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Cash and Receivables

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ACCOUNTS RECEIVABLE
3. Define receivables and identify the different types of receivables. Receivables are claims held against customers and others for money, goods, or services. For financial statement purposes, companies classify receivables as either current (short-term) or noncurrent (long-term). Companies expect to collect current receivables within a year or during the current operating cycle, whichever is longer. They classify all other receivables as noncurrent. Receivables are further classified in the balance sheet as either trade or nontrade receivables. Customers often owe a company amounts for goods bought or services rendered. A company may subclassify these trade receivables , usually the most significant item it possesses, into accounts receivable and notes receivable. Accounts receivable are oral promises of the purchaser to pay for goods and services sold. They represent open accounts resulting from short-term extensions of credit. A company normally collects them within 30 to 60 days. Notes receivable are written promises to pay a certain sum of money on a specified future date. They may arise from sales, financing, or other transactions. Notes may be shortterm or long-term. Nontrade receivables arise from a variety of transactions. Some examples of nontrade receivables are: 1. Advances to officers and employees. 2. Advances to subsidiaries. 3. Deposits paid to cover potential damages or losses. 4. Deposits paid as a guarantee of performance or payment. 5. Dividends and interest receivable. 6. Claims against: (a) Insurance companies for casualties sustained. (b) Defendants under suit. (c) Governmental bodies for tax refunds. (d) Common carriers for damaged or lost goods. (e) Creditors for returned, damaged, or lost goods. (f) Customers for returnable items (crates, containers, etc.). Because of the peculiar nature of nontrade receivables, companies generally report them as separate items in the balance sheet. Illustration 7-3 shows the reporting of trade and nontrade receivables in the balance sheets of Molson Coors Brewing Company and Seaboard Corporation.

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ILLUSTRATION 7-3 Receivables Balance Sheet Presentations

The basic issues in accounting for accounts and notes receivable are the same: recognition, valuation, and disposition. We discuss these basic issues for accounts and notes receivable next.

Recognition of Accounts Receivable

4. Explain accounting issues related to recognition of accounts receivable. In most receivables transactions, the amount to be recognized is the exchange price between the two parties. The exchange price is the amount due from the debtor (a customer or a borrower). Some type of business document, often an invoice, serves as evidence of the exchange price. Two factors may complicate the measurement of the exchange price: (1) the availability of discounts (trade and cash discounts), and (2) the length of time between the sale and the due date of payments (the interest element).

Trade Discounts
Prices may be subject to a trade or quantity discount. Companies use such trade discounts to avoid frequent changes in catalogs, to alter prices for different quantities purchased, or to hide the true invoice price from competitors. Trade discounts are commonly quoted in percentages. For example, say your cell phone has a list price of $90, and the manufacturer sells it to Best Buy for list less a 30 percent trade discount. The manufacturer then records the receivable at $63 per phone. The manufacturer, per normal practice, simply deducts the trade discount from the list price and bills the customer net. As another example, Maxwell House at one time sold a 10-ounce jar of its instant coffee listing at $5.85 to supermarkets for $5.05, a trade discount of approximately 14 percent. The supermarkets in turn sold the instant coffee for $5.20 per jar. Maxwell House records the receivable and related sales revenue at $5.05 per jar, not $5.85.

Cash Discounts (Sales Discounts)

Companies offer cash discounts (sales discounts ) to induce prompt payment. Cash discounts generally presented in terms such as 2/10, n/30 (2 percent if paid within 10 days, gross amount due in 30 days), or 2/10, E.O.M., net 30, E.O.M. (2 percent if paid any time before the tenth day of the following month, with full payment due by the thirtieth of the following month). Companies usually take sales discounts unless their cash is severely limited. Why? A company that receives a 1 percent reduction in the sales price for payment within 10 days, total payment due within 30 days, effectively earns 18.25 percent , or at least avoids that rate of interest cost. Companies usually record sales and related sales discount transactions by entering the receivable and sale at the gross amount. Under this method, companies recognize sales discounts only when they receive payment within the discount period. The income statement shows sales discounts as a deduction from sales to arrive at net sales. Some contend that sales discounts not taken reflect penalties added to an established price to encourage prompt payment. That is, the seller offers sales on account at a slightly higher price than if selling for cash. The cash discount offered offsets the increase. Thus, customers who pay within the discount period actually purchase at the cash price. Those who pay after expiration of the discount period pay a penalty for the delayan amount in excess of the cash price. Per this reasoning, some companies record sales and receivables net. They subsequently debit any discounts not taken to Accounts Receivable and credit to Sales Discounts Forfeited. The entries in Illustration 7-4 show the difference between the gross and net methods.

