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Class 5
Accounts Receivables
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Recap

 Preparation of Financial Statements – An Illustration

 Closing Process and Summarize Accounting Cycle
 Presentation of Financial Statements
 Error Correction
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The Accounting Cycle

• Analyze transactions from source documents

Analyze
Chapter 2
• Journalize transactions, Post amounts to the general ledger
Record • Prepare unadjusted trial balance

• Journalize adjusting entries

Chapter 3
Adjust • Prepare adjusted trial balance

• Prepare financial statements

Report
Chapter 4
• Journalize closing entries
Close • Prepare post-closing trial balance
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Exercise

Green Valley Company prepared the following trial balance at the end of its first year of operations
ending December 31. To simplify the case, the amounts given are in thousands of dollars.
UNADJUSTED
Account Titles Debit Credit
Cash 20
Accounts receivable 13
Prepaid insurance 8
Machinery 85
Accumulated depreciation
Accounts payable 11
Wages payable
Income taxes payable
Common stock (4,000 shares) 4
Contributed Capital
Additional paid-in capital 67
Retained earnings 6
Revenues (not detailed) 82
Expenses (not detailed) 32
Totals 164 164
Other data not yet recorded at December 31 include:
a. Insurance expired during the current year, $6. b. Wages payable, $4.
c. Depreciation expense for the current year, $9. d. Income tax expense, $7.
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Exercise

 1. Using the adjusted balances, prepare an income statement for the current year.

 2. Using the adjusted balances, prepare statement of stockholders’ equity for the
current year. The debit balance in retained earnings represents dividends that were
declared and paid in the current year.

 3. Using the adjusted balances, prepare balance sheet for the current year.
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Class Progress

Recording Accrual Financial

Introduction
Transactions Accounting Statements

Accounts Non-current Investment &

Inventory
Receivables Assets Liabilities

Financial
Statement of
Equity Statement
Cash Flow
Analyses
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Agenda

 Receivables
 Accounting for Sales Revenue
 Earnings Management
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Overview: Types of Receivables

Amounts due from individuals and companies that are expected to

be collected in cash.

Amounts customers owe Written promise (formal Other receivables such as

on account that result instrument) for amount interest, loans to officers,
from the sale of goods to be received. and advances to
and services. employees.

Accounts Notes Other

Receivable Receivable Receivables
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Overview: Types of Receivables

Amounts due from individuals and companies that are expected to be

collected in cash.

Accounts Receivable Long-term Notes Receivable

Short-term Notes Receivable Other Receivables (long-term)
Other Receivables (short-term)

Non-current
Current Asset
Asset
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Accounts Receivable

 Accounts receivable is the current asset resulting from a sale or

service executed on a credit basis.

Dr. Accounts receivable 100

Cr. Sales revenue 100
To record sale on account.

Dr. Cash 100

Cr. Accounts receivable 100
To record collection of cash from customer.
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Losses from Accounts Receivable

 Businesses extend credit in order to increase their volume of

sales relative to a cash-only policy.
 Businesses understand, however, that they will likely not collect
100 percent of all of their outstanding accounts receivable.
 Credit losses are considered an operating expense and are
debited to bad debt expense/uncollectible-account expense.
 The magnitude of these losses is usually closely related to a firm’s
credit granting policy.
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Losses from Accounts Receivable

 Are Bad Debt Expenses avoidable?

In theory, yes. But would require selling
1. only for cash, or
2. to such low-risk customers that many sales would be missed
Practically speaking, they’re not avoidable
 Problem! - The company doesn’t know which customers will not pay!
Solution: “Allowance Method”
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Allowance Method

 Entities are required to measure the loss allowance at an amount equal to

lifetime expected credit losses
 It is a contra-asset account with a normal credit balance.
 The allowance account is subtracted from gross accounts receivable to yield a
net amount.
 Assume that Scripps Company has gross accounts receivable of $14,000
Current Assets
Cash $ 3,000
Accounts receivable $14,000
Less: Allowance for doubtful accounts 5,000 9,000
Other current assets 1,000
Total Current Assets $13,000
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Allowance Method

On the Income Statement: Recognize estimated bad debt expense related to

credit sales made in the current period
 Why do we need to do this? The Matching Principle!

