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Chapter 10

Receivables

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

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

Accounts receivable (Trade receivables)

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

Use the allowance method

to account for bad debts

Objective 1

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 Anna’s

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

Decrease in Net Profits

Decrease in net Accounts Receivable

What is the effect of this adjusting entry?

Percentage of Sales Example

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 Hospital’s

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

Accounts Receivable

Allowance for

Bad Debts

Length Amount %

1-30 $1,900,000 2 $ 38,000

31-60 1,000,000 3 30,000

61-90 700,000 5 35,000

90 + 500,000 8 40,000

Total $4,100,000 $143,000

Ageing of Receivables Example

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

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

June 30

Bad Debts Expense 43,000 Allowance for Bad debts 43,000

To record the allowance for bad debts

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

Ageing of Receivables

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

Allowance for Bad Debts

Adjustment 1,000 144,000

Adjusted balance 143,000

Ageing of Receivables

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

Comparing the Percentage of Sales and Ageing Methods

p.406

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

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

Use the direct write-off

method to account for

bad debts.

Objective 2

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

Report receivables on the

balance sheet.

Objective 3

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

Use the acid-test ratio and

days’ sales in receivables

to evaluate a business.

Objective 4

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

Acid-test ratio = (Cash + Short-term investments

+ Net current receivables) ÷ Total current liabilities

Acid-test Ratio

This is a more stringent test of liquidity

than the current ratio.

It measures the entity’s ability to pay its

current liabilities immediately.

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

One day’s sales = Net sales ÷ 365 days

Days’ sales in average accounts receivable =

Average net accounts receivable ÷ One day’s sales

Days’ Sales in Receivables

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End of Chapter 10