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ILLUSTRATION 7-4 Entries under Gross and Net Methods of Recording Cash (Sales) Discounts

If using the gross method, a company reports sales discounts as a deduction from sales in the income statement. Proper expense recognition dictates that the company also reasonably estimates the expected discounts to be taken and charges that amount against sales. If using the net method, a company considers Sales Discounts Forfeited as an Other revenue item. 4To the extent that discounts not taken reflect a short-term financing, some argue that companies could use an interest revenue account to record these amounts. Theoretically, the recognition of Sales Discounts Forfeited is correct. The receivable is stated closer to its realizable value, and the net sales figure measures the revenue recognized from the sale. As a practical matter, however, companies seldom use the net method because it requires additional analysis and bookkeeping. For example, the net method requires adjusting entries to record sales discounts forfeited on accounts receivable that have passed the discount period.

Nonrecognition of Interest Element

Ideally, a company should measure receivables in terms of their present value, that is, the discounted value of the cash to be received in the future. When expected cash receipts require a waiting period, the receivable face amount is not worth the amount that the company ultimately receives. To illustrate, assume that Best Buy makes a sale on account for $1,000 with payment due in four months. The applicable annual rate of interest is 12 percent, and payment is made at the end of four months. The present value of that receivable is not $1,000 but . In other words, the $1,000 Best Buy receives four months from now is not the same as the $1,000 received today. Theoretically, any revenue after the period of sale is interest revenue. In practice, companies ignore interest revenue related to accounts receivable because the amount of the discount is not usually material in relation to the net income for the period. The profession specifically excludes from present value considerations receivables arising from transactions with customers in the normal course of business which are due in customary trade terms not exceeding approximately one year. [2]

Underlying Concepts
Materiality means it mus t make a differenc e to a dec is ion-maker. T he FASB believes that pres ent value c onc epts c an be ignored for s hort-term rec eivables .

Valuation of Accounts Receivable

5. Explain accounting issues related to valuation of accounts receivable. Reporting of receivables involves (1) classification and (2) valuation on the balance sheet. Classification involves determining the length of time each receivable will be outstanding. Companies classify receivables intended to be collected within a year or the operating cycle, whichever is longer, as current. All other receivables are classified as long-term.
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Companies value and report short-term receivables at net realizable value the net amount they expect to receive in cash. Determining net realizable value requires estimating both uncollectible receivables and any returns or allowances to be granted.

Uncollectible Accounts Receivable

As one revered accountant aptly noted, the credit manager's idea of heaven probably would be a place where everyone (eventually) paid his or her debts. 5William J. Vatter, Managerial Accounting (Englewood Cliffs, N.J.: Prentice-Hall, 1950), p. 60. Unfortunately, this situation often does not occur. For example, a customer may not be able to pay because of a decline in its sales revenue due to a downturn in the economy. Similarly, individuals may be laid off from their jobs or faced with unexpected hospital bills. Companies record credit losses as debits to Bad Debt Expense (or Uncollectible Accounts Expense). Such losses are a normal and necessary risk of doing business on a credit basis. Two methods are used in accounting for uncollectible accounts: (1) the direct write-off method and (2) the allowance method. The following sections explain these methods.

