RECEIVABLES
1. Accounts receivable are normally presented just
below cash and short-term marketable
securities in the
current assets section of the balance sheet, but they are noncurrent if
they will not be
collected within the longer of 1 year or the entity’s normal operating cycle.
Accounts
receivable are recorded for credit transactions when title passes in sales of
goods
or when services
are performed. The balance sheet
measurement is based on the net
realizable value
(NRV) of the receivables. NRV for short-term receivables equals the
cash
to be received
minus direct costs (e.g., bad debts). An
adjustment for the time value of
money (present
value) is normally not made for
accounts receivable or other short-term
receivables
because the effect is deemed to be immaterial.
a. The net method records receivables net of the applicable cash (sales) discount
allowed for early
payment. If the payment is not
received during the discount period,
an interest revenue
account, such as sales discounts forfeited, is credited at the end
of the discount
period or when the payment is received.
b. The gross method accounts for receivables at their face amount. If a cash (sales)
discount is
taken, it is recorded and classified as an offset to sales in the income
statement to
yield net sales.
c. Receivables from
officers and owners are assets and should be presented in the
balance sheet as
assets, not as offsets to equity. Those
receivables that arise from
normal business
operations are trade receivables. Those that do not, such as
receivables from
officers and owners, are nontrade receivables.
discounts are
allowed for early payment, trade discounts are used to determine
prices,
especially to differentiate alternative prices among different classes of
buyers.
An item with a
list price of $1,000 might be subject to a 40% trade discount. $400 is
deducted from the
list price in arriving at the actual selling price of $600. Only the
$600 is recorded. The accounts do not reflect trade
discounts. Some sellers will
offer chain-trade
discounts, such as 40%, 10%, which means certain classes of
buyers receive
both a 40% discount and a 10% discount. In
this example, the $600
would be further
reduced by another $60 to bring the actual selling price down to
$540. All journal entries on the buyer’s and
seller’s books would be for $540 with no
indication of the
original list price or the discount. In
summary, trade discounts are
nothing more than
a means of calculating the sales price; they are not recorded.
Bad Debts. There are two approaches to bad debts: the direct write-off method and the
allowance method.
a. The direct write-off method
expenses bad debts as uncollectible when they are
determined to be
uncollectible. The direct write-off
method is subject to manipulation
because timing is
at the discretion of management. It
is not acceptable under
GAAP.
b. The allowance method matches bad debt expense with the related revenue and
determines the
NRV of the accounts receivable. It
records bad debt expense
systematically as
a percentage of either sales or the level of accounts receivable on
an annual basis. The allowance method is acceptable under
GAAP.
1) The credit is to
an allowance account (contra to accounts receivable).
2) As accounts
receivable are written off, they are charged to the allowance
account. The write-off of a bad debt has no effect
on working capital or total
assets because
the asset account (accounts receivable) and the contra account
are reduced by
equal amounts.
3) If bad debt
expense is computed as a percentage of sales (e.g., 1% of sales),
bad debts are
considered a function of sales on account. This
is an
income-statement approach. The amount calculated is debited to an
expense account.
4) If the allowance
is adjusted to reflect a percentage of accounts receivable (e.g.,
10% at year-end),
bad debt expense is a function of both sales and collections.
This is a balance-sheet approach.
a) A common and more
sophisticated balance-sheet method of estimating
bad debt expense
is to develop an analysis of accounts receivable known
as an aging schedule. Stratifying
the receivables according to the time
they have been
outstanding permits the use of different percentages for
each category. The result should be a more accurate
estimate than if a
single rate is
used.
b) Under the
balance-sheet approach, the amount calculated is the desired
ending balance in
the allowance account. The
adjustment to reach that
balance
is bad debtexpense.
c) In the event of
the collection of a written-off account, the first entry is to
reestablish the
account by debiting accounts receivable and crediting the
allowance (or
uncollectible accounts recovered, a revenue account used
when the direct
write-off method is applied.) The
second entry is to debit
cash and credit
accounts receivable for the amount recovered.
