Companies sometimes provide goods or services to customers, not for cash, but on account. Accounts receivable represent the amount of cash owed to a company by its customers from the sale of products or services on account.
In a credit sale, products and services are transferredto a customer today while bearing the risk of collecting payment from that customer in the future.Credit sales transactions are also known as sales on account or services on account.Credit sales are common for large business transactions. Businesses usually prefer to make multiple purchases using credit and then make a single payment at the end of the period. Businesses may also want to buy on credit because they have insufficient cash at the moment, or the transaction amount exceeds typical credit card limits. The benefit of extending credit is that the seller makes it more convenient for the buyer to purchase goods and services. Credit sales should benefit the seller by increasing profitability of the company, but the downside of extending credit is the delay in collecting cash from customers. As already discussed, some customers may end up not paying at all.
Even though the seller does not receive cash at the time of the credit sale, the firm records revenue immediately, as long as future collection from the customer is reasonably certain.Along with the recognized revenue, at the time of sale the seller also obtains a legal right to receive cash from the buyer. The legal right to receive cash is valuable and represents an asset of the company.This asset is referred to as accounts receivable (sometimes called trade receivables), and the firm records it at the time of a credit sale.
Link’s Dental records this entry at the time of the whitening.Notice that instead of debiting Cash, as in a cash sale, Link’s Dental debits another asset—Accounts Receivable—for the credit sale.Companies record an asset (accounts receivable) and revenue when they sell products and services to their customers on account, expecting payment in the future.
Nontrade receivables are receivables that originate from sources other than customers. They include tax refund claims, interest receivable, and loans by the company to other entities, including stockholders and employees.Notes receivable are receivables that are accompanied by formal credit arrangements made with written debt instruments (or notes).
Companies offer discounts to customers. These discounts offer ways to quickly sell old inventory, attract new customers, reward long-term loyal customers, and encourage customers to pay quickly on their accounts. Such discounts reduce the revenue reported in the current period. Revenues also reduce when a company’s customers return unsatisfactory products or demand allowances for inferior services or competitive pricing. Net revenues refer to a company’s total revenues less any amounts for discounts, returns, and allowances.
Trade discounts represent a reduction in the listed price of a product or service. Companies typically use trade discounts to provide incentives to larger customers or consumer groups to purchase from the company. Trade discounts also can be a way to change prices without publishing a new price list or to disguise real prices from competitors. When recording a transaction, companies don’t recognize trade discounts directly. Instead, they recognize trade discounts indirectly by recording the sale at the discounted price.
Link’s Dental, which typically charges $500 for teeth whitening. Assume that in order to entice more customers, Dr. Link offers a 20% discount on teeth whitening to any of his regular patients. Since Dee Kay is one of Dr. Link’s regular patients, she can take advantage of the special discount and have her teeth whitened for only $400.Notice that Link’s Dental records the trade discount indirectly by recognizing revenue equal to the discounted price, which is $500 less the trade discount of $100 (= $500 × 20%).
In some cases, customers may not be satisfied with a product or service purchased.If a customer returns a product, we call that a sales return. After a sales return, (a) we reduce the customer’s account balance if the sale was on account or (b) we issue a cash refund if the sale was for cash.In other cases, the customer does not return the product or service, but the seller reduces the customer’s balance owed to provide at least a partial refund. Such a reduction or partial refund is called a sales allowance.
Suppose on March 5, after she gets her teeth whitened but before she pays, Dee notices that another local dentist is offering the same procedure for $350, which is $50 less than Link’s discounted price of $400. Dee brings this to Dr. Link’s attention and because his policy is to match any competitor’s pricing, he offers to reduce Dee’s account balance by $50. Link’s Dental records the following sales allowance. This transaction reduces accounts receivable, showing that Dee owes less after the allowance—she now owes only $350.
The sales allowance is recorded as a contra revenue.A contra revenue account is an account with a balance that is opposite, or “contra,” to that of its related revenue account. The reason we use a contra revenue account is to be able to keep a record of the total revenue earned separate from the reduction due to subsequent sales allowances.
Sales discounts represent a reduction in the amount to be paid by a credit customer if payment is made within a specified period of time. It’s a discount intended to provide incentive for quick payment. Discount terms, such as 2/10, n/30, are a shorthand way to communicate the amount of the discount and the time period within which it’s available. The term “2/10,” pronounced “two ten,” for example, indicates the customer will receive a 2% discount if the amount owed is paid within 10 days. The term “n/30,” pronounced “net thirty,” means that if the customer does not take the discount, full payment net of any returns or allowances is due within 30 days.
