000 Provision for Bad debts 5,000 Recorded bad debts expense for the year

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Decrease in Net Profits Decrease in Net Profits Decrease in net Accounts Receivable Decrease in net Accounts Receivable What is the effect of this adjusting entry? Percentage of Sales Example

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Aging of Accounts Receivable l This approach is also called the statement of financial position approach because it focuses on accounts receivable. l Individual accounts receivable from specific customers are analysed according to the length of time they remain outstanding.

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Aging of Receivables Example l Assume that International Hospital’s past collection experience indicates the following: l Length of time % uncollectible 1-30 days days days days8.0

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Accounts Receivable Provision for Bad Debts Length Amount % 1-30$1,900,000 2$ 38, ,000, , , , , ,000 Total$4,100,000 $143,000 Aging of Receivables Example

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Aging of Receivables Example l The provision account is adjusted to this $143,000 balance: l Assume that the account currently has a credit balance of $100,000. l What is the adjustment?

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia June 30 Bad debts Expense 43,000 Provision for Bad debts 43,000 To record the provision for bad debts June 30 Bad debts Expense 43,000 Provision for Bad debts 43,000 To record the provision for bad debts What if the account had a debit balance of $1,000? What if the account had a debit balance of $1,000? Aging of Receivables

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Provision for Bad Debts Adjustment 1, ,000 Adjusted balance 143,000 Provision for Bad Debts Adjustment 1, ,000 Adjusted balance 143,000 Aging of Receivables

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Comparing the Percentage of Sales and Aging Methods Provision Method Percent of Sales Method Aging of Accounts Receivable Method Adjusts Provision For Bad Debts Adjusts Provision For Bad debts BYTO BAD DEBTS EXPENSE EXPECTED UNCOLLECTABLE ACCOUNTS RECEIVABLE Amount of

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Writing Off Bad Debts l What happens when it becomes apparent that an account will not be collected? l It must be written off. l How? Debit Provision for Bad Debts. Credit Accounts Receivable.

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Recoveries l How is the collection of a previously written- off account recorded? Debit Accounts Receivable (to reinstate the account). Credit Provision for Bad Debts. l Then Debit Cash. Credit Accounts Receivable (to record the collection).

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Use the direct write-off method to account for bad debts. Objective 3

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Direct Write-Off Method l Using this method, an account is written off only when it becomes uncollectible. l No provision account is created. l This method is simple to use – but: l The statement of financial position is overstated. l The statement of financial performance is understated.

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Credit Card and Bankcard Sales l These save retailers the cost of a credit department. l The retailer is required to pay a fee (called a discount) for usage.

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Credit Card and Bankcard Sales l How would Anna’s Boutique record a $100 credit card sale with a 3% service charge? Accounts Receivable (credit card)97 Credit Card Charge 3 Sales Revenue100 To record a credit card sale of $100 less a 3% service charge fee Accounts Receivable (credit card)97 Credit Card Charge 3 Sales Revenue100 To record a credit card sale of $100 less a 3% service charge fee

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Debit Card Sales Using a debit card is like paying with cash. Using a debit card is like paying with cash.

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Bills Receivable: an Overview l A bill receivable may arise from a sale or may be given in settlement of an account receivable. l The ‘Acceptor’ pays the ‘Drawer’ the maturity value. l The maturity value is paid on the maturity date and includes principal plus interest. l See Exhibit 8-5 page 342 of the textbook

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Identifying a Bill’s Maturity Date l When the period is given in days… – the maturity date is determined by counting the days from the date of issue. l When the period is given in months… – the maturity date is on the same day of the month as the date the bill was issued. l Although the period of the bill is usually less than one year interest rates are usually stated as an annual rates.

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Principal × Rate × Time = Interest $10,000 × 10% × 90 ÷ 360 = $ Calculating Interest on a Bill Calculate interest on the bill due to State Bank. Principal:$10,000 Interest:10% Time:June 1, 2004, to August 29, 2004 Calculate interest on the bill due to State Bank. Principal:$10,000 Interest:10% Time:June 1, 2004, to August 29, 2004

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Account for bills receivable. Objective 4

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Recording Bills Receivable l Assume the accounting period ended June 30. l How much interest was earned by the bank as of June 30? l $10,000 × 10% × (30* ÷ 365) = $82.19 [* 30 days from June 1 to June 30]

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Recording Bills Receivable June 30 Interest Receivable82.19 Interest Revenue82.19 To accrue interest on the bill June 30 Interest Receivable82.19 Interest Revenue82.19 To accrue interest on the bill

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Recording Bills Receivable l How does the bank record the collection at maturity? August 29 Cash10, Bill Receivable10, Interest Receivable Interest Revenue Record interest on bill August 29 Cash10, Bill Receivable10, Interest Receivable Interest Revenue Record interest on bill

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Discounting a Bill Receivable l The drawer (one who will receive the money) may sell (discount) a bill so they receive money now, rather than at maturity. l From the previous example State Bank discounts the bill on June 21, discount rate is 12% (this is not the actual interest rate). l $10, × 12% × 70* / 365 = $ [*70 days is June 21 to August 29]

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Discounting a Bill Receivable l How does the bank record the discounting? June 21 Cash10, Bill Receivable10, Interest Revenue Record interest on bill June 21 Cash10, Bill Receivable10, Interest Revenue Record interest on bill $10.77 = $10, $235.81

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Dishonored Bills Receivable l If the maker of the bill fails to pay the maturity value to the new payee, then the original payee legally must pay the bank the amount due (unless the discounting is without recourse). l This gives rise to a contingent liability for the drawer when they discount a bill.

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Report receivables on the statement of financial position Objective 5

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Reporting Receivables l Some companies report a single amount for its current receivables in the body of the statement of financial position. l They use a note to the financial statements to give more details. l See Qantas example pages text.

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Use the acid-test ratio and days’ sales in receivables to evaluate a firm’s financial position. Objective 6

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Acid-test ratio = (Cash + Short-term investments + Net current receivables) ÷ Total current liabilities Acid-test ratio = (Cash + Short-term investments + Net current receivables) ÷ Total current liabilities Acid-Test Ratio l This is a stringent test of liquidity than the current ratio. l It measures the entity’s ability to pay its current liabilities immediately.

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Days’ Sales in Receivables l It is a measure of the time it takes to collect receivables. l A smaller number indicates a quick conversion to cash.

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia One day’s sales = Net sales ÷ 365 days Days’ sales in average accounts receivable = Average net accounts receivable ÷ One day’s sales Days’ sales in average accounts receivable = Average net accounts receivable ÷ One day’s sales Days’ Sales in Receivables

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia End of Chapter 8