Lecture 5

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Introductory Financial Accounting Lecture 5 - Internal Control, Cash, and Receivables 1 Introductory Financial Accounting Lecture 5 - Internal Control, Cash, and Receivables Overview: Types of Receivables Accounts Receivable Amounts due from individuals and companies that are expected to be collected in cash. no interest involves Notes Receivable Written promise (formal instrument) for amount to be received. Other Receivables Other receivables such as interest, loans to officers, and advances to employees Current Asset Accounts Receivable Short-term Notes Receivable Other Receivables (short-term) Non-current Asset Long-term Notes Receivable Other Receivables (long-term) [LO2] Accounts Receivable Accounts receivable is the current asset resulting from a sale or service executed on a credit basis.

Introductory Financial Accounting Lecture 5 - Internal Control, Cash, and Receivables 2 Losses from Accounts Receivable Businesses extend credit in order to increase their volume of sales relative to a cash-only policy Businesses understand, however, that they will likely not collect 100 percent of all of their outstanding accounts receivable. Credit losses are considered an operating expense and are debited to bad debt expense/uncollectible-account expense. What if everyone assumes 100% accounts are collectible? If everyone assumes that 100% of accounts receivable are collectible, it may lead to an overly optimistic financial outlook. What if everyone assumes 100% accounts are collectible? The assets will be overstated if assuming the AR is 100% collectible Expense will be understated Allowance Method An estimate is required to be made of bad debt expenses at the time of the revenue recognition even though the actual accounts to be written off are unknown at this time. This is an example of the matching principle This process is executed using the allowance method. The estimate results in an adjusting entry to the contra-asset account called Allowance for Doubtful Accounts. Why not recognize expenses after collecting the receivables?

Introductory Financial Accounting Lecture 5 - Internal Control, Cash, and Receivables 3 match all the expense in this period Avoid risk shifting to next period. Assume Scripps Company estimates its bad debts expense for its first year of operations to be $5,000 Allowance Method: Reporting Allowance for Doubtful Accounts (ADA) The allowance for doubtful accounts is a contra-asset account with a normal credit balance. The allowance account is subtracted from gross accounts receivable to yield a net amount Assume that Scripps Company has gross accounts receivable of $14,000 Writing Off Specific Receivables The company will write off a receivable when it is determined the amount will not be collected. Assume $200 of the outstanding receivables is determined to be uncollectible

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Introductory Financial Accounting Lecture 5 - Internal Control, Cash, and Receivables 4 Doesn't affect value of assets No Effect effect on Net Income These changes not affect cash, related to account receivable only Recovery of Accounts Written Off Occasionally an account written off will be later collected. Assume the previous $200 write off was actually collected. Two entries will be recorded Reverse the original write off Collect the cash

Introductory Financial Accounting Lecture 5 - Internal Control, Cash, and Receivables 5 Estimating Credit Losses 1: Percentage of Sales Method Percentage of Sales Method Estimates bad debt expense/uncollectible-account expenseas a percentage of credit sales for a given period. Percentage used is usually based on historical past credit losses. Bad debt expense = percentage x total credit sales Why do not use account receivable account receivable is a permanent account it will carry the balance from previous year If using AR to estimate the bad debt expense, it may overstate the expense Assume Scripps Company has 2016 credit sales of $700,000 and past experience is that three percent of these sales will not be ultimately collected. Bad debts expense is calculated as $700,000 x 0.03 = $21,000 Scripps must monitor the balance in the allowance for doubtful accounts for reasonableness.

Introductory Financial Accounting Lecture 5 - Internal Control, Cash, and Receivables 6 Aging Method Method—Example Scripps 2016 accounts receivable total $30,000 as follows: current $10,000; 0-30 days $8,000; 31-60 days $5,000; 61-90 days $3,000; over 90 days $4,000. The following schedule computes the required balance for the allowance for doubtful accounts using historical probabilities of non-collection. Aging Method Estimates the allowance for doubtful accounts as a percentage of the outstanding accounts receivable. Total estimated uncollectible accounts per the aging schedule is the ending balance in the Allowance for Doubtful Accounts (ADA) Adjusted amounts for Bad debts expense and ADA are then determined as the amount necessary to achieve the proper balance in the allowance account. Beginning allowance - Receivables Write offs + Bad Debt Expense = Ending Allowance Assume Scripps had a beginning credit balance in the allowance for doubtful accounts of $400. The required entry would be as follows:

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Introductory Financial Accounting Lecture 5 - Internal Control, Cash, and Receivables 7 [LO3] Notes Receivable Promissory notes receivable are often used in sale transactions when the credit period is longer than the 30-60 day period common for accounts receivable Key characteristics include: A fixed due date or on demand A certain principal sum to be paid An interest rate usually stated as an annual rate Notes Receivable Payee: the party to whom payment is to be made Maker: the party making the promise to pay. To the payee, the promissory note is a note receivable To the maker, the promissory note is a note payable Notes Receivable: Interest Calculation Interest is calculated according to the following formula: Interest = Principal x Interest rate x Interest time Assume a 3 month note for $10,000 at an annual interest rate of 6 percent Interest = $10,000 x 0.06 x 3/12 = $150 Recording Notes Receivable and Interest

Introductory Financial Accounting Lecture 5 - Internal Control, Cash, and Receivables 8 Jordan Company sold $12,000 of merchandise on account to Bowman Company. On October 1, after the regular credit period had elapsed, the Bowman Company gave the Jordon Company a 60 day, 9% note receivable for $12,000. Jordan Company makes the following journal entry to record receiving the note: If the Bowman Company pays its note receivable on the November 30 maturity date (i.e. honor the note), the Jordon Company makes the following journal entry: Adjusting Entry for Interest Income Assume that Jordan Company prepares financial statements as of September 30. The notes receivable from Garcia Company is dated June 1, has a principal amount of $10,000, an interest rate of nine percent, and a maturity date of November 1

Introductory Financial Accounting Lecture 5 - Internal Control, Cash, and Receivables 9 The adjusting entry that Jordan Company makes at September 30 is as follows: When the note is subsequently paid on November 1, Jordan Company makes the following journal entry [LO 4] Other issues of Accounts Receivable Computing Cash Collections from Customers Receivables typically hold five items: If you know all other items except for collections, you can compute collections by solving for X. Beginning Receivables + Sales - Write-off - Cash Collection = Ending Receivables Evaluate a Company’s Ability To Collect Receivables

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