The allowance method involves setting aside a reserve for bad debts that are expected in the future. The reserve is based on a percentage of the sales generated in a reporting period, possibly adjusted for the risk associated with certain customers. By creating this allowance, bad debt expenses are being matched against sales within the same period, so that readers of the financial statements will have a better understanding of the true profitability of sales. Show
The mechanics of the allowance method are that the initial entry is a debit to bad debt expense and a credit to the allowance for doubtful accounts (which increases the reserve). The allowance is a contra account, which means that it is paired with and offsets the accounts receivable account. When a specific bad debt is identified, the allowance for doubtful accounts is debited (which reduces the reserve) and the accounts receivable account is credited (which reduces the receivable asset). If a customer subsequently pays an invoice that has already been written off, then the process is reversed to increase both the allowance and the accounts receivable account, after which the cash account is debited to increase the cash balance and the accounts receivable account is credited to reduce the receivable asset. Example of the Allowance MethodThe historical bad debt experience of a company has been 3% of sales, and the current month’s sales are $1,000,000. Based on this information, the bad debt reserve to be set aside is $30,000 (calculated as $1,000,000 x 3%). In the following month, $20,000 of the accounts receivable are written off, leaving $10,000 of the reserve still available for additional write-offs. The Direct Write-Off MethodThe alternative to the allowance method is the direct write-off method, under which bad debts are only written off when specific receivables cannot be collected. This may not occur until several months after a sale transaction was completed, so the entire profitability of a sale may not be apparent for some time. The direct write-off method is a less theoretically correct approach to dealing with bad debts, since it does not match revenues with all applicable expenses in a single reporting period.
Chapter 8 Reporting and Analyzing Receivables Study Objectives v Identify the different types of receivables. v Explain how accounts receivable are recognized in the accounts. v Describe the methods used to account for bad debts. v Compute the interest on notes receivable. v Describe the entries to record the disposition of notes receivable. v Explain the statement presentation of receivables. v Describe the principles of sound accounts receivable management. v Identify ratios to analyze a company's receivables. v Describe methods to accelerate the receipt of cash from receivables. Chapter OutlineStudy Objective 1 - Identify the Different Types of Receivables¨ The term receivables refers to amounts due from individuals and companies. ¨ Receivables are claims that are expected to be collected in cash. ¨ Receivables represent one of a company’s most liquid assets. ¨ Receivables are frequently classified as: § Accounts receivable · Amounts owed by customers on account. · Result from the sale of goods and services (often called trade receivables). · Expected to be collected within 30 to 60 days. · Usually the most significant type of claim held by a company. § Notes receivable · Represent claims for which formal instruments of credit are issued as evidence of debt. · Credit instrument normally requires payment of interest and extends for time periods of 60-90 days or longer. · May result from sale of goods and services (often called trade receivables). § Other receivables · Nontrade receivables including interest receivable, loans to company officers, advances to employees, and income taxes refundable. · Generally classified and reported as separate items in the balance sheet. Study Objective 2 - Explain how Accounts Receivable are Recognized in the Accounts¨ For a service organization, a receivable is recorded when service is provided on account. ¨ Merchandisers record accounts receivable at the point of sale of merchandise on account. ¨ Entry is recorded to increase both Sales and Accounts Receivable. ¨ Receivable may be reduced by sales discount and/or sales return. Study Objective 3 - Describe the Methods Used to Account for Bad Debts¨ Credit losses are debited to Bad Debt Expense (or Uncollectible Accounts Expense). ¨ Two methods are used in accounting for uncollectible accounts: (1) the Direct Write-off Method and (2) the Allowance Method. ¨ Direct write-off method § When a specific account is determined to be uncollectible, the loss is charged to Bad Debt Expense. § For example, assume that Warden Co. writes off M. E. Doran’s $200 balance as uncollectible on December 12. The entry is: Dec. 12 Bad Debts Expense 200 Accounts Receivable--M. E. Doran 200 (To record write-off of M. E. Duran account) § Bad debts expense will show only actual losses from uncollectibles. § Bad debts expense is often recorded in a period different from that in which the revenue was recorded. No attempt is made to show accounts receivable in the balance sheet at the amount actually expected to be received. § Use of the direct write-off method can reduce the usefulness of both the income statement and balance sheet. § 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. § Provides better matching of expenses and revenues on the income statement and ensures that receivables are stated at their cash (net) realizable value on the balance sheet. § Cash (net) realizable value is the net amount of cash expected to be received; it excludes amounts that the company estimates it will not collect. § Receivables are therefore reduced by estimated uncollectible receivables on the balance sheet through use of the allowance method. § The allowance method is required for financial reporting purposes when bad debts are material. It has three essential features: 1. Uncollectible accounts receivable are estimated and matched against sales in the same accounting period in which the sales occurred. 