Today Sometime in the Future

$100,000 credit sales in the current period $9,000 is uncollectible

$9,000 estimated expense recognized

Adjusting Dr. Bad Debt Expense (+E, -SE) 9,000

Entry Cr. Allowance for Doubtful Accounts (+xA, -A) 9,000
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Estimating Uncollectible Accounts

Percentage of Credit Sales Method:

Current
Bad Debt % Estimated to be
Period Credit
Expense Uncollectible
Sales
Percentage used is usually based on historical past credit losses.
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Estimating Uncollectible Accounts

 Assume Scripps Company has 2016 credit sales of $700,000 and past experience
is that three percent of these sales will not be ultimately collected.
 Bad debts expense is calculated as $700,000 x 0.03 = $21,000

Dr. Bad debt expense/uncollectible-account expense 21,000

Cr. Allowance for doubtful accounts 21,000
To record bad debt expense estimate for the year.

 Scripps must monitor the balance in the allowance for doubtful accounts for
reasonableness.

Allowance for Doubtful Accounts

10,000
21,000
31,000
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Exercise

The Accounts Receivable of Company WMY had a balance of 20,000 at the

beginning of the month. At the end of the month, the balance of A/R becomes
34,000. There were total of $7,000 cash sales and there was no cash collection
during the month. Assume 5% of the credit sales are estimated to be uncollectible.
What is the bad debt expense for WMY for the month?
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Estimating Uncollectible Accounts

Aging Method

 To more accurately estimate the ending balance in the allowance account,

company often prepares an aging schedule.

 This schedule classifies customer balances by number of days they have

been past due.

 The longer the days past due, the more percentage is estimated uncollectible.
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Estimating Uncollectible Accounts

Aging Method
 Scripps 2016 accounts receivable total $30,000 as follows: current $10,000; 0-30 days
$8,000; 31-60 days $5,000; 61-90 days $3,000; over 90 days $4,000. The following
schedule computes the required balance for the allowance for doubtful accounts
using historical probabilities of non-collection.

Probability of Allowance
Amount Noncollection Required
Current $10,000 3 $300
0-30 days past due 8,000 4 320
31-60 days past due 5,000 5 250
61-90 days past due 3,000 10 300
Over 90 days past due 4,000 30 1,200
Total allowance required $2,370
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Estimating Uncollectible Accounts

 Estimates the allowance for doubtful accounts as a percentage of the

outstanding accounts receivable.

 Total estimated uncollectible accounts per the aging schedule is the

ending balance in the Allowance for Doubtful Accounts

 Adjusted amounts for Bad debts expense and Allowance for

Doubtful Accounts are then determined as the amount necessary to
achieve the proper balance in the allowance account.
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Estimating Uncollectible Accounts

 Assume Scripps had a beginning credit balance in the allowance for doubtful accounts
of $400. The required entry would be as follows:

Dr. Bad debt expense/uncollectible-account expense 1,970

Cr. Allowance for doubtful accounts 1,970
To record bad debt expense for the period.

Allowance for Doubtful Accounts

$ 400 Beginning balance
1,970 Required entry to obtain desired balance
$2,370 Desired balance per Aging Method
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Quick Question 1

Flyer Company has provided the following information prior to any year-end bad debt
adjustment:
• Cash sales, $150,000
• Credit sales, $450,000
• Selling and administrative expenses, $110,000
• Sales returns and allowances, $30,000
• Gross profit, $490,000
• Accounts receivable, $110,000
• Sales discounts, $14,000
• Allowance for doubtful accounts credit balance, $1,200
Flyer prepares an aging of accounts receivable and the result shows that 5% of accounts
receivable is estimated to be uncollectible. How much is bad debt expense?
A. $5,500
B. $6,700
C. $4,240
D. $4,300
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Estimating Uncollectible Accounts

 Assume Scripps had a beginning debit balance in the allowance for doubtful accounts
of $400. The required entry would be as follows:

Dr. Bad debt expense/uncollectible-account expense 2,770

Cr. Allowance for doubtful accounts 2,770
To record bad debt expense for the period.

Allowance for Doubtful Accounts

Beginning balance $ 400
2,770 Required entry to obtain desired balance
$2,370 Desired balance per Aging Method
• How can ADA have a debit balance prior to adjustment?
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Writing Off Specific Receivables

We made an estimate before knowing which accounts would be

uncollectible
Today Sometime in the Future

$100,000 credit sales in the current period $9,000 is uncollectible

$9,000 estimated expense recognized

In the future, we’ll find out which customers aren’t going to pay.
Last Period Today

$100,000 credit sales We learn that a customer who owes $5,000 won’t pay
(If our estimate was good, ~$4,000 more will end up being uncollectible)
$9,000 estimated expense recognized

When it’s clear that a specific receivable will not be collected,

we “write off ” the Accounts Receivable and Allowance for Doubtful Accounts
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Writing Off Specific Receivables

Example: We learn that a customer who owes us $5,000 is not going to pay.
Dr. Allowance for doubtful accounts 5,000
Cr. Accounts receivable 5,000
To write off account deemed uncollectible.