Direct Write-Off Method for Uncollectible Accounts

Under the direct write-off method , when a company determines a particular account to be uncollectible, it charges the loss to Bad Debt Expense. Assume, for example, that on December 10 Cruz Co. writes off as uncollectible Yusado's $8,000 balance. The entry is: December 10 Bad Debt Expense 8,000 Accounts Receivable (Yusado) 8,000 (To record write-off of Yusado account) Under this method, Bad Debt Expense will show only actual losses from uncollectibles. The company will report accounts receivable at its gross amount. Supporters of the direct write-off-method (which is often used for tax purposes) contend that it records facts, not estimates. It assumes that a good account receivable resulted from each sale, and that later events revealed certain accounts to be uncollectible and worthless. From a practical standpoint, this method is simple and convenient to apply. But the direct write-off method is theoretically deficient. It usually fails to record expenses in the same period as associated revenues. Nor does it result in receivables being stated at net realizable value on the balance sheet. As a result, using the direct write-off method is not considered appropriate, except when the amount uncollectible is immaterial.

Allowance Method for Uncollectible Accounts

The allowance method of accounting for bad debts involves estimating uncollectible accounts at the end of each period. This ensures that companies state receivables on the balance sheet at their net realizable value. Net realizable value is the net amount the company expects to receive in cash. The FASB considers the collectibility of receivables a loss contingency. Thus, the allowance method is appropriate in situations where it is probable that an asset has been impaired and that the amount of the loss can be reasonably estimated. [3] Although estimates are involved, companies can predict the percentage of uncollectible receivables from past experiences, present market conditions, and an analysis of the outstanding balances. Many companies set their credit policies to provide for a certain percentage of uncollectible accounts. (In fact, many feel that failure to reach that percentage means that they are losing sales due to overly restrictive credit policies.) Thus, the FASB requires the allowance method for financial reporting purposes when bad debts are material in amount. This method has three essential features: 1. Companies estimate uncollectible accounts receivable. They match this estimated expense against revenues in the same accounting period in which they record the revenues. 2. Companies debit estimated uncollectibles to Bad Debt Expense and credit them to Allowance for Doubtful Accounts (a contra asset account) through an adjusting entry at the end of each period. 3. When companies write off a specific account, they debit actual uncollectibles to Allowance for Doubtful Accounts and credit that amount to Accounts Receivable. Recording Estimated Uncollectibles. To illustrate the allowance method, assume that Brown Furniture has credit sales of $1,800,000 in 2014. Of this amount, $150,000 remains uncollected at December 31. The credit manager estimates that $10,000 of these sales will be uncollectible. The adjusting entry to record the estimated uncollectibles is:
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December 31, 2014 Bad Debt Expense 10,000 Allowance for Doubtful Accounts 10,000 (To record estimate of uncollectible accounts) Brown reports Bad Debt Expense in the income statement as an operating expense. Thus, the estimated uncollectibles are matched with sales in 2014. Brown records the expense in the same year it made the sales. As Illustration 7-5 shows, the company deducts the allowance account from accounts receivable in the current assets section of the balance sheet.