d) EXAMPLE: A company has the following account
balances at year-end:
Sales on credit $500,000 (Credit balance)
Accounts
receivable 100,000 (Debit balance)
Allowance for
uncollectibles 1,600 (Debit balance)
1) Based on its
experience, the company expects bad debts to average
2% of sales (an
income-statement approach). Hence,
the
estimated expense
is $10,000 (2% × $500,000). The
year-end
adjusting journal
entry is
Bad debt expense $10,000
Allowance for
uncollectibles $10,000
a) Because the
allowance account previously had a debit
balance, the new
credit balance is $8,400. The
balance sheet
presentation is
Accounts
receivable $100,000
Minus: allowance for uncollectibles (8,400)
Net realizable
value $ 91,600
2) If the company
adopts a balance-sheet approach and estimates that
bad debts will be
10% of receivables, the calculation is to multiply
10% times the
$100,000 of receivables. The result
is an ending
credit balance in
the allowance account of $10,000. The
adjusting
entry given an
initial debit balance of $1,600 is
Bad debt expense $11,600
Allowance for
uncollectibles $11,600
a) The balance sheet
presentation is
Accounts
receivable $100,000
Minus: allowance for uncollectibles (10,000)
Net realizable
value $ 90,000
EXAMPLE: When an account is to be written off,
perhaps because a
customer has
filed for bankruptcy or cannot be located, the bad debt is
debited to the
allowance account. For example, if a
company has
$100,000 in
accounts receivable and a $10,000 credit in its allowance
account, the NRV
of the receivables is $90,000. If a
$300 account is
deemed
uncollectible, the entry to record the write-off is
Allowance for
uncollectibles $300
Accounts
receivable $300
1) After the
write-off, the allowance account is reduced to $9,700, and
the accounts receivable
account is reduced to $99,700. However,
the NRV is
unchanged at $90,000.
2) If the customer
subsequently pays or proceeds are received from a
bankruptcy
trustee, the first entry is to reverse the write-off entry.
Next, the cash
collected is recorded in the normal manner:
Accounts
receivable $300
Allowance for
uncollectibles $300
Cash $300
Accounts
receivable $300
a) The net effect of
these entries is to return the $300 to the
allowance account
to absorb future write-offs. The
assumption is
that the original write-off entry was in error and
that another
account(s) is (are) uncollectible.
3. Sales Returns
and Allowances. A provision
must be made for the return of merchandise
because of
product defects, customer dissatisfaction, etc.
a. If returns are
immaterial, the usual accounting is to debit sales returns and allowances
(a contra-revenue
account) and credit accounts receivable at the time of the
adjustment. Tax law does not permit this method.
1) If the amounts
are material, however, this method will be inconsistent with the
matching
principle when the sale and the return or other adjustment occur in
different
periods. Accordingly, an allowance
should be established at the end
of the period for
material estimated sales returns.
4. Costs of Collection
and Freight Charges. The expenses of collecting receivables,
such
as legal fees,
may be accounted for using the allowance method. Freight charges paid by
customers and
deducted from their remittances may also be accounted for by accruing an
expense and an
allowance if receivables and sales are recorded at the gross amounts
billed.
a. Thus, collection
expense or transportation-out (freight-out) is debited and an allowance
is credited in an
adjusting entry at the end of a period. The
allowance is deducted
from receivables
on the balance sheets.
1) Tax law does not
permit accrual of collection costs and freight charges. If these
amounts are
immaterial or are stable from period to period, recording at the
time of sale is acceptable
under GAAP. Most companies choose
this
approach.
Finance charges
may be imposed for late payment.
a. For example,
payment within 30 days of a receivable with terms of net 30 incurs no
interest charge. Payment beyond the agreed period, however,
will be subject to
interest charges.
b. Finance charges
are added to receivable balances with appropriate credits to the
allowance for bad
debts accounts and a revenue account.
1) Finance charges
on overdue accounts may not be collected if the underlying
account is
uncollectible.
Notes Receivable
a. A note receivable
is documented by a promissory note, which is a two-party
negotiable
instrument. It must be in writing,
be signed by the maker (the promisor),
and contain an
unconditional promise to pay a fixed amount of money to the payee at
a definite time.
b. Discounting notes
receivable. When a note receivable is discounted (usually at a
bank), the holder
is borrowing the maturity amount (principal + interest at maturity) of
the note. The bank usually collects the maturity
amount from the maker of the note.
1) Thus, the steps
in discounting are to
a) Compute the
maturity amount.
b) Compute the
interest on the loan from the bank (the bank’s interest rate ×
the maturity
amount of the note × the discount period).
c) Subtract the bank’s
interest charges from the maturity amount to determine
the loan
proceeds.