How do write-offs affect Net Income?

• They don’t! We already recorded the expense associated with this bad debt last period!
Dr. Bad Debt Expense (+E, -SE) $9,000
Cr. Allowance for Doubtful Accounts (+xA, -A) $9,000
How do write-offs affect net receivables?
• Accounts Receivable (A) and Allowance for DA (xA) decrease
• Since the asset and the contra-asset are both reduced,
net receivables do not change
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Writing Off Specific Receivables
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Compute Cash Collection

 Collections from customers are the single most important source of cash for
any business.
 We can compute a company’s collections from customers by analyzing its
Accounts Receivable account.

Accounts Receivable
Beg. Bal 200 Write-off of uncollectible 1500
Credit Sales 1800 Cash collection 100

End. Bal 400

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Group Exercise: Valuing Accounts Receivable

On January 1, 2018, Dewey Corporation had Accounts Receivable of $63,000 and

Allowance for Doubtful Accounts of $3,400.
During 2018, Dewey:
▪ made $575,000 in sales on credit
▪ collected $557,400 on outstanding accounts receivable
▪ wrote off $2,600 of receivables as uncollectible

On December 31, 2018, using the aging of receivables method, Dewey estimated
that 4% of its outstanding Accounts Receivable would be uncollectible.

What journal entry would Dewey record for bad debt expense in 2018, and
how would Accounts Receivable be reported on Dewey’s December 31,
2018 Balance Sheet?
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Group Exercise

First, draw T-Accounts and fill in the information that’s given:

Next, figure out what you can solve for with T-Account Inference:

Ending A/R = Beginning A/R + Credit Sales – Cash Collections – Write-offs

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Group Exercise

To find Bad Debt Expense, need to determine the ending balance for ADA

Since Dewey estimates that 4% of its outstanding A/R will be uncollectible,

Allowance for Doubtful Accounts = Accounts Receivable × 4% = $78,000 × 4% = $3,120
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Group Exercise

Now, we can use T-Account Inference to solve for Bad Debt Expense

What journal entry would Dewey record for bad debt expense in 2018?
Dr. Bad Debt Expense (+E, -SE) 2,320
Cr. Allowance for Doubtful Accounts (+xA, -A) 2,320
How would Accounts Receivable be reported on Dewey’s December 31, 2018
Balance Sheet?
“Accounts Receivable, net” of $74,880
(78,000 A/R, gross - 3,120 Allowance for DA)
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Quick Question 2

The CHS Company has provided the following information:

• Accounts receivable written-off as uncollectible during the year amounted to $11,500.
• The accounts receivable balance at the beginning of the year was $150,000.
• The accounts receivable balance at the end of the year was $210,000.
• The allowance for doubtful accounts balance at the beginning of the year was $14,000.
• The allowance for doubtful accounts balance at the end of the year after the recording
of bad debt expense was $12,900.
• Credit sales during the year totaled $900,000.
How much was CHS Company's bad debt expense?
A. $11,500.
B. $12,900.
C. $10,400.
D. $14,000.
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Overview: Types of Receivables

Amounts due from individuals and companies that are expected to

be collected in cash.

Amounts customers owe Written promise (formal Other receivables such as

on account that result instrument) for amount interest, loans to officers,
from the sale of goods to be received. and advances to
and services. employees.

Accounts Notes Other

Receivable Receivable Receivables
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Notes Receivable

 Promissory notes receivable are often used in sale

transactions when the credit period is longer than the 30-60
day period common for accounts receivable.
 More formal than accounts receivable.
 Key characteristics include:
▪ A fixed due date or on demand
▪ A certain principal sum to be paid
▪ An interest rate usually stated as an annual rate
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Notes Receivable
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Notes Receivable

 Interest is calculated according to the following formula:

Principal x Interest rate x Interest time

 Assume a 3 month note for $10,000 at an annual interest

rate of 6 percent
Interest = $10,000 x 0.06 x 3/12 = $150
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Recording Notes Receivable and Interest

Jordan Company sold $12,000 of merchandise on account to

Bowman Company. On October 1, after the regular credit period
had elapsed, the Bowman Company gave the Jordon Company a 60
day, nine percent note receivable for $12,000. Jordan Company
makes the following journal entry to record receiving the note:
Oct. 1 Dr. Notes Receivable —Bowman Company 12,000
Cr. Accounts Receivable—Bowman Company 12,000
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Recording Notes Receivable and Interest

 If the Bowman Company pays its note receivable on the

November 30 maturity date (i.e. honor the note), the
Jordon Company makes the following journal entry:

Nov. 30 Dr. Cash 12,180

Cr. Interest income 180
Cr. Notes receivable—Bowman Company 12,000
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Adjusting Entry for Interest Income

Assume that Jordan Company prepares financial statements as of September 30.