ILLUSTRATION 7-5 Presentation of Allowance for Doubtful Accounts

Allowance for Doubtful Accounts shows the estimated amount of claims on customers that the company expects will become uncollectible in the future. 6The account description employed for the allowance account is usually Allowance for Doubtful Accounts or simply Allowance. Accounting Trends and Techniques recently indicated that approximately 83 percent of the companies surveyed used allowance in their description. Companies use a contra account instead of a direct credit to Accounts Receivable because they do not know which customers will not pay. The credit balance in the allowance account will absorb the specific write-offs when they occur. The amount of $140,000 in Illustration 7-5 represents the net realizable value of the accounts receivable at the statement date. Companies do not close Allowance for Doubtful Accounts at the end of the fiscal year. Recording the Write-Off of an Uncollectible Account. When companies have exhausted all means of collecting a past-due account and collection appears impossible, the company should write off the account. In the credit card industry, for example, it is standard practice to write off accounts that are 210 days past due. To illustrate a receivables write-off, assume that the financial vice president of Brown Furniture authorizes a write-off of the $1,000 balance owed by Randall Co. on March 1, 2015. The entry to record the write-off is: March 1, 2015 Allowance for Doubtful Accounts 1,000 Accounts Receivable (Randall Co.) 1,000 (Write-off of Randall Co. account) Bad Debt Expense does not increase when the write-off occurs. Under the allowance method, companies debit every bad debt write-off to the allowance account rather than to Bad Debt Expense. A debit to Bad Debt Expense would be incorrect because the company has already recognized the expense when it made the adjusting entry for estimated bad debts. Instead, the entry to record the write-off of an uncollectible account reduces both Accounts Receivable and Allowance for Doubtful Accounts. Recovery of an Uncollectible Account. Occasionally, a company collects from a customer after it has written off the account as uncollectible. The company makes two entries to record the recovery of a bad debt: (1) It reverses the entry made in writing off the account. This reinstates the customer's account. (2) It journalizes the collection in the usual manner. To illustrate, assume that on July 1, 2015, Randall Co. pays the $1,000 amount that Brown had written off on March 1. These are the entries: July 1, 2015 Accounts Receivable (Randall Co.) Allowance for Doubtful Accounts 1,000 1,000
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(To reverse write-off of account) Cash 1,000 Accounts Receivable (Randall Co.) 1,000 (Collection of account) Note that the recovery of a bad debt, like the write-off of a bad debt, affects only balance sheet accounts . The net effect of the two entries above is a debit to Cash and a credit to Allowance for Doubtful Accounts for $1,000. 7If using the direct write-off approach, the company debits the amount collected to Cash and credits a revenue account entitled Uncollectible Amounts Recovered, with proper notation in the customer's account. Bases Used for Allowance Method. To simplify the preceding explanation, we assumed we knew the amount of the expected uncollectibles. In real life, companies must estimate that amount when they use the allowance method. Two bases are used to determine this amount: (1) percentage of sales and (2) percentage of receivables . Both bases are generally accepted. The choice is a management decision. It depends on the relative emphasis that management wishes to give to expenses and revenues on the one hand or to net realizable value of the accounts receivable on the other. The choice is whether to emphasize income statement or balance sheet relationships. Illustration 7-6 compares the two bases.

ILLUSTRATION 7-6 Comparison of Bases for Estimating Uncollectibles

The percentage-of-sales basis results in a better matching of expenses with revenuesan income statement viewpoint. The percentage-of-receivables basis produces the better estimate of net realizable valuea balance sheet viewpoint. Under both bases, the company must determine its past experience with bad debt losses.

Underlying Concepts
T he perc entage-of-s ales method illus trates the expens e rec ognition princ iple, w hic h relates expens es to revenues rec ognized. Percentage-of-sales (income statement) approach. In the percentage-of-sales approach , management estimates what percentage of credit sales will be uncollectible. This percentage is based on past experience and anticipated credit policy. The company applies this percentage to either total credit sales or net credit sales of the current year. To illustrate, assume that Gonzalez Company elects to use the percentage-of-sales basis. It concludes that 1 percent of net credit sales will become uncollectible. If net credit sales for 2014 are $800,000, the estimated bad debts expense is . The adjusting entry is: December 31, 2014 Bad Debt Expense 8,000 Allowance for Doubtful Accounts 8,000 After the adjusting entry is posted, assuming the allowance account already has a credit balance of $1,723, the accounts of Gonzalez Company will show the following:
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ILLUSTRATION 7-7 Bad Debt Accounts after Posting

The amount of bad debt expense and the related credit to the allowance account are unaffected by any balance currently existing in the allowance account. Because the bad debt expense estimate is related to a nominal account (Sales Revenue), any balance in the allowance is ignored. Therefore, the percentage-of-sales method achieves a proper matching of cost and revenues. This method is frequently referred to as the income statement approach. Percentage-of-receivables (balance sheet) approach. Using past experience, a company can estimate the percentage of its outstanding receivables that will become uncollectible, without identifying specific accounts. This procedure provides a reasonably accurate estimate of the receivables' realizable value. But, it does not fit the concept of matching cost and revenues. Rather, it simply reports receivables in the balance sheet at new realizable value. Hence, it is referred to as the percentage-of-receivables (or balance sheet) approach . Companies may apply this method using one composite rate that reflects an estimate of the uncollectible receivables. Or, companies may set up an aging schedule of accounts receivable, which applies a different percentage based on past experience to the various age categories. An aging schedule also identifies which accounts require special attention by indicating the extent to which certain accounts are past due. The schedule of Wilson & Co. in Illustration 7-8 is an example.

