978-1133939283 Chapter 9 Lecture Note

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Chapter 9

Receivables

Learning Objectives

1. Dene receivables, and explain the allowance method for valuation of receivables as an

application of accrual accounting.

2. Apply the allowance method of accounting for uncollectible accounts.

3. Make common calculations for notes receivable.

4. Show how to evaluate the level of receivables, and identify alternative means of

nancing receivables.

Section 1: Concepts

Concepts

 Accrual accounting (matching principle)

 Valuation

 Disclosure

Lecture Outline

I. Accounts receivable and notes receivable are short-term nancial assets.

II. A note receivable is a promissory note and is an unconditional promise to pay a sum of

money on demand or on a certain date.

A. The maker of the note records Notes Payable.

B. The payee of the note records Notes Receivable.

III. There are two methods of accounting for uncollectible accounts.

A. Journalize the write-o1 of an account under the direct charge-o1 method.

B. Journalize the year-end adjustment for uncollectible accounts under the allowance

method.

IIV. Illustrate the balance sheet presentation of Allowance for Uncollectible Accounts.

Summary

The most common receivables are accounts receivable and notes receivable. Accounts

receivable are classied as current assets and represent payments due from credit

customers. Wholesalers and retailers usually allow customers to pay for merchandise over

time (i.e., they extend credit) because many customers cannot or will not make full payment

immediately. This type of credit, often called trade credit, makes expensive items

a1ordable and increases sales for the merchant. Most companies that sell on credit have

credit departments whose responsibility it is to approve or refuse credit to individuals or

companies. In some retail businesses, installment accounts receivable are common. Under

these terms, the buyer is allowed to make a series of payments over an extended period.

These receivables are considered current assets if the terms are the industry norm.

or posted to a publicly accessible website, in whole or in part.

Chapter 9: Receivables Instructor’s Manual, p. 2

Uncollectible accounts (also called bad debts), the accounting term for nonpayment by

customers, are an expense of selling on credit. The matching principle requires that the

expense be recorded in the same period as the related sale. Because the amount of

uncollectible accounts can only be estimated, this process may be subject to manipulation

via unethical and questionable practices.

Under the direct charge-o method, an expense is recorded when a specic customer’s

account is written o1. However, this violates the matching principle, which requires that the

expense be recorded in the same period as the related sale.

A promissory note is an unconditional promise to pay a denite sum of money on demand

or at a future date. The person who signs the note and thereby promises to pay is called the

maker of the note. The person to whom money is owed is called the payee. The payee

records long- or short-term notes receivable; the maker records long- or short-term notes

payable.

Generally accepted accounting principles require use of the allowance method, in which

losses from bad debts appear on the same income statement as the corresponding sales.

Since at the time of sale the company does not know whether the customer eventually will

pay, an estimate of uncollectible accounts must be made at the end of the accounting

period. An adjusting entry is then made debiting Uncollectible Accounts Expense and

crediting Allowance for Uncollectible Accounts for the estimated amount. Uncollectible

Accounts Expense is closed out in a manner similar to other expenses and appears on the

income statement.

Any interest accrued on notes receivable is included on the balance sheet as interest

receivable in the current assets section. Allowance for Uncollectible Accounts is a

contra-asset account to Accounts Receivable that reduces Accounts Receivable on the

balance sheet to the amount estimated to be collectible.

Relevant Examples and Exhibits

 Exhibit 1 Accounts Receivable as a Percentage of Total Assets for Selected Industries

 Exhibit 2 A Promissory Note

Teaching Strategy

It is important the students have an understanding of why receivables are important to the

operation of a business and that this arrangement is an extension of credit to their

customers. Explain to students that just like they may have friends who may not pay them

money that is owed to them businesses have the same issue. This will allow the student to

clearly understand why the allowance method is necessary and how the allowance helps

company estimate the actual amount of money that they expect to collect from their

accounts receivables.

or posted to a publicly accessible website, in whole or in part.

Chapter 9: Receivables Instructor’s Manual, p. 3

Section 2: Accounting Applications

Accounting Applications

 Estimate uncollectible accounts and uncollectible accounts expense using

oPercentage of net sales method

oAccounts receivable aging method

 Write o1 uncollectible accounts

 Make common calculations for notes receivable

Lecture Outline

I. There are two methods of accounting for uncollectible accounts.

A. Estimate uncollectible accounts using the percentage of net sales method. Any

previous balance in Allowance for Uncollectible Accounts is irrelevant in making

the adjusting entry.

B. Journalize the year-end adjustment for uncollectible accounts under the allowance

method.

