“Sometimes you have to know when to be very tough, and sometimes you can give them a bit of a break,” says Vivi Su. She's not talking about her children but about the customers of a subsidiary of pharmaceutical company Whitehall-Robins, where she works as supervisor of credit and collections.
For example, while the company's regular terms are 1/15, n/30 (1% discount if paid within 15 days), a customer might ask for and receive a few days of grace and still get the discount. Or a customer might place orders above its credit limit, in which case, depending on its payment history and the circumstances, Ms. Su might authorize shipment of the goods anyway.
“It's not about drawing a line in the sand, and that's all,” she explains. “You want a good relationship with your customers—but you also need to bring in the money.”
“The money,” in Whitehall-Robins’ case, amounts to some $170 million in sales a year. Nearly all of it comes in through the credit accounts Ms. Su manages. The process starts with the decision to grant a customer an account in the first place, Ms. Su explains. The sales rep gives the customer a credit application. “My department reviews this application very carefully; a customer needs to supply three good references, and we also run a check with a credit firm like Equifax. If we accept them, then based on their size and history, we assign a credit limit.”
Once accounts are established, “I get an aging report every single day,” says Ms. Su. “The rule of thumb is that we should always have at least 85% of receivables current—meaning they were billed less than 30 days ago,” she continues. “But we try to do even better than that—I like to see 90%.”
At 15 days overdue, Whitehall-Robins phones the client. After 45 days, Ms. Su notes, “I send a letter. Then a second notice is sent in writing. After the third and final notice, the client has 10 days to pay, and then I hand it over to a collection agency, and it's out of my hands.”
Ms. Su's boss, Terry Norton, records an estimate for bad debts every year, based on a percentage of receivables. The percentage depends on the current aging history. He also calculates and monitors the company's accounts receivable turnover, which the company reports in its financial statements.
Ms. Su knows that she and Mr. Norton are crucial to the profitability of Whitehall-Robins. “Receivables are generally the second-largest asset of any company (after its capital assets),” she points out. “So it's no wonder we keep a very close eye on them.”
Preview of Chapter 9
As indicated in the Feature Story, receivables are a significant asset for many pharmaceutical companies. Because a large portion of sales in the United States are done on credit, receivables are important to companies in other industries as well. As a consequence, companies must pay close attention to their receivables and manage them carefully. In this chapter you will learn what journal entries companies make when they sell products, when they collect cash from those sales, and when they write off accounts they cannot collect.
The content and organization of the chapter are as follows.
The term receivables refers to amounts due from individuals and companies. Receivables are claims that are expected to be collected in cash. The management of receivables is a very important activity for any company that sells goods or services on credit.
Receivables are important because they represent one of a company's most liquid assets. For many companies, receivables are also one of the largest assets. For example, receivables represented 21.9% of the current assets of pharmaceutical giant Rite Aid in 2011. Illustration 9-1 lists receivables as a percentage of total assets for five other well-known companies in a recent year.
The relative significance of a company's receivables as a percentage of its assets depends on various factors: its industry, the time of year, whether it extends long-term financing, and its credit policies. To reflect important differences among receivables, they are frequently classified as (1) accounts receivable, (2) notes receivable, and (3) other receivables.
Accounts receivable are amounts customers owe on account. They result from the sale of goods and services. Companies generally expect to collect accounts receivable within 30 to 60 days. They are usually the most significant type of claim held by a company.
Notes receivable are a written promise (as evidenced by a formal instrument) for amounts to be received. The note normally requires the collection of interest and extends for time periods of 60–90 days or longer. Notes and accounts receivable that result from sales transactions are often called trade receivables.
Other receivables include nontrade receivables such as interest receivable, loans to company officers, advances to employees, and income taxes refundable. These do not generally result from the operations of the business. Therefore, they are generally classified and reported as separate items in the balance sheet.
Ethics Note
Companies report receivables from employees separately in the financial statements. The reason: Sometimes those assets are not the result of an “arm's-length” transaction.
Three accounting issues associated with accounts receivable are:
1. Recognizing accounts receivable.
2. Valuing accounts receivable.
3. Disposing of accounts receivable.
Recognizing accounts receivable is relatively straightforward. A service organization records a receivable when it performs service on account. A merchandiser records accounts receivable at the point of sale of merchandise on account. When a merchandiser sells goods, it increases (debits) Accounts Receivable and increases (credits) Sales Revenue.
The seller may offer terms that encourage early payment by providing a discount. Sales returns also reduce receivables. The buyer might find some of the goods unacceptable and choose to return the unwanted goods.
To review, assume that Jordache Co. on July 1, 2014, sells merchandise on account to Polo Company for $1,000, terms 2/10, n/30. On July 5, Polo returns merchandise worth $100 to Jordache Co. On July 11, Jordache receives payment from Polo Company for the balance due. The journal entries to record these transactions on the books of Jordache Co. are as follows. (Cost of goods sold entries are omitted.)
Ethics Note
In exchange for lower interest rates, some companies have eliminated the 25-day grace period before finance charges kick in. Be sure you read the fine print in any credit agreement you sign.
Helpful Hint These entries are the same as those described in Chapter 5. For simplicity, we have omitted inventory and cost of goods sold from this set of journal entries and from end-of-chapter material.
