Chapter 8 Reporting and Analyzing Receivables Flashcards
Types of receivables
Receivables can include 1) accounts receivable, 2) notes receivable, and 3) other types of receivables.
1) Accounts receivable are amounts owed by customers on account. They result from the sale of goods and services. Receivables are generally expected to be collected within 30 days or so, and are classified as current assets.
2) Notes receivable are claims where formal instruments of credit—a written promise to repay— are issued as evidence of the debt. The credit instrument normally requires the debtor to pay interest and is for time periods of 30 days or longer. Notes receivable may be either current assets or non-current assets, depending on their due dates.
Accounts and notes resulting from sales transactions are called trade receivables.
3) Other receivables include nontrade receivables that do not result from the operations of the business, including interest receivable, loans to company officers, advances to employees, sales tax recoverable, and income tax receivable.
Account for bad debts.
The allowance method, using a percentage of receivables, is used to match bad debts expense against revenue, in the period in which the revenue was earned.
To record bad debts:
Bad Debts Expense
Allowance for Doubtful Accounts
Allowance for Doubtful Accounts is a contra asset account with a normal credit balance that is deducted from Accounts Receivable. A contra account is used instead of a direct credit to Accounts Receivable for two reasons:
1) we do not know which individual customers will not pay, therefore we are unable to credit specific customer accounts in the subsidiary ledger to show they are uncollectible; we are also unable to credit the control account itself as this would mean that its balance would not equal the sum of all customer accounts in the subsidiary ledger.
2) the balance in Allowance for Doubtful Accounts is just an estimate. A contra account helps to separate estimates from actual amounts, such as those found in Accounts Receivable.
To measure uncollectible accounts:
A percentage of total receivables, or an aging schedule applying percentages to different categories of receivables (based on the number of days outstanding), is used to estimate the uncollectible accounts or ending balance in the Allowance for Doubtful Accounts.
Bad debts expense is the difference between the estimated total uncollectible accounts (required balance in the allowance account) and the unadjusted balance in the allowance account.
Bad debts expense is reported in the income statement as an operating expense. The balance in Allowance for Doubtful Accounts is deducted from Accounts Receivable in the current assets section of the statement of financial position as shown below:
Accounts receivable $A
Less: Allowance for doubtful accouints $B
Net realizable value $(A - B)
To write off uncollectible accounts:
When a specific account receivable is determined to be uncollectible, it is written off and the allowance account reduced. When a previously written-off account is collected, the write off is reversed and the collection recorded.
Note that to prevent premature or unauthorized write offs, each write off should be formally approved in writing by authorized management personnel. To adhere to the appropriate internal control activity, authorization to write off accounts should not be given to someone who also has daily responsibili- ties related to cash or receivables, in order to prevent them from misappropriating the cash receipt and writing off the account to hide the theft.
To record write offs:
Allowance for Doubtful Accounts
Accounts Receivable
Note that bad debts expense is not increased (debited) when the write off occurs. Under the allowance method, every accounts receivable write off entry is debited to the allowance account and not to bad debts expense. The entry to record the write off of an uncollectible account reduces both accounts receivable and allowance for doubtful accounts. Therefore, a write off affects only statement of financial position accounts and reduces both Accounts Receivable and Allowance for Doubtful Accounts equally. Net realizable value on the statement of financial position remains the same.
To record the recovery of a bad debt, 1) the entry made in writing off the account is reversed to reinstate the customer’s account, and 2) the subsequent collection is recorded in the usual way:
Accounts Receivable
Allowance for Doubtful Accounts
Cash
Accounts Receivable
Account for notes receivable.
Notes receivable are recorded at their principal amount. Interest is earned from the date the note is issued until it matures and is recorded in a separate interest receivable account. Similar to accounts receivable, estimated uncollectible notes receivable are recorded as an allowance for doubtful notes.
Notes can be held to maturity, at which time the principal plus any unpaid interest is due and the note is removed from the accounts when paid (honoured). In some situations, the maker of the note dishonours the note (defaults). If eventual collection is expected, an account receivable replaces the note receivable and any unpaid interest. If the amount is not expected to be repaid, the note is written off.
