Principles of financial accounting 12e by needles crosson chapter 09

C HAP TE R

9

Receivables

Principles of
Accounting
12e
Needles
Powers
Crosson
©human/iStockphoto


Accounts Receivable

 Accounts receivable are shortterm financial assets that arise
from sales on credit and are often
called trade credit.
– In setting credit terms, a company must
keep in mind the credit terms of its
competitors and the needs of its customers.
– Companies that are too lenient in granting
credit can run into difficulties when
customers don’t pay.

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Accounts Receivable

 The accounts of customers who
cannot or will not pay are called
uncollectible accounts (or bad
debts).
– There are two methods of accounting for
uncollectible accounts:
 Direct charge-off method: recognize a loss
when an account is determined to be
uncollectible. (This is not in accordance with
accrual accounting.)
 Allowance method: recognize a loss at the
time credit sales are made. (This is in
accordance with accrual accounting.)
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Notes Receivable

 Notes receivable are short-term
financial assets supported by written
agreements called promissory notes.
– A promissory note is an unconditional
promise to pay a definite sum of money on
demand or at a future date.
 The person or entity that signs the note and
promises to pay is the maker of the note.
 The entity to whom payment is to be made
is the payee.

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The Allowance Method: Using Accrual
Accounting to Value Receivables
 The allowance method is an application of
accrual accounting, which requires
estimated losses from bad debts to be
matched with the revenue they help to
produce.
– It serves to value accounts receivable on the
balance sheet.
– Because management cannot identify at the
time of sale which customers will not pay or how
much the company will lose, losses from
uncollectible accounts must be estimated, and
the estimate becomes an expense in the period
in which the sales are made.
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Disclosure of Receivables
 A payee includes all the promissory notes it holds that
are due in less than one year as notes receivable in
the current assets section of the balance sheet.
 Any interest accrued on these notes is also included
in the current assets section—as interest
receivable.
 Uncollectible Accounts Expense appears on the
income statement as an operating expense.

 Allowance for Uncollectible Accounts appears on
the balance sheet as a contra account, deducted from
accounts receivable in the current assets section.
– It reduces the accounts receivable to the amount
expected to be collectible (net realizable value).
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Uncollectible Accounts
 The allowance account is necessary
because the specific uncollectible
accounts will not be identified until later.
The company’s accountant makes an
estimate based on past experience and
current economic conditions.
– Two common methods of estimating
uncollectible accounts expense are:
 Percentage of net sales method—The basis for
this method is the amount of this year’s net sales
that will not be collected.
 Accounts receivable aging method—The basis
for this method is the amount of the ending balance
of accounts receivable that will not be collected.
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Accounts Receivable Aging Method
 The aging of accounts receivable is
the process of listing each customer’s
receivable account according to the due

date of the account.
– If the customer’s account is past due, there
is a possibility that the account will not be
paid.
– That possibility increases as the account
extends further beyond the due date.

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Writing Off Uncollectible Accounts
 The total of accounts receivable written
off in a period will rarely equal the
estimated uncollectible amount.
 When it becomes clear that a specific
account receivable will not be collected,
the amount should be written off to
Allowance for Uncollectible Accounts.

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Maturity Date and Duration of a Note
 The maturity date is the date on
which a promissory note must be paid.
This date must be stated on the note or
be determinable from the facts on the
note.
 The duration of a note is the time
between a promissory note’s issue date

and its maturity date.
– Interest is calculated on the basis of the
duration of a note.

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Interest
 Interest is the cost of borrowing money
or the return on lending money,
depending on whether one is the borrower
or the lender. The amount of interest is
based on three factors:
– Principal (the amount of money borrowed or
lent)
– Rate of interest
– Length of the loan

 The formula used in computing interest is:
Principal × Rate of Interest × Time = Interest
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Maturity Value
 The maturity value is the total
proceeds of a promissory note—face
value plus interest—at the maturity date.
 The maturity value of a 90-day, 8
percent, $1,000 note is computed as
follows:

Maturity Value = Principal + Interest
= $1,000 + ($1,000 × 8/100 × 90/365)
= $1,000 + $19.73
= $1,019.73

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Accrued Interest
(slide 1 of 2)

 Accrued interest must be apportioned
to the periods in which it belongs.
 Assume that a $1,000, 90-day, 8
percent note was received on August
31 and that the fiscal year ends
September 30. Interest for 30 days is
calculated as follows:
Principal X Rate of Interest × Time =
Interest
$1,000 × 8/100 × 30/365 = $6.58
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Accrued Interest
(slide 2 of 2)

 The remainder of the interest income
would be calculated as follows:
Principal × Rate of Interest × Time =

Interest
$1,000 × 8/100 × 60/365 = $13.15
-

$6.58 of the interest would be recorded as income
in the fiscal year ending September 30, and the
interest receivable ($6.58) would be shown as
received when the note is paid.

-

The remainder of the interest, $13.15, would be
recorded as income in the next fiscal year.

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Dishonored Note
 A note not paid at maturity is called a
dishonored note.
– The holder, or payee, of a dishonored note
should transfer the total amount due
(including interest income) from Notes
Receivable to an individual account
receivable for the debtor.

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Receivables Turnover

 The receivables turnover shows how

many times, on average, a company
turned its receivables into cash during
a period.
– It is computed by dividing net sales by the
average accounts receivable (net of
allowances).

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Days’ Sales Uncollected
 Day’s sales uncollected shows, on
average, how long it takes to collect
accounts receivable.
– To determine the days’ sales uncollected,
the number of days in a year is divided by
the receivables turnover.

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Factoring
 Factoring is the sale or transfer of accounts
receivable to an entity, called a factor. Factoring
can be done with or without recourse.
– With recourse means that the seller of the
receivables is liable to the factor if a receivable
cannot be collected.

 In accounting terminology, a seller of receivables with
recourse is said to be contingently liable. A contingent
liability is a potential liability that can develop into a
real liability if a particular event occurs—in this case, a
customer’s nonpayment of a receivable.

– Without recourse means that the factor bears
any losses from unpaid accounts.

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Securitization
 Securitization is a process in which a
company groups its receivables in
batches and sells them at a discount to
other companies or investors.
– When the receivables are paid, the buyers
get the full amount.
– Their profit depends on the amount of the
discount.

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Discounting
 Discounting is a method of financing
receivables by selling promissory notes
held as notes receivable to a financial
lender, usually a bank.

– The bank derives its profit by deducting the
interest from the maturity value of the note.
– The holder of the note endorses the note
and turns it over to the bank.
– The bank expects to collect the maturity
value of the note (principal plus interest),
but it also has recourse against the note’s
endorser.
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Ethics and Estimates in
Accounting for Receivables
 Because the amount of uncollectible
accounts can only be estimated, a
company’s earnings can be easily
manipulated.
– Misstatements of earnings can occur simply
because of a bad estimate.
– They can also be deliberately made to meet
analysts’ estimates of earnings, reduce income
taxes, or meet benchmarks for bonuses.
– Companies will high ethical standards try to be
accurate in their estimates of uncollectible
accounts, and they disclose the basis of their
estimates.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.