Cash and Receivables
CURRENT RECEIVABLES
Receivables are the amount owed to the organization by its customers and/or others. Current
receivables will be collected within one year or the current operating cycle which ever is longer.
Noncurrent receivables will be collected at some later date beyond the operating cycle. Trade
receivables are those owed by customers in the ordinary course of business. Accounts receivable
are promises to pay that are not supported by any written documents. Notes receivable are
evidenced by a written note and normally carry an interest rate.
ACCOUNTS RECEIVABLE
Trade accounts receivable are evidenced by invoices that reflect the exchange price of the goods
or services. This exchange price is affected by trade discounts and cash discounts.
a. Trade discounts
Trade discounts are typically quoted as a percentage of the list price of the item. This allows
the seller to give the buyer a discount without having to adjust the list price. The account
receivable is recorded on the seller’s books at the amount net of the trade discount.
b. Cash discounts (sales discounts)
Cash or sales discounts are incentives offered to the buyer to pay the invoice early. They are
typically quoted as a percentage discount on the invoice price is paid within a limited period
of time. For example, if the terms are 2/10, net/30. The buyer can take a 2% discount on the
invoice price if the invoice is paid within the first 10 days. If the invoice is not paid within
10 days then the total amount is due on the 30th day.
Most business organizations use the gross method for recording cash discounts. Under this
method the total invoice is booked as an account receivable. At the time the payment is
received the discount is recorded.
Example: assume that Spencer Company sold $10,000 worth of merchandise to Sophie
Company under terms of 2/10, net/30. Within the first 10 days Sophie Company pays the
invoice less the 2% discount. The following reflects the journal entries to record the sale and the
collection on Spencer Company’s books.
ACCOUNT
DEBIT
Accounts receivable
10,000
Sales
To record the sale of merchandise to Sophie Company
Cash
Sales discounts
Accounts receivable
To record the collection of the receivable from
Sophie Company net of the 2% discount
CREDIT
10,000
9,800
200
10,000
Valuation of Accounts Receivable
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Cash and Receivables
Short-term receivables are valued and reported on the balance sheet at net realizable value. The
net amount reported in the balance sheet is the amount that management expects to actually
collect in the future. This requires estimation by management based on the best information
available at the time.
Sales Returns and Allowances
In certain industries sales returns and allowances can be material. If there is a history of returns
and allowances then the company might be required to establish an allowance to accounts
receivable (a contra asset account) estimating the amount included in the accountants receivable
that are currently reported in the balance sheet.
Uncollectible Accounts Receivable
There are two methods of recording uncollectible accounts.
• Direct write-off method
Under the direct write-off method the accounts are not written off until it has been
determined that they are uncollectible. The journal entry is a debit to bad debt expense and a
credit to the account receivable. This method is not GAAP and so therefore will not be used
in any future examples.
•
Allowance method
Under the allowance method we use estimates to establish an allowance account “allowance
for doubtful accounts” which is a contra-asset account offsetting accounts receivable. The
net of the two accounts is the net realizable receivables reported in the balance sheet. There
are two methods of estimating the amount that should be reported in the allowance account.
a) Balance Sheet Approach
Using the balance sheet approach we are interested in reporting net realizable receivables
correctly in the balance sheet. This is accomplished by examining the aged accounts
receivable and establishing the amount that should be allocated to the allowance account
based on management’s estimate of the accounts that may become uncollectible in the
future. The whole point of this approach is to get the correct balance in the allowance
account so that net realizable receivables are fairly stated in the balance sheet. The
resulting charge to bad debt expense in the current period is a residual as a result of this
analysis.
Example: Spencer Company has the following aged accounts receivable at year end December
31, 2000.