Some retailers issue their own credit cards. When you use a retailer's credit card (JCPenney, for example), the retailer charges interest on the balance due if not paid within a specified period (usually 25–30 days).
To illustrate, assume that you use your JCPenney Company credit card to purchase clothing with a sales price of $300 on June 1, 2014. JCPenney will increase (debit) Accounts Receivable for $300 and increase (credit) Sales Revenue for $300 (cost of goods sold entry omitted) as follows.
Assuming that you owe $300 at the end of the month and JCPenney charges 1.5% per month on the balance due, the adjusting entry that JCPenney makes to record interest revenue of $4.50 ($300 × 1.5%) on June 30 is as follows.
Interest revenue is often substantial for many retailers.
ANATOMY OF A FRAUD
Tasanee was the accounts receivable clerk for a large non-profit foundation that provided performance and exhibition space for the performing and visual arts. Her responsibilities included activities normally assigned to an accounts receivable clerk, such as recording revenues from various sources that included donations, facility rental fees, ticket revenue, and bar receipts. However, she was also responsible for handling all cash and checks from the time they were received until the time she deposited them, as well as preparing the bank reconciliation. Tasanee took advantage of her situation by falsifying bank deposits and bank reconciliations so that she could steal cash from the bar receipts. Since nobody else logged the donations or matched the donation receipts to pledges prior to Tasanee receiving them, she was able to offset the cash that was stolen against donations that she received but didn't record. Her crime was made easier by the fact that her boss, the company's controller, only did a very superficial review of the bank reconciliation and thus didn't notice that some numbers had been cut out from other documents and taped onto the bank reconciliation.
Total take: $1.5 million
THE MISSING CONTROL
Segregation of duties. The foundation should not have allowed an accounts receivable clerk, whose job was to record receivables, to also handle cash, record cash, make deposits, and especially prepare the bank reconciliation.
Independent internal verification. The controller was supposed to perform a thorough review of the bank reconciliation. Because he did not, he was terminated from his position.
Source: Adapted from Wells, Fraud Casebook (2007), pp. 183–194.
Distinguish between the methods and bases companies use to value accounts receivable.
Once companies record receivables in the accounts, the next question is: How should they report receivables in the financial statements? Companies report accounts receivable on the balance sheet as an asset. But determining the amount to report is sometimes difficult because some receivables will become uncollectible.
Each customer must satisfy the credit requirements of the seller before the credit sale is approved. Inevitably, though, some accounts receivable become uncollectible. For example, a customer may not be able to pay because of a decline in its sales revenue due to a downturn in the economy. Similarly, individuals may be laid off from their jobs or faced with unexpected hospital bills. Companies record credit losses as debits to Bad Debt Expense (or Uncollectible Accounts Expense). Such losses are a normal and necessary risk of doing business on a credit basis.
Recently, when U.S. home prices fell, home foreclosures rose and the economy in general slowed, lenders experienced huge increases in their bad debt expense. For example, during one quarter Wachovia (a large U.S. bank now owned by Wells Fargo) increased bad debt expense from $108 million to $408 million. Similarly, American Express increased its bad debt expense by 70%.
Two methods are used in accounting for uncollectible accounts: (1) the direct write-off method and (2) the allowance method. The following sections explain these methods.
Alternative Terminology
You will sometimes see Bad Debt Expense called Uncollectible Accounts Expense.
Under the direct write-off method, when a company determines a particular account to be uncollectible, it charges the loss to Bad Debt Expense. Assume, for example, that Warden Co. writes off as uncollectible M. E. Doran's $200 balance on December 12. Warden's entry is:
Under this method, Bad Debt Expense will show only actual losses from uncollectibles. The company will report accounts receivable at its gross amount.
Although this method is simple, its use can reduce the usefulness of both the income statement and balance sheet. Consider the following example. Assume that in 2014, Quick Buck Computer Company decided it could increase its revenues by offering computers to college students without requiring any money down and with no credit-approval process. On campuses across the country, it distributed one million computers with a selling price of $800 each. This increased Quick Buck's revenues and receivables by $800 million. The promotion was a huge success! The 2014 balance sheet and income statement looked great. Unfortunately, during 2015, nearly 40% of the customers defaulted on their loans. This made the 2015 income statement and balance sheet look terrible. Illustration 9-2 shows the effect of these events on the financial statements if the direct write-off method is used.
Under the direct write-off method, companies often record bad debt expense in a period different from the period in which they record the revenue. The method does not attempt to match bad debt expense to sales revenues in the income statement. Nor does the direct write-off method show accounts receivable in the balance sheet at the amount the company actually expects to receive. Consequently, unless bad debt losses are insignificant, the direct write-off method is not acceptable for financial reporting purposes.
The allowance method of accounting for bad debts involves estimating uncollectible accounts at the end of each period. This provides better matching on the income statement. It also ensures that companies state receivables on the balance sheet at their cash (net) realizable value. Cash (net) realizable value is the net amount the company expects to receive in cash. It excludes amounts that the company estimates it will not collect. Thus, this method reduces receivables in the balance sheet by the amount of estimated uncollectible receivables.
GAAP requires the allowance method for financial reporting purposes when bad debts are material in amount. This method has three essential features:
1. Companies estimate uncollectible accounts receivable. They match this estimated expense against revenues in the same accounting period in which they record the revenues.
