Honoring a note receivable indicates that the maker has

356

Chapter

Accounting for Receivables After studying this chapter, you should be able to: 1 Identify the different types of receivables. 2 Explain how companies recognize

accounts receivable. 3 Distinguish between the methods and

bases companies use to value accounts receivable.

4 Describe the entries to record the disposition of accounts receivable.

5 Compute the maturity date of and interest on notes receivable.

6 Explain how companies recognize notes receivable.

7 Describe how companies value notes receivable.

8 Describe the entries to record the disposition of notes receivable.

9 Explain the statement presentation and analysis of receivables.

S T U D Y O B J E C T I V E S

Feature Story

The Navigator✓

8

A DOSE OF CAREFUL MANAGEMENT KEEPS RECEIVABLES HEALTHY

”Sometimes you have to know when to be very tough, and sometimes you can give them a bit of a break,” says Vivi Su. She’s not talking about her children, but about the customers of a subsidiary of pharmaceutical company Whitehall-Robins (www.whitehall-robins.com), where she works as supervisor of credit and collections.

Scan Study Objectives ■

Read Feature Story ■

Read Preview ■

Read text and answer p. 366 ■ p. 369 ■ p. 373 ■ p. 375 ■

Work Comprehensive p. 377 ■

Review Summary of Study Objectives ■

Answer Self-Study Questions ■

Complete Assignments ■

The Navigator✓

Do it!

Do it!

JWCL165_c08_356-395.qxd 8/4/09 7:19 PM Page 356

357

For example, while the company’s regular terms are 1/15, n/30 (1% discount if paid within 15 days), a customer might ask for and receive a few days of grace and still get the discount. Or a customer might place orders above its credit limit, in which case, depending on its payment history and the circumstances, Ms. Su might authorize shipment of the goods anyway.

Nearly all of the company’s sales come through the credit accounts Ms. Su manages. The process starts with the decision to grant a customer an account in the first place, Ms. Su explains. The sales rep gives the customer a credit application. “My department reviews this application very carefully; a customer needs to supply three good references, and we also run a check with a credit firm like Equifax. If we accept them, then based on their size and history, we assign a credit limit.”

Once accounts are established, the company supervises them very carefully. ”I get an aging report every single day,” says Ms. Su.

“The rule of thumb is that we should always have at least 85% of receivables current—meaning they were billed less than 30 days ago,” she continues. “But we try to do even better than that—I like to see 90%.” Similarly, her guideline is never to have more than 5% of receivables at over 90 days. But long before that figure is reached, “we jump on it,” she says firmly.

At 15 days overdue, Whitehall-Robins phones the client. Often there’s a reasonable explanation for the delay—an invoice may have gone astray, or the payables clerk is away. ”But if a customer keeps on delaying, and tells us several times that it’ll only be a few more days, we know there’s a problem,” says Ms. Su. After 45 days, “I send a letter. Then a second notice is sent in writing. After the third and final notice, the client has 10 days to pay, and then I hand it over to a collection agency, and it’s out of my hands.”

Ms. Su knows that management of receivables is crucial to the profitability of Whitehall-Robins. “Receivables are generally the second-largest asset of any company (after its capital assets),” she points out. “So it’s no wonder we keep a very close eye on them.”

The Navigator✓

Inside Chapter 8…

• When Investors Ignore Warning Signs (p. 366)

• How Does a Credit Card Work? (p. 367)

• All About You: Should You Be Carrying Plastic? (p. 376)

JWCL165_c08_356-395.qxd 8/4/09 7:20 PM Page 357

TYPES OF RECEIVABLES

Preview of Chapter 8 As indicated in the Feature Story, receivables are a significant asset for many pharmaceutical companies. Because a significant portion of sales in the United States are done on credit, receivables are significant to companies in other industries as well. As a consequence, companies must pay close attention to their receiv- ables and manage them carefully. In this chapter you will learn what journal entries companies make when they sell products, when they collect cash from those sales, and when they write off accounts they cannot collect.

