©2009 The McGraw-Hill Companies, Inc.
Chapter 5
Receivables and Sales
5-2
Credit sales
o
Are common for large business transactions in
which buyers don’t have sufficient cash available
or where credit cards cannot be used because the
transaction amount exceeds typical credit card
limits.
o
Revenue is recognized at the time of a credit sale.
o
An asset (accounts receivable) is recognized at
the time of a credit sale.
©2009 The McGraw-Hill Companies, Inc.
Part A
Recognition of Accounts
Receivable
5-4
LO1 Recognize Accounts
Receivable
o
Credit sales transfer products and services to a
customer today while bearing the risk of collecting
payment from that customer in the future.
o
Even though the seller does not receive cash at the
time of the credit sale, the firm records revenue
immediately, as long as future collection from the
customer is reasonably certain.
o
Along with the recognized revenue, at the time of sale
the seller also obtains a legal right to receive cash
from the buyer. The legal right to receive cash is
valuable and represents an asset of the company.
5-5
Recording of Credit Sales
Jay’s Dental charges $500 for teeth whitening. Dee
Kay decides to take advantage of the service, has
her teeth whitened on March 1, but doesn’t pay
cash at the time of service. Dee promises to pay the
$500 whitening fee to Jay by March 31. Jay makes
the following entry at the time of the cleaning.
5-6
Other types of receivables
Nontrade
receivables
• Are receivables from those
other than customers and
include tax refund claims,
interest receivable, and
loans by the company to
other entities including
stockholders and
employees.
Notes
receivable
• Are receivables that are
accompanied by formal
credit arrangements made
with written debt
instruments (or notes).
5-7
Trade Discounts
o
o
o
Represent a reduction in the listed price of a product or service.
Companies don’t recognize trade discounts directly when
recording a transaction. Instead, they recognize trade
discounts indirectly by recording the sale at the discounted
price.
Let’s go back to Jay’s Dental, which typically charges $500 for
teeth whitening. Jay offers a 20% discount on teeth whitening to
any of his regular patients.
LO2 Understand contra revenues–sales
discounts, returns, and allowances–
associated with sales
Sales Discount
o
o
o
Represents a reduction, not in the selling price of a product or
service, but in the amount to be paid by a credit customer if
payment is made within a specified period of time.
It’s a discount intended to provide incentive for quick payment.
The amount of the discount and the time period within which it’s
available usually are communicated in short-hand terms such as
2/10, n/30.
o
o
The term “2/10,” indicates the customer will receive a 2% discount if
the amount owed is paid within 10 days.
The term “n/30,” means that if the customer does not take the
discount, full payment is due within 30 days.
5-8
5-9
First scenario, assume Dee pays on March
10th, which is within the 10-day discount
period
5-10
First scenario, assume Dee pays on March
10th, which is within the 10-day discount
period
5-11
Second scenario, assume that Dee waits
until March 31 to pay, which is not within the
10-day discount period
Jay records the following entry at the time he collects cash from
Dee.
Notice that there is no indication in recording the transaction that the
customer does not take the sales discount. This is the typical entry to
record a cash collection on account when no sales discounts are
involved.
5-12
Sales Return and Allowances
a.
b.
Sales Return
If a customer returns
a product it is sales
return. After a sales
return,
we reduce the
customer’s account
balance if the sale
was on account or
we issue a cash
refund if the sale was
for cash.
Sales Allowances
If a customer does not
return a product, but
the seller reduces the
customer’s balance
owed or provides at
least a partial refund
because of some
deficiency in the
company’s product or
service, we call that a
sales allowance.
5-13
Sales Return and Allowances
On March 5, after Dee gets her teeth cleaned but before she
pays, she notices that another local dentist is offering the same
procedure for $350. Dee brings this to Jay’s attention and
because Jay’s policy is to match any competitor’s pricing, he
offers to reduce Dee’s account balance by $50. Jay records the
following sales allowance entry.
©2009 The McGraw-Hill Companies, Inc.
Part B
Valuation of Accounts Receivable
5-15
LO3 Record an allowance for
future uncollectible accounts
o
The right to receive cash from a customer is a valuable resource for
the company. This makes accounts receivable an asset to be
recognized in the company’s balance sheet .
o
To be useful to decision makers, it should be reported at net
realizable value, which is the amount of cash the firm expects to
collect.
Should companies sell goods and services to their customers on account,
or should they accept only cash payment at the time of purchase?
The upside, allowing customers the
ability to purchase on account and
pay cash later boosts sales.
The downside of extending credit to
customers is that not all customers
will pay fully on their accounts
5-16
Allowance Method
Involves recording an adjusting entry at the end of each period to
allow for the possibility of future uncollectible accounts.
The adjusting entry has the effect of
1. reducing accounts receivable by an estimate of the amount we don’t
expect to collect and
2. recording an expense to reflect the cost of offering credit to
customers.