Customer
Balance Current 30 Days 60 Days 90 Days Over 90 Days
Able Supply Company
500
500
Barney Custom Supply
1,200
100
600
400
100
Casey Grooming
600
600
Dogs Unlimited
1,400
200
500
500
200
Totals
3,700
800
1,100
1,000
600
200
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Cash and Receivables
Based on past experience the credit manager has determined the following amounts should be
allocated to the allowance for doubtful accounts to properly reflect the net realizable receivables
as of December 31, 2000.
Age
Current
30 Days
60 Days
90 Days
Over 90 Days
Amount
800
1,100
1,000
600
200
3,700
%
2%
3%
4%
5%
20%
Required
16
33
40
30
40
159
This means that the balance in the allowance for doubtful accounts should have a balance of
$159 after all of the year-end adjusting journal entries have been posted. The following is the TAccount of the allowance for doubtful accounts before any year-end adjustment.
Description
Beginning balance
Accounts written off during 2000
Accounts reinstated during 2000
Debit
Credit
225
15
Balance
(200)
25
10
As we can see, prior to posting any adjusting journal entry the allowance for doubtful accounts
account has a debit balance of $10. If we need a credit balance of $159 in order to bring the
accounting records current then the adjusting journal entry will be as follows:
ACCOUNT
Bad debt expense
Allowance for doubtful accounts
To record bad debt expense by adjusting the allowance
for doubtful accounts
DEBIT
169
CREDIT
169
After the above adjusting journal entry has been posted to the accounting records the allowance
for doubtful accounts account will reflect the correct balance of $159.
Description
Debit
Credit
Balance
Beginning balance
(200)
Accounts written off during 2000
225
25
Accounts reinstated during 2000
15
10
Required adjusting journal entry at 12/31/00
169
(159)
The purpose of the balance sheet approach is to fairly state net realizable receivables in the
balance sheet
b) Income Statement Approach
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Cash and Receivables
Using the income statement approach we are interested in matching bad debt expense
with sales revenue for the current period. The estimate is actually an estimate of the bad
debt expense, normally as a percentage of credit sales. The ending balance of the
allowance account is not really of concern to management.
Example: The following information pertains to Spencer Company for the year ended
December 31, 2000.
Cash Sales (net)
Credit sales
Sales returns and allowances
Sales discounts
Net credit sales
10,000
5,000
1,000
500
3,500
Based on prior experience the controller estimates that bad debt expense should be
approximately 5% of net credit sales.
Therefore the adjusting journal entry using the income statement approach will be as follows:
ACCOUNT
Bad debt expense
Allowance for doubtful accounts
To record bad debt expense for
2000 based on 5% of net credit
sales
Analysis of bad debt expense:
Net credit sales
Provision for bad debts
Bad debt expense
DEBIT
175
CREDIT
175
3,500
5%
175
As we can see from the above example, the object of using the income statement approach is to
get a proper matching of bad debt expense to net credit sales. There is no consideration being
given to the presentation of net realizable receivables.
Accounts Written Off
When an account is deemed uncollectible it must be removed from the balance of accounts
receivable--that is, the account must be written off. In previous periods, an allowance has
been set aside using one of the allowance methods. At this point, the allowance is used to
write off the uncollectible account.
Example: On February 1, 2001, Spencer Company wrote off a $500 as uncollectible. The
following journal entries must be recorded remove the account and reduce the balance of
accounts receivable.
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Cash and Receivables
ACCOUNT
Allowance for doubtful accounts
Accounts receivable
DEBIT
500
CREDIT
500
To record the removal of an
uncollectible account receivable
Collection of Accounts Written Off
If there is a collection on an account previously written off, using one of the allowance
methods we must first reestablish the account in accounts receivable and then record the
collection.
Example: On April 1, 2001, Spencer Company received payment $500 on the account that had
previously been written off as uncollectible. The following journal entries must be recorded in
order to (1) get the account back on the books and (2) record the collection of the account.