2. Estimated uncollectibles are recorded as an increase to Bad Debts Expense and an increase to Allowance for Doubtful Accounts (a contra asset account) through an adjusting entry at the end of each period. 3. Actual uncollectibles are debited to Allowance for Doubtful Accounts and credited to Accounts Receivable at the time the specific account is written off as uncollectible. § Allowance for Doubtful Accounts shows the estimated amount of claims on customers that are expected to become uncollectible in the future. § The credit balance in the allowance account will absorb the specific write-offs when they occur. § Allowance for Doubtful Accounts is not closed at the end of the fiscal year. § Bad Debts Expense is reported in the income statement as an operating expense. § Each write-off should be approved in writing by authorized management personnel. § Under the allowance method, every bad debt write-off is debited to the allowance account and not to Bad Debt Expense. § A write-off affects only balance sheet accounts. Cash realizable value in the balance sheet, therefore, remains the same. § When a customer pays after the account has been written off, two entries are required: 1. The entry made in writing off the account is reversed to reinstate the customer’s account. 2. The collection is journalized in the usual manner. § The recovery of a bad debt, like the write-off of a bad debt, affects only balance sheet account. ¨In “real life,” companies must estimate the amount of expected uncollectible accounts if they use the allowance method. § Frequently the allowance is estimated as a percentage of the outstanding receivables. § Under the percentage of receivables basis, management establishes a percentage relationship between the amount of receivables and expected losses from uncollectible accounts. § A schedule is prepared in which customer balances are classified by the length of time they have been unpaid. § Because of its emphasis on time, this schedule is often called an aging schedule, and the analysis of it is often called aging the accounts receivable. § After the accounts are arranged by age, the expected bad debt losses are determined by applying percentages, based on past experience, to the totals of each category. § The estimated bad debts represent the existing customer claims expected to become uncollectible in the future. § This amount represents the required balance in Allowance for Doubtful Accounts at the balance sheet date. § Accordingly, the amount of the bad debts adjusting entry is the difference between the required balance and the existing balance in the allowance account. § Occasionally the allowance account will have a debit balance prior to adjustment because write-offs during the year have exceeded previous provisions for bad debts. § In such a case, the debit balance is added to the required balance when the adjusting entry is made. Study Objective 4 - Compute the Interest on Notes Receivable ¨ A promissory note is a written promise to pay a specified amount of money on demand or at a definite time. § 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 payee may be specifically identified by name or may be designated simply as the bearer of the note. § Notes receivable give the holder a stronger legal claim to assets than accounts receivable. § Notes receivable are frequently accepted from customers who need to extend the payment of an outstanding account receivable, and they are often required from high-risk customers. § Like accounts receivable, notes receivable can be readily sold to another party. Promissory notes are negotiable instruments. § There are three basic issues in accounting for notes receivable: 1. Recognizing notes receivable. 2. Valuing notes receivable. 3. Disposing of notes receivable. ¨ The formula for computing interest is: Face Value of Note (principle) x Annual Interest Rate x Time (in terms of one year) ¨ The interest rate specified on the note is an annual rate of interest. The time factor in the computation expresses the fraction of a year that the note is outstanding. ¨ When the maturity date is stated in days, the time factor is frequently the number of days divided by 360. For example, the maturity date of a 60-day note dated July 17 is determined as follows: Term of note 60 July 31 days Date of note 17 14 August 31 45 Maturity date, September 15 ¨ When the due date is stated in terms of months, the time factor is the number of months divided by 12. ¨ To illustrate the basic entry for notes receivable, the text uses Brent Company’s $1,000, two-month, 12% promissory note dated May 1. Assume that the note was written to settle an open account. The entry for the receipt of the note by Wilma Company is as follows: May 1 Notes Receivable 1,000 Accounts Receivable—Brent Company. 1,000 (To record acceptance of Brent Company note) ¨ The note receivable is recorded at its face value, the value 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 earned. Interest is earned (accrued) as time passes. ¨ If a note is exchanged for cash, the entry is a debit to Notes Receivable and a credit to Cash in the amount of the loan. ¨ Like accounts receivable, short-term notes receivable are reported at their cash (net) realizable value. ¨ The notes receivable allowance account is Allowance for Doubtful accounts. Study Objective 5 - Describe the Entries to Record the Disposition of Notes Receivable ¨ 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 appropriate adjustment must be made. ¨ A note is honored when it is paid in full at maturity. ¨ A dishonored note is a note that is not paid in full at maturity. ¨ If the lender expects that it will eventually be able to collect, the Notes Receivable account is transferred to an Account Receivable for both the face value of the note and the interest due. ¨ If there is no hope of collection, the face value of the note should be written off. Study Objective 6 - Explain the Statement Presentation of Receivables¨ Each of the major types of receivables should be identified in the balance sheet or in the notes to the financial statements. ¨ Short-term receivables are reported in the current asset section of the balance sheet below short-term investments. ¨ Both the gross amount of receivables and the allowance for doubtful accounts should be reported. ¨ Notes receivable are listed before accounts receivable because notes are more easily converted to cash. ¨ Bad Debts Expense is reported under “Selling expenses” in the income statement. ¨ Interest Revenue is shown under “Other Revenues and Gains” in the nonoperating section of the income statement. ¨ If a company has significant risk of uncollectible accounts or other problems with receivables, it is required to discuss this possibility in the notes to the financial statements. Study Objective 7 - Describe the Principles of Sound Accounts Receivable Management ¨ Managing accounts receivable involves five steps: 1. Determine to whom to extend credit. 