5-17
Estimating Uncollectible Accounts
Kimzey specializes in emergency outpatient care. It doesn’t verify
the patient’s health insurance, It understands that a high proportion
of fees for emergency care provided will not be collected. In 2010, it
bills customers $50 million. By the end of the year, $20 million
remains due from customers. Of this amount, it estimates that 30%
is likely to be uncollected. The year-end adjusting entry to allow for
these future uncollectible accounts is as follows:
5-18
Bad Debt
o
Equals the amount of the adjustment to the
allowance for uncollectible accounts, representing
the cost of estimated future bad debts charged to
the current period. This expense is included in the
same income statement as the credit sales revenue
it helps generate.
o
There is no cash outflow associated with bad debts.
o
It is not possible to record actual future bad debts in
the current period because we don’t know the future
expense when preparing the current period’s
financial statements.
5-19
Match Future Bad Debts with Current
Credit Sales
5-20
Accounts Receivable Portion of the
Balance Sheet
After we adjust for future uncollectible accounts, the accounts
receivable portion of Kimzey’s year-end balance sheet appears
below
5-21
LO4 Apply the procedure to write off
accounts receivable as uncollectible
On February 23, 2011, Kimzey receives notice that one of its
former patients, Bruce, has filed for bankruptcy. He believes it is
unlikely Bruce will pay his account of $4,000. Remember, Kimzey
previously allowed for the likelihood that some of its customers
would not pay. Now it knows a specific customer will not pay, it
can adjust the allowance and reduce the accounts receivable.
Kimzey makes the following entry.
5-22
Collection of Accounts previously
Written Off
Later in 2011, on September 8, Bruce’s bankruptcy proceedings
are complete. Kimzey had expected to receive none of the
$4,000 Bruce owed. After liquidating all assets, Bruce is able to
pay each of his creditors 25% of the amount due them. Kimzey
records the following two entries.
5-23
Balance of Kimzey’s Net Accounts
Receivable
Total accounts written off by Kimzey during 2011 equaled $5 million but
that $1 million of this amount was collected by the end of the year. The
timeline of events related to accounts receivable during 2010 and 2011 is
this:
(1) Accounts receivable total $20 million at the end of 2010.
(2) Made an adjusting entry at the end of 2010 for estimated bad debts of $6
million.
(3) Actual accounts wrote off as uncollectible in 2011 total $5 million.
(4) Of the $5 million written off, $1 million later appears receivable.
(5) Received $1 million cash for the accounts re-established in (4).
5-24
Estimating Uncollectible Accounts in
the following year
At the end of 2011, Kimzey must once again estimate uncollectible
accounts and make a year-end adjusting entry. Suppose that in
2011 it bills customers for services $80 million, and $30 million are
still receivable at the end of the year. Of $30 million receivable, it
estimates 30% will not be collected. For what amount would it
record the year-end adjusting entry for bad debts in 2011?.
The current balance of the allowance account is
5-25
Estimating Uncollectible Accounts in
the following year
Based on all available information at the end of 2011, Kimzey
estimates that the allowance for uncollectible accounts should
be $9 million. Allowance account needs to increase from its
current balance of $2 million credit to the estimated ending
balance of $9 million credit. It can accomplish this by adjusting
the account for $7 million as follows:
5-26
Estimating Uncollectible Accounts in
the following year
5-27
LO5 Use the aging method to estimate
future uncollectible accounts
o
Management can estimate this percentage using
historical averages, current economic conditions,
industry comparisons, or other analytical
techniques.
o
A more accurate method than assuming a single
percentage uncollectible for all accounts is to
consider the age of various accounts receivable,
and use a higher percentage for “old” accounts
than for “new” accounts. This is known as the
aging method.
o
For instance, accounts that are 60 days past due
are older than accounts that are 30 days past due.
The older the account, the less likely it is to be
collected
5-28
Use the aging method to estimate
future uncollectible accounts
Kimzey Medical Clinic – How aging of accounts receivable can
be used to estimate uncollectible accounts. Recall that accounts
receivable at the end of 2011 totaled $30 million. Below image
shows its accounts receivable aging schedule at the end of
2011.
5-29
Use the aging method to estimate
future uncollectible accounts.
LO6 Contrast the allowance method and
direct write-off method when accounting
for uncollectible accounts
5-30
Direct Write-Off Method
o
o
Recording bad debt expense at the time we know the account
to be uncollectible.
The direct write-off method is used for tax purposes but is
generally not permitted for financial reporting.
Suppose a company provides services for $10,000 on account in 2010,
but makes no allowance for uncollectible accounts at the end of the year.
On September 17, 2011, $2,000 is considered uncollectible. The
company records the write-off as follows.
