Chapter 8: Receivables

1. Chapter 8: Receivables Learning Objectives: The methods used to estimate uncollectible accounts and the net realizable value of accounts receivable. How firms estimate and record sales returns and allowances. How to evaluate whether or not receivables arose from real sales.

2. Learning Objectives (contd.) How to impute and record interest when notes receivable have either no implicit interest or unrealistic low interest rate. How companies use receivables to accelerate cash inflows and how the accounting treatment affect the financial ratios. Securitization and off-balance sheet financing.

3. Receivables • Current receivables--Collected within one operating cycle or one year, whichever is longer. • Trade receivables: amount owed by customers for goods sold and services rendered as part of normal business operations, including • Accounts receivable: receivables arise from credit sales or performing services to customers on account.

4. Receivables • Trade Receivables (contd.): • Notes receivable: receivables arise when the seller extends long-term credit to the buyer, who then signs a note. • Nontrade Receivables: all others (i.e., interest receivable, advances to employees, deposits to cover potential damages, etc.)

5. Accounts Receivable • Accounts receivable are recorded at face amount to be collected. • Management must periodically assess the allowance for uncollectibles. • Management has to concern with: • Recognition - when • Valuation – how • Disposition – collected/sell/write-offs

6. Accounts Receivable : Recognition and Valuation • Recognition: Consistent with revenue recognition criteria. • Valuation: Follow conservatism • GAAP requires that accounts receivable be reported on the balance sheet at their net realizable value (NRV). • NRV is to estimate value of Accounts Receivables to be ultimately collected by the firm.

7. Accounts receivable:Assessing NRV of Receivables • Two amounts must be estimated to determine the NRV of receivables: • Uncollectibles—the amount that will not be collected because customers are unable to pay. • Returns and allowances—the amount that will not be collected because customers return the merchandise or are allowed a reduction in the amount owed. NRV of receivables Gross amount owned Estimated uncollectibles Estimated returns & allowances - - =

8. Uncollectible Accounts Describe the accounting treatment of anticipated uncollectible accounts receivable.

9. Accounts Receivable:Why estimating uncollectibles is important? • Most companies establish credit policies by weighing the following: • Expected cost(e.g. Customer collection and billing costs plus potential bad debts) of credit sale. • Benefit of increased sales. • The bad debts are often unavoidable. The matching principle requires that the estimate of uncollectible accounts be offset against current period sales--- Allowance Method Some future dates Today Time $10,000 current period sales $500 is uncollectible $500 estimated expense

10. Uncollectible Accounts Receivable • Bad debts: the uncollectible accounts receivable. • Methods to report receivables at the NRV: • Direct Write-off • Allowance method: Bad debt expense is recorded in thesameaccounting period in which the sales related to the uncollectible accounts were recorded. • This method is in compliance with thematching principle.

11. Direct Write-off Method If uncollectible accounts are immaterial, bad debts are simply recorded as they occur (without the use of an allowance account).

12. Normally classified asaselling expenseandclosed at year-end. Contra assetaccount toAccounts Receivable. Allowance Method Allowance Method: Most businesses record an estimate of the bad debt expense by an adjusting entry at the end of the accounting period.

13. Allowance for Uncollectible Accounts Accounts Receivable Less: Allowance for Uncollectible Accounts Less: Returns and allowances Net Realizable Value Net realizable value is the amount of the accounts receivable that the business expects to collect.

14. Uncollectible Accounts Allowance