1. Estimate uncollectible accounts using the accounts receivable aging method.

Any previous balance in Allowance for Uncollectible Accounts is relevant in

making the adjusting entry.

2. Explain an aging of accounts receivable.

C. Compare the two methods.

D. Journalize the write-o1 of a specic account under the allowance method. The net

realizable value of Accounts Receivable is unchanged.

E. Journalize the recovery of accounts receivable written o1 under the allowance

method.

II. There are ve common calculations for notes receivable.

A. Determine the maturity date of a note if it is not specically stated.

B. Calculate the duration of a note if it is not specically stated.

C. Interest equals principal × rate of interest × time (length of note).

D. The maturity value equals principal plus interest.

E. The interest on a note accrues by a small amount each date of the note’s duration.

III. When the maker of a note does not pay the note at maturity, it is said to be a

dishonored note.

IV. The estimation of uncollectible credit sales and the interest income on notes receivable

a1ect both the balance sheet (net accounts receivable and interest receivable) and the

income statement (uncollectible accounts expense and interest revenue).

Summary

The two most common methods for estimating uncollectible accounts are the percentage of

net sales method and the accounts receivable aging method. Under the percentage of net

sales method, the estimated percentage for uncollectible accounts is multiplied by net

sales for the period. The resulting gure is then used in the adjusting entry. Any previous

balance in Allowance for Uncollectible Accounts represents amounts from previous years

that have not yet been written o1 and is irrelevant in making the adjusting entry.

Under the accounts receivable aging method, customer accounts are placed into a “not

yet due” category or into one of several “past due” categories (called the aging of

or posted to a publicly accessible website, in whole or in part.

Chapter 9: Receivables Instructor’s Manual, p. 4

accounts receivable). The amounts in each category are totaled; each total is then

multiplied by a di1erent percentage for estimated bad debts. The sum of these products

represents estimated bad debts on ending Accounts Receivable. Again, the debit is to

Uncollectible Accounts Expense and the credit is to Allowance for Uncollectible Accounts.

Under the aging method, however, the entry is for the amount that brings Allowance for

Uncollectible Accounts to the computed gure.

When it becomes clear that a specic account will not be collected, it should be written o1

by a debit to Allowance for Uncollectible Accounts and a credit to Accounts Receivable. The

debit is not made to Uncollectible Accounts Expense. After an account has been written o1,

Accounts Receivable and Allowance for Uncollectible Accounts decrease by the same

amount, but the net gure for expected receivables stays the same.

When a customer whose account has been written o1 pays in full or in part, two entries

must be made. First, the customer’s receivable is reinstated by a debit to Accounts

Receivable and a credit to Allowance for Uncollectible Accounts. Second, Cash is debited and

Accounts Receivable is credited for each collection.

The following journal entries are introduced in this section:

Uncollectible Accounts Expense XX (amount estimated)

Allowance for Uncollectible Accounts XX (amount

estimated)

To record uncollectible accounts expense at a

percent of net sales

Uncollectible Accounts Expense XX (amount estimated)

Allowance for Uncollectible Accounts XX (amount

estimated)

To bring the allowance for uncollectible accounts to

the level of estimated losses

Allowance for Uncollectible Accounts XX (defaulted amount)

Accounts Receivable XX (defaulted amount)

Write-o1 of account

Several calculations are common to promissory notes, including maturity date, duration of

note, interest, maturity value, and accrued interest. The maturity date and duration of

note must be either stated on the promissory note or determinable from the information on

the note.

To the borrower, interest is the cost of borrowing money. To the lender, it is the reward for

lending money. The principal is the amount of money borrowed or loaned. The rate of

interest is the annual charge for borrowing money, expressed as a percentage. A note may

be either interest-bearing or non-interest-bearing.

Interest (not interest rate) is a dollar gure. It is computed as follows:

Interest = Principal × Rate of Interest × Time (length of note)

For example, interest on $800 at 5 percent for 90 days is $9.86, which is computed by

solving

$800 × (5 ÷ 100) × (90 ÷ 365). If the length of the note were expressed in months, then the

number of months divided by 12 would constitute the time.

The maturity value of an interest-bearing note is the face value of the note (principal) plus

interest. For a non-interest-bearing note, maturity value is equal to the face amount (which,

however, includes implied interest).

or posted to a publicly accessible website, in whole or in part.

Chapter 9: Receivables Instructor’s Manual, p. 5

End-of-period adjustments must be made for notes that apply to both the current and future

periods. In this way, interest can be divided correctly among the periods.

A dishonored note is one that is not paid at the maturity date. The payee debits Accounts

Receivable for the principal plus interest and credits Notes Receivable and Interest Income.

