Scarica Accounting for Receivables: Direct Write-off Method, Notes Receivable, and Ratios e più Schemi e mappe concettuali in PDF di Cost Accounting solo su Docsity!
WHAT ARE COMMON TYPES OF RECEIVABLES, AND HOW
ARE CREDIT SALES RECORDED?
- A^ RECEIVABLE^ occurs when a business sells goods or services to another party on account (on credit).
- A receivable is a monetary claim against a business or an individual.
- RECEIVABLE = right to receive cash in the future from a current transaction.
- CREDITOR = the party who receives a receivable.
- DEBTOR = the party to a credit transaction who is obligated to pay later.
ACCOUNTS RECEIVABLE
- Accounts receivable, also called trade receivables, represents the right to receive cash in the future from customers for goods or services performed.
- Generally collected within 30 to 60 days
- Reported as a current asset on the balance sheet
NOTES RECEIVABLE
- Notes receivable usually have longer terms than accounts receivable.
- Notes receivable are sometimes called promissory notes.
- A note receivable represents a promise to pay a fixed amount of principle plus interest by a certain due date.
- The maturity date is the date on which a note receivable is due.
OTHER RECEIVABLES
- Any other type of receivable is considered other receivables.
- Receivables are classified as either current or long-term, depending on whether they will be received in one year or less.
- Examples include:
- (^) Dividends receivable
- (^) Interest receivable
- (^) Taxes receivable
Exercising Internal Control Over Receivables
- Internal control over cash payments received by mail (usually checks) or online (EFTs) is important.
- A critical element of internal control is the separation of cash-handling and cash- accounting duties
- Credit department should have no access to cash
- Those who handle cash should not be in a position to grant credit to customers.
Recording Sales on Credit
Smart Touch Learning provides $5,000 in services to Brown on account and sells $10,000 (sales price) of merchandise inventory to Smith on account on August 8. Ignore Cost of Goods Sold.
Decreasing Collection Time and Credit Risk
- Companies must wait to receive cash from sales on account.
- Some accounts are never collected.
- Options to decrease collection time while transferring the risk of noncollection to a third party include:
- Credit Card and Debit Card Sales
- Factoring and Pledging Receivables
HOW ARE UNCOLLECTIBLES ACCOUNTED FOR WHEN
USING THE DIRECT WRITE- OFF METHOD?
- Bad debts expense arises from failure to collect from some customers who purchase on account.
- There are two methods of accounting for uncollectible receivables:
- Direct write-off method
- Allowance method (GAAP method)
Recording and Writing Off Uncollectible Accounts—Direct
Write-off Method
- The direct write-off method is a method of accounting for uncollectible receivables in which the company records bad debts expense when a customer’s account receivable is uncollectible.
- Primarily used by small, nonpublic companies.
- Accounts receivable are written off when the business determines that it will never collect from a specific customer.
- Once an account receivable is written off, the company stops pursuing the collection.
Recording and Writing Off Uncollectible Accounts—Direct
Write-off Method
On August 9, Smart Touch Learning determines that it will not be able to collect $200 from customer Dan King for a sale of merchandise inventory made on May 5. On September 10, Smart Touch Learning unexpectedly receives $200 cash from Dan King.
Limitations of the Direct Write-off Method
- The direct write-off method violates the matching principle
- Example: A company records sales revenue in 2017 and related bad debts expense in
- This results in:
- (^) Overstated net income in 2017
- (^) Understated net income in 2018
- (^) Overstated Accounts Receivable in 2017
- The direct write-off^ method is only acceptable for companies that have very few uncollectible receivables.
Recording Bad Debts Expense— Allowance Method
Writing Off Uncollectible Accounts— Allowance Method
- An allowance is established for the estimated uncollectible accounts.
- Instead of recording a debit to Bad Debts Expense, the company records a debit to Allowance for Bad Debts.
- The entry to write off an account under the allowance method has no effect on net income at the time of entry. On January 10, 2020, Smart Touch Learning determines that it cannot collect a total of $25 from its customer Shawn Clark.