2. Companies debit estimated uncollectibles to Bad Debt Expense and credit them to Allowance for Doubtful Accounts through an adjusting entry at the end of each period. Allowance for Doubtful Accounts is a contra account to Accounts Receivable.
3. When companies write off a specific account, they debit actual uncollectibles to Allowance for Doubtful Accounts and credit that amount to Accounts Receivable.
Helpful Hint In this context, material means significant or important to financial statement users.
RECORDING ESTIMATED UNCOLLECTIBLES To illustrate the allowance method, assume that Hampson Furniture has credit sales of $1,200,000 in 2014. Of this amount, $200,000 remains uncollected at December 31. The credit manager estimates that $12,000 of these sales will be uncollectible. The adjusting entry to record the estimated uncollectibles increases (debits) Bad Debt Expense and increases (credits) Allowance for Doubtful Accounts, as follows.
Hampson reports Bad Debt Expense in the income statement as an operating expense (usually as a selling expense). Thus, the estimated uncollectibles are matched with sales in 2014. Hampson records the expense in the same year it made the sales.
Allowance for Doubtful Accounts shows the estimated amount of claims on customers that the company expects will become uncollectible in the future. Companies use a contra account instead of a direct credit to Accounts Receivable because they do not know which customers will not pay. The credit balance in the allowance account will absorb the specific write-offs when they occur. As Illustration 9-3 shows, the company deducts the allowance account from accounts receivable in the current assets section of the balance sheet.
Helpful Hint Cash realizable value is sometimes referred to as accounts receivable (net).
The amount of $188,000 in Illustration 9-3 represents the expected cash realizable value of the accounts receivable at the statement date. Companies do not close Allowance for Doubtful Accounts at the end of the fiscal year.
RECORDING THE WRITE-OFF OF AN UNCOLLECTIBLE ACCOUNT As described in the Feature Story, companies use various methods of collecting past-due accounts, such as letters, calls, and legal action. When they have exhausted all means of collecting a past-due account and collection appears impossible, the company writes off the account. In the credit card industry, for example, it is standard practice to write off accounts that are 210 days past due. To prevent premature or unauthorized write-offs, authorized management personnel should formally approve each write-off. To maintain segregation of duties, the employee authorized to write off accounts should not have daily responsibilities related to cash or receivables.
To illustrate a receivables write-off, assume that the financial vice president of Hampson Furniture authorizes a write-off of the $500 balance owed by R. A. Ware on March 1, 2015. The entry to record the write-off is:
Bad Debt Expense does not increase when the write-off occurs. Under the allowance method, companies debit every bad debt write-off to the allowance account rather than to Bad Debt Expense. A debit to Bad Debt Expense would be incorrect because the company has already recognized the expense when it made the adjusting entry for estimated bad debts. Instead, the entry to record the write-off of an uncollectible account reduces both Accounts Receivable and Allowance for Doubtful Accounts. After posting, the general ledger accounts appear as shown in Illustration 9-4.
A write-off affects only balance sheet accounts—not income statement accounts. The write-off of the account reduces both Accounts Receivable and Allowance for Doubtful Accounts. Cash realizable value in the balance sheet, therefore, remains the same, as Illustration 9-5 shows.
RECOVERY OF AN UNCOLLECTIBLE ACCOUNT Occasionally, a company collects from a customer after it has written off the account as uncollectible. The company makes two entries to record the recovery of a bad debt: (1) It reverses the entry made in writing off the account. This reinstates the customer's account. (2) It journalizes the collection in the usual manner.
To illustrate, assume that on July 1, R. A. Ware pays the $500 amount that Hampson had written off on March 1. Hampson makes these entries:
Note that the recovery of a bad debt, like the write-off of a bad debt, affects only balance sheet accounts. The net effect of the two entries above is a debit to Cash and a credit to Allowance for Doubtful Accounts for $500. Accounts Receivable and Allowance for Doubtful Accounts both increase in entry (1) for two reasons. First, the company made an error in judgment when it wrote off the account receivable. Second, after R. A. Ware did pay, Accounts Receivable in the general ledger and Ware's account in the subsidiary ledger should show the collection for possible future credit purposes.
ESTIMATING THE ALLOWANCE For Hampson Furniture in Illustration 9-3, the amount of the expected uncollectibles was given. However, in “real life,” companies must estimate that amount when they use the allowance method. Two bases are used to determine this amount: (1) percentage of sales and (2) percentage of receivables. Both bases are generally accepted. The choice is a management decision. It depends on the relative emphasis that management wishes to give to expenses and revenues on the one hand or to cash realizable value of the accounts receivable on the other. The choice is whether to emphasize income statement or balance sheet relationships. Illustration 9-6 compares the two bases.
The percentage-of-sales basis results in a better matching of expenses with revenues—an income statement viewpoint. The percentage-of-receivables basis produces the better estimate of cash realizable value—a balance sheet viewpoint. Under both bases, the company must determine its past experience with bad debt losses.
Percentage-of-Sales. In the percentage-of-sales basis, management estimates what percentage of credit sales will be uncollectible. This percentage is based on past experience and anticipated credit policy.