2. Establish a payment period. 3. Monitor collections. 4. Evaluate the receivables balance. 5. Accelerate cash receipts from receivables when necessary. ¨ Determine to whom to extend credit. § Risky customers might be required to provide letters of credit or bank guarantees. § Risky customers might be required to pay cash on delivery. § Ask potential customers for references from banks and suppliers and check the references. § Periodically check financial health of continuing customers. ¨ Establish a payment period. § Determine a required payment period and communicate that policy to customers. § Make sure company's payment period is consistent with that of competitors. ¨ Monitor collections. § Prepare accounts receivable aging schedule at least monthly. § Pursue problem accounts with phone calls, letters, and legal action if necessary. ¨ If a company has significant concentrations of credit risk, it is required to discuss this risk in the notes to its financial statements. ¨ A concentration of credit risk is a threat of nonpayment from a single customer or class of customers that could adversely affect the financial health of the company. Study Objective 8 - Identify Ratios to Analyze a Company's Receivables ¨ Liquidity is measured by how quickly certain assets can be converted into cash. The ratio used to assess the liquidity of the receivables is the receivables turnover ratio. ¨ The ratio measures the number of times, on average, receivables are collected during the period. ¨ The receivables turnover ratio is computed by dividing net credit sales (net sales less cash sales) by the average gross accounts receivables during the year. ¨ A popular variant of the receivables turnover ratio is to convert it into an average collection period in terms of days. This is computed by dividing the receivables turnover ratio into 365 days. Study Objective 9 - Describe Methods to Accelerate the Receipt of Cash from Receivables ¨ Two common expressions apply to the collection of receivables: 1. Time is money—that is, waiting for the normal collection process costs money. 2. A bird in the hand is worth two in the bush—that is, getting the cash now is better than getting it later or not at all. ¨ There are three reasons for the sale of receivables. 1. The first is their size. In recent years, for competitive reasons, sellers (retailers, wholesalers, and manufacturers) often have provided financing to purchasers of their goods. 2. Second, receivables may be sold because they may be the only reasonable source of cash. When credit is tight, companies may not be able to borrow money in the usual credit markets. 3. A final reason for selling receivables is that billing and collection are often time-consuming and costly. As a result, it is often easier for a retailer to sell the receivables to another party that has expertise in billing and collection matters. ¨ A common way to accelerate receivables collection is a sale to a factor. A factor is a finance company or a bank that buys receivables from businesses for a fee and then collects the payments directly from the customers. ¨ Factoring arrangements vary widely, but typically the factor charges a commission of 1% to 3%. ¨ Approximately one billion credit cards were estimated to be in use recently. A common type of credit card is a national credit card such as Visa and MasterCard. ¨ Three parties are involved when national credit cards are used in making retail sales: The credit card issuer, who is independent of the retailer, the retailer, and the customer. ¨ A retailer’s acceptance of a national credit card is another form of selling—factoring—the receivable by the retailer. ¨ There are several advantages of credit cards for the retailer: 1. Issuer does credit investigation of customer. 2. Issuer maintains customer accounts. 3. Issuer undertakes collection process and absorbs any losses. 4. Retailer receives cash more quickly from credit card issuer. ¨ Sales resulting from the use of Visa and MasterCard are considered cash sales by the retailer. Upon receipt of credit card sales slips from a retailer, the bank that issued the card immediately adds the amount to the seller’s bank balance. ¨ To illustrate, Morgan Marie purchases $1,000 of compact discs for her restaurant from Sondgeroth Music Co., and she charges this amount on her Visa First Bank Card. The service fee that First Bank charges Sondgeroth Music is 3 percent. The entry by Sondgeroth Music to record this transaction is:
 Service Charge Expense 30 Sales 1,000 (To record Visa credit card sales) Chapter 8 Reviewü What are the different types of receivables? Why is it necessary to have them in different categories? ü Explain how accounts receivable are recognized in the accounts. ü What are the two methods used to account for bad debts? Which method is required by GAAP if bad debts are material? How is bad debt estimated when using the allowance method? ü What is the formula for computing interest on notes receivable? ü Describe the entries to record the disposition of notes receivable. ü Explain the statement presentation of receivables. ü What are the five steps in managing accounts receivable? ü Identify and compute ratios to analyze a company's receivables. ü What methods are used to accelerate the receipt of cash from receivables? |
Of the two methods of accounting for uncollectible receivables, the allowance method provides
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