ILLUSTRATION 7-8 Accounts Receivable Aging Schedule

Wilson reports bad debt expense of $37,650 for this year, assuming that no balance existed in the allowance account. To change the illustration slightly, assume that the allowance account had a credit balance of $800 before adjustment. In this case, Wilson adds to the allowance account and makes the following entry. Bad Debt Expense 36,850 Allowance for Doubtful Accounts 36,850 Wilson therefore states the balance in the allowance account at $37,650. If the Allowance for Doubtful Accounts balance before adjustment had a debit balance of $200, then Wilson records bad debt expense of . In the percentage-of-receivables method, Wilson cannot ignore the balance in the allowance account because the percentage is related to a real account (Accounts Receivable). Companies usually do not prepare an aging schedule to determine bad debt expense. Rather, they prepare it as a control device to determine the composition of receivables and to identify delinquent accounts. Companies base the estimated loss percentage developed for each category on previous loss experience and the advice of credit department personnel.
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Whether using a composite rate or an aging schedule, the primary objective of the percentage of outstanding receivables method for financial statement purposes is to report receivables in the balance sheet at net realizable value. However, it is deficient in that it may not match the bad debt expense to the period in which the sale takes place. The allowance for doubtful accounts as a percentage of receivables will vary, depending on the industry and the economic climate. Companies such as Eastman Kodak , General Electric, and Monsanto have recorded allowances ranging from $3 to $6 per $100 of accounts receivable. Other large companies, such as CPC International ($1.48), Texaco ($1.23), and USX Corp. ($0.78), have had bad debt allowances of less than $1.50 per $100. At the other extreme are hospitals that allow for $15 to $20 per $100 of accounts receivable. Regardless of the method chosenpercentage-of-sales or -receivablesdetermining the expense associated with uncollectible accounts requires a large degree of judgment. Recent concern exists that, similar to Citigroup in our opening story, some banks use this judgment to manage earnings. By overestimating the amounts of uncollectible loans in a good earnings year, the bank can save for a rainy day in a future period. In future (less-profitable) periods, banks can reduce the overly conservative allowance for loan loss account to increase earnings. 8The SEC brought action against Suntrust Banks , requiring a reversal of $100 million of bad debt expense. This reversal increased after-tax profit by $61 million. Recall from our earnings management discussion in Chapter 4 that increasing or decreasing income through management manipulation can reduce the quality of financial reports. Gateway to the Profession Tutorial on Recording Uncollectible Accounts

What do the numbers mean?

I'M STILL WAITING

Small companies are in a bind. Many of their suppliers are demanding payment earlier, and their customers (represented by their accounts receivable) are taking longer to pay. That means companies with the least clout get squeezed the hardest. As one company executive noted, The slowdown of currency, of money, the exchange, puts us in a very precarious position. The average time small companies took to collect accounts receivable increased to 27 days in 2010 from about 23 days in the previous four-year period. Many small companies are seeing their payments from larger customers stretch from 30 days to 60 and even 90 days after an invoice is issued. Wal-Mart Stores, Inc. , for example, took 29.5 days to pay its bills in the first quarter of 2010, up from 27 days a year earlier. Apple took 52 days, up from 43 days a year earlier. As one individual stated, If you are working with one of these large companies, as your only customer, they have the power. They can go to somebody else, but you can't go anywhere. The chart on the right indicates that, overall, companies are increasing their payment times past the due date regardless of their size. For example, in the first quarter of 2012, companies paid their bills an average of 7.6 days past due, a 14.1 percent increase from the same period the previous period. The very small companies and the large companies generally have delayed payment the most.

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The recession is taking its toll. As companies get squeezed between late payments and tighter credit terms, nonpayments often result. As a result, much judgment must be exercised in determining the proper percentage to record for bad debts.
Sources: Anonym ous, A Cash-Flow Crisis Is the Recession's Legacy, Bloomberg Businessweek (March 28-April 3, 2011), pp. 59-60; and A. Lote n, Small Firms' Big Customers Are Slow to Pay, Wall Street Journal (June 7, 2012), p. B7.

Copyright 2012 John Wiley & Sons, Inc. All rights reserved.

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