The company applies this percentage to either total credit sales or net credit sales of the current year. To illustrate, assume that Gonzalez Company elects to use the percentage-of-sales basis. It concludes that 1% of net credit sales will become uncollectible. If net credit sales for 2014 are $800,000, the estimated bad debt expense is $8,000 (1% × $800,000). The adjusting entry is:
After the adjusting entry is posted, assuming the allowance account already has a credit balance of $1,723, the accounts of Gonzalez Company will show the following.
This basis of estimating uncollectibles emphasizes the matching of expenses with revenues. As a result, Bad Debt Expense will show a direct percentage relationship to the sales base on which it is computed. When the company makes the adjusting entry, it disregards the existing balance in Allowance for Doubtful Accounts. The adjusted balance in this account should be a reasonable approximation of the realizable value of the receivables. If actual write-offs differ significantly from the amount estimated, the company should modify the percentage for future years.
Percentage-of-Receivables. Under the percentage-of-receivables basis, management estimates what percentage of receivables will result in losses from uncollectible accounts. The company prepares an aging schedule, in which it classifies customer balances by the length of time they have been unpaid. Because of its emphasis on time, the analysis is often called aging the accounts receivable. In the Feature Story, Whitehall-Robins prepared an aging report daily.
After the company arranges the accounts by age, it determines the expected bad debt losses. It applies percentages based on past experience to the totals in each category. The longer a receivable is past due, the less likely it is to be collected. Thus, the estimated percentage of uncollectible debts increases as the number of days past due increases. Illustration 9-8 shows an aging schedule for Dart Company. Note that the estimated percentage uncollectible increases from 2% to 40% as the number of days past due increases.
Helpful Hint Where appropriate, companies may use only a single percentage rate.
Helpful Hint The older categories have higher percentages because the longer an account is past due, the less likely it is to be collected.
Total estimated bad debts for Dart Company ($2,228) represent the amount of existing customer claims the company expects will become uncollectible in the future. This amount represents the required balance in Allowance for Doubtful Accounts at the balance sheet date. The amount of the bad debt adjusting entry is the difference between the required balance and the existing balance in the allowance account. If the trial balance shows Allowance for Doubtful Accounts with a credit balance of $528, the company will make an adjusting entry for $1,700 ($2,228 − $528), as shown here.
After Dart posts its adjusting entry, its accounts will appear as follows.
Occasionally, the allowance account will have a debit balance prior to adjustment. This occurs when write-offs during the year have exceeded previous provisions for bad debts. In such a case, the company adds the debit balance to the required balance when it makes the adjusting entry. Thus, if there had been a $500 debit balance in the allowance account before adjustment, the adjusting entry would have been for $2,728 ($2,228 + $500) to arrive at a credit balance of $2,228 (see T-account in margin). The percentage-of-receivables basis will normally result in the better approximation of cash realizable value.
DO IT!
Uncollectible Accounts Receivable
Brule Co. has been in business five years. The unadjusted trial balance at the end of the current year shows:
Accounts Receivable | $30,000 Dr. |
Sales Revenue | $180,000 Cr. |
Allowance for Doubtful Accounts | $2,000 Dr. |
Brule estimates bad debts to be 10% of receivables. Prepare the entry necessary to adjust Allowance for Doubtful Accounts.
Action Plan
Report receivables at their cash (net) realizable value.
Estimate the amount the company does not expect to collect.
Consider the existing balance in the allowance account when using the percentage-of-receivables basis.
Solution
Related exercise material: BE9-3, BE9-4, BE9-5, BE9-6, BE9-7, E9-3, E9-4, E9-5, E9-6, and DO IT! 9-1.
In the normal course of events, companies collect accounts receivable in cash and remove the receivables from the books. However, as credit sales and receivables have grown in significance, the “normal course of events” has changed. Companies now frequently sell their receivables to another company for cash, thereby shortening the cash-to-cash operating cycle.
Companies sell receivables for two major reasons. First, they may be the only reasonable source of cash. When money is tight, companies may not be able to borrow money in the usual credit markets. Or if money is available, the cost of borrowing may be prohibitive.
A second reason for selling receivables is that billing and collection are often time-consuming and costly. It is often easier for a retailer to sell the receivables to another party with expertise in billing and collection matters. Credit card companies such as MasterCard, Visa, and Discover specialize in billing and collecting accounts receivable.
A common sale of receivables is a sale to a factor. A factor is a finance company or bank that buys receivables from businesses and then collects the payments directly from the customers. Factoring is a multibillion dollar business.
Factoring arrangements vary widely. Typically, the factor charges a commission to the company that is selling the receivables. This fee ranges from 1−3% of the amount of receivables purchased. To illustrate, assume that Hendredon Furniture factors $600,000 of receivables to Federal Factors. Federal Factors assesses a service charge of 2% of the amount of receivables sold. The journal entry to record the sale by Hendredon Furniture on April 2, 2014, is as follows.
If the company often sells its receivables, it records the service charge expense (such as that incurred by Hendredon) as a selling expense. If the company infrequently sells receivables, it may report this amount in the “Other expenses and losses” section of the income statement.