Comparison of the Allowance Method and
the Direct Write-off Method for Recording
Uncollectible Accounts
Assume that by the end of 2010 we estimate $2,000 of
accounts receivable won’t be collected. Also assume that our
estimate of future bad debts turns out to be correct, and actual
bad debts in 2011 total $2,000.
5-31
LO7 Calculate key ratios investors use to
monitor a company’s effectiveness in
managing receivables
o
o
o
o
o
The amount of a company’s accounts receivable is influenced
by a variety of factors, including the level of sales, the nature of
the product or service sold, and credit and collection policies.
More liberal credit policies—allowing customers a longer time to
pay or offering cash discounts for early payment—often are
initiated with the specific objective of increasing sales volume.
Management’s choice of credit and collection policies results in
trade-offs.
Investors, creditors, and financial analysts can gain important
insights by monitoring a company’s investment in receivables.
Two important ratios that help in understanding the company’s
effectiveness in managing receivables are the
o
o
receivables turnover ratio and
the average collection period.
5-32
5-33
Receivables Turnover Ratio
It shows the number of times during a year that the
average accounts receivable balance is collected.
Receivables turnover ratio =
Net Sales
Average accounts receivable
The average collection period is another way to
express the same measure. It shows the approximate
number of days the average accounts receivable
balance is outstanding.
Average collection period =
365 Days
Receivables turnover ratio
5-34
Receivables Turnover Ratio
Net credit sales are $400,000 for the year and the average
accounts receivable balance is $40,000. We could say the
turnover ratio is 10, or average receivables were collected 10
times during the year. If the turnover is 10 times a year (365
days), then the average balance is collected every 36.5 days.
©2009 The McGraw-Hill Companies, Inc.
Part C
Notes Receivable
LO8 Apply the procedure to account for
notes receivable, including interest
calculation
5-36
o
Notes receivable are similar to accounts receivable
but are more formal credit arrangements evidenced
by a written debt instrument, or note.
o
Notes receivables are classified as either Current
or Noncurrent depending on the expected
collection date.
o
If the time to maturity is longer than one year, the
note receivable is a long-term asset.
5-37
Notes Receivable
February 1, 2010, Kimzey has a patient, Justin Payne, who has
a severely past due account receivable of $10,000. In place of
the account receivable, it accepts a six-month, 12% promissory
note from him. An example of a typical note receivable is shown
below. It records the note as follows.
5-38
Interest Calculation
o
o
Many of the same issues we discussed concerning accounts
Receivable, apply also to notes receivable.
One issue that applies to notes receivable but not accounts
receivable is interest.
Kimzey issued a six-month, 12% promissory note. It will
charge Justin Payne one-half year of interest. Interest on its
note receivable is calculated as follows.
5-39
Collection of Notes Receivables
We record the collection of notes receivable the same way as a
collection of accounts receivable, except we record interest
earned as interest revenue in the income statement.
August 1, 2010, the maturity date, Justin repays the note and
interest in full as promised. Kimzey will record the following entry.
5-40
Accrued Interest
o
o
o
o
o
It happens that notes are issued in one year and the maturity date
occurs in the following year.
What if Justin issued the previous six-month note to Kimzey on
November 1, 2010, instead of February 1, 2010?
$10,000 face value and $600 interest on the six-month note are
not due until May 1, 2011.
The length of the note and interest rate remain the same, the total
interest charged to Justin remains the same.
Kimzey will record interest revenue for two months of the sixmonth note, and four months in the next year.
5-41
Accrued Interest
Remember, interest is earned as time goes by, so Kimzey earns
two months’ interest ($200) in 2010 even though it won’t collect it
until 2011. On May 1, 2011, the maturity date, It records the
collection of the note receivable and interest receivable as well
as the revenue related to four months’ interest earned in 2011.
5-42
Calculating Interest Revenue over
Time for Kimzey Medical Clinic
On May 1, 2011, it has received the note receivable recorded
on November 1, 2010, and the interest receivable recorded on
December 31, 2010, and has eliminated their balances. The
remaining four months’ interest occurs in 2011 and it
recognizes as revenue then. Interest receivable from its sixmonth, $10,000, 12% note is $100 per month (= $10,000 x
12% x 1/12).
©2009 The McGraw-Hill Companies, Inc.
Appendix
Percentage of Credit Sales Method
5-44
LO9 Estimate uncollectible accounts using
the percentage of credit sales method.
Percentage of
receivables method
Based on the estimate of bad
debts on a balance sheet
account—accounts receivable
Balance sheet method
Percentage of
Credit sales method
Based on the estimate of bad
debts on a income statement
account—credit sales
Income statement method
5-45
Adjusting for Estimates of Uncollectible
Accounts
5-46
Financial Statement: Effects of
Estimating Uncollectible Accounts
©2009 The McGraw-Hill Companies, Inc.
End of chapter 5