2) The entries to
record the transaction are
Cash $(amount received
from the bank)
Interest expense
or revenue (the difference dr or cr)
Notes receivable $(carrying
amount)
3) The discounted
note receivable must be disclosed as a contingent
liability. If
the maker
dishonors the note, the bank will collect from the person or entity that
discounted the
note. Alternatively, the credit in
the previous entry is sometimes
made to notes receivable discounted, a
contra-asset account.
4) When computing
yearly interest, the day the note is received, made, etc., is not
included, but the
last day of the note is counted.
a) EXAMPLE: A 30-day note dated January 17 matures on
February 16.
There are 14 days
(31 – 17) left in January, and 16 days must be counted
in February for a
30-day note. Accordingly, the
maturity date is
February 16.
Long-term notes
receivable should be recorded at
their present value using standard
time-value-of-money
tables. Thus, interest-bearing notes
are recorded at the sum of
the present
values of the future payments discounted at the effective (usually the
market) rate. The result may require recognition and
amortization of discount or
premium using the effective interest method.
Noninterest-bearing notes.
A note may bear no explicit interest because interest is
included in its
maturity amount. The entry is to
debit notes receivable for the face
amount, credit
sales or another appropriate account, and credit a discount. The
discount is
amortized to interest revenue. An
alternative is to debit notes receivable
at the note’s
present value. Subsequent accruals
of interest are debited to notes
receivable.
1) Under APB 21, Interest on Receivables and Payables, when the note arises in
the ordinary
course of business and is “due in customary trade terms not
exceeding
approximately 1 year,” the interest element need not be recognized.
However, APB 21
still requires that discount or premium recorded as a direct
subtraction from
or addition to the face amount, respectively, still apply.
2) Under APB 21,
when a note is exchanged solely for cash, and no other
right
or privilege is
exchanged, the proceeds are assumed to reflect the present
value of the
note, and the effective interest rate is therefore the interest rate
implicit in that
present value. Periodic interest
will equal the nominal interest
adjusted for
amortization of any premium or discount.
3) The term “noninterest-bearing”
is confusing because it is used not only when a
note bears
implicit interest but also when no actual interest is charged (the cash
proceeds equal
the nominal amount). When a note is
noninterest-bearing in
the latter sense,
or when it bears interest at a rate that is unreasonable in the
circumstances,
APB 21 requires imputation (estimation) of an interest rate. An
imputed interest
rate should be distinguished from
the real or effective interest
rate determinable
from the stated rate (when reasonable); the fair value of the
note; or the fair
value of the property, goods, services, or other rights.
4) When a note is exchanged for property, goods, or services,
the interest rate
determined by the
parties in an arm’s-length transaction is presumed to be fair,
but that
presumption is overcome when no interest is stated, the stated rate is
unreasonable, or
the nominal amount of the note materially differs from the
cash price of the
item or the fair value of the note.
a) In these
circumstances, the transaction should be recorded at the more
clearly
determinable of the fair value of the property, goods, or services;
fair value of the
note; or discounted value of future payments based on an
imputed rate of
interest.
b) If the present
value of a note with no stated rate or an unreasonable rate
must be
determined by discounting future payments using an imputed
rate, the
prevailing rate for similar instruments of issuers with similar
credit ratings
normally helps determine the appropriate rate.
5) The stated rate
may be less than the effective (or imputed) rate because the
lender has
received other stated (or unstated) rights and privileges as part
of the bargain. The difference between the respective
present values of the
note computed at
the stated rate and at the effective or imputed rate should be
accounted for as
the cost of the rights or privileges obtained.
SFAS 140,
Accounting for Transfers and Servicing of Financial Assets and Extinguishments
of Liabilities,
adopts a financial-components approach based on control. After a transfer,
an entity
recognizes the assets it controls and the liabilities it has incurred,
derecognizes
the assets it no
longer controls, and derecognizes extinguished liabilities.
a. A transfer of
financial assets (or a portion of an asset) over which the transferor
surrenders
control is a sale to the extent that the consideration does not consist of a
beneficial interest
in the transferred assets. The
transferor surrenders control
when three
conditions are met:
1) The transferred
assets are isolated from the transferor. Thus,
they are
presumed to be
beyond the reach of the transferor and its creditors, even in
bankruptcy.
2) Each regular
transferee or holder of a beneficial interest in a qualifying
special-purpose
entity (SPE) that is itself a transferee (e.g., certain trusts) has a
right to pledge
or exchange the assets or interests received.