The notes receivable from Garcia Company is dated June 1, has a principal
amount of $10,000, an interest rate of nine percent, and a maturity date of
November 1.

The adjusting entry that Jordan Company makes at September 30 is as follows:

Dr. Interest receivable 300
Cr. Interest income 300
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Adjusting Entry for Interest Income

 When the note is subsequently paid on November 1, Jordan Company makes

the following journal entry

Dr. Cash 10,375

Cr. Notes receivable 10,000
Cr. Interest receivable 300
Cr. Interest income 75
($10,000 × 9% × 1/12)
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Factoring Receivables

 What if the company wants to speed up the cash receipts/collection?

▪ Can sell these accounts receivable to another business, called a factor.
▪ As a result, the company get cash immediately. What’s the cost?
▪ Often quite expensive.
▪ Might still be responsible for any bad debts that may arise after the factoring.

Dr Cash 95,000
Dr Financing Expense 5,000
Cr Accounts Receivable 100,000
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Agenda

 Receivables
 Accounting for Sales Revenue
 Earnings Management
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Accounting for Sales Revenue

 Companies frequently offer one or more of the following:

1) Credit card sales to consumers
2) Sales discounts to other businesses
3) Sales returns and allowances

 Why?

 All of these may affect the number reported as “Net Sales” in the Income Statement.
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Accounting for Sales Revenue

Credit Card Sales to Consumers

 Why do companies let customers use credit cards?
▪ Typically increases sales
▪ Reduces need to directly offer credit to customers which would be ______ and result in
_______ cash collections
 Credit card companies typically charge a transaction fee (~ 2-4% of sales price)
 Journal Entries for Credit Card Sales
▪ Assume a 3% fee on a $2,000 sale
▪ Also assume cash deposited on the day of sale
Dr. Cash (+A)
Dr. ____________(+xR, -R, -SE)
Cr. Sales Revenue (+R, +SE)

Note: _____________ is a Contra-Revenue Account

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Accounting for Sales Revenue
Sales Discounts to Businesses
 Discounts can be offered to encourage prompt payment of a receivable
Number of days in Net (Total sales less
discount period returns)

Discount percentage Maximum credit period

2/10, n/30
 If taken, discount is recorded as a contra-revenue at the time of payment.
 Journal Entry at Time of Sale:
Dr. Accounts Receivable (+A) 1,000
Cr. Sales Revenue (+R, +SE) 1,000
 Journal Entry if Payment within Discount Period (10 days, per the terms above):
Dr. Cash (+A) Sales Amount * Discount %
Dr. ___________(+xR, -R, -SE)
Cr. Accounts Receivable (-A)
 Journal Entry if Payment after Discount Period:
Dr. Cash (+A) 1,000
Cr. Accounts Receivable (-A) 1,000
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Accounting for Sales Revenue

 Not all sales are final – Companies need to record when goods are returned

 Journal Entry at Time of Sale:

Dr. Accounts Receivable (+A) or Cash (+A) 500
Cr. Sales Revenue (+R, +SE) 500
 Journal Entry when Returned:

Dr. Sales Returns and Allowances (+xR, -R, -SE) 500

Cr. __________(-A) or ________ (-A) 500
 *Note that COGS and Inventory would also need to be adjusted.

Sales Returns and Allowances is a contra-revenue account.

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Accounting for Sales Revenue

The following accounts are Contra-Revenues, which are deducted from Sales to
arrive at Net Sales:
1 Credit Card Discounts (transaction fees from credit card sales to consumers)
2 Sales Discounts (provided to other businesses to encourage timely payment)
3 Sales Returns and Allowances (when goods are returned by customers)

Total Sales Recorded at Original Sale

- Credit Card Discounts
- Sales Discounts Contra-Revenues
- Sales Returns and Allowances
Presented on the
Net Sales
Income Statement
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Group Exercise: Net Sales

What journal entries would be recorded for the following transactions?