The content and organization of the chapter are as follows.

The Navigator✓

358

Accounting for Receivables

Types of Receivables

• Accounts receivable • Notes receivable • Other receivables

Notes Receivable

• Determining maturity date • Computing interest • Recognizing notes

receivable • Valuing notes receivable • Disposing of notes

receivable

Accounts Receivable

• Recognizing accounts receivable

• Valuing accounts receivable

• Disposing of accounts receivable

Statement Presentation and Analysis

• Presentation • Analysis

The term receivables refers to amounts due from individuals and other companies. Receivables are claims that are expected to be collected in cash.They are frequently classified as (1) accounts receivable, (2) notes re- ceivable, and (3) other receivables.

Accounts receivable are amounts owed by customers on account. They result from the sale of goods and services. Companies generally expect to collect these re- ceivables within 30 to 60 days. Accounts receivable are the most significant type of claim held by a company.

Notes receivable are claims for which formal instruments of credit are issued as proof of the debt. A note receivable normally extends for time periods of 60–90

days or longer and requires the debtor to pay interest. Notes and ac- counts receivable that result from sales transactions are often called trade receivables.

Other receivables include nontrade receivables. Examples are interest receivable, loans to company officers, advances to employees, and income taxes refundable. These do not generally result from the operations of the business. Therefore companies generally classify and report them as sepa- rate items in the balance sheet.

Identify the different types of receivables.

S T U D Y O B J E C T I V E 1

E T H I C S N O T E

Companies report receiv- ables from employees separately in the financial statements. The reason: Sometimes those assets are not the result of an ”arm’s- length” transaction.

ACCOUNTS RECEIVABLE

Three accounting issues associated with accounts receivable are:

1. Recognizing accounts receivable. 2. Valuing accounts receivable. 3. Disposing of accounts receivable.

JWCL165_c08_356-395.qxd 8/4/09 7:21 PM Page 358

Recognizing Accounts Receivable Recognizing accounts receivable is relatively straightforward. In Chapter 5 we saw how the sale of merchandise affects accounts receivable.To review, assume that Jordache Co. on July 1, 2010, sells merchandise on account to Polo Company for $1,000 terms 2/10, n/30. On July 5, Polo returns mer- chandise worth $100 to Jordache Co. On July 11, Jordache receives payment from Polo Company for the balance due.The journal entries to record these transactions on the books of Jordache Co. are as follows.

Accounts Receivable 359

Explain how companies recognize accounts receivable.

S T U D Y O B J E C T I V E 2

H E L P F U L H I N T These entries are the same as those described in Chapter 5. For sim- plicity, we have omitted inventory and cost of goods sold from this set of journal entries and from end-of-chapter material.

July 1 Accounts Receivable—Polo Company 1,000 Sales 1,000

(To record sales on account)

July 5 Sales Returns and Allowances 100 Accounts Receivable—Polo Company 100

(To record merchandise returned)

July 11 Cash ($900�$18) 882 Sales Discounts ($900 � .02) 18

Accounts Receivable—Polo Company 900 (To record collection of accounts receivable)

The opportunity to receive a cash discount usually occurs when a manufacturer sells to a wholesaler or a wholesaler sells to a retailer.The selling company gives a discount in these situations either to encourage prompt payment or for competitive reasons.

Retailers rarely grant cash discounts to customers. In fact, when you use a retailer’s credit card (Sears, for example), instead of giving a dis- count, the retailer charges interest on the balance due if not paid within a specified period (usually 25–30 days).

To illustrate, assume that you use your JCPenney credit card to pur- chase clothing with a sales price of $300. JC Penney will make the follow- ing entry at the date of sale.