Link’s Dental wants Dee to pay quickly on her teeth-whitening bill and offers her terms of 2/10, n/30. This means that if Dee pays within 10 days, the amount due ($350 after the $100 trade discount and the $50 sales allowance) will be reduced by 2% (or $7=$350 × 2%).Notice that Link receives only $343 cash, the $350 amount owed less the 2% sales discount. Similar to sales returns and allowances, we record sales discounts in a contra revenue account. The reason we use a contra revenue account is to be able to keep up with the total revenue separate from the reduction in that revenue due to quick payment. The net effect is that sales discounts increase, reducing net revenues of the company.If unpaid within the discount period, the full amount will be collected and Cash will be debited for $350.
The right to receive cash from a customer is a valuable resource for the company. This is why accounts receivable is an asset, reported in the company’s balance sheet. If the company expects to receive the cash within one year, it classifies the receivable as a current asset; otherwise it classifies the receivable as a long-term asset.To be useful to decision makers, accounts receivable should be reported at the amount of cash the firm expects to collect, an amount known as net realizable value.
We account for uncollectible accounts using what is called the allowance method. This method involves allowing for the possibility that some accounts will be uncollectible at some point in the future. Using the allowance method we account for events (customers’ bad debts) that have not yet occurred but that are likely to occur. Under theallowance method, companies are required to estimate future uncollectible accounts and record those estimates in the current year.Uncollectible accounts have the effect of (1) reducing assets (accounts receivable) by an estimate of the amount we don’t expect to collect and (2) increasing expenses (bad debt expense) to reflect the cost of offering credit to customers. An account receivable we do not expect to collect has no value. Thus, we need to reduce assets because we don’t expect to collect the entire accounts receivable (assets).Failure to collect a customer’s cash represents a cost inherent in using credit sales. The cost of uncollectible accounts is an operating expense, decreasing net income by the uncollectible amount.
This illustration demonstrates how the effects of uncollectible accounts should therefore be reflected in the financial statements.
To use the allowance method, a company first estimates at the end of the current year how much in uncollectible accounts will occur in the following year.The percentage-of-receivables method estimates uncollectible accounts based on the percentage of accounts receivable expected not to be collected.In the appendix to this chapter, we’ll consider a second method, the percentage-of-credit-sales method (also referred to as the income statement method). In practice, companies are required to follow the percentage-of-receivables method, so that will be our focus here.
First, bad debt expense represents the cost of the estimated future bad debts. We include this expense in the same income statement as the credit sales with which these bad debts are associated. By doing so, we properly “match” expenses (bad debts) with the revenues (credit sales) they help to generate.Second, we adjust for future bad debts by making an allowance for uncollectible accounts. The contra asset account Allowance for Uncollectible Accounts represents the amount of accounts receivable we do not expect to collect. Like sales discounts, returns, and allowances,the allowance account provides a way to reduce accounts receivable indirectly to its net realizable value, rather than decreasing the accounts receivable balance itself. We report the allowance for uncollectible accounts in the asset section of the balance sheet, but it represents a reduction in the balance of accounts receivable. The difference between total accounts receivable and the allowance for uncollectible accounts is referred to as net accounts receivable, which is net realizable value.
Using the 30% estimate, Kimzey expects that $6 million of its accounts receivable (or 30% of $20 million) likely will never be collected. It makes the this year-end adjustment to allow for these future uncollectible accounts.In the 2015 income statement, we reduce the $50 million of revenue from credit sales by $6 million for estimated future bad debts. Even though the company reports credit sales of $50 million, the expected profit on these sales, after considering the cost of future bad debts, is only $44 million.
After we estimate uncollectible accounts to be $6 million, we reduce the $20 million balance of accounts receivable and report them at their net realizable value of $14 million. Kimzey’s prediction of $6 million for uncollectible accounts might be too high, or it might be too low. In either case, it’s generally more informative than making no estimate at all.Recording an allowance for uncollectible accounts correctly reports accounts receivable at their net realizable value.