ACCOUNT
Accounts receivable
Allowance for doubtful accounts
Cash
Accounts receivable
DEBIT
500
CREDIT
500
500
500
To record the reinstatement of an
account receivable and the receipt
of the payment on said account
NOTES RECEIVABLE
Notes receivable are evidenced by a written promissory note normally with terms that require
interest on the outstanding balance. Short-term notes are typically reported at face value,
whereas long-term notes are reported at the present value of the expected future cash collections.
Note Issued at Face Value
If a note is issued at the market rate of interest then the face amount and the net present value are
the same. The note is therefore record at face value in the accounting records. The collection of
interest payments are recorded as interest income as received.
Example: Spencer Company receives a $100,000 note receivable in exchange for cash. The
note is to be repaid in five years with interest payable at 10% per annum. The market rate of
interest at the time the note was issued is 10%. The following journal entries reflect the
issuance of the note and the receipt of interest at the end of the first year.
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Cash and Receivables
ACCOUNT
Note receivable
Cash
Cash
Interest revenue
DEBIT
100,000
CREDIT
100,000
10,000
10,000
To record the receipt of a note
receivable and the receipt of the first
interest payment at the end of year 1
Zero-Interest-Bearing Notes
A zero-interest-bearing note is one that is issued at an amount less than the face value. Interest is
included in the face value of the note, but is not specifically stated in the contract. The difference
between the cash paid and the amount to be received in the future is interest income. We use the
effective interest method to record the interest income earned in the interim accounting periods
before the final cash collection is made.
Example: Spencer Company received a zero-interest-bearing note of $100,000 in exchange for
cash. The note is to be repaid in five years. The implied rate of interest on the note is 10% per
annum. The following is the present value of the note that will be recorded in Spencer
Company’s books when received.
Analysis of Present Value of Note Receivable:
Face amount of note
PV of $1, n=5, i=10%
Present value of note
ACCOUNT
100,000
0.62092
62,092
DEBIT
100,000
Note receivable
Discount on note receivable
Cash
CREDIT
37,908
62,092
To record the receipt of a zero-interest-bearning note receivable
At the end of each year interest income will be recorded as amortization of the discount. The
following is an amortization table for the entire life of the note.
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Cash and Receivables
Date
Issue date
End of year 1
End of year 2
End of year 3
End of year 4
End of year 5
Cash
Received
0
0
0
0
100,000
Interest Amortization Carrying
Revenue of Discount Amount
62,092
6,209
6,209
68,301
6,830
6,830
75,131
7,513
7,513
82,644
8,264
8,264
90,909
9,091
9,091
(0)
The journal entry at the end of year 1 to reflect the interest earned would be as follows:
ACCOUNT
Discount on note receivable
Interest revenue
DEBIT
6,209
CREDIT
6,209
At the end of the five years the carrying amount of the note receivable will be $100,000, which is
the amount the Spencer Company will receive when the note is paid off.
Interest-Bearing Notes
If the stated interest rate and the effective interest rate are different the interest-bearing note will
be issued at a premium or discount. The interest collected in each accounting period is adjusted
for the amortization of premium or discount.
Notes Received for Cash and Other Rights
If a note is received in exchange for cash and other rights (such as the right to purchase
merchandise at a bargain price) the value of the right will be treated as a discount against the
note receivable. The debit side of this entry will be to a deferred debit account such as prepaid
purchases. When the merchandise is purchased the value carried in the deferred debit account
will be charged added to the cost of the purchased merchandise.
Notes Received for Property, Goods or Services
A note received in exchange for property, goods or services must be valued based on the fair
value of the property, goods or services exchanged. Gains or losses should be record and the
difference between the fair value and the face value of the note receivable will be treated as a
discount on note receivable.
Example: Spencer Company sold an office building with a book value of $20,000 and a fair
market value of $50,000 in exchange for a 5-year note receivable of $60,000 with no stated
interest rate. The journal entry to record this transaction will establish the carrying value of the
note receivable as the fair value of the property exchanged. The difference is charge to the
discount on notes receivable account.