Accounts Receivable 300 Sales 300

(To record sale of merchandise)

JCPenney will send you a monthly statement of this transaction and any others that have occurred during the month. If you do not pay in full within 30 days, JCPenney adds an interest (financing) charge to the balance due. Although inter- est rates vary by region and over time, a common rate for retailers is 18% per year (1.5% per month).

The seller recognizes interest revenue when it adds financing charges. Assuming that you owe $300 at the end of the month, and JCPenney charges 1.5% per month on the balance due, the adjusting entry to record interest revenue of $4.50 ($300 � 1.5%) is as follows.

Accounts Receivable 4.50 Interest Revenue 4.50

(To record interest on amount due)

Interest revenue is often substantial for many retailers.

E T H I C S N O T E

In exchange for lower interest rates, some companies have eliminated the 25-day grace period before finance charges kick in. Be sure you read the fine print in any credit agreement you sign.

Cash Flows no effect

A SEL� �

�300 �300 Rev

Cash Flows no effect

A SEL� �

�4.50 �4.50 Rev

JWCL165_c08_356-395.qxd 7/31/09 3:20 PM Page 359

Valuing Accounts Receivable Once companies record receivables in the accounts, the next question is: How should they report receivables in the financial statements? Companies report accounts receivable on the balance sheet as an asset. But determining the amount to report is sometimes difficult because some receivables will become uncollectible.

Each customer must satisfy the credit requirements of the seller before the credit sale is approved. Inevitably, though, some accounts receivable become un- collectible. 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 Debts 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 Debts Expense. Assume, for example, that on December 12 Warden Co. writes off as uncollectible M. E. Doran’s $200 balance. The entry is:

360 Chapter 8 Accounting for Receivables

Distinguish between the methods and bases companies use to value accounts receivable.

S T U D Y O B J E C T I V E 3

Dec. 12 Bad Debts Expense 200 Accounts Receivable—M. E. Doran 200

(To record write-off of M. E. Doran account)

Under this method, Bad Debts Expense will show only actual losses from un- collectibles. The company will report accounts receivable at its gross amount.

Although this method is simple, its use can reduce the usefulness of both the in- come statement and balance sheet. Consider the following example. Assume that in 2011, Quick Buck Computer Company decided it could increase its revenues by offering computers to college students without requiring any money down and with no credit-approval process. On campuses across the country it distributed one million computers with a selling price of $800 each. This increased Quick Buck’s revenues and receivables by $800 million. The promotion was a huge success! The 2011 balance sheet and income statement looked great. Unfortunately, during 2012, nearly 40% of the customers defaulted on their loans. This made the 2012 in- come statement and balance sheet look terrible. Illustration 8-1 shows the effect of these events on the financial statements if the direct write-off method is used.

Cash Flows no effect

A SEL� �

�200 Exp �200

Year 2011 Year 2012

Net income

Net income

Huge sales promotion. Sales increase dramatically.

Accounts receivable increases dramatically.

Customers default on loans. Bad debts expense increases dramatically.

Accounts receivable plummets.

Illustration 8-1 Effects of direct write-off method

JWCL165_c08_356-395.qxd 7/31/09 3:20 PM Page 360

Under the direct write-off method, companies often record bad debts expense in a period different from the period in which they record the revenue.The method does not attempt to match bad debts expense to sales revenues in the income state- ment. Nor does the direct write-off method show accounts receivable in the balance sheet at the amount the company actually expects to receive. Consequently, unless bad debts losses are insignificant, the direct write-off method is not acceptable for financial reporting purposes.

ALLOWANCE METHOD FOR UNCOLLECTIBLE ACCOUNTS The allowance method of accounting for bad debts involves estimating uncol- lectible accounts at the end of each period.This provides better matching on the in- come statement. It also ensures that companies state receivables on the balance sheet at their cash (net) realizable value. Cash (net) realizable value is the net amount the company expects to receive in cash. It excludes amounts that the com- pany estimates it will not collect. Thus, this method reduces receivables in the bal- ance sheet by the amount of estimated uncollectible receivables.