Over one billion credit cards are in use in the United States—more than three credit cards for every man, woman, and child in this country. Visa, MasterCard, and American Express are the national credit cards that most individuals use. Three parties are involved when national credit cards are used in retail sales: (1) the credit card issuer, who is independent of the retailer; (2) the retailer; and (3) the customer. A retailer's acceptance of a national credit card is another form of selling (factoring) the receivable.
Illustration 9-10 shows the major advantages of national credit cards to the retailer. In exchange for these advantages, the retailer pays the credit card issuer a fee of 2−6% of the invoice price for its services.
ACCOUNTING FOR CREDIT CARD SALES The retailer generally considers sales from the use of national credit card sales as cash sales. The retailer must pay to the bank that issues the card a fee for processing the transactions. The retailer records the credit card slips in a similar manner as checks deposited from a cash sale.
To illustrate, Anita Ferreri purchases $1,000 of compact discs for her restaurant from Karen Kerr Music Co., using her Visa First Bank Card. First Bank charges a service fee of 3%. The entry to record this transaction by Karen Kerr Music on March 22, 2014, is as follows.
ACCOUNTING ACROSS THE ORGANIZATION
How Does a Credit Card Work?
Most of you know how to use a credit card, but do you know what happens in the transaction and how the transaction is processed? Suppose that you use a Visa card to purchase some new ties at Nordstrom. The salesperson swipes your card, which allows the information on the magnetic strip on the back of the card to be read. The salesperson then enters in the amount of the purchase. The machine contacts the Visa computer, which routes the call back to the bank that issued your Visa card. The issuing bank verifies that the account exists, that the card is not stolen, and that you have not exceeded your credit limit. At this point, the slip is printed, which you sign.
Visa acts as the clearing agent for the transaction. It transfers funds from the issuing bank to Nordstrom's bank account. Generally this transfer of funds, from sale to the receipt of funds in the merchant's account, takes two to three days.
In the meantime, Visa puts a pending charge on your account for the amount of the tie purchase; that amount counts immediately against your available credit limit. At the end of the billing period, Visa sends you an invoice (your credit card bill) which shows the various charges you made, and the amounts that Visa expended on your behalf, for the month. You then must “pay the piper” for your stylish new ties.
Assume that Nordstrom prepares a bank reconciliation at the end of each month. If some credit card sales have not been processed by the bank, how should Nordstrom treat these transactions on its bank reconciliation? (See page 467.)
DO IT!
Disposition of Accounts Receivable
Mehl Wholesalers Co. has been expanding faster than it can raise capital. According to its local banker, the company has reached its debt ceiling. Mehl's suppliers (creditors) are demanding payment within 30 days of the invoice date for goods acquired, but Mehl's customers are slow in paying (60–90 days). As a result, Mehl has a cash flow problem.
Mehl needs $120,000 in cash to safely cover next Friday's payroll. Its balance of outstanding accounts receivable totals $750,000. To alleviate this cash crunch, Mehl sells $125,000 of its receivables on September 7, 2014. Record the entry that Mehl would make when it raises the needed cash. (Assume a 1% service charge.)
To speed up the collection of cash, sell receivables to a factor.
Calculate service charge expense as a percentage of the factored receivables.
Solution
Related exercise material: BE9-8, E9-7, E9-8, E9-9, and DO IT! 9-2.
Companies may also grant credit in exchange for a formal credit instrument known as a promissory note. A promissory note is a written promise to pay a specified amount of money on demand 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 credit period exceed normal limits, or (3) in settlement of accounts receivable.
In a promissory note, the party making the promise to pay is called the maker. The party to whom payment is to be made is called the payee. The note may specifically identify the payee by name or may designate the payee simply as the bearer of the note.
In the note shown in Illustration 9-11, Calhoun Company is the maker and Wilma Company is the payee. To Wilma Company, the promissory note is a note receivable. To Calhoun Company, it is a note payable.
Helpful Hint Who are the two key parties to a note, and what entry does each party make when the note is issued?
Answer:
1. The maker, Calhoun Company, debits Cash and credits Notes Payable.
2. The payee, Wilma Company, debits Notes Receivable and credits Cash.
Notes receivable give the holder a stronger legal claim to assets than do accounts receivable. Like accounts receivable, notes receivable can be readily sold to another party. Promissory notes are negotiable instruments (as are checks), which means that they can be transferred to another party by endorsement.
Companies frequently accept notes receivable from customers who need to extend the payment of an outstanding account receivable. They often require such notes from high-risk customers. In some industries (such as the pleasure and sport boat industry), all credit sales are supported by notes. The majority of notes, however, originate from loans.
The basic issues in accounting for notes receivable are the same as those for accounts receivable:
1. Recognizing notes receivable.
2. Valuing notes receivable.
3. Disposing of notes receivable.
On the following pages, we will look at these issues. Before we do, we need to consider two issues that do not apply to accounts receivable: maturity date and computing interest.
When the life of a note is expressed in terms of months, you find the date when it matures by counting the months from the date of issue. For example, the maturity date of a three-month note dated May 1 is August 1. A note drawn on the last day of a month matures on the last day of a subsequent month. That is, a July 31 note due in two months matures on September 30.
When the due date is stated in terms of days, you need to count the exact number of days to determine the maturity date. In counting, omit the date the note is issued but include the due date. For example, the maturity date of a 60-day note dated July 17 is September 15, computed as follows.
