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Chapter 10
Receivables

Learning Objectives
1. Use the allowance method to account for bad debts 2. Use the direct write-off method to account for bad debts 3. Report receivables on the balance sheet 4. Use the acid-test ratio and days sales in receivables to evaluate a business

Horngren, Best, Fraser, Willett: Accounting 6e 2010 Pearson Australia

Receivables

Accounts receivable (Trade receivables)

Bills receivable (Notes receivable)

Horngren, Best, Fraser, Willett: Accounting 6e 2010 Pearson Australia

The Allowance Method

Firms with significant credit sales will use the allowance method to measure bad debts This makes an estimate of what debts will go bad based on experience This is recorded in a contra account related to accounts receivable
Allowance for doubtful debts

Horngren, Best, Fraser, Willett: Accounting 6e 2010 Pearson Australia

Objective 1

Use the allowance method to account for bad debts

Horngren, Best, Fraser, Willett: Accounting 6e 2010 Pearson Australia

Methods for Estimating Bad Debts

Percentage of Sales

Ageing of Accounts Receivable

Horngren, Best, Fraser, Willett: Accounting 6e 2010 Pearson Australia

Percentage of Sales
This is also called the income statement approach. It is based on prior experience of the business. It is calculated as a percentage of credit sales. It ignores the current balance of the allowance account. The percentage used is adjusted as needed to reflect collection experience.
Horngren, Best, Fraser, Willett: Accounting 6e 2010 Pearson Australia

Percentage of Sales Example

The credit department of Annas Boutique estimates (based on prior experience) that 1% of net credit sales are uncollectible. Net credit sales for the year just ended (Dec 31) were $500,000. What is the adjusting entry? $500,000 1.5% = $7,500.

Horngren, Best, Fraser, Willett: Accounting 6e 2010 Pearson Australia

Percentage of Sales Example

Dec 31,
Bad Debts Expense 7,500 Allowance for Bad Debts 7,500
Recorded bad debts expense for the year

Horngren, Best, Fraser, Willett: Accounting 6e 2010 Pearson Australia

Percentage of Sales Example

What is the effect of this adjusting entry?

Decrease in Net Profits

Decrease in net Accounts Receivable

Horngren, Best, Fraser, Willett: Accounting 6e 2010 Pearson Australia

Ageing of Accounts Receivable

This approach is also called the balance sheet approach because it focuses on accounts receivable. Individual accounts receivable from specific customers are analysed according to the length of time they remain outstanding.

Horngren, Best, Fraser, Willett: Accounting 6e 2010 Pearson Australia

Ageing of Receivables Example

Assume that International Hospitals past collection experience indicates the following: Length of time % uncollectible 1-30 days 2.0 31-60 days 3.0 61-90 days 5.0 90 + days 8.0

Horngren, Best, Fraser, Willett: Accounting 6e 2010 Pearson Australia

Ageing of Receivables Example

Length 1-30 31-60 61-90 90 + Total Amount $1,900,000 1,000,000 700,000 500,000 $4,100,000 % 2 3 5 8

$ 38,000 30,000 35,000 40,000 $143,000

Accounts Receivable
Horngren, Best, Fraser, Willett: Accounting 6e 2010 Pearson Australia

Allowance for Bad Debts

Ageing of Receivables Example

The allowance account is adjusted to this $143,000 balance: Assume that the account currently has a credit balance of $100,000. What is the adjustment?

Horngren, Best, Fraser, Willett: Accounting 6e 2010 Pearson Australia

Ageing of Receivables
June 30 Bad Debts Expense Allowance for Bad debts 43,000 43,000

To record the allowance for bad debts

What if the account had a debit balance of $1,000?

Horngren, Best, Fraser, Willett: Accounting 6e 2010 Pearson Australia

Ageing of Receivables

Allowance for Bad Debts

Adjustment 1,000 144,000

Adjusted balance

143,000

Horngren, Best, Fraser, Willett: Accounting 6e 2010 Pearson Australia

Comparing the Percentage of Sales and Ageing Methods

Horngren, Best, Fraser, Willett: Accounting 6e 2010 Pearson Australia

p.406

Writing Off Bad Debts

What happens when it becomes apparent that an account will not be able to be collected? It must be written off. How? Debit Allowance for Bad Debts. Credit Accounts Receivable.

Horngren, Best, Fraser, Willett: Accounting 6e 2010 Pearson Australia

Recoveries
How is the collection of a previously written off account recorded? Debit Accounts Receivable (to reinstate the account) and Credit Allowance for Bad Debts. Then Debit Cash and Credit Accounts Receivable (to record the collection).

Horngren, Best, Fraser, Willett: Accounting 6e 2010 Pearson Australia

Objective 2

Use the direct write-off method to account for bad debts.

Horngren, Best, Fraser, Willett: Accounting 6e 2010 Pearson Australia

Direct Write-Off Method

Using this method, an account is written off only when it becomes uncollectible. No allowance account is created. This method is simple to use but:

The balance sheet is overstated.

(No contra account).

The income statement is understated.

Horngren, Best, Fraser, Willett: Accounting 6e 2010 Pearson Australia

Objective 3

Report receivables on the balance sheet.

Horngren, Best, Fraser, Willett: Accounting 6e 2010 Pearson Australia

Reporting Receivables
Some companies report a single amount for their current receivables in the body of the balance sheet. They use a note to the financial statements to give more details. See BHP Billiton's example page 416 textbook.

Horngren, Best, Fraser, Willett: Accounting 6e 2010 Pearson Australia

Objective 4

Use the acid-test ratio and days sales in receivables to evaluate a business.

Horngren, Best, Fraser, Willett: Accounting 6e 2010 Pearson Australia

Acid-test Ratio
This is a more stringent test of liquidity than the current ratio. It measures the entitys ability to pay its current liabilities immediately.
Acid-test ratio = (Cash + Short-term investments + Net current receivables) Total current liabilities
Horngren, Best, Fraser, Willett: Accounting 6e 2010 Pearson Australia

Days Sales in Receivables

It is a measure of the time it takes to collect receivables. A smaller number indicates a quick conversion to cash.

Horngren, Best, Fraser, Willett: Accounting 6e 2010 Pearson Australia

Days Sales in Receivables

One days sales = Net sales 365 days

Days sales in average accounts receivable = Average net accounts receivable One days sales
Horngren, Best, Fraser, Willett: Accounting 6e 2010 Pearson Australia

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End of Chapter 10