GAAP 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 esti- mated expense against revenues in the same accounting period in which they record the revenues.

2. Companies debit estimated uncollectibles to Bad Debts 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 Hampson Furniture has credit sales of $1,200,000 in 2011. Of this amount, $200,000 remains uncollected at December 31. The credit manager esti- mates that $12,000 of these sales will be uncollectible.The adjusting entry to record the estimated uncollectibles is:

Accounts Receivable 361

Dec. 31 Bad Debts Expense 12,000 Allowance for Doubtful Accounts 12,000

(To record estimate of uncollectible accounts)

Hampson reports Bad Debts Expense in the income statement as an operating ex- pense (usually as a selling expense).Thus, the estimated uncollectibles are matched with sales in 2011. Hampson records the expense in the same year it made the sales.

As Illustration 8-2 shows, the company deducts the allowance account from ac- counts receivable in the current assets section of the balance sheet.

H E L P F U L H I N T In this context, material means significant or important to financial statement users.

Cash Flows no effect

A SEL� �

�12,000 Exp �12,000

HAMPSON FURNITURE Balance Sheet (partial)

Current assets Cash $ 14,800 Accounts receivable $200,000 Less: Allowance for doubtful accounts 12,000 188,000 Merchandise inventory 310,000 Prepaid expense 25,000

Total current assets $537,800

Illustration 8-2 Presentation of allowance for doubtful accounts

JWCL165_c08_356-395.qxd 7/31/09 3:20 PM Page 361

Allowance for Doubtful Accounts shows the estimated amount of claims on cus- tomers that the company expects will become uncollectible in the future. 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 ac- count will absorb the specific write-offs when they occur.The amount of $188,000 in Illustration 8-2 represents the expected cash 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. As described in the Feature Story, companies use various methods of collecting past-due accounts, such as letters, calls, and legal action. When they 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 prevent premature or unautho- rized write-offs, management should formally approve, in writing, each write-off. To maintain good internal control, companies should not give authorization to write off accounts to someone who also has daily responsibilities related to cash or receivables.

To illustrate a receivables write-off, assume that the financial vice president of Hampson Furniture authorizes a write-off of the $500 balance owed by R.A.Ware on March 1, 2012. The entry to record the write-off is:

362 Chapter 8 Accounting for Receivables

Illustration 8-3 General ledger balances after write-off

Illustration 8-4 Cash realizable value comparison

Accounts Receivable Allowance for Doubtful Accounts

Jan. 1 Bal. 200,000 Mar. 1 500 Mar. 1 500 Jan. 1 Bal. 12,000

Mar. 1 Bal. 199,500 Mar. 1 Bal. 11,500

Before Write-Off After Write-Off

Accounts receivable $200,000 $199,500 Allowance for doubtful accounts 12,000 11,500

Cash realizable value $188,000 $188,000

Mar. 1 Allowance for Doubtful Accounts 500 Accounts Receivable—R. A. Ware 500

(Write-off of R. A. Ware account)

Bad Debts 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 Debts Expense. A debit to Bad Debts 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 the Allowance for Doubtful Accounts. After posting, the general ledger accounts will appear as in Illustration 8-3.

A write-off affects only balance sheet accounts—not income statement accounts. The write-off of the account reduces both Accounts Receivable and Allowance for Doubtful Accounts. Cash realizable value in the balance sheet, therefore, remains the same, as Illustration 8-4 shows.

Cash Flows no effect

A SEL� �

�500 �500

H E L P F U L H I N T Cash realizable value is sometimes referred to as accounts receivable (net).

JWCL165_c08_356-395.qxd 7/31/09 3:20 PM Page 362

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, R. A. Ware pays the $500 amount that Hampson had written off on March 1. These are the entries:

Accounts Receivable 363

(1) July 1 Accounts Receivable—R. A. Ware 500

Allowance for Doubtful Accounts 500 (To reverse write-off of R. A. Ware account)

(2) July 1 Cash 500

Accounts Receivable—R. A. Ware 500 (To record collection from R. A. Ware)

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 $500. Accounts Receivable and the Allowance for Doubtful Accounts both increase in entry (1) for two reasons: First, the company made an error in judgment when it wrote off the account receivable. Second, after R. A. Ware did pay, Accounts Receivable in the general ledger and Ware’s account in the subsidiary ledger should show the collec- tion for possible future credit purposes.

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 cash realizable value of the accounts receivable on the other. The choice is whether to emphasize income statement or balance sheet relationships. Illustration 8-5 compares the two bases.

The percentage-of-sales basis results in a better matching of expenses with revenues—an income statement viewpoint. The percentage-of-receivables basis

Percentage of Sales

Matching

Sales Bad Debts Expense

Percentage of Receivables

Cash Realizable Value

Accounts Receivable

Allowance for

Doubtful Accounts

Emphasis on Income Statement Relationships

Emphasis on Balance Sheet Relationships

Illustration 8-5 Comparison of bases for estimating uncollectibles

Cash Flows no effect

A SEL� �

�500 �500

Cash Flows �500

A SEL� �

�500 �500

JWCL165_c08_356-395.qxd 7/31/09 3:20 PM Page 363

produces the better estimate of cash realizable value—a balance sheet viewpoint. Under both bases, the company must determine its past experience with bad debt losses.

Percentage-of-Sales. In the percentage-of-sales basis, management esti- mates 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% of net credit sales will become uncollectible. If net credit sales for 2011 are $800,000, the estimated bad debts expense is $8,000 (1% � $800,000). The adjusting entry is:

364 Chapter 8 Accounting for Receivables

Dec. 31 Bad Debts Expense 8,000 Allowance for Doubtful Accounts 8,000

(To record estimated bad debts for year)

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:

This basis of estimating uncollectibles emphasizes the matching of expenses with revenues. As a result, Bad Debts Expense will show a direct percentage rela- tionship to the sales base on which it is computed. When the company makes the adjusting entry, it disregards the existing balance in Allowance for Doubtful Accounts. The adjusted balance in this account should be a reasonable approxi- mation of the realizable value of the receivables. If actual write-offs differ signifi- cantly from the amount estimated, the company should modify the percentage for future years.

Percentage-of-Receivables. Under the percentage-of-receivables basis, management estimates what percentage of receivables will result in losses from uncollectible accounts. The company prepares an aging schedule, in which it classifies customer balances by the length of time they have been unpaid. Because of its emphasis on time, the analysis is often called aging the accounts receivable. In the opening story, Whitehall-Robins prepared an aging report daily.

After the company arranges the accounts by age, it determines the expected bad debt losses. It applies percentages based on past experience to the totals in each category.The longer a receivable is past due, the less likely it is to be collected. Thus, the estimated percentage of uncollectible debts increases as the number of days past due increases. Illustration 8-7 shows an aging schedule for Dart Company. Note that the estimated percentage uncollectible increases from 2 to 40% as the number of days past due increases.

Bad Debts Expense Allowance for Doubtful Accounts

Dec. 31 Adj. 8,000 Jan. 1 Bal. 1,723 Dec. 31 Adj. 8,000

Dec. 31 Bal. 9,723

Illustration 8-6 Bad debts accounts after posting

Cash Flows no effect

A SEL� �

�8,000 Exp �8,000

JWCL165_c08_356-395.qxd 7/31/09 3:20 PM Page 364

Total estimated bad debts for Dart Company ($2,228) represent the amount of existing customer claims the company expects will become uncollectible in the future. This amount represents the required balance in Allowance for Doubtful Accounts at the balance sheet date. The amount of the bad debt adjusting entry is the difference between the required balance and the existing balance in the allowance account. If the trial balance shows Allowance for Doubtful Accounts with a credit balance of $528, the company will make an adjusting entry for $1,700 ($2,228 � $528), as shown here.

Accounts Receivable 365

Worksheet.xls

File Edit View Insert Format Tools Data Window Help

A B C D E F G

Number of Days Past Due1 2 3 4 5 6 7 8 9 10

11

12

13

Customer Total Not

Yet Due 1–30 31–60 61–90 Over 90TotalCustomer T. E. Adert R. C. Bortz B. A. Carl O. L. Diker T. O. Ebbet

Total Estimated Bad Debts $ 540

Others

Estimated Percentage Uncollectible 2%

$ 300

500

26,200

$ 2,228

$ 600

450 300

700 600

36,950 $39,600

$ 100

300 1,500

$1,900

$ 200

200

1,600 $2,000

$ 250

300 2,450

$3,000

$ 300

200

5,200 $5,700$27,000

$ 228

4%

$ 300

10%

$ 400

20%

$ 760

40%

Illustration 8-7 Aging schedule

H E L P F U L H I N T The older categories have higher percentages because the longer an account is past due, the less likely it is to be collected.

Dec. 31 Bad Debts Expense 1,700 Allowance for Doubtful Accounts 1,700

(To adjust allowance account to total estimated uncollectibles)

After the adjusting entry is posted, the accounts of the Dart Company will show:

Occasionally the allowance account will have a debit balance prior to adjustment. This occurs when write-offs during the year have exceeded previous provisions for bad debts. In such a case the company adds the debit balance to the required balance when it makes the adjusting entry. Thus, if there had been a $500 debit balance in the allowance account before adjustment, the adjusting entry would have been for $2,728 ($2,228 � $500) to arrive at a credit balance of $2,228. The percentage-of-receivables basis will normally result in the better approximation of cash realizable value.

Bad Debts Expense Allowance for Doubtful Accounts

Dec. 31 Adj. 1,700 Bal. 528 Dec. 31 Adj. 1,700

Bal. 2,228

Illustration 8-8 Bad debts accounts after posting

Cash Flows no effect

A SEL� �

�1,700 Exp �1,700

JWCL165_c08_356-395.qxd 8/4/09 7:21 PM Page 365

before you go on...

366 Chapter 8 Accounting for Receivables

When would it be appropriate for a company to lower its allowance for doubtful accounts as a percentage of its receivables?

I N V E S T O R I N S I G H T When Investors Ignore Warning Signs

At one time, Nortel Networks announced that half of its previous year’s earnings were ”fake.” Should investors have seen this coming? Well, there were issues in its annual report that should at least have caused investors to ask questions. The company had cut its al- lowance for doubtful accounts on all receivables from $1,253 million to $544 million, even though its total balance of receivables remained relatively unchanged.

This reduction in bad debts expense was responsible for a very large part of the company’s earnings that year. At the time it was unclear whether Nortel might have set the reserves too high originally and needed to reduce them, or whether it slashed the allowance to artificially boost earnings. But one thing is certain—when a company makes an accounting change of this magnitude, investors need to ask questions.

Source: Jonathan Weil, “Outside Audit: At Nortel, Warning Signs Existed Months Ago,” Wall Street Journal, May 18, 2004, p. C3.

Do it! Brule Co. has been in business five years. The ledger at the end of the current

year shows:

Accounts Receivable $30,000 Dr. Sales $180,000 Cr. Allowance for Doubtful Accounts $2,000 Dr.

Bad debts are estimated to be 10% of receivables. Prepare the entry to adjust the Allowance for Doubtful Accounts.

Solution

Uncollectible Accounts Receivable

The following entry should be made to bring the balance in the Allowance for Doubtful Accounts up to a balance of $3,000 (0.1 � $30,000):

Bad Debts Expense [(0.1 � $30,000) � $2,000] 5,000 Allowance for Doubtful Accounts 5,000

(To record estimate of uncollectible accounts)

Related exercise material: BE8-3, BE8-4, BE8-5, BE8-6, BE8-7, E8-3, E8-4, E8-5, E8-6, and 8-1.Do it!

