slide 8-1 accounting for receivables financial accounting, seventh edition chapter 8

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Accounting for Accounting for ReceivablesReceivables

Financial Accounting,

Seventh Edition

Chapter 8

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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.

Accounts Accounts ReceivableReceivableAccounts Accounts

ReceivableReceivable

Types of ReceivablesTypes of ReceivablesTypes of ReceivablesTypes of Receivables

Claims for which formal

instruments of credit are

issuedas proof of debt.

“Nontrade” (interest, loans to officers, advances

to employees, and income taxes

refundable).

Notes Notes ReceivableReceivable

Notes Notes ReceivableReceivable

Other Other ReceivableReceivable

ss

Other Other ReceivableReceivable

ss

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Three accounting issues:

1. Recognizing accounts receivable.

2. Valuing accounts receivable.

3. Disposing of accounts receivable.

Accounts ReceivableAccounts ReceivableAccounts ReceivableAccounts Receivable

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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 ReceivableRecognizing Accounts ReceivableRecognizing Accounts ReceivableRecognizing Accounts Receivable

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Illustration: On March 5, UVA Company returns defective merchandise worth $100 to Terps Company. Prepare the journal entry for Terps Company.

Recognizing Accounts ReceivableRecognizing Accounts ReceivableRecognizing Accounts ReceivableRecognizing Accounts Receivable

Illustration: On Mar 10, Terps Company receives payment from UVA Company for the balance due. Prepare the journal entry for Terps Company.

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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.


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Some customers may not pay Some customers may not pay their account. Uncollectible their account. Uncollectible amounts are referred to as bad amounts are referred to as bad debts. When an account debts. When an account receivable becomes receivable becomes uncollectible, a firm incurs a bad uncollectible, a firm incurs a bad debt expense.debt expense.

There are two methods of dealing There are two methods of dealing with bad debts expense:with bad debts expense:

Direct Write-Off MethodDirect Write-Off MethodAllowance MethodAllowance Method

Some customers may not pay Some customers may not pay their account. Uncollectible their account. Uncollectible amounts are referred to as bad amounts are referred to as bad debts. When an account debts. When an account receivable becomes receivable becomes uncollectible, a firm incurs a bad uncollectible, a firm incurs a bad debt expense.debt expense.

There are two methods of dealing There are two methods of dealing with bad debts expense:with bad debts expense:

Direct Write-Off MethodDirect Write-Off MethodAllowance MethodAllowance Method

Valuing Accounts ReceivableValuing Accounts ReceivableValuing Accounts ReceivableValuing Accounts Receivable

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Allowance MethodAllowance Method

Losses are estimated:Follows matching principle.

Receivable stated at net realizable value.

Required by GAAP.

Methods of Accounting for Uncollectible Accounts

Direct Write-OffDirect Write-Off

Theoretically undesirable:

Violates matching principle.

Receivable not stated at net realizable value.

Not acceptable for financial reporting (violates GAAP).


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On March 1, Terps Company determines On March 1, Terps Company determines that they cannot collect $5,000 from Mr. that they cannot collect $5,000 from Mr.

Bad Guy, a credit customer.Bad Guy, a credit customer.

On March 1, Terps Company determines On March 1, Terps Company determines that they cannot collect $5,000 from Mr. that they cannot collect $5,000 from Mr.

Bad Guy, a credit customer.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 MethodDirect Write-Off MethodDirect Write-Off MethodDirect Write-Off Method

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The Direct Write-off Method is a violation of GAAP. WHY?

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.

Matching Principle requires expenses to be reported in the same accounting

period as the revenue they help to generate.

Direct Write-off versus Allowance Direct Write-off versus Allowance MethodMethodDirect Write-off versus Allowance Direct Write-off versus Allowance MethodMethod

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At the end of each period, a company At the end of each period, a company estimatesestimates total total bad debts expected to be realized from that bad debts expected to be realized from that

period’s sales, based on industry averages or its period’s sales, based on industry averages or its past experience. This is done by using an past experience. This is done by using an

Allowance for Doubtful Accounts - this is a contra-Allowance for Doubtful Accounts - this is a contra-asset account that is offset against Accounts asset account that is offset against Accounts

Receivable on the balance sheet.Receivable on the balance sheet.