The estimation of uncollectible credit sales a1ects both the balance sheet (net accounts

receivable) and the income statement (uncollectible accounts expense). Accrued interest on

notes receivable a1ects the balance sheet (interest receivable) and the income statement

(interest revenue).

Relevant Examples and Exhibits

 Exhibit 3 Analysis of Accounts Receivable by Age

 Exhibit 4 Two Methods of Estimating Uncollectible Accounts

 Exhibit 5 Valuation of Accounts Receivable on the Balance Sheet Impacts Net Sales

on the Income Statement

Teaching Strategy

Tying anticipated uncollectible accounts to the matching principle builds the foundation for

understanding the journal entry that sets up the Allowance for Uncollectible Accounts to

correspond to the period’s sales. Refer to the illustration in the text that shows the use of

that account to present more accurately the value of Accounts Receivable. Review the

denition of a contra-asset account if necessary.

Students often have diLculty understanding the necessity for calculating the anticipated

uncollectible accounts expense. Through calculation and demonstrations, the rationale does

become clear.

The percentage of net sales method is straightforward and easily mastered.

Aging of accounts receivable poses some diLculty for students. A discussion of the

relationship between older accounts and their resulting collectibility is helpful before the

required calculations are introduced. After such a discussion, refer to Exhibit 3, which

identies a company’s historical experience and the resulting calculation of anticipated

uncollectible accounts expense.

The journal entries required for this section of the text are confusing to students. T accounts

are helpful in demonstrating the journal entries and the sequence of events in the ledger

accounts. Demonstrate a full sequence, from the establishment of the allowance account

through actual occurrences of uncollectibility and the end-of-period adjustment when there

is either a debit or a credit balance in the allowance account prior to adjustment. Complete

the demonstration for each of the two methods of accounting for uncollectible accounts.

Take time to allow for a clear understanding of the di1erences between the two methods.

Address the issue of collecting on accounts previously written o1. Point out that the

account, which was once considered uncollectible and charged to the allowance account,

has to be reinstated and the allowance account and accounts receivable account adjusted.

Short Exercises 3 through 5 and Exercises 2A through 7A are appropriate for classroom

presentation.

Take the time to dene each element of the calculation for interest on a note and maturity

value of a note. Each calculation, as well as its place in the sequence of events involved in

or posted to a publicly accessible website, in whole or in part.

Chapter 9: Receivables Instructor’s Manual, p. 6

accounting for notes receivable, must be understood. Use Short Exercises 6 through 8,

Exercises 8A through11A, and Problem 8 to illustrate these calculations.

Section 3: Business Applications

Business Applications

 Receivables turnover

 Days’ sales uncollected

 Financing receivables

oFactoring of accounts receivable

oSecuritization of accounts receivable

oDiscounting of accounts receivable

 Ethics

Lecture Outline

I. The following measures of the e1ectiveness of credit policies should be compared with

industry averages.

A. Receivable turnover (net credit sales divided by average net accounts receivable)

B. Days’ sales uncollected (365 days divided by the receivable turnover)

II. Some companies nance receivables to maintain nancial Nexibility.

A. Establish a nance company

B. Pledge accounts receivable

C. Factor (sell) accounts receivable

1. “Without recourse” (e.g., Visa, MasterCard, American Express) means that the

factor bears the risk of loss.

2. “With recourse” means that the seller bears the risk of loss.

a. A contingent liability is a potential liability that may develop into a real

liability depending upon a future occurrence.

D. Through securitization, group receivables in batches and sell them at a discount to

companies and investors

E. Discount (sell) notes receivable

V. Deliberately overstating or understating earnings as a result of misrepresenting the

level of uncollectible accounts is a serious ethical violation.

Summary

The receivable turnover and days’ sales uncollected are commonly used to measure the

e1ectiveness of a company’s credit policies. The receivable turnover is computed by

dividing net credit sales by average net accounts receivable. It shows how many times, on

average, receivables were collected during the period. The days’ sales uncollected is

computed by dividing 365 days by the receivable turnover. It shows how many days, on

average, accounts receivable are outstanding. These ratios vary considerably from industry

to industry.

or posted to a publicly accessible website, in whole or in part.

Chapter 9: Receivables Instructor’s Manual, p. 7

Occasionally, companies cannot a1ord to wait until their receivables are collected.