Illustration 9-13 shows three ways of stating the maturity date of a promissory note.
Illustration 9-14 gives the basic formula for computing interest on an interest-bearing note.
Helpful Hint The interest rate specified is the annual rate.
The interest rate specified in a note is an annual rate of interest. The time factor in the computation in Illustration 9-14 expresses the fraction of a year that the note is outstanding. When the maturity date is stated in days, the time factor is often the number of days divided by 360. When counting days, omit the date that the note is issued but include the due date. When the due date is stated in months, the time factor is the number of months divided by 12. Illustration 9-15 shows computation of interest for various time periods.
There are different ways to calculate interest. For example, the computation in Illustration 9-15 assumes 360 days for the length of the year. Most financial instruments use 365 days to compute interest. For homework problems, assume 360 days to simplify computations.
To illustrate the basic entry for notes receivable, we will use Calhoun Company's $1,000, two-month, 12% promissory note dated May 1. Assuming that Calhoun Company wrote the note to settle an open account, Wilma Company makes the following entry for the receipt of the note.
The company records the note receivable at its face value, the amount shown on the face of the note. No interest revenue is reported when the note is accepted, because the revenue recognition principle does not recognize revenue until the performance obligation is satisfied. Interest is earned (accrued) as time passes.
If a company lends money using a note, the entry is a debit to Notes Receivable and a credit to Cash in the amount of the loan.
Valuing short-term notes receivable is the same as valuing accounts receivable. Like accounts receivable, companies report short-term notes receivable at their cash (net) realizable value. The notes receivable allowance account is Allowance for Doubtful Accounts. The estimations involved in determining cash realizable value and in recording bad debt expense and the related allowance are done similarly to accounts receivable.
Can Fair Value Be Unfair?
The FASB and the International Accounting Standards Board (IASB) are considering proposals for how to account for financial instruments. The FASB has proposed that loans and receivables be accounted for at their fair value (the amount they could currently be sold for), as are most investments. The FASB believes that this would provide a more accurate view of a company's financial position. It might be especially useful as an early warning when a bank is in trouble because of poor-quality loans. But, banks argue that fair values are difficult to estimate accurately. They are also concerned that volatile fair values could cause large swings in a bank's reported net income.
Source: David Reilly, “Banks Face a Mark-to-Market Challenge,” Wall Street Journal Online (March 15, 2010).
What are the arguments in favor of and against fair value accounting for loans and receivables? (See page 467.)
Notes may be held to their maturity date, at which time the face value plus accrued interest is due. In some situations, the maker of the note defaults, and the payee must make an appropriate adjustment. In other situations, similar to accounts receivable, the holder of the note speeds up the conversion to cash by selling the receivables (as described later in this chapter).
A note is honored when its maker pays in full at its maturity date. For each interest-bearing note, the amount due at maturity is the face value of the note plus interest for the length of time specified on the note.
To illustrate, assume that Wolder Co. lends Higley Co. $10,000 on June 1, accepting a five-month, 9% interest note. In this situation, interest is $375 ($10,000 × 9% × ). The amount due, the maturity value, is $10,375 ($10,000 + $375). To obtain payment, Wolder (the payee) must present the note either to Higley Co. (the maker) or to the maker's agent, such as a bank. If Wolder presents the note to Higley Co. on November 1, the maturity date, Wolder's entry to record the collection is:
Suppose instead that Wolder Co. prepares financial statements as of September 30. The timeline in Illustration 9-16 presents this situation.
To reflect interest earned but not yet received, Wolder must accrue interest on September 30. In this case, the adjusting entry by Wolder is for four months of interest, or $300, as shown below.
At the note's maturity on November 1, Wolder receives $10,375. This amount represents repayment of the $10,000 note as well as five months of interest, or $375, as shown below. The $375 is comprised of the $300 Interest Receivable accrued on September 30 plus $75 earned during October. Wolder's entry to record the honoring of the Higley note on November 1 is:
In this case, Wolder credits Interest Receivable because the receivable was established in the adjusting entry on September 30.
A dishonored (defaulted) note is a note that is not paid in full at maturity. A dishonored note receivable is no longer negotiable. However, the payee still has a claim against the maker of the note for both the note and the interest. Therefore the note holder usually transfers the Notes Receivable account to an Account Receivable.
To illustrate, assume that Higley Co. on November 1 indicates that it cannot pay at the present time. The entry to record the dishonor of the note depends on whether Wolder Co. expects eventual collection. If it does expect eventual collection, Wolder Co. debits the amount due (face value and interest) on the note to Accounts Receivable. It would make the following entry at the time the note is dishonored (assuming no previous accrual of interest).
If instead, on November 1, there is no hope of collection, the note holder would write off the face value of the note by debiting Allowance for Doubtful Accounts. No interest revenue would be recorded because collection will not occur.
The accounting for the sale of notes receivable is recorded similarly to the sale of accounts receivable. The accounting entries for the sale of notes receivable are left for a more advanced course.
