Accounts Receivable and Notes Receivable

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Accounts Receivable and Notes Receivable

• Overview
• Accounts Receivable
• Notes Receivable
• Liquidity Ratios

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Accounts Receivable

• Definition
• Amounts owed the company by customers resulting
  from the normal business transactions of selling
  goods and services on credit.
• An agreement, by the customer, to pay a certain
  amount at some point in the future.

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Accounts Receivable

• Meets Asset criteria as follows
• Probable future value is met because a
  receivable is the right to receive payment at
  some future date.
• Measurable through the contract or sales
  invoice.
• Right to use and past event is evidenced
  through formal contract or a less formal
  agreement (e.g. a sales invoice).

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Accounts Receivable

• Valuation of A/R is less certain than cash
• Future purchasing power of cash received may be
  affected by inflation/deflation.
• Customer may not pay cash as agreed.
• Customer may return good for credit.
• Price adjustment may be demanded.
• Prompt payment discount may be taken.

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Accounts Receivable

• Valuation (under GAAP)
• Ideally, companies should show receivables at
  present value of gross payments less allowances
  for bad debts, returns, etc.
• Gross payments are used, however, if time between
  sale and collection is relatively short (30-60
  days) and interest rates are not extremely high
  (i.e. interest rates and differences between PV
  and gross payment are immaterial).
• Therefore, most companies account for A/R based
  on gross amounts less allowances.

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Accounts Receivable

• Valuation (under GAAP)
• If a company believes that some customers may not
  pay, it must set up an allowance method to
  recognize doubtful accounts. Reason So that
  shareholders wealth is not overstated.
• The company will establish a credit policy to
  check on its customers credit worthiness.
• It must balance its desire to sell the product to
  the customer against the likelihood the customer
  will pay.

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Accounts Receivable

• Bad Debts Direct Write-off Method
• This is a simple method that ignores the
  matching concept.
• For simplicity, it is used by small companies and
  can be used if bad debts are not material.
• If bad debts are significant, then the
  mismatching cant be ignored. This method would
  be unacceptable.

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Accounts Receivable

• Bad Debts Direct Write-off Method
• Recognizes the loss from an uncollected account
  in the period that it is determined to be
  uncollectible as per the companys write-off
  policy. (e.g. maybe after 120 days).
• Bad debts are grouped with other expenses and not
  shown as a reduction of revenues.

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Accounts Receivable

• Bad Debts Direct Write-off Method
• Debit Bad Debt Expense and Credit
  Accounts Receivable
• Also, the specific customer accounts within the
  subsidiary ledger are reduced.

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Accounts Receivable

• Bad Debts Allowance Methods
• A contra-asset account is set up to record
  estimates of uncollectible accounts.
• The allowance for doubtful accounts reduces the
  amount of accounts receivable to the net amount
  of cash that the corporation expects to receive.
• As a contra-asset account, the allowance for
  doubtful accounts is grouped with accounts
  receivable.

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Accounts Receivable

• Bad Debts Allowance Methods
• When a sale is made, set up allowance and record
  expense
• Debit Bad Debt Expense and Credit Allowance
  for Doubtful Accounts
• When a write-off is made, reduce A/R and the
  allowance since the s are no longer required as
  an allowance
• Debit Allowance for Doubtful Accounts and
  Credit Accounts Receivable
• (Note specific A/R accounts would also be
  reduced)

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Accounts Receivable

• Bad Debts Allowance Methods
• If an account already written-off is paid, this
  is called a recovery. Reverse the w/o entry
• Debit Accounts Receivable and Credit
  Allowance for Doubtful Accounts
• then,
• Debit Cash and Credit Accounts Receivable
  

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Accounts Receivable

• Bad Debts Allowance Methods
• The Percentage of Credit Sales Method is
  commonly used to estimate the amounts that are
  doubtful.
• Based on the past collection history of the
  corporation (or industry averages, if a new
  company) a percentage of estimated bad debt
  expense is calculated.
• The credit sales for the period are multiplied by
  the appropriate percentage.

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Accounts Receivable

• The Percentage of Credit Sales Method
• This percentage must be adjusted for present and
  future economic conditions and, on an on-going
  basis, for types of customers, changes in credit
  policy and to reflect the corporations recent
  credit experience.
• Few companies provide details of the amount of
  the allowance on their balance sheet. The
  allowance account is netted against the accounts
  receivable account to show a single line.