Accordingly, there are ways to obtain cash before collection from customers occurs. Some

companies establish nance companies. Others pledge their accounts receivable as

collateral on a loan. Or a company may sell its accounts receivable for cash to a bank or

nance company (known as the factor), in a process called factoring. If this is done

without recourse, the factor bears any losses from uncollectible accounts. Credit cards are

an example of factoring without recourse. Factoring with recourse means that the seller

bears the risk. This risk is disclosed in the nancial statements as a contingent liability, a

potential liability that can develop into a real liability depending on a future event. Another

possible means for a company to obtain cash is through securitization, whereby the

company groups its receivables in batches and sells them at a discount to companies and

investors. Discounting, or selling, notes receivable is yet another way companies maintain

liquidity.

Uncollectible accounts (also called bad debts), the accounting term for nonpayment by

customers, are an expense of selling on credit. The matching principle requires that the

expense be recorded in the same period as the related sale. Because the amount of

uncollectible accounts can only be estimated, this process may be subject to manipulation

via unethical and questionable practices.

Relevant Examples and Exhibits

 Ratio: Receivables Turnover

 Ratio: Days’ Sales Uncollected

 Exhibit 6 How Factoring Works

Teaching Strategy

Review the denition of liquidity and discuss its importance to the operations of a rm.

Emphasize the signicance of the ratios presented and how management uses them. Point

out that ratios can vary considerably by company and by industry and that they should be

compared with prior periods and similar companies in the same industry.

Students have had experience with the credit policies of companies with which they have

dealt. A class discussion on this topic helps students recognize how credit policies t into the

overall accounting system.

Dene contingent liability and give other examples. It is an important concept that students

will encounter again.

Short Exercise 10 and Exercise 13A are appropriate for classroom work. Cases 3, 4, and 6

apply to concepts from this section. Use those that are of interest to your students to

reinforce key points.

Student Engagement Tactics

1. Assign Case 7 as advance reading for class. Ask for two volunteers to participate in

the role-play and tell them you will provide specic guidance on preparing for the

role-play. This may include the following:

Owner (Ms. Caldwell):

or posted to a publicly accessible website, in whole or in part.

Chapter 9: Receivables Instructor’s Manual, p. 8

Ms. Caldwell believes that lowering the estimate of uncollectible accounts expense is

the best way to ensure increased earnings during a year when earnings are actually

down. This action will improve reported net income for the current year. With higher

sales and earnings expected next period, the nancial community will not be

alarmed. Historically, this company has been protable even in economic downturns.

She believes that the community can absorb many laid-o1 employees into its work

force. Owner’s personality traits: optimistic (does not focus on bad news), does not

like to be challenged by bankers or anyone else.

Controller:

The controller believes that underestimating uncollectible accounts would be a

violation of conservatism by overstating assets and income. The controller knows

that how much and which accounts are uncollectible is eventually known with

certainty. Cash Nows are adversely a1ected if collections are not made and

repossessions are necessary. Bankers look carefully when sales are down but

earnings are up. While the nancials for the current year may fool lenders in the

short run, the lack of candor about uncollectibles could hurt the company in the long

run because the company’s credibility with its lenders could be jeopardized, possibly

resulting in higher nancing costs or, worse, the lenders preferring to no longer make

loans to Caldwell Interiors. Suggest generating a report of current receivables from all

the insurance company employees with a schedule of who is currently delinquent.

Assess the potential impact of layo1s on receivables. Controller’s personality traits:

persuasive, careful not to o1end the boss, thoughtful.

2. Introduce the role-play. Relate to the class objectives to support varied learning styles

and to enhance communication skills. Distribute assessment questionnaire. (Sample

questions follow in the assessment section.) Allow time to read and ask students

what questions they have about this information. Students/observers of the role-play

enactment must listen carefully to points made. Tell students this activity will be

graded. Quiet students as the role-play begins, if necessary. The instructor should

stay out of sight during the role-play but end the role-play if players can’t seem to

quit and if key points have already been made.

3. After enacting the role-play, follow up with evaluation and debrieng. As a part of the

debrieng, stand next to the role-players. Ask the controller what his or her feelings

are toward Ms. Caldwell and whether he or she continues to have any ethical

concerns. Ask Ms. Caldwell what her feelings are toward the controller and whether

she has any ethical concerns about this situation. Allow students/observers to ask

role-players questions.

4. Ask the following questions on a short questionnaire: What ethical dilemma does the

role-play present? What reasons did the owner give for his position? What reasons did

the controller give for his or her position? As a lender, how important is it to be

accurate in estimating losses from uncollectibles?

5. The questionnaire requires students to practice their listening and writing skills. If

e1ective presentation skills have been introduced in your class, the questionnaire

could include questions that provide feedback to each role-player. Did the owner

speak clearly, make points e1ectively, and use good eye contact with the controller?

Did the controller use gestures e1ectively and appear condent?

or posted to a publicly accessible website, in whole or in part.