There are two advantages to the allowance method:There are two advantages to the allowance method:

1.1. It records It records estimatedestimated bad debts expense in the bad debts expense in the period when the related sales are recorded.period when the related sales are recorded.

2.2. It reports accounts receivable on the balance sheet It reports accounts receivable on the balance sheet at the at the estimatedestimated amount of cash to be collected. amount of cash to be collected.

At the end of each period, a company At the end of each period, a company estimatesestimates total total bad debts expected to be realized from that bad debts expected to be realized from that

period’s sales, based on industry averages or its period’s sales, based on industry averages or its past experience. This is done by using an past experience. This is done by using an

Allowance for Doubtful Accounts - this is a contra-Allowance for Doubtful Accounts - this is a contra-asset account that is offset against Accounts asset account that is offset against Accounts

Receivable on the balance sheet.Receivable on the balance sheet.

There are two advantages to the allowance method:There are two advantages to the allowance method:

1.1. It records It records estimatedestimated bad debts expense in the bad debts expense in the period when the related sales are recorded.period when the related sales are recorded.

2.2. It reports accounts receivable on the balance sheet It reports accounts receivable on the balance sheet at the at the estimatedestimated amount of cash to be collected. amount of cash to be collected.

Allowance MethodAllowance MethodAllowance MethodAllowance Method

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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.



2012, is $300,000.Prepare the appropriate journal entry.

Recording Estimated UncollectiblesRecording Estimated UncollectiblesRecording Estimated UncollectiblesRecording Estimated Uncollectibles

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2012, is $300,000.How would this be reported in the balance sheet of Terps Company?



2012, is $300,000.How would this be reported in the balance sheet of Terps Company?

Recording Estimated UncollectiblesRecording Estimated UncollectiblesRecording Estimated UncollectiblesRecording Estimated Uncollectibles

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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

Let us do some financial analysisLet us do some financial analysisLet us do some financial analysisLet us do some financial analysis

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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:

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Recording the Write-Off of an Uncollectible Account:

The write-off affects only balance sheet accounts.

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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?

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Two MethodsTwo Methods 1.1. Percent of Sales Method Percent of Sales Method 2.2. Percent of Accounts Receivable Method Percent of Accounts Receivable Method

Two MethodsTwo Methods 1.1. Percent of Sales Method Percent of Sales Method 2.2. Percent of Accounts Receivable Method Percent of Accounts Receivable Method

Estimating Allowance for Doubtful Estimating Allowance for Doubtful AccountsAccountsEstimating Allowance for Doubtful Estimating Allowance for Doubtful AccountsAccounts

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Bases Used for Allowance Method


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Bad debts expense is computed as a straight Bad debts expense is computed as a straight percentage of the current year’s credit percentage of the current year’s credit sales. The percentage is based on prior sales. The percentage is based on prior

years’ experience, modified for changes in years’ experience, modified for changes in current year. Any existing balance in the current year. Any existing balance in the Allowance for Doubtful Accounts is NOT Allowance for Doubtful Accounts is NOT

considered in calculating Bad Debts considered in calculating Bad Debts Expense.Expense.

Percentage of Sales MethodPercentage of Sales MethodPercentage of Sales MethodPercentage of Sales Method

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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 MethodPercentage of Sales MethodPercentage of Sales MethodPercentage of Sales Method

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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 sales MethodPercentage of sales MethodPercentage of sales MethodPercentage of sales Method

Percentage-of-Sales

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Compute the estimate of the Allowance for Compute the estimate of the Allowance for Doubtful Accounts.Doubtful Accounts.

Bad Debts Expense is computed as:Bad Debts Expense is computed as:

Percentage of Receivables MethodPercentage of Receivables MethodPercentage of Receivables MethodPercentage of Receivables Method

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Year-end Accounts Receivable is broken down into age classifications.