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Accounts Receivable Turnover Ratio

• Measures how often the accounts receivable are
  turned over (i.e. fully paid and replaced by
  new accounts.)
• Total Sales Revenue
• Average Accounts Receivable
• Acceptable numbers vary with industry.
• Trends over time should be considered.

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Accounts Receivable Number of Days Sales

• Measures the number of days it takes to collect
  sales on account.
• _________365______________
• Accounts Receivable Turnover
• Acceptable numbers would approximate the normal
  credit terms of the company.
• Trends over time should be considered.

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Accounts Receivable Bad Debts
Analysis

• Measures the trend, over time, of the ratio of
  the amounts written off vs. the accounts
  receivable balance.
• Also, the trend, over time, of the age of the
  allowance for doubtful accounts of the accounts
  receivable balance can be measured.
• A trend of increasing ratios or ages would be a
  warning sign that accounts receivable management
  needs to be improved.

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Notes Receivable

• Definition
• Recognition and valuation methods are the same as
  accounts receivable.
• The difference is that a note receivable is
  supported by a more formal agreement
  - a promissory note.
• This promissory note is a contract between two
  parties the maker and the payee.
• The maker promises to pay specific amounts at a
  definite time in the future or, on demand by the
  payee.

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Notes Receivable

• Definition
• The maturity of notes is generally longer than
  accounts receivable but less than a year.
  Therefore, usually current assets.
  (As opposed to long-term
  notes).
• Usually a secured note through a financial
  institution and secured with collateral
  (i.e. some asset the payee has a right to if the
  maker defaults.) Also, sometimes arranged
  between a company and a customer to extend
  payment of an accounts receivable.
• If the maker has a high level of credit
  worthiness, the financial institution may issue
  an unsecured note.

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Notes Receivable

• Interest Calculation
• Short-term notes generally require that interest
  payments be calculated using simple interest.
  (Long-term notes generally use compound
  interest.)
• Interest is calculated based on the amount
  borrowed (the principal), the interest rate
  (stated as a yearly amount), and the amount of
  time to maturity.

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Notes Receivable

• Interest Calculation
• Explicit- the interest rate is stated and the
  face value of the note (the principal) is
  multiplied by the interest rate and, then, by the
  time factor (a fraction of a year).
  (e.g. 1,000 x 12 x 6/12 mos.
  60)
• Implicit- the face value of the note is the
  amount to be paid at maturity. The difference
  between the face value and the amount borrowed
  is the interest. (discounted notes). (e.g.
  1,020 - 1,000 20)

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Notes Receivable

• Journal Entries
• Explicit- using previous example
• At time of issuance
• Debit Notes Receivable 1,000 Credit Cash
  1,000
• At 6 mo. maturity
• Debit Cash 1,060 Credit
  Notes Receivable 1,000
• Credit Interest Revenue 60

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Notes Receivable

• Journal Entries
• Implicit- using previous example
• At time of issuance
• Debit Notes Receivable 1,000 Credit Cash
  1,000
• At 4 mo. maturity
• Debit Cash 1,020 Credit
  Notes Receivable 1,000
• Credit Interest Revenue 20

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Notes Receivable

• Like factoring (selling) an accounts
  receivable, a notes receivable can be sold to
  another party.
• The purchaser will have (sold with recourse) or
  not have (sold without recourse) the right to
  collect from the payee if the maker doesnt pay.
• Notes recble. are uncommon on the balance sheet
  --gt amounts are relatively small --gt
  normally grouped with accts. recble

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Short-term Liquidity Ratios

• Current Ratio
• Measures the ability of a company to pay its
  short-term obligations.
• Current Assets
• Current Liabilities
• Must be greater than 11. Rule of thumb is 21.
  (varies with industry.)

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Short-term Liquidity Ratios

• Quick Ratio
• Again, measures the ability of a company to pay
  its short-term obligations. But, omits
  inventories (which may not be very liquid,
  depending on the industry or business) and often
  prepaid expenses.
• Current Assets-Inventories-Prepaid Expenses
• Current Liabilities
• Rule of thumb is 11. (varies with industry.)