To record notes receivables:
Notes Receivable
Accounts Receivable
To record interest on the note (apply only to short-term notes receivable with interest due at maturity):
Interest Receivable
Interest Revenue
Note that while interest on an overdue account receivable is debited to Accounts Receivable, interest on a note receivable is not debited to the Notes Receivable account. Instead, a separate account for the interest receivable is used. Since the note is a formal credit instrument, its recorded principal amount must remain unchanged.
Non-current or long-term notes (with a maturity date beyond one year from the statement of financial position date) are generally repayable in instalments rather than at maturity. Although not as common, short-term notes can also be repaid in instalments rather than at maturity. Interest calculations for instalment notes use a method to determine interest revenue called the effective-interest method.
Valuing notes receivable:
Because companies generally don’t have many notes, preparing an aging schedule, as is usually done for accounts receivable, is not the best way to estimate uncollectible notes. Instead, each note should be individually analyzed to determine its probability of collection. If circumstances suggest that eventual collection is in doubt, bad debts expense and an allowance for doubtful notes must be recorded in the same way they are recorded for accounts receivable.
To derecognize notes receivable:
In the normal course of events, the principal amount of a note receivable and its accrued interest is collected when due and then removed from the books, or derecognized. Notes that are collected when due are said to be honoured. In some situations, the maker of the note defaults and an appropriate adjustment must be made. This is known as a dishonoured (not collected) note.
To hornor notes receivalbe:
Cash
Notes Receivable
Interest Receivable
Interest Revenue
(To record collection of note and interest)
To record dishonoured note if eventural collection is expected:
Accounts Receivable
Notes Receivable
Interest Receivable
Interest Revenue
(To record dishornoured note, eventual collection expected)
To record dishornored note if eventul collection is not expected (write off):
Allowance for Doubtful Notes
Notes Receivable
Interest Receivable
(To write off dishonored note)
Explain the statement presentation of receivables.
Each major type of receivable should be identified in the statement of financial position, with supplemental detail included in the statement or supporting notes. Companies must report the net realizable value of their receivables on the statement of financial position. The gross amount of receivables and allowance for doubtful accounts can be reported directly on the statement or in the notes. Bad debts expense is reported in the income statement as an operating expense, and interest revenue is shown in the non-operating section of the statement.
If a company has a significant risk of uncollectible accounts or other problems with its receivables, it is required to discuss this possibility in the notes to the financial statements.
Income statement accounts related to receivables can include revenues such as sales or services on account and interest and expenses such as bad debts expense. Sales and service revenue and bad debts expense are reported in the operating expense section of the income statement. Interest revenue is reported separately in the non-operating section.
Apply the principles of sound accounts receivable management.
To properly manage receivables, management must
(a) determine whom to extend credit to,
(b) establish a payment period,
(c) monitor collections, and
(d) evaluate the liquidity of receivables (by calculating the receivables turnover and average collection period).
Extending credit:
If the credit policy is too tight, the company may lose revenue. On the other hand, if the credit policy is too loose, the company may end up extending credit to risky customers who pay late or do not pay at all. Certain steps can be taken to help minimize losses if credit standards are relaxed: 1) require risky customers to provide letters of credit or bank guarantees; 2) require particularly risky customers to pay a deposit in advance or cash on delivery; 3) ask potential customers for references from banks and suppliers to determine their payment history, check these references on potential new customers and to periodically check the financial health of existing customers.
Establishing a payment period:
Normally, this period would be similar to the period used by competitors and offer sales discounts for customers paying early.
Monitoring collections:
An accounts receivable aging schedule should be prepared and reviewed often. In addition to its use in estimating the allowance for doubtful accounts, the aging schedule helps estimate the timing of future cash inflows when preparing a cash budget. It also provides information about the company’s overall collection experience, and it identifies problem accounts. Credit risk can increase during periods of economic downturn. Credit policies and collection experience must always be monitored not only in comparison with past experience, but also in light of current economic conditions.
