Accounting Chapter 5: Internal Control, Cash and Receivables

1. ACCOUNTS & NOTES REVEIVABLE

TYPES OF RECEIVABLES
Receivables: monetary claims against others acquired mainly by selling goods and services (accounts
receivable) and by lending money (notes receivable)

1) Accounts receivables (trade receivables, debtors, receivables): amounts collectible from

customers from the sale of goods & services
 When items are sold on account, the amount recognized as receivable is the fair value of the
consideration to be received
 classified as a current asset as it represents future economic benefits and can be measured
reliably through a contract, invoice, or some other form of sales document
 the accounts receivables account in the general ledger serves as a control account that
summarizes the total amount receivable from all customers
 companies also keep a subsidiary account with a separate account for each customer
2) Notes receivables (promissory notes): more formal contracts than accounts receivable, the
borrower signs a written promise to pay the lender a definite sum plus interest at a future date,
sometimes the borrower needs to pledge security for loan (means that the borrower gives the
lender permission to claim certain assets, called collateral, if the borrower fails to pay the
amount due)
3) Other receivables: various advances and loans to employees and other parties

INTERNAL CONTROL OVER CASH COLLECTIONS ON ACCOUNT

• cash-handling & cash-accounting duties must be separated
• best solution: using a bank lock box  customers send their cash directly to the company’s bank
which records the cash and the bank then forwards the remittance advice to the firm’s
bookkeeper who credits the customer account (takes away the liability)

2. ACCOUNTING FOR UNCOLLECTIBLE RECEIVABLES

Selling on credit creates both a benefit and a cost:

• 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

HOW TO ACCOUNT FOR UNCOLLECTIBLE-ACCOUNT EXPENSE

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

LOSS EVENTS THAT LEAD TO RECEIVABLES BEING IMPAIRED

• financial difficulty of a specific debtor including the possibility of bankruptcy

• breach of contract by a specific debtor such as default or inability to make interest and/or
principal payments
• adverse changes in the number of delayed payments by debtors in general
• national or local economic conditions that correlate with defaults by debtors in general

 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

METHOD FOR ESTIMATING UNCOLLECTIBLES – AGING OF RECEIVABLES

Aging-of-receivables method: balance-sheet approach because it focuses on what should be the
most relevant and faithful representation of accounts receivable as of the balance sheet date,
analyses individual receivables from specific customers based on how long they have been
outstanding

• 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

Net receivables: the amount a company expects to collect

 Beginning Allowance−Receivables Write Offs+ Bad debt Expense=Ending Allowance

WRITING OFF UNCOLLECTIBLE ACCOUNTS

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):

After the write off:

 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

ADJUSTING ENDING ALLOWANCE FOR DOUBTFUL RECEIVABLES

• end of 2017, firm has a beginning allowance of $20 less the write-off of $12 = $8 left
• estimation of an appropriate level of allowance for ending receivables ($200) = $30
 adjust the allowance for uncollectible receivables to the desired ending balance
 30€ new allowance – 8€ bad debt expense = 22€

RECOVERY OF PREVIOUSLY WRITTEN-OFF RECEIVABLES

• 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:

a) reversing the write-off entry

b) decreasing the bad debt expense by the amount recovered

DIRECT WRITE OFF METHOD

Direct write-off method: less preferable method to account for uncollectible receivables. The
company waits until a specific customer’s receivable proves uncollectible, then the accountant writes
off the customer’s account & records Uncollectible-Account expense

• 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

COMPUTING CASH COLLECTIONS FROM CUSTOMERS

• possible to compute a firm’s collections from customers by analysing its accounts receivable
account

• if X=collections is missing, you can easily solve with the formula

Beginning Receivabels+ Sales−WriteOffs−Collections=Ending Receivables

3. NOTES RECEIVABLE
Long-term receivables: notes due beyond one year, reported as long-term assets

 Notes receivable due within one year or less  current assets

• notes may be collected in instalments (firm holds 20,000 note receivable but only 6,000 is
current asset as it is what the customer pays in one year)

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

ACCOUNTING FOR NOTES RECEIVABLE

• when the creditor gives out a loan, the principal will be stated as debit and cash will be credited
 total assets will not change
• throughout the term, the creditor receives interest: debit interest receivable and credit interest
revenue (accrued interest revenue)  assets and revenues increase
• when the note is collected: debit cash (principal + interest) and credit note receivable (by the
principal), interest receivable and interest revenue zeroes out notes receivable and interest
receivable and record the interest revenue
• after transactions, the firm will only report interest revenue earned on the financial statements
 no note receivable or interest receivable will be reported on the balance sheet as those items
zero out when the note is collected at maturity

INTEREST COMPUTATION & EXECEPTIONS

PRINCIPAL * INTEREST RATE * TIME (months/12 or days/365) = AMOUNT OF INTEREST

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”

4. HOW TO SPEED UP CASH FLOW

 two common strategies generate cash quickly

CREDIT CARD OR BANKCARD SALES

• 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

SELLING (FACTORING) RECEIVABLES

Factoring: whenever a firm sells its accounts receivables to another business (called a factor)

• 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:

5. USING TWO KEY RATIOS TO MAKE DECISIONS

• often firms or banks must make an assessment about a company’s financial position (eg: to
decide whether a borrower can repay the loan)  decision makers use ratios

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

COMPUTED IN TWO STEPS:

1. calculate the receivables turnover (number of times average receivables are converted into
cash in a year):

Sales Revenue
Average Receivables

(Average Receivables = (Beginning + Ending Balances of Receivables)/ 2)

2. convert this number of times into days by dividing 365 by the receivable turnover