Accounting for Receivables

 

Typical current assets listed in order of liquidity are:

          Cash

          Short Term Investments

          Accounts Receivable

          Inventory

          Prepaid Expenses

 

The most liquid of current assets are cash, short-term investments, and accounts receivable.   

 

Receivables are commonly divided into three categories:

 

          Accounts Receivable - Amounts owed by customers arising from credit sales

          Notes Receivable - Written promises to pay a definite sum at a future date

          Other receivables - Amounts lent to employees, subsidiaries, etc.

 

Credit sales are extremely important to the economy of the United States.  To an individual company there are many advantages of selling on credit (increasing revenue is the principal benefit) and a few disadvantages such as the cost of maintaining a credit department and the fact that not all customers will pay what they owe. 

 

From an accounting and a business standpoint it is important to determine the expense which arises when customers buy on credit and do not pay their bills.  We call this expense Bad Debt Expense or Uncollectible Account Expense.

 

There are two methods to record Bad Debt Expense

Direct Write Off Method
          Allowance Method

 

Entries under the Direct Write-Off Method include the following:

At time of sale

Accounts Receivable, Customer ABC

          Sales Revenue

When specific account goes bad

Bad Debt Expense

                                      Accounts Receivable, Customer ABC

 

Because the determination of when an account is uncollectible is often made in a period after when the credit sales occurred, the direct write-off method does not do a good job of matching expense with revenue.   Consequently, GAAP generally does not allow the direct write-off method.

 

The allowance method involves estimating bad debts in the period when revenue is earned.  Thus it does a good job of complying with the matching principle.

 

Entries under the Allowance Method include:

At time of sale

Accounts Receivable

          Sales Revenue

At end of period (adjusting entry)

                             Bad Debt Expense (an estimate)

                                      Allowance for Doubtful Accounts

 

Allowance for Doubtful Accounts is a contra asset account matched to Accounts Receivable. 

 

There are two methods used to estimate Bad Debt Expense

Percentage of Sales Method - Income Statement approach

Aging of Accounts Receivable - Balance Sheet approach

 

Under the percentage of sales method Bad Debt Expense is based on a percentage of credit sales.  When using the Percentage of Sales Method ignore the balance in the Allowance Account when recording the expense.  See the example on Page 392.

 

The Aging of Receivables method considers the age and amount of the ending Accounts Receivable balance.  This method assumes the longer an account goes uncollected, the more likely it is to go bad.  The prior balance in the Allowance Account must be considered when recording the amount of expense under this method.  See the example on pages 393-4.

 

Many firms use the percentage of sales method on interim statements and use the more precise aging of receivables method on year end statements.

 

Under the allowance method when an account is deemed to be uncollectible it is written off.  The journal entry takes the following form:

Allowance for Doubtful Accounts

Accounts Receivable, Customer ABC

 

There is a short discussion of credit card sales on the top of Pages 396-7.  Note that the journal entry to record a credit card sale must take into consideration the fact that the seller incurs financing expense on credit card sales.  A sale in which the customer uses a credit card is treated as a cash sale and journalized as follows:
                   Cash
                   Service Charge Expense
                                      Sales

 

 

A Note Receivable is a written promise to pay.  See the promissory note on Page 398.   Carefully review typical note receivable journal entries on Pages 400-402.  Note that the interest on a promissory note is stated in annual terms.  Also note the that interest expense is calculated as follows:

           Interest expense = Principle * Rate * Time

  

Several common liquidity ratios are introduced on Pages 403-4  The accounts receivable turnover ratio measures the number of times, on average, that accounts receivable are collected during the period.  It is computed as follows:

 

          A/R Turnover = Net Credit Sales
                                  Average Net A/R

 

Average College Period  indicates how long it takes to the collect the average level of receivables.  Companies strive to reduce this ratio and lower the number of days it takes to collect receivables.  The ratio is computed as follows:

 

          Average Collection Period =    365 Days 
                                                   A/R Turnover

 

Again, at the end of this chapter there is a comprehensive demonstration problem.  Again, I urge you to work the problem before you look at the solution.