Management can estimate the percentage of future uncollectible accounts using historical averages, current economic conditions, industry comparisons, or other analytical techniques. A more accurate method than assuming a single percentage uncollectible for all accounts is to consider the age of various accounts receivable, and use a higher percentage for “old” accounts than for “new” accounts. This is known as the aging method.
Let’s return to Kimzey Medical Clinic to see how this looks. This illustration lists Kimzey’s individual patients’ accounts, including the amount owed by each patient and the number of days past due. Notice that each age group has its own estimate of the percent uncollectible, and this percentage increases with the age of the account.Summing the estimated amount uncollectible for each age group results in a total estimate of $5 million. Using the aging method to estimate futureuncollectible accounts should be more accurate. The reason is that accounting for the age of each account should more accurately predict the probability of the account balance not being collected. Theadjusting entry at the end of 2015 to allow for future bad debts would instead be $5 million using the aging method.
The write-off of the account receivable has no effect on total amounts reported in the balance sheet or in the income statement.There is no decrease in total assets and no decrease in net income with the write-off. We have already recorded the negative effects of the bad news.
Let’s suppose that on February 23, 2016 (the following year), Kimzey receives notice that one of its formerpatients, Bruce Easley, has filed for bankruptcy protection against all creditors. Based on this information, Kimzey believes it is unlikely Bruce will pay his account of $4,000. Kimzey previously allowed for the likelihood that some of its customers would not pay, though it didn’t know which ones. Now that it knows a specific customer will not pay, it can adjust the allowance and reduce the accounts receivable balance itself. Upon receiving news of this actual bad debt, Kimzey records this entry.Overall, the write-off of the account receivable has no effect on total amounts reported in the balance sheet or in the income statement. There is no decrease in total assets and no decrease in net income with the write-off. This is because we have already recorded the negative effects of the bad news. Kimzey recorded those effects when it estimated future bad debts at the end of 2015 and both reduced assets and recorded the bad debt expense.
Later in 2016, on September 8, Bruce’s bankruptcy proceedings are complete. Kimzey had expected to receive none of the $4,000 Bruce owed. However, after liquidating all assets, Bruce is able to pay each of his creditors 25% of the amount due them. So, when Kimzey receives payment of $1,000 (= $4,000 × 25%), it makes the following two entries.The first entry simply reverses a portion of the previous entry that Kimzey made on February 23 to write off the account. The second entry records the collection of the account receivable. Notice that in both entries the debit entry increases total assets by the same amount that the credit entry decreases total assets. Therefore, collecting cash on an account previously written off has no effect on total assets and no effect on net income. Continuing our example, suppose that by the end of 2016 total accounts written off by Kimzey equal $4 million. Because Kimzey allowed for bad debts by setting up the Allowance for Uncollectible Accounts for $5 million at the end of 2015, the write-offs in 2016 will have no effect on total assets or net income.
At the end of 2016, Kimzey must once again estimate uncollectible accounts and make a year-end adjustment. Kimzey estimated bad debts in 2016 to be $5 million but only $4 million was actually written off. This means the balance of the allowance account at the end of 2016 prior to any year-end adjustment is $1 million.Suppose that in 2016 Kimzey bills customers for services totaling $80 million, and $30 million are still receivable at the end of the year. Of the $30 million stillreceivable, Kimzey uses the aging method and estimates $8 million will not be collected.Notice that the balance before the year-end adjustment in this example is a $1 million credit. A credit balance before adjustment indicates that the estimateof uncollectible accounts at the beginning of the year (or end of last year) may have been too high. However, it’s possible that some of the estimated uncollectible accounts have not proven bad yet. A debit balance before adjustment indicates that the estimate at the beginning of the year was too low.Based on all available information at the end of 2016, Kimzey estimates that the allowance for uncollectible accounts should be $8 million. This means the allowance account needs to increase from its current balance of $1 million credit to the estimated ending balance of $8 million credit. Kimzey can accomplish this by adjusting the account for $7 million as the journal entry shown in the slide.
If uncollectible accounts are not anticipated or are immaterial, or if it’s not possible to reliably estimate them, we need not make an allowance for them. In these rare situations, we do not estimate uncollectible accounts, but we write off any bad debts that do arise as bad debt expense at that time.Recording bad debt expense at the time we know the account to be uncollectible is known as the direct write-off method. The direct write-off method is used for tax purposes but is generally not permitted for financial reporting.A firm must use the allowance method if it is probable that the firm will not collect a material amount of receivables and it can reasonably estimate that amount.
