Needles Powers Principles of Financial Accounting 12e Receivables 9 C H A P T E R human/iStockphoto

NeedlesPowers

Principles of Financial Accounting

12e

Receivables9C H A P T E R

©human/iStockphoto

Accounts Receivable

Accounts receivable are short-term financial assets that arise from sales on credit and are often called trade credit.– In setting credit terms, a company must

keep in mind the credit terms of its competitors and the needs of its customers.

– Companies that are too lenient in granting credit can run into difficulties when customers don’t pay.

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Accounts Receivable

The accounts of customers who cannot or will not pay are called uncollectible accounts (or bad debts).– There are two methods of accounting for

uncollectible accounts: Direct charge-off method: recognize a loss

when an account is determined to be uncollectible. (This is not in accordance with accrual accounting.)

Allowance method: recognize a loss at the time credit sales are made. (This is in accordance with accrual accounting.)


Notes Receivable

Notes receivable are short-term financial assets supported by written agreements called promissory notes. – A promissory note is an unconditional

promise to pay a definite sum of money on demand or at a future date. The person or entity that signs the note and

promises to pay is the maker of the note. The entity to whom payment is to be made is

the payee.


The Allowance Method: Using Accrual Accounting to Value Receivables

The allowance method is an application of accrual accounting, which requires estimated losses from bad debts to be matched with the revenue they help to produce.– It serves to value accounts receivable on the

balance sheet.– Because management cannot identify at the time

of sale which customers will not pay or how much the company will lose, losses from uncollectible accounts must be estimated, and the estimate becomes an expense in the period in which the sales are made.


Disclosure of Receivables

A payee includes all the promissory notes it holds that are due in less than one year as notes receivable in the current assets section of the balance sheet.

Any interest accrued on these notes is also included in the current assets section—as interest receivable.

Uncollectible Accounts Expense appears on the income statement as an operating expense.

Allowance for Uncollectible Accounts appears on the balance sheet as a contra account, deducted from accounts receivable in the current assets section. – It reduces the accounts receivable to the amount

expected to be collectible (net realizable value).


Uncollectible Accounts

The allowance account is necessary because the specific uncollectible accounts will not be identified until later. The company’s accountant makes an estimate based on past experience and current economic conditions. – Two common methods of estimating

uncollectible accounts expense are: Percentage of net sales method—The basis for

this method is the amount of this year’s net sales that will not be collected.

Accounts receivable aging method—The basis for this method is the amount of the ending balance of accounts receivable that will not be collected.


Accounts Receivable Aging Method

The aging of accounts receivable is the process of listing each customer’s receivable account according to the due date of the account.– If the customer’s account is past due, there

is a possibility that the account will not be paid.

– That possibility increases as the account extends further beyond the due date.


Writing Off Uncollectible Accounts

The total of accounts receivable written off in a period will rarely equal the estimated uncollectible amount.

When it becomes clear that a specific account receivable will not be collected, the amount should be written off to Allowance for Uncollectible Accounts.


Maturity Date and Duration of a Note

The maturity date is the date on which a promissory note must be paid. This date must be stated on the note or be determinable from the facts on the note.

The duration of a note is the time between a promissory note’s issue date and its maturity date.– Interest is calculated on the basis of the

duration of a note.


Interest

Interest is the cost of borrowing money or the return on lending money, depending on whether one is the borrower or the lender. The amount of interest is based on three factors:– Principal (the amount of money borrowed or

lent)– Rate of interest– Length of the loan

The formula used in computing interest is:Principal × Rate of Interest × Time = Interest


Maturity Value

The maturity value is the total proceeds of a promissory note—face value plus interest—at the maturity date.

The maturity value of a 90-day, 8 percent, $1,000 note is computed as follows:Maturity Value = Principal + Interest = $1,000 + ($1,000 × 8/100 × 90/365) = $1,000 + $19.73 = $1,019.73


Accrued Interest(slide 1 of 2)

Accrued interest must be apportioned to the periods in which it belongs.

Assume that a $1,000, 90-day, 8 percent note was received on August 31 and that the fiscal year ends September 30. Interest for 30 days is calculated as follows:

Principal X Rate of Interest × Time = Interest

$1,000 × 8/100 × 30/365 = $6.58


Accrued Interest(slide 2 of 2)

The remainder of the interest income would be calculated as follows:

Principal × Rate of Interest × Time = Interest$1,000 × 8/100 × 60/365 = $13.15

- $6.58 of the interest would be recorded as income in the fiscal year ending September 30, and the interest receivable ($6.58) would be shown as received when the note is paid.

- The remainder of the interest, $13.15, would be recorded as income in the next fiscal year.


Dishonored Note

A note not paid at maturity is called a dishonored note. – The holder, or payee, of a dishonored note

should transfer the total amount due (including interest income) from Notes Receivable to an individual account receivable for the debtor.


Receivables Turnover

The receivables turnover shows how many times, on average, a company turned its receivables into cash during a period.– It is computed by dividing net sales by the

average accounts receivable (net of allowances).


Days’ Sales Uncollected

Day’s sales uncollected shows, on average, how long it takes to collect accounts receivable.– To determine the days’ sales

uncollected, the number of days in a year is divided by the receivables turnover.


Factoring

Factoring is the sale or transfer of accounts receivable to an entity, called a factor. Factoring can be done with or without recourse.– With recourse means that the seller of the

receivables is liable to the factor if a receivable cannot be collected. In accounting terminology, a seller of receivables with

recourse is said to be contingently liable. A contingent liability is a potential liability that can develop into a real liability if a particular event occurs—in this case, a customer’s nonpayment of a receivable.

– Without recourse means that the factor bears any losses from unpaid accounts.


Securitization

Securitization is a process in which a company groups its receivables in batches and sells them at a discount to other companies or investors.– When the receivables are paid, the buyers

get the full amount.– Their profit depends on the amount of the

discount.


Discounting

Discounting is a method of financing receivables by selling promissory notes held as notes receivable to a financial lender, usually a bank.– The bank derives its profit by deducting the

interest from the maturity value of the note.

– The holder of the note endorses the note and turns it over to the bank.

– The bank expects to collect the maturity value of the note (principal plus interest), but it also has recourse against the note’s endorser.


Ethics and Estimates in Accounting for Receivables

Because the amount of uncollectible accounts can only be estimated, a company’s earnings can be easily manipulated.– Misstatements of earnings can occur simply

because of a bad estimate.– They can also be deliberately made to meet

analysts’ estimates of earnings, reduce income taxes, or meet benchmarks for bonuses.

– Companies will high ethical standards try to be accurate in their estimates of uncollectible accounts, and they disclose the basis of their estimates.


Documents

Needles Powers Principles of Financial Accounting 12e Receivables 9 C H A P T E R human/iStockphoto