Moreover, no
such party is
subject to a condition that both constrains that right and provides
more than a
trivial benefit to the transferor.
3) The transferor
does not maintain effective control over the transferred assets
through
a) An agreement
entered into concurrently with the transfer that both entitles
and obligates the
transferor to repurchase or redeem substantially the
same assets on
substantially the agreed terms before their maturity and
at a fixed or
determinable price, or
b) The ability
unilaterally to cause the holder to return specific assets, except
through a cleanup
call (e.g., an option held by a servicer to repurchase
the transferred
assets if they fall to a level at which servicing costs are
burdensome
relative to benefits).
b. A transfer conveys a noncash financial
asset by and to a party other than its issuer,
including sale of
a receivable, its placement in a securitization trust, or its pledge as
collateral. A transfer excludes origination or
settlement of a receivable.
1) After any
transfer of financial assets, the transferor continues to recognize in the
balance sheet any
retained interest, such as a servicing asset, beneficial
interest in an
SPE resulting from a securitization, or an undivided interest.
a) A servicing asset is a contract under which future revenues from servicing
fees, late
charges, etc., are expected to more than adequately
compensate the
servicer. A servicing liability
arises when such
compensation is
inadequate.
b) An undivided interest is partial ownership as a tenant in common, for
example, the
right to the interest but not the principle of a security. This
interest also may
be pro rata, for example, a right to a proportion of the
interest payments
on a security.
2) Whether or not a
transfer is a sale, servicing assets and other retained interests
in the
transferred assets are measured by allocating the previous carrying
amount between
the assets sold and retained interests based on their relative
fair values at
the transfer date.
rate, the
prevailing rate for similar instruments of issuers with similar
credit ratings
normally helps determine the appropriate rate.
c. If a transfer of
financial assets qualifies as a sale,
the transferor
1) Derecognizes all
assets sold.
2) Recognizes all
assets obtained and liabilities incurred in consideration as
proceeds.
3) Initially
measures the assets obtained and liabilities incurred at fair value, if
practicable.
4) Recognizes any
gain or loss in earnings.
d. If a transfer of
financial assets qualifies as a sale,
the transferee initially recognizes
assets obtained
and liabilities incurred at fair value.
e. Transfers of
receivables with recourse. Whether the conditions for surrender of
control are met
may depend on the law in a given jurisdiction with regard to the effect
of the recourse
provision. If the conditions are
met, a transfer of receivables with
recourse is accounted
for as a sale, with the proceeds of the sale reduced by the fair
value of the
recourse obligation.
f. If the transfer
does not meet the criteria for a sale, the parties account for the transfer
as a secured borrowing with a pledge
of noncash collateral.
1) If the secured
party (the transferee) may sell or repledge the
collateral, the
debtor (the
transferor) reclassifies and separately reports that asset.
2) If the transferee
sells the collateral, it recognizes
the proceeds and a liability to
return the
collateral.
3) If the transferor
defaults, it derecognizes the
pledged asset, and the transferee
initially
recognizes an asset at fair value or derecognizes the liability to return
the collateral.
4) Thus, absent
default, the collateral is an asset of the transferor, not the
transferee.
g. A liability is NOT extinguished by an in-substance defeasance. Thus, it is
derecognized only
if the debtor
1) Pays the creditor
and is relieved of its obligation or
2) Is legally
released from being the primary obligor.
a) However, if the
release is on the condition that the original debtor become
secondarily
liable as a guarantor, a guarantee obligation should be
recognized at
fair value. This amount reduces the
gain or increases the
loss on the
extinguishment.
According to SFAS
140, factoring discounts receivables
on a nonrecourse notification
basis, so
payments will be made directly to the factor.
The receivables are sold outright,
usually to a
transferee (the factor) that assumes the full risk of collection, even in the
event
of a loss. When the factoring arrangement satisfies
the three conditions for surrender of
control, the
transaction is accounted for as a sale of financial assets to the extent that
no
beneficial
interest is retained.
a. The company
involved receives money that can be immediately reinvested into new
inventories. The company can offset the fee charged by
the factor by eliminating its
bad debts, credit
department, and accounts receivable staff.
b. The factor
usually receives a high financing fee (at least two points above prime), plus
a fee for doing
the collection. Furthermore, the
factor can often operate more
efficiently than
its clients because of the specialized nature of its services.
fair values at
the transfer date.
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