The entry to write off a receivable reduces the amount of the Allowance for Bad Debts account and also the Accounts Receivable account, but it does not affect the net realizable value shown on the balance sheet.
Recovery of Accounts Previously Written Off—Allowance
Method
Recall that Smart Touch Learning wrote off the $25 receivable from Shawn Clark on January 10, 2020. It is now March 4, 2020, and Smart Touch Learning unexpectedly receives $25 cash from Clark.
At December 31, Smart Touch Learning records the following adjusting entry to recognize bad debts expense for the year: After posting the adjusting entry, Smart Touch Learning has the following balances in its accounts. Ignore the previously recorded reversal of the write-off and assume collections on account during the year are $58,000:
B. PERCENT- OF- RECEIVABLES METHOD
- The percent-of-receivables method computes bad debts expense as a percentage of accounts receivable. On December 31, 2020, Smart Touch Learning’s unadjusted Accounts Receivable balance is $6,375, and 4% of accounts receivable is estimated to be uncollectible. The Allowance for Bad Debts account has a credit balance of $55, so the adjustment is $200.
Martin’s Music has a debit balance in its Allowance for Bad Debts account of $150. It estimates uncollectible accounts will be 2% of $40,000 of Accounts Receivable.
C. AGING- OF- RECEIVABLES METHOD
- The aging-of-receivables method is similar to the percent-of-receivables method.
- In the aging method, businesses group individual accounts based on how long the receivable has been outstanding.
- Different percentages are applied to each category.
The procedure for recording the year-end adjusting entry under the aging-of- receivables method is similar to the percent- of-receivables method. Smart Touch Learning knows the target balance of the Allowance for Bad Debts account is $185.
HOW ARE NOTES RECEIVABLE ACCOUNTED FOR?
- PROMISSORY NOTE = written promise to pay a specified amount of money at a particular future date, usually with interest.
- Maker of the note (debtor) = The entity that signs the note and promises to pay the required amount.
- The maker of the note is the debtor. •Payee of the note (creditor) = The entity to whom the maker promises future payment; the payee of the note is the creditor.
- The creditor is the company that loans the money.
- PRINCIPAL — The amount loaned by the payee and borrowed by the maker of the note.
- INTEREST — The revenue to the payee for loaning money.
- Interest is an expense to the debtor and revenue to the creditor.
- Interest period — The period of time during which interest is computed.
- It extends from the original date of the note to the maturity date.
- Also called the note term.
- INTEREST RATE^ — The percentage rate of interest specified by the note.
- Interest rates are almost always stated for a period of one year.
- MATURITY RATE — As stated earlier, this is the date when final payment of the note is due.
- Also called the due date.
- MATURITY VALUE — The sum of the principal plus interest due at maturity.
- Maturity value is the total amount that will be paid back.
COMPUTING INTEREST ON A NOTE
The formula for computing the interest is as follows:
- In the formula, time represents the portion of a year that interest has accrued on the note.
- It may be expressed as a fraction of a year in months (number of months/12)
- Or a fraction of a year in days (number of days/365)
- Using the data in Exhibit 8-4, Smart Touch Learning computes interest revenue for one year as follows: - (^) The maturity value of the note is $1,060 ($1,000 principal + $60 interest). - (^) The time element is 12/12 or 1 because the note’s term is one year. Interest on a $2,000 note at 10% for nine months is computed as follows: The interest on a $5,000 note at 12% for 60 days can be computed as follows:
Accruing Interest Revenue and Recording Honored Notes
Receivable
Refer back to Exhibit 8-4: Smart Touch Learning lending Lauren Holland $1,000 on September 30, 2019, for one year at an annual interest rate of 6%. On December 31, interest should be accrued. For 2020, Smart Touch Learning earns nine months of interest: On the maturity date of the note, Smart Touch Learning will receive cash for the principal amount plus interest. The company considers the note honored and makes the following entry:
