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Accounting Chapter 5: Internal Control, Cash and Receivables 1. Accounts & Notes Reveivable
Accounting Chapter 5: Internal Control, Cash and Receivables 1. Accounts & Notes Reveivable
• BENEFIT: customers who cannot pay cash immediately can still buy on credit sales and profits
increase
• COST: some customers do not pay their debt uncollectible-account expense (doubtful-
account expense / bad-debt expense / impairment of receivables expense): operating expense
along with salaries, depreciation, rent and utilities
1. BALANCE SHEET: Measure and report receivables on the balance sheet at their net carrying
amount, the amount we expect to collect debt receivables, credit (less) allowance for
uncollectibles
2. INCOME STATEMENT: Measure and report the expense associated with failure to collect
receivables sales revenue – uncollectible debt expense
ALLOWANCE METHOD
To measure uncollectible-account expense, accountants use the allowance method or, in certain
limited cases, the direct write-off method
IAS 39 – Financial Instruments: recognition and measurement stipulates that loans and
receivables are impaired if there is objective evidence of impairments as a result of one or more
“loss events” that occurred after their initial recognition
the allowance method thus records collection losses based on estimates developed from the
company’s collection experience and information about debtors
a firm records an estimated amount of uncollectible expenses and sets up an Allowance for
uncollectible receivables account (Allowance for doubtful receivables / Allowance for receivables
impairment): contra account to accounts receivable, shows the amount of the receivables the
business expects not to collect how much of the receivable is unlikely to be collected
• simplifies version lists the status or age of the receivables for the receivables, typically classified
into age groups (such as ‘Not yet due’, ‘1-30 days due’) and assigns a percentage of not being
able to collect it to each group determines the allowance for each age group vertically & then
adds up the totals of these allowances which will be what the business will need to provide at the
year-end
• the total amount of allowance calculation depends on the age groups and the individual
percentage uncollectible assigned to each age group
• limitation: only determines vertically but not horizontally, does not consider that one specific
customer could default and all his payments (in each group) would be impaired a combination
of aging and specific customer information may be used
Firm realises it cannot collect from Fiesta & Stop-N-Shop and writes off the receivables from the
customers with the following entry (beginning balances of the customers’ accounts receivable were:
fiesta – 9 and stop n shop – 3):
the receivables are reduced because it is now clear that these amounts will not be collected and
the allowance previously set aside is now used by the write off
the write-off of uncollectibles has no effect on the firm’s total assets, current assets or net
accounts receivables
net income is unaffected because the write-off affects no expense account, it is merely a
realisation of the allowance of uncollectible receivables that has been provided in previous
accounting periods
• sometimes, accounts that have been written off may be partially recovered may take place
after liquidation of the customer’s business and can be treated in one of two ways:
• considered as a defective method and thus not an accepted accounting practice for financial
statements as it fails to take into account the possibility of impairment of receivables at balance
sheet date result: receivables are always reported at their full amount (which is more than the
business expects to collect) assets on the balance sheet may be overstated
• sometimes used for tax purposes
3. NOTES RECEIVABLE
Long-term receivables: notes due beyond one year, reported as long-term assets
TERMS
Creditor: the party to whom money is owed, also called the lender – has a note receivable
Debtor: the party that borrowed and owes money on the note, also called the maker of the note or
the borrower – has a note payable
Interest: the cost of borrowing money, stated as an annual percentage rate – revenue to the creditor
Maturity date: date on which the debtor must pay the note
Maturity value: sum of principal and interest on the note payable on maturity
Principal: amount of money borrowed by the debtor
Term: length of time from when the note was signed by the debtor to when the debtor must pay the
note
1. interest rates are always for an annual period unless stated otherwise
2. the time element is the fraction of the year that the note has been in force during the day it was
given
3. interest is often computed for a number of days (x/365)
• sometimes firms sell goods on notes receivables instead of accounts receivables when the
payment term extends beyond the customary accounts receivables period of 30 to 60 days
• firm may also accept a note receivable from a trade customer whose account receivable is past
due then debits Notes Receivable and credits Accounts Receivable which is called “received a
note receivable on account”
• letting a customer pay with a credit card: may increase sales but it comes at a cost typically about
2% to 3% of the total amount of the sale
• the factor earns revenue by paying a discounted price for the receivable and then hopefully
collecting the full amount later
• benefit: immediate receipt of cash, disadvantage: often quite expensive, company that factors its
receivables may lose control over the collection process and yet be responsible for any bad debts
that may arise after the factoring
• high financing costs & thus mostly only used by start-ups who have insufficient credit history to
obtain bank loans at reasonable costs not used by firms who get good loans or can afford to
wait
• example of a firm selling receivables:
CURRENT RATIO
CURRENT RATIO=TOTAL CURRENT ASSETS /TOTAL CURRENT LIABILITIES
Current ratio: divides total current assets by total current liabilities and measures the firm’s ability to
pay current liabilities with current assets
rule of thumb: strong ratio is 1.5 (has $1.50 in current assets for every $1.00 of current liabilities)
less than 1.00 is considered low but it has to be seen in the context of the business operations
and cash flows
any ratio is meaningless unless you give it a context (compare with firms in the same industry etc)
RECEIVABLE TURNOVER & COLLECTION PERIOD
Receivable collection period: tells a company how long it takes to collect its average level of
receivables, also called the days’sales in receivables or days sales outstanding
1. calculate the receivables turnover (number of times average receivables are converted into
cash in a year):
Sales Revenue
Average Receivables
2. convert this number of times into days by dividing 365 by the receivable turnover