Chapter 8

Receivables

Receivables mean amounts owed to the company by others. Accounts

Receivable are receivables resulting from the company rendering services or
selling products to the public. The company bills its customers/clients. There is
no formal debt instrument.

Notes Receivable are amounts owed to the company from promissory notes,
which are formal written debt instruments that usually bear interest. Sometimes
when customers are slow to pay their accounts receivable, the account
receivable is converted into a promissory note that bears interest.

Uncollectible Accounts

A company should write off an account receivable when it has no hope of

collecting the account. A principle of GAAP is conservatism.  We don't want to
show an account receivable as an asset when the company doesn't think that it
will be collected.  This is misleading to people looking at the balance sheet.  

Two methods are used to write off bad accounts receivable, the direct method
(also called the direct charge-off method or direct write-off method) and the
allowance method. The allowance method is GAAP.  The direct method is not.

GAAP also has another principle which is materiality.  If something is not a
material amount, then you can report it the wrong way. Since it isn't material, the
thought is that no one is harmed by doing it wrong. Something is material if a
person's actions would have been different if he or she had known of the item in
question.

Therefore, if a company's bad accounts receivable are so small that they are not
a material amount, then you can use the direct method to write off uncollectible
accounts.

Direct Method

The direct method charges uncollectible accounts to an expense (a selling

expense) in the period of default, which may or may not coincide with the period
of the related sale. A debit to Bad Debt expense or Uncollectible Accounts
Expense and a credit to Accounts Receivable are made.

D. Uncollectible Accounts Expense $100

 Cr. Accounts Receivable $100

The direct charge-off method frequently violates the matching rule because
accounts are often written off in periods subsequent to the sale.  If this expense
is not material, then companies may still use it.

If a customer later pays the accounts receivable, you first must reinstate the
account receivable, and then treat it as being paid. In order the reinstate the
account receivable, you reverse the prior journal entry.

D. Accounts Receivable $100

Cr. Uncollectible Accounts Expense $100

Then you record that the account has been paid:

D. Cash $100

Cr. Accounts Receivable $100

Allowance Method

To follow the matching rule, the expense should be recorded in the same period
as the related sale. Uncollectible accounts (also called bad debts), the
accounting term for nonpayment by customers, are an expense of selling on
credit. Under the matching rule, uncollectible accounts expense must appear in
the same income statement as the corresponding sale, even if the customer
defaults in a later period.

An estimate of bad debts must be made at the end of each year. At the time of a
credit sale, however, the company does not know whether the customer will
eventually pay. Therefore, an estimate of uncollectible accounts must be made at
the end of the accounting period.

An adjusting entry is then made debiting Uncollectible Accounts Expense (also

called Bad Debt Expense, Doubtful Accounts Expense & Provision for
Uncollectible Accounts) and crediting Allowance for Uncollectible Accounts (also
called Allowance for Bad Debts & Allowance for Doubtful Accounts) for the
estimated amount. Uncollectible Accounts Expense is closed out in a manner
Short-Term Liquid Assets similar to other expenses and appears in the income
statement.
D. Uncollectible Accounts Expense $12,000

Cr. Allowance for Uncollectible Accounts $12,000

Allowance for Uncollectible Accounts is a contra account to Accounts Receivable
that reduces Accounts Receivable to the amount estimated to be collectible.  The
net number is the net realizable value of the accounts receivable.

Accounts Receivable $200,000

Less: Allowance for Uncollectible Accounts 12,000
-------------
$188,000

The two most common methods for estimating uncollectible accounts are the
percentage of net sales method and the accounts receivable aging method.

Write-Offs to the Allowance Account

When it becomes clear that a specific account will not be collected, it should be
written off by a debit to Allowance for Uncollectible Accounts and a credit to
Accounts Receivable. Note that the Uncollectible Accounts Expense account is
not involved in the entry.

D. Allowance for Uncollectible Accounts $100

Cr. Accounts Receivable $100

After the write-off, the accounts receivable net value does not change. After a
specific account has been written off, Accounts Receivable and Allowance for
Uncollectible Accounts decrease by the same amount, but the net figure for
expected receivables stays the same.

When a customer whose account has been written off pays in full or in part, two
entries must be made:

 First, the customer's receivable is reinstated by a debit to Accounts

Receivable and a credit to Allowance for Uncollectible Accounts for the
amount now considered collectible.

D. Accounts Receivable $100

Cr. Allowance for Uncollectible Accounts $100

 Second, Cash is debited and Accounts Receivable is credited for each

collection.

D. Cash $100
Cr. Accounts Receivable $100
 Estimating Uncollectibles

Under the percentage of sales method (also called the percentage of credit sales
method or the income statement method), the estimated percentage for
uncollectible accounts is multiplied by net sales (or net credit sales) for the
period. The resulting figure is then used in the adjusting entry.

Any previous balance in Allowance for Uncollectible Accounts is irrelevant in

making the adjusting entry. Any previous balance in Allowance for Uncollectible
Accounts represents amounts from previous years that have not yet been written
off and is irrelevant in making the adjusting entry under this method. In other
words, if you have net sales of $300,000 and you believe that 1% of your sales
will not be collected, you would place $3,000 into the allowance.