Year-end Accounts Receivable is broken down into age classifications.

Compute a separate allowance for each age grouping.

Compute a separate allowance for each age grouping.

Each age grouping has a different likelihood of being uncollectible.

Aging of Receivables MethodAging of Receivables MethodAging of Receivables MethodAging of Receivables Method

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Terps CompanySchedule of Accounts Receivable by Age

December 31, 2010

Days Past Due

Accounts Receivable

Balance Percent

Uncollectible

Estimated Uncollectible

Amount

Not Yet Due 64,500$ 1% 645$ 1 - 30 Days Past Due 18,500 3% 555 31 - 60 Days Past Due 10,000 7% 700 61 - 90 Days Past Due 3,900 40% 1,560 Over 90 Days Past Due 3,100 60% 1,860

100,000$ 5,320$

Aging of Receivables MethodAging of Receivables MethodAging of Receivables MethodAging of Receivables Method

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The unadjusted balance in the allowance account is

$900.

We estimated the proper balance to be $5,320.

The unadjusted balance in the allowance account is

$900.

We estimated the proper balance to be $5,320.

Percentage of Receivables MethodPercentage of Receivables MethodPercentage of Receivables MethodPercentage of Receivables Method

Occasionally the allowance account will have a debit balance prior to adjustment.

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Knowledge Check Question 1:Knowledge Check Question 1:The two methods of accounting for bad The two methods of accounting for bad debts are the direct write-off method debts are the direct write-off method and the allowance method. When and the allowance method. When comparing the two, which of the comparing the two, which of the following is true?following is true?1.1. The direct write-off method is exact and also The direct write-off method is exact and also

better illustrates the matching principle.better illustrates the matching principle.2.2. The allowance method is less exact, but it The allowance method is less exact, but it

better illustrates the matching principle.better illustrates the matching principle.3.3. The direct write-off method is theoretically The direct write-off method is theoretically

superior.superior.4.4. The direct write-off method requires two The direct write-off method requires two

separate entries to write off an uncollectible separate entries to write off an uncollectible account.account.

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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 Comprehensive Example: Terps CompanyCompanyComprehensive Example: Terps Comprehensive Example: Terps CompanyCompany

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Comprehensive Example: Terps Comprehensive Example: Terps CompanyCompanyComprehensive Example: Terps Comprehensive Example: Terps CompanyCompany

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Percentage of Sales approach:

Summary

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.


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A company used the percent of sales method to determine A company used the percent of sales method to determine its bad debts expense. At the end of the current year, the its bad debts expense. At the end of the current year, the company's unadjusted trial balance reported the following company's unadjusted trial balance reported the following selected amounts: selected amounts: Accounts receivableAccounts receivable $ 245,000 debit $ 245,000 debitAllowance for doubtful accounts $ 300 creditAllowance for doubtful accounts $ 300 creditNet SalesNet Sales $ 900,000 credit $ 900,000 credit

All sales are made on credit. Based on past experience, All sales are made on credit. Based on past experience, the company estimates 0.5% of credit sales to be the company estimates 0.5% of credit sales to be uncollectible. What amount should be debited to Bad uncollectible. What amount should be debited to Bad Debts Expense when the year-end adjusting entry is Debts Expense when the year-end adjusting entry is prepared? prepared?

1.1. $4,200 $4,200 2.2. $1,225 $1,225 3.3. $45,000 $45,000 4.4. $4,500 $4,500

Knowledge Check Question 2:Knowledge Check Question 2:Knowledge Check Question 2:Knowledge Check Question 2:

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On December 31 of the current year, a company's On December 31 of the current year, a company's unadjusted trial balance included the following: unadjusted trial balance included the following:

Accounts Receivable, debit balance of $97,250; Accounts Receivable, debit balance of $97,250; Allowance for Doubtful Accounts, credit balance of $951.Allowance for Doubtful Accounts, credit balance of $951. What amount should be debited to Bad Debts Expense, What amount should be debited to Bad Debts Expense, assuming 6% of outstanding accounts receivable at the assuming 6% of outstanding accounts receivable at the end of the current year will be uncollectible?end of the current year will be uncollectible?