Evaluating liquidity of receivables:
Accounts receivable rising faster than sales may be an indication of collection problems. Perhaps the company increased its sales by loosening its credit policy, and these receivables may be difficult or impossible to collect, which will impact liquidity.
The receivables turnover ratio is used to assess the liquidity of receivables:
Receivables turnover = Net credit sales / Average gross accounts receivable
Gross accounts receivable is the amount reported in the accounts receivable account (before deducting allowance for doubtful accounts).
Unless seasonal factors are significant, average gross accounts receivable can be calculated by adding together the beginning and ending balances and dividing by 2.
Since companies seldom report the amount of net credit sales in their financial statements, net sales (including both cash and credit sales) can be used as a substitute. As long as one consistently chooses the same component to use in a ratio, the resulting ratio will be useful for comparisons.
The higher the turnover ratio, the more liquid the company’s receivables are.
A popular variant of the receivables turnover is to convert it into an average collection period in terms of days. The average collection period is frequently used to assess the effectiveness of a company’s credit and collection policies. The general rule is that the collection period should not greatly exceed the credit term period (the time allowed for payment).
Average collection period = 365 days / Receivables turnover
The lower the average collection period, the more liquid are a company’s receivables.
Both the receivables turnover and average collection period are important components of a company’s overall liquidity. Ideally, and should be analyzed along with other information about a company’s liquidity, including the current ratio and inventory turnover.
In addition, in some cases, receivables turnover and collection periods can be misleading. Some large retail chains that issue their own credit cards encourage customers to use these cards for purchases. If customers pay slowly, the stores earn a healthy return on the outstanding receivables in terms of interest revenue earned. Consequently, to interpret these ratios correctly, you must know how a company manages its receivables.
Aging the accounts receivable
The analysis of customer balances by the length of time they have been unpaid.
Allowance method
A method of accounting for bad debts that involves estimating uncollectible accounts at the end of each period.
Average collection period
The average amount of time that a receivable is outstanding. It is calculated by dividing 365 days by the receivables turnover.
Control account
An account in the general ledger that summarizes the details for a subsidiary ledger and controls it.
Derecognized note
A note that is removed from the accounts, either when honoured (collected) or dishonoured (not collected).
Dishonoured note
A note that is not paid in full at maturity.
A dishonoured note receivable is no longer negotiable. However, the payee still has a claim against the maker of the note for both the principal and any unpaid interest.
To record dishonoured note if eventural collection is expected:
Accounts Receivable
Notes Receivable
Interest Receivable
Interest Revenue
(To record dishornoured note, eventual collection expected)
To record dishornored note if eventul collection is not expected (write off):
Allowance for Doubtful Notes
Notes Receivable
Interest Receivable
(To write off dishonored note)
Financial assets
Receivables and investments that have a contractual right to receive cash or another financial asset.
Honoured note
A note that is paid in full at maturity.
Net realizable value
The difference between gross receivables and the allowance for doubtful accounts. Net realizable value measures the net amount expected to be received in cash.
Promissory note
A written promise to pay a specified amount of money on demand (as soon as the payee demands repayment) or at a definite time.
Promissory notes may be used (1) when individuals and companies lend or borrow money, (2) when the amount of the transaction and the length of the credit period exceed normal limits, and (3) in settlement of accounts receivable.
In a promissory note, the party making the promise to pay is called the maker; the party who will be paid is called the payee. For the maker of the note, the note would be classified as a note payable. For the payee of the note, the note would be classified as a note receivable. A note receivable and a note payable are accounted for similarly in each company’s records except that the payee’s note is an asset while the maker’s is a liability.
A promissory note details the names of the maker and the payee, the principal amount or face value of the loan, the loan period, the interest rate, and whether interest is payable monthly or at maturity (the note’s due date), along with the principal amount. Other details might include whether any security is pledged as collateral for the loan and what happens if the maker defaults (does not pay).