 November 25: Sold 20 computers to Customer A at a total invoice price of $8,000, with
payment terms 3/10, n/30

 November 28: Sold 10 identical computers to Customer B at a total invoice price of

$4,000, with payment terms 3/10, n/30

 November 29: Sold 2 computers to Customer C, who paid $1,000 with a credit card. The
company pays a transaction fee of 4% for credit card sales.
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Group Exercise: Net Sales

 November 29: Customer B returned one of the computers; it was not defective. (Inventory
value 300) $4,000/10 items = $400

 December 6: Customer B paid their account balance in full.

Terms 3/10, n/30:
3% Discount on (Sales - Returns)

 December 20: Customer A paid the full balance of their November 25 invoice
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Group Exercise: Net Sales

What effect would these transactions have on reported net sales for the period?

 Calculation of Net Sales:

Sales Revenue
Less: Credit Card Discounts
Less: Sales Returns and Allowances
Less: Sales Discounts
Net Sales
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Agenda

 Receivables
 Accounting for Sales Revenue
 Earnings Management
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Some things to watch out for…

Many accruals/deferrals involve estimates, which can be manipulated to

manage (smooth) earnings
• Examples:
– Allowance for Doubtful Accounts
– Depreciation

• Techniques:
– Overestimate expense in good years (save for a rainy day; aka “cookie jar” reserves)
– Underestimate expense in bad years
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Some things to watch out for…

Sales on credit may allow for “channel stuffing” or earnings management

 Techniques:
▪ Year-end sales push (legal)
▪ Encouraging customers to accept extra inventory with special payment terms (legal)
▪ Encouraging customers to accept extra inventory now with expectation they’ll return
(illegal to recognize as revenue)
▪ Bill and hold (illegal unless specific conditions are met)
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Earnings Management

Burgstahler and Dichev (1997)

“Zero-Earnings Discontinuity”
Why are there so few instances
firms reporting small net losses
(earnings per share just under 0)
and so many instances of firms
reporting small net incomes?

Managers have incentives to avoid losses, beat analysts’

forecasts, and meet internal targets.
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Earnings Management

 Graham, Harvey and Rajgopal (2005) surveyed over 400 top executives. To meet
earnings targets:
▪ 78% admitted to cutting advertising, R&D, maintenance, etc.
▪ 55% admitted to delaying the start of new projects, even if it destroys value to wait
▪ 20% admitted to selling assets (that the company was still using) and investments to
recognize gains
▪ 8% admit to changing accounting assumptions
 Do these practices violate GAAP?
▪ “No” for most cases; “yes” for the extreme cases of fraud
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Red Flags with Accounts Receivable

 Should we worry if Accounts Receivable grow as a % of sales?

 Some potential explanations that aren’t always worrisome:

▪ Company is extending credit to riskier (but still reasonable) customers
▪ Existing customers having a harder time paying quickly (but will still eventually pay)
▪ Company changed credit terms to give customers more time to pay (but they will still eventually pay)
▪ Company made a year-end sales push (high sales at year-end reflected in statements, but most
payments are not yet collected)
 None of these are particularly problematic, as long as the company collects
on receivables quickly enough to make payments on its liabilities
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Red Flags with Accounts Receivable

Explanations that are worrisome:

 The company is pushing out unwanted products to inflate sales (where most
end up being returned)

Real-world example: In 2000 and 2001, Take-Two (maker of Grand Theft Auto) shipped
games to Capitol Distributing, a company that had no intention of actually purchasing
them. Revenues (and receivables) for Take-Two went up by about $15 million temporarily,
but games were eventually returned and revenues reduced.

Outcome: SEC charged top Take-Two executives

with fraud, penalized them with fines.
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Red Flags with Accounts Receivable
Key Point: Be skeptical! Use what you know about accounting rules to
understand how they might be misused!

Explanations that are worrisome:

 The company is recording sales that don’t even exist

Real-world example: In the late 1990’s, Anicom, a distributor of wire and cable
products, booked nonexistent sales.

March 13, 2003 – “The feds allege that bogus sales of more than $24 million
were created out of thin air. The company credited sales that never took place,
and in at least one instance, to a company that didn't even exist and had as an
address a vacant lot, court records show.”

Outcome: Company went out of business, 1,200 people lost their jobs,
shareholders lost $80 million, some top executives went to prison
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Recap

 Accounting for Sales Revenue

 Receivables
 Earnings Management