ACCOUNTING ACROSS THE ORGANIZATION
Bad Information Can Lead to Bad Loans
Many factors have contributed to the recent credit crisis. One significant factor that resulted in many bad loans was a failure by lenders to investigate loan customers sufficiently. For example, Countrywide Financial Corporation wrote many loans under its “Fast and Easy” loan program. That program allowed borrowers to provide little or no documentation for their income or their assets. Other lenders had similar programs, which earned the nickname “liars’ loans.” One study found that in these situations, 60% of applicants overstated their incomes by more than 50% in order to qualify for a loan. Critics of the banking industry say that because loan officers were compensated for loan volume and because banks were selling the loans to investors rather than holding them, the lenders had little incentive to investigate the borrowers’ creditworthiness.
Source: Glenn R. Simpson and James R. Hagerty, “Countrywide Loss Focuses Attention on Underwriting,” Wall Street Journal (April 30, 2008), p. B1; and Michael Corkery, “Fraud Seen as Driver in Wave of Foreclosures,” Wall Street Journal (December 21, 2007), p. A1.
What steps should the banks have taken to ensure the accuracy of financial information provided on loan applications? (See page 467.)
DO IT!
Notes Receivable
Gambit Stores accepts from Leonard Co. a $3,400, 90-day, 6% note dated May 10 in settlement of Leonard's overdue account. (a) What is the maturity date of the note? (b) What entry does Gambit make at the maturity date, assuming Leonard pays the note and interest in full at that time?
Action Plan
Count the exact number of days to determine the maturity date. Omit the date the note is issued, but include the due date.
Determine whether interest was accrued.
Compute the accrued interest.
Prepare the entry for payment of the note and interest.
The entry to record interest at maturity in this solution assumes no interest has been previously accrued on this note.
Solution
Related exercise material: BE9-9, BE9-10, BE9-11, E9-10, E9-11, E9-12, E9-13, and DO IT! 9-3.
Companies should identify in the balance sheet or in the notes to the financial statements each of the major types of receivables. Short-term receivables appear in the current assets section of the balance sheet. Short-term investments appear before short-term receivables because these investments are more liquid (nearer to cash). Companies report both the gross amount of receivables and the allowance for doubtful accounts.
In a multiple-step income statement, companies report bad debt expense and service charge expense as selling expenses in the operating expenses section. Interest revenue appears under “Other revenues and gains” in the nonoperating activities section of the income statement.
Investors and corporate managers compute financial ratios to evaluate the liquidity of a company's accounts receivable. They use the accounts receivable turnover to assess the liquidity of the receivables. This ratio measures the number of times, on average, the company collects accounts receivable during the period. It is computed by dividing net credit sales (net sales less cash sales) by the average net accounts receivable during the year. Unless seasonal factors are significant, average net accounts receivable outstanding can be computed from the beginning and ending balances of net accounts receivable.
For example, in 2011 Cisco Systems had net sales of $34,526 million for the year. It had a beginning accounts receivable (net) balance of $4,929 million and an ending accounts receivable (net) balance of $4,698 million. Assuming that Cisco's sales were all on credit, its accounts receivable turnover is computed as follows.
The result indicates an accounts receivable turnover of 7.2 times per year. The higher the turnover, the more liquid the company's receivables.
A variant of the accounts receivable turnover that makes the liquidity even more evident is its conversion into an average collection period in terms of days. This is done by dividing the accounts receivable turnover into 365 days. For example, Cisco's turnover of 7.2 times is divided into 365 days, as shown in Illustration 9-18, to obtain approximately 51 days. This means that it takes Cisco 51 days to collect its accounts receivable.
Companies frequently use the average collection period 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 (that is, the time allowed for payment).
DO IT!
In 2014, Phil Mickelson Company has net credit sales of $923,795 for the year. It had a beginning accounts receivable (net) balance of $38,275 and an ending accounts receivable (net) balance of $35,988. Compute Phil Mickelson Company's (a) accounts receivable turnover and (b) average collection period in days.
Action Plan
Review the formula to compute the accounts receivable turnover.
Make sure that both the beginning and ending accounts receivable balances are considered in the computation.
Review the formula to compute the average collection period in days.
Solution
Related exercise material: BE9-12, E9-14, and DO IT! 9-4.
The following selected transactions relate to Dylan Company.
Mar. 1 | Sold $20,000 of merchandise to Potter Company, terms 2/10, n/30. |
11 | Received payment in full from Potter Company for balance due on existing accounts receivable. |
12 | Accepted Juno Company's $20,000, 6-month, 12% note for balance due. |
13 | Made Dylan Company credit card sales for $13,200. |
15 | Made Visa credit card sales totaling $6,700. A 3% service fee is charged by Visa. |
Apr. 11 | Sold accounts receivable of $8,000 to Harcot Factor. Harcot Factor assesses a service charge of 2% of the amount of receivables sold. |
13 | Received collections of $8,200 on Dylan Company credit card sales and added finance charges of 1.5% to the remaining balances. |
May 10 | Wrote off as uncollectible $16,000 of accounts receivable. Dylan uses the percentage-of-sales basis to estimate bad debts. |
June 30 | Credit sales recorded during the first 6 months total $2,000,000. The bad debt percentage is 1% of credit sales. At June 30, the balance in the allowance account is $3,500 before adjustment. |
July 16 | One of the accounts receivable written off in May was from J. Simon, who pays the amount due, $4,000, in full. |
Instructions
Prepare the journal entries for the transactions.
Action Plan
Generally, record accounts receivable at invoice price.