1.1. $3,992. $3,992.

2.2. $4,884. $4,884.

3.3. $5,835. $5,835.

4.4. $6,786. $6,786.

Knowledge Check Question 3:Knowledge Check Question 3:Knowledge Check Question 3:Knowledge Check Question 3:

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Companies sell receivables for two major reasons.

1. Receivables may be the only reasonable source of cash.

2. Billing and collection are often time-consuming and costly.


Disposing of Accounts Receivable

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Disposing of Accounts ReceivableDisposing of Accounts ReceivableDisposing of Accounts ReceivableDisposing 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

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Illustration: Illustration: AAssume 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.

Disposing of Accounts ReceivableDisposing of Accounts ReceivableDisposing of Accounts ReceivableDisposing of Accounts Receivable

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Bank Credit Card SalesBank Credit Card SalesBank Credit Card SalesBank 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 Terps Company has a bank credit card sale of $500 to a customer. The bank charges a $500 to a customer. The bank charges a processing fee of 3%. Record the processing fee of 3%. Record the transaction.transaction.

Terps Company has a bank credit card sale of Terps Company has a bank credit card sale of $500 to a customer. The bank charges a $500 to a customer. The bank charges a processing fee of 3%. Record the processing fee of 3%. Record the transaction.transaction.

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On October 18 of the current year, a On October 18 of the current year, a company concluded that a customer's company concluded that a customer's $4,400 account receivable was $4,400 account receivable was uncollectible and that the account uncollectible and that the account should be written off. What effect will should be written off. What effect will this write-off have on this company's this write-off have on this company's net income and total assets assuming net income and total assets assuming the allowance method is used to the allowance method is used to account for bad debts?account for bad debts? 1.1. Decrease in net income; decrease in total assets. Decrease in net income; decrease in total assets. 2.2. Increase in net income; no effect on total assets. Increase in net income; no effect on total assets. 3.3. No effect on net income; no effect on total No effect on net income; no effect on total

assets.assets.4.4. No effect on net income; decrease in total assets. No effect on net income; decrease in total assets.

Knowledge Check:Knowledge Check:Knowledge Check:Knowledge Check:

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Accounts Receivable Turnover measures the number of times on average the company collects accounts receivables during the period.

Net Credit Sales

Average Net Accounts Receivable

Accounts Receivable Turnover

=

Statement Presentation and AnalysisStatement Presentation and AnalysisStatement Presentation and AnalysisStatement Presentation and Analysis

Average Collection Period in Days measures the average number of days the company takes to collect its accounts receivable

Days in Year (365)

Accounts Receivable Turnover Average

Collection Period in

Days

=

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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.

Statement Presentation and AnalysisStatement Presentation and AnalysisStatement Presentation and AnalysisStatement Presentation and Analysis

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Let us analyze Target Corporation’s Let us analyze Target Corporation’s Bad Debts ExpenseBad 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

430 690 1,016

Write offs of delinquent accounts

572 1,007 1,287

Recoveries of previously written off

accounts

152 153 108

Bad Debts Expense ? ? ?

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(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

430 690 1,016

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

Let us analyze Target Corporation’s Let us analyze Target Corporation’s Bad Debts ExpenseBad Debts Expense

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Shifting Income Shifting Income Allowance account sometimes used by managers to shift Allowance account sometimes used by managers to shift

income from one year into anotherincome from one year into another Cookie jar reserve is createdCookie 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

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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

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End Chapter 8End Chapter 8

slide 8-1 accounting for receivables financial accounting, seventh edition chapter 8

Documents

account receivable

valuing accounts receivables

uva company

possibility of accounts

books of terps company

allowance method losses

bad debts expense

bad debt expense