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Cash and Receivables
ACCOUNT
Note receivable
Discount on note receivable
Building
Gain on sale of building
DEBIT
60,000
CREDIT
10,000
20,000
30,000
Analysis of discount on note receivable:
Face value of note
Fair value of building
Discount on note receivable
60,000
50,000
10,000
The discount will be amortized using the effective interest method over the five years so that the
face amount of the note receivable when paid off will be $60,000, the amount received.
Imputed Interest
Is a note is received with no stated interest or an unreasonably low rate of interest then the
recipient of the note will need to record the note receivable with an appropriate discount so that
the carrying amount reflects the market rate of interest. This is called the imputed interest rate.
Imputed interest is demonstrated in the above example where Spencer Company received a zerointerest-bearing note receivable.
Valuation of Notes Receivable
Short-term notes receivable are recorded and reported at net realizable value. Long-term notes
receivable must be recorded and reported at the present value of the expected future cash flows
determined using the market interest rate at the date the note was issued.
FINANCING WITH RECEIVABLES
Secured Borrowing
If a company uses its receivables as collateral for a loan, its customers are not notified of the
transaction. The company continues to collect the receivables and the financial institution is not
involved unless the debtor is unable to repay the loan. In such a situation the financial institution
will step in and collect the receivables in payment of the loan.
Sales of Receivables
If receivables are actually sold (factored) the purchasing company (factor) collects the
receivables from the customers. In this situation, the company actually removes the receivables
from the books and records a loss on the transaction.
Example: Spencer Company sold $500,000 of its accounts receivable to a factor. The factor
will hold back $20,000 for possible sales discounts, sales returns, and sales allowances. The
factor charges a 5% fee for purchasing the accounts receivable. Spencer Company will record the
following journal.
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Cash and Receivables
ACCOUNT
Cash
Due from factor
Loss on sale of receivables
Accounts receivable
DEBIT
455,000
20,000
25,000
CREDIT
500,000
Analysis of loss:
Face value of receivables
Discount charged by factor
Loss on sale of receivable
500,000
5%
25,000
Discounting a Note
As with accounts receivable, notes receivable may be pledged as collateral for a loan or may be
sold outright. If they are sold the transaction is called discounting a note. The financial
institution is purchasing the future cash flow of the note and will apply a discount rate equal to
the amount of interest required in order to purchase the note. This discount is the financing fee
incurred by the seller of the note.
PRESENTATION AND ANALYSIS
Presentation of Receivables
Receivables should be presented with appropriate disclosure in the notes to the financial
statements according to the following criteria.
(1)
(2)
(3)
(4)
(5)
(6)
Segregated based on the different types of receivables
Valuation accounts are disclosed and offset the appropriate receivables
Current receivables will be converted into cash within on year or the operating cycle
Disclosure of possible loss contingencies on receivables
Disclose receivables that have been pledged as collateral
Disclose significant concentrations of credit risk
Analysis of Receivables
An important ratio that is used to analyze the liquidity of an entities accounts receivable is the
“receivables turnover ratio.” This is calculated as follows:
Accounts Receivable Turnover
=
Net Sales
Average Trade Receivables (net)
Example: Spencer Company has net sales of $2,375,000 for the year ended December 31, 2001.
The accounts receivable on January 1, 2001 were $240,000. At December 31, 2001 the accounts
receivable balance was $260,000. What are the inventory turnover ratio and the average
collection period for accounts receivable?
ACCOUNTS RECEIVABLE TURNOVER RATIO
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Cash and Receivables
Net Sales
Average Trade Receivables (net)
=
2,375,000
[(240,000+260,000)/2]
Net Sales
Average Trade Receivables (net)
=
2,375,000
250,000
Net Sales
Average Trade Receivables (net)
=
9.5
AVERAGE COLLECTION PERIOD FOR ACCOUNTS RECEIVABLE
365 Days
Accounts Receivable Turnover
=
365
9.5
365 Days
Accounts Receivable Turnover
=
38.42 Days
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