Recognize that sales returns and allowances and cash discounts reduce the amount received on accounts receivable.
Record service charge expense on the seller's books when accounts receivable are sold.
Prepare an adjusting entry for bad debt expense.
Ignore any balance in the allowance account under the percentage-of-sales basis. Recognize the balance in the allowance account under the percentage-of-receivables basis.
Record write-offs of accounts receivable only in balance sheet accounts.
Solution to Comprehensive DO IT!
1 Identify the different types of receivables. Receivables are frequently classified as (1) accounts, (2) notes, and (3) other. Accounts receivable are amounts customers owe on account. Notes receivable are claims for which lenders issue formal instruments of credit as proof of the debt. Other receivables include nontrade receivables such as interest receivable, loans to company officers, advances to employees, and income taxes refundable.
2 Explain how companies recognize accounts receivable. Companies record accounts receivable when they provide a service on account or at the point of sale of merchandise on account. Accounts receivable are reduced by sales returns and allowances. Cash discounts reduce the amount received on accounts receivable. When interest is charged on a past due receivable, the company adds this interest to the accounts receivable balance and recognizes it as interest revenue.
3 Distinguish between the methods and bases companies use to value accounts receivable. There are two methods of accounting for uncollectible accounts: the allowance method and the direct write-off method. Companies may use either the percentage-of-sales or the percentage-of-receivables basis to estimate uncollectible accounts using the allowance method. The percentage-of-sales basis emphasizes the expense recognition (matching) principle. The percentage-of-receivables basis emphasizes the cash realizable value of the accounts receivable. An aging schedule is often used with this basis.
4 Describe the entries to record the disposition of accounts receivable. When a company collects an account receivable, it credits Accounts Receivable. When a company sells (factors) an account receivable, a service charge expense reduces the amount received.
5 Compute the maturity date of and interest on notes receivable. For a note stated in months, the maturity date is found by counting the months from the date of issue. For a note stated in days, the number of days is counted, omitting the issue date and counting the due date. The formula for computing interest is Face value × Interest rate × Time.
6 Explain how companies recognize notes receivable. Companies record notes receivable at face value. In some cases, it is necessary to accrue interest prior to maturity. In this case, companies debit Interest Receivable and credit Interest Revenue.
7 Describe how companies value notes receivable. As with accounts receivable, companies report notes receivable at their cash (net) realizable value. The notes receivable allowance account is Allowance for Doubtful Accounts. The computation and estimations involved in valuing notes receivable at cash realizable value, and in recording the proper amount of bad debt expense and the related allowance, are similar to those for accounts receivable.
8 Describe the entries to record the disposition of notes receivable. Notes can be held to maturity. At that time the face value plus accrued interest is due, and the note is removed from the accounts. In many cases, the holder of the note speeds up the conversion by selling the receivable to another party (a factor). In some situations, the maker of the note dishonors the note (defaults), in which case the company transfers the note and accrued interest to an account receivable or writes off the note.
9 Explain the statement presentation and analysis of receivables. Companies should identify in the balance sheet or in the notes to the financial statements each major type of receivable. Short-term receivables are considered current assets. Companies report the gross amount of receivables and the allowance for doubtful accounts. They report bad debt and service charge expenses in the multiple-step income statement as operating (selling) expenses. Interest revenue appears under other revenues and gains in the nonoperating activities section of the statement. Managers and investors evaluate accounts receivable for liquidity by computing a turnover ratio and an average collection period.
Accounts receivable Amounts owed by customers on account. (p. 430).
Accounts receivable turnover A measure of the liquidity of accounts receivable; computed by dividing net credit sales by average net accounts receivable. (p. 447).
Aging the accounts receivable The analysis of customer balances by the length of time they have been unpaid. (p. 437).
Allowance method A method of accounting for bad debts that involves estimating uncollectible accounts at the end of each period. (p. 433).
Average collection period The average amount of time that a receivable is outstanding; calculated by dividing 365 days by the accounts receivable turnover. (p. 447).
Bad Debt Expense An expense account to record uncollectible receivables. (p. 432).
Cash (net) realizable value The net amount a company expects to receive in cash. (p. 433).
Direct write-off method A method of accounting for bad debts that involves expensing accounts at the time they are determined to be uncollectible. (p. 432).
Dishonored (defaulted) note A note that is not paid in full at maturity. (p. 445).
Factor A finance company or bank that buys receivables from businesses and then collects the payments directly from the customers. (p. 439).
Maker The party in a promissory note who is making the promise to pay. (p. 441).
Notes receivable Written promise (as evidenced by a formal instrument) for amounts to be received. (p. 430).
Other receivables Various forms of nontrade receivables, such as interest receivable and income taxes refundable. (p. 430).
Payee The party to whom payment of a promissory note is to be made. (p. 441).
Percentage-of-receivables basis Management estimates what percentage of receivables will result in losses from uncollectible accounts. (p. 437).
Percentage-of-sales basis Management estimates what percentage of credit sales will be uncollectible. (p. 436).
Promissory note A written promise to pay a specified amount of money on demand or at a definite time. (p. 441).
Receivables Amounts due from individuals and other companies. (p. 430).
Trade receivables Notes and accounts receivable that result from sales transactions. (p. 430).