Under the aging of accounts receivable method (also called the percentage of
receivables basis, or the balance sheet method), customer accounts are placed
into a "not yet due" category or into one of several "past due" categories. The
amounts in each category are totaled; each total is then multiplied by a different
percentage (a probability of default to each age category) for estimated bad
debts.

The sum of these products represents estimated bad debts on ending Accounts
Receivable. Again, the debit is to Uncollectible Accounts Expense and the credit to
Allowance for Uncollectible Accounts.

Under the aging method, however, the entry is for the amount that brings Allowance for
Uncollectible Accounts to the computed figure. In other words, if you decide that a total
of $3,000 of your accounts receivable will not be paid, and your allowance has a credit
balance of $1,000, you would credit the allowance (and debit bad debt expense) for
$2,000.

Notes Receivable

A promissory note has two parties, the maker and the payee.  The maker
promises to pay specified amounts to the payee.

A promissory note has certain characteristics.  For example, it must have a due
date (a maturity date).  A demand note is a promissory note that is due on
demand (at any time).

A promissory note usually provides for the payment of interest.  When the
interest is paid is negotiated by the parties.  For example, interest could be paid
monthly, quarterly or annually.  Interest on notes with terms of a year or less
usually provide that interest is paid at maturity.
The maturity value is the amount paid by the maker at the maturity date of the
promissory note.

Promissory notes are created:

 As part of a company lending money to someone

 As consideration in the sale of expensive merchandise with extended
payments (e.g., sales of automobiles) or other assets.
 In exchange for a delinquent account receivable.

When the promissory note is being issued to take the place of an accounts
receivable, the maker is usually a customer to whom credit was extended, and
the maker needs more time to pay the amount due.  So, the company is
converting it into a interest bearing promissory note.  Assume that a $6,000,
10%, six-month promissory note was issued:

D. Notes Receivable $6,000

Cr. Accounts Receivable $6,000

When the note matures, the maker pays the principle and the accrued interest.

D. Cash $6,300

Cr. Notes Receivable $6,000

Interest Revenue 300

If the note is dishonored, then the company just has an account receivable again.
No more interest will accrue thereafter:

D. Account Receivable $6,300

Cr. Notes Receivable $6,000

Interest Revenue 300

As was noted when we discussed adjusting entries.  You are supposed to accrue
the interest revenue in the period it was earned even though it hasn't been paid.
Assume that a 3-month promissory note is issued in December:

Dec. 1 D. Notes Receivable $6,000

 Cr. Accounts Receivable $6,000

Dec.31 D. Interest Receivable $50

Cr. Interest Revenue $50

 A promissory note is honored when it is paid in full at its maturity date.

March 1 D. Cash $6,150

Cr. Notes Receivable $6,000

Interest Receivable 50

Interest Revenue 100

Managing Accounts Receivable

When a company has accounts receivable, they need to watch the following steps
carefully:

 Extending Credit – Pay attention to which customers you are extending credit.
(e.g., look at credit reports, ask for guarantees or letters of credit). Your credit
policies have to be competitive, but you want to make sure that you do not
extend credit to the people who will not pay you.

 Establishing a Payment Period – Again, your policies have to be competitive.

Consider offering incentives for customers to pay early (e.g., sales discounts).

 Monitoring Collections -- Check to see whether customers are paying you. A

handy tool for this is to look at the Credit Risk Ratio:

Allowance for Doubtful Accounts

---------------------------------------------
Accounts Receivable

A disproportionate increase in the ratio is a warning that customers may begin to

default on their accounts receivable.

 Accelerating Cash Receipts – Sometimes a company may wish to sell its

accounts receivables (e.g., the company needs cash faster than can be obtained
by collecting its accounts receivable). A company can sell its accounts
receivable to a factor. The factor charges a fee to purchase the accounts
receivable. This is treated as an expense (operating expense or other expense):

D. Cash $588,000

Service Charge Expense 12,000

 Cr. Accounts Receivable $600,000

This is similar to the treatment that is received when a Company makes a VISA
or MasterCard credit card sale. The credit card company is agreeing to issue
credit to your customers so that you don’t have to:

D. Cash $970

Service Charge Expense 30

Cr. Sales $1,000

 Evaluating the Receivable Balance -- When evaluating the company’s credit

policies management looks at two measures: (i) Receivables Turnover Ratio, and
(ii) Average Collection Period.

Receivables Turnover Ratio

The Receivables Turnover Ratio tells you how many times you give and collect
credit (accounts receivable) during the year, on average:

Net Credit Sales

-----------------------------------------------------
Average Net Accounts Receivable
                                                                                
Average Collection Period

The Average Collection Period (also called Number of Days' Sales in

Receivables, and the Number of Days’ Sales Uncollected) is supposed to reflect
the number of days it takes to collect a firm’s accounts receivable:

365
---------------------------------------------
Receivables Turnover Ratio
I prefer to think of this ratio as follows:

First, calculate the amount of credit sales made in one day:

Net Credit Sales

---------------------------------
365

Second, take this number and divide it into the average net accounts receivables:

Average Net Accounts Receivable

---------------------------------------------------
One Day’s Credit Sales

This tells you how many days’ sales make up a company’s average accounts
receivable or how long it takes the company to collect its accounts receivable.