The Navigator✓

Action Plan

• Report receivables at their cash (net) realizable value.

• Estimate the amount the company does not expect to collect.

• Consider the existing balance in the allowance account when using the percentage- of-receivables basis.

Disposing of Accounts Receivable In the normal course of events, companies collect accounts receivable in cash and remove the receivables from the books. However, as credit sales and receivables have grown in significance, the “normal course of events” has changed. Companies now frequently sell their receivables to another company for cash, thereby shortening the cash-to-cash operating cycle.

Describe the entries to record the disposition of accounts receivable.

S T U D Y O B J E C T I V E 4

JWCL165_c08_356-395.qxd 8/4/09 7:21 PM Page 366

Companies sell receivables for two major reasons. First, they may be the only reasonable source of cash. When money is tight, companies may not be able to borrow money in the usual credit markets. Or, if money is available, the cost of borrowing may be prohibitive.

A second reason for selling receivables is that billing and collection are often time- consuming and costly. It is often easier for a retailer to sell the receivables to another party with expertise in billing and collection matters. Credit card companies such as MasterCard,Visa, and Discover specialize in billing and collecting accounts receivable.

SALE OF RECEIVABLES A common sale of receivables is a sale to a factor.A factor is a finance company or bank that buys receivables from businesses and then collects the payments directly from the customers. Factoring is a multibillion dollar business.

Factoring arrangements vary widely. Typically the factor charges a commission to the company that is selling the receivables. This fee ranges from 1–3% of the amount of receivables purchased. To illustrate, assume that Hendredon Furniture factors $600,000 of receivables to Federal Factors. Federal Factors assesses a ser- vice charge of 2% of the amount of receivables sold. The journal entry to record the sale by Hendredon Furniture is as follows.

Accounts Receivable 367

Cash 588,000 Service Charge Expense (2% � $600,000) 12,000

Accounts Receivable 600,000 (To record the sale of accounts receivable)

If the company often sells its receivables, it records the service charge expense (such as that incurred by Hendredon) as selling expense. If the company infre- quently sells receivables, it may report this amount in the “Other expenses and losses” section of the income statement.

Cash Flows �588,000

A SEL� �

�588,000 �12,000 Exp

�600,000

How Does a Credit Card Work?

Most of you know how to use a credit card, but do you know what happens in the transaction and how the transaction is processed? Suppose that you use a

Visa card to purchase some new ties at Nordstrom. The salesperson swipes your card, and the swiping machine reads the information on the magnetic strip on the back of the card. The salesperson then types in the amount of the purchase. The machine contacts the Visa com- puter, which routes the call back to the bank that issued your Visa card. The issuing bank verifies that the account exists, that the card is not stolen, and that you have not exceeded your credit limit. At this point, the slip is printed, which you sign.

Visa acts as the clearing agent for the transaction. It transfers funds from the issuing bank to Nordstrom’s bank account. Generally this transfer of funds, from sale to the receipt of funds in the merchant’s account, takes two to three days.

In the meantime, Visa puts a pending charge on your account for the amount of the tie purchase; that amount counts immediately against your available credit limit. At the end of the billing period, Visa sends you an invoice (your credit card bill) which shows the various charges you made, and the amounts that Visa expended on your behalf, for the month. You then must “pay the piper” for your stylish new ties.

Assume that Nordstrom prepares a bank reconciliation at the end of each month. If some credit card sales have not been processed by the bank, how should Nordstrom

treat these transactions on its bank reconciliation?

ACCOUNTING ACROSS THE ORGANIZATION

JWCL165_c08_356-395.qxd 7/31/09 3:20 PM Page 367

368 Chapter 8 Accounting for Receivables

Issuer maintains customer accounts

Issuer does credit investigation of customer

Credit card issuer