This illustration highlights the difference between the allowance method and the direct write-off method for our example.Under the allowance method, future bad debts are estimated and recorded as an expense and a reduction in assets in 2015. Under the direct write-off method, though, we make no attempt to estimate future bad debts. We record bad debt expense in the period the account proves uncollectible.Notice that, either way, the ultimate effect is a $2,000 debit to Bad Debt Expense and a $2,000 credit to Accounts Receivable. The difference is in the timing.
Notes receivable are similar to accounts receivable but are more formal credit arrangements evidenced by a written debt instrument, or note.They arise from loans to other entities (including affiliated companies); loans to stockholders and employees; and occasionally the sale of merchandise, other assets, or services.
Like accounts receivable, notes receivable are assets and therefore have a normal debit balance. We classify notes receivable as either current or noncurrent, depending on the expected collection date. If the time to maturity is longer than one year, the note receivable is a long-term asset.
When Justin is not able to pay for the services immediately and offers a six-month, 12% promissory note, Kimzey records the note as shown here.
Justin received $10,000 of services on account, but Kimzey originally recorded the amount due as a typical account receivable. Over time, it became apparent that Justin would not be able to pay quickly, so Kimzey required Justin to sign a six-month, 12% promissory note on February 1, 2015. When Justin signs the note, Kimzey records this transaction to reclassify the existing account receivable as a note receivable.
Justin Payne would record the reclassification as shown here.By signing the note, Justin has an account payable that becomes reclassified as a note payable.
We calculate interest as the face value of the note multiplied by the stated annual interest rate multiplied by the appropriate fraction of the year that the note is outstanding.
We record the collection of notes receivable the same way as collection of accounts receivable. We also record interest earned as interest revenue in theincome statement.Over the six-month period, Kimzey earns interest revenue of $600. The credit to Notes Receivable reduces the balance in that account to $0, which is the amount Justin owes after payment to Kimzey.
Because Kimzey earns two months of interest in 2015, it must accrue that interest as revenue on December 31, 2015 (even though no cash has been collected). The first entry is to record the adjustment to accrue interest revenue.On the maturity date, Kimzey records the collection of the note receivable and interest receivable from 2015 as well as the revenue related to the remaining four months’ interest earned in 2016.
The receivables turnover ratio shows the number of times during a year that the average accounts receivable balance is collected (or “turns over”).The “net” in net credit sales refers to total credit sales net of discounts, returns, and allowances. The amount for net credit sales is obtained from the current period’s income statement; average accounts receivable equals the average of accounts receivable reported in this period’s and last period’s balance sheets. The more frequently a business is able to “turn over” its average accounts receivable, the more quickly it is receiving cash from its customers.
The average collection period is another way to express the same efficiency measure. This ratio shows the approximate number of days the average accounts receivable balance is outstanding.
Previously, we estimated uncollectible accounts based on a percentage of accounts receivable at the end of the period. As an alternative, we can estimate uncollectible accounts based on the percentage of credit sales for the year, aptly referred to as the percentage-of-credit-sales method or the income statement method, because we base the estimate of bad debts on an income statement amount—credit sales.When applying the percentage-of-credit-sales method, we adjust the allowance for uncollectible accounts for the current year’s credit sales that we don’t expect to collect (rather than adjusting at the end of the year for the percentage of accounts receivable we don’t expect to collect).
This slide demonstrates the differences in the two methods when adjusting for estimates of uncollectible accounts. Recall that the balance of the allowance account before adjustment is a $1 million credit. After adjustment, the balance of the allowance account will differ between the two methods, as will the amount of bad debt expense.
This slide summarizes the differences in financial statement effects. From an income statement perspective, some argue that the percentage-of-credit-sales method provides a better method for estimating bad debts because expenses (bad debts) are better matched with revenues (credit sales). A better matching of expenses and revenues results in a more accurate measure of net income for the period. From a balance sheet perspective, though, the percentage-of-receivables method is preferable because assets (net accounts receivable) are reported closer to their net realizable value. The current emphasis on better measurement of assets (balance sheet focus) outweighs the emphasis on better measurement of net income (income statement focus). This is why the percentage-of-receivables method (balance sheet method) is the preferable method, while the percentage-of-credit-sales method (income statement method) is allowed only if amounts do not differ significantly from estimates using the percentage-of-receivables method.