Accounts and Bills Receivable Chapter 8 HORNGREN HARRISON

Accounts and Bills Receivable Chapter 8 HORNGREN ♦ HARRISON ♦ BAMBER ♦ BEST ♦ FRASER ♦ WILLETT

Objectives 1. Design internal controls for receivables 2. Use the provision method to account for bad debts by the percentage of sales and aging of accounts method 3. Use the direct write off method to account for bad debts 4. Accounts for bills receivable 5. Report receivables on the financial statements 6. Use the acid-test ratio and days’ sales in receivables to evaluate a firms financial position Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4 e Copyright © 2004 Pearson Education Australia 8 -2

Receivables Accounts receivable (Trade receivables) Bills receivable (Notes receivable) Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4 e Copyright © 2004 Pearson Education Australia 8 -3

Objective 1 Design internal controls for receivables. Horngren ♦ Harrison ♦ Bamber ♦ Best

Establishing Internal Control l What are some controls over accounts receivable? Control over mail receipts Approval for write-off Separation of duties Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4 e Copyright © 2004 Pearson Education Australia 8 -5

The Credit Department Companies grant credit to customers in order to increase sales. l The credit department evaluates customers who apply for credit cards. l Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4 e Copyright © 2004 Pearson Education Australia 8 -6

Accounting for Bad Debts Provision method Direct write-off method Horngren ♦ Harrison ♦ Bamber

Objective 2 Use the provision method to account for bad debts by the percent of sales and aging of accounts method. Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4 e Copyright © 2004 Pearson Education Australia 8 -8

Methods for Estimating Bad Debts Percentage of Sales Aging of Accounts Receivable Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4 e Copyright © 2004 Pearson Education Australia 8 -9

Percentage of Sales This is also called the statement of financial performance approach. l It is based on prior experience of the business. l It is calculated as a percentage of credit sales. l It ignores the current balance of the provision account. l The percentage used is adjusted as needed to reflect collection experience. l Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4 e Copyright © 2004 Pearson Education Australia 8 - 10

Percentage of Sales Example The credit department of Anna’s Boutique estimates (based on prior experience) that 1% of net credit sales are uncollectible. l Net credit sales for the year just ended were $500, 000. l What is the adjusting entry? l $500, 000 × 1% = $5, 000 l Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4 e Copyright © 2004 Pearson Education Australia 8 - 11

Percentage of Sales Example June 30, 2004 Bad Debts Expense 5, 000 Provision for Bad debts 5, 000 Recorded bad debts expense for the year Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4 e Copyright © 2004 Pearson Education Australia 8 - 12

Percentage of Sales Example What is the effect of this adjusting entry? Decrease in Net Profits Decrease in net Accounts Receivable Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4 e Copyright © 2004 Pearson Education Australia 8 - 13

Aging of Accounts Receivable This approach is also called the statement of financial position approach because it focuses on accounts receivable. l Individual accounts receivable from specific customers are analysed according to the length of time they remain outstanding. l Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4 e Copyright © 2004 Pearson Education Australia 8 - 14

Aging of Receivables Example Assume that International Hospital’s past collection experience indicates the following: l Length of time % uncollectible 1 -30 days 2. 0 31 -60 days 3. 0 61 -90 days 5. 0 90 + days 8. 0 l Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4 e Copyright © 2004 Pearson Education Australia 8 - 15

Aging of Receivables Example Length 1 -30 31 -60 61 -90 90 + Total Amount $1, 900, 000 1, 000 700, 000 500, 000 $4, 100, 000 Accounts Receivable % 2 3 5 8 $ 38, 000 30, 000 35, 000 40, 000 $143, 000 Provision for Bad Debts Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4 e Copyright © 2004 Pearson Education Australia 8 - 16

Aging of Receivables Example The provision account is adjusted to this $143, 000 balance: l Assume that the account currently has a credit balance of $100, 000. l What is the adjustment? l Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4 e Copyright © 2004 Pearson Education Australia 8 - 17

Aging of Receivables June 30 Bad debts Expense Provision for Bad debts 43, 000 To record the provision for bad debts What if the account had a debit balance of $1, 000? Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4 e Copyright © 2004 Pearson Education Australia 8 - 18

Aging of Receivables Provision for Bad Debts Adjustment 1, 000 144, 000 Adjusted balance 143, 000 Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4 e Copyright © 2004 Pearson Education Australia 8 - 19

Comparing the Percentage of Sales and Aging Methods Provision Method Percent of Sales Method Aging of Accounts Receivable Method Adjusts Provision For Bad debts Adjusts Provision For Bad Debts BY TO Amount of BAD DEBTS EXPENSE EXPECTED UNCOLLECTABLE ACCOUNTS RECEIVABLE Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4 e Copyright © 2004 Pearson Education Australia 8 - 20

Writing Off Bad Debts What happens when it becomes apparent that an account will not be collected? l It must be written off. l How? Debit Provision for Bad Debts. Credit Accounts Receivable. l Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4 e Copyright © 2004 Pearson Education Australia 8 - 21

Recoveries How is the collection of a previously writtenoff account recorded? Debit Accounts Receivable (to reinstate the account). Credit Provision for Bad Debts. l Then Debit Cash. Credit Accounts Receivable (to record the collection). l Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4 e Copyright © 2004 Pearson Education Australia 8 - 22

Objective 3 Use the direct write-off method to account for bad debts. Horngren ♦

Direct Write-Off Method Using this method, an account is written off only when it becomes uncollectible. l No provision account is created. l This method is simple to use – but: l The statement of financial position is overstated. l The statement of financial performance is understated. l Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4 e Copyright © 2004 Pearson Education Australia 8 - 24

Credit Card and Bankcard Sales These save retailers the cost of a credit department. l The retailer is required to pay a fee (called a discount) for usage. l Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4 e Copyright © 2004 Pearson Education Australia 8 - 25

Credit Card and Bankcard Sales l How would Anna’s Boutique record a $100 credit card sale with a 3% service charge? Accounts Receivable (credit card) 97 Credit Card Charge 3 Sales Revenue 100 To record a credit card sale of $100 less a 3% service charge fee Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4 e Copyright © 2004 Pearson Education Australia 8 - 26

Debit Card Sales Using a debit card is like paying with cash. Horngren ♦

Bills Receivable: an Overview A bill receivable may arise from a sale or may be given in settlement of an account receivable. l The ‘Acceptor’ pays the ‘Drawer’ the maturity value. l The maturity value is paid on the maturity date and includes principal plus interest. l See Exhibit 8 -5 page 342 of the textbook l Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4 e Copyright © 2004 Pearson Education Australia 8 - 28

Identifying a Bill’s Maturity Date When the period is given in days… – the maturity date is determined by counting the days from the date of issue. l When the period is given in months… – the maturity date is on the same day of the month as the date the bill was issued. l Although the period of the bill is usually less than one year interest rates are usually stated as an annual rates. l Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4 e Copyright © 2004 Pearson Education Australia 8 - 29

Calculating Interest on a Bill Principal × Rate × Time = Interest Calculate interest on the bill due to State Bank. Principal: $10, 000 Interest: 10% Time: June 1, 2004, to August 29, 2004 $10, 000 × 10% × 90 ÷ 360 = $246. 58 Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4 e Copyright © 2004 Pearson Education Australia 8 - 30

Objective 4 Account for bills receivable. Horngren ♦ Harrison ♦ Bamber ♦ Best ♦

Recording Bills Receivable Assume the accounting period ended June 30. l How much interest was earned by the bank as of June 30? l $10, 000 × 10% × (30* ÷ 365) = $82. 19 l [* 30 days from June 1 to June 30] Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4 e Copyright © 2004 Pearson Education Australia 8 - 32

Recording Bills Receivable June 30 Interest Receivable Interest Revenue 82. 19 To accrue interest on the bill Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4 e Copyright © 2004 Pearson Education Australia 8 - 33

Recording Bills Receivable l How does the bank record the collection at maturity? August 29 Cash Bill Receivable Interest Revenue 10, 246. 58 10, 000. 00 82. 19 164. 39 Record interest on bill Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4 e Copyright © 2004 Pearson Education Australia 8 - 34

Discounting a Bill Receivable The drawer (one who will receive the money) may sell (discount) a bill so they receive money now, rather than at maturity. l From the previous example State Bank discounts the bill on June 21, discount rate is 12% (this is not the actual interest rate). l l $10, 246. 58 × 12% × 70* / 365 = $235. 81 [*70 days is June 21 to August 29] Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4 e Copyright © 2004 Pearson Education Australia 8 - 35

Discounting a Bill Receivable l How does the bank record the discounting? June 21 Cash Bill Receivable Interest Revenue 10, 010. 77 10, 000. 00 10. 77 Record interest on bill $10. 77 = $10, 246. 58 - $235. 81 Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4 e Copyright © 2004 Pearson Education Australia 8 - 36

Dishonored Bills Receivable If the maker of the bill fails to pay the maturity value to the new payee, then the original payee legally must pay the bank the amount due (unless the discounting is without recourse). l This gives rise to a contingent liability for the drawer when they discount a bill. l Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4 e Copyright © 2004 Pearson Education Australia 8 - 37

Objective 5 Report receivables on the statement of financial position Horngren ♦ Harrison ♦

Reporting Receivables Some companies report a single amount for its current receivables in the body of the statement of financial position. l They use a note to the financial statements to give more details. l See Qantas example pages 346 -47 text. l Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4 e Copyright © 2004 Pearson Education Australia 8 - 39

Objective 6 Use the acid-test ratio and days’ sales in receivables to evaluate a firm’s financial position. Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4 e Copyright © 2004 Pearson Education Australia 8 - 40

Acid-Test Ratio This is a stringent test of liquidity than the current ratio. l It measures the entity’s ability to pay its current liabilities immediately. l Acid-test ratio = (Cash + Short-term investments + Net current receivables) ÷ Total current liabilities Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4 e Copyright © 2004 Pearson Education Australia 8 - 41

Days’ Sales in Receivables It is a measure of the time it takes to collect receivables. l A smaller number indicates a quick conversion to cash. l Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4 e Copyright © 2004 Pearson Education Australia 8 - 42

Days’ Sales in Receivables One day’s sales = Net sales ÷ 365 days Days’ sales in average accounts receivable = Average net accounts receivable ÷ One day’s sales Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4 e Copyright © 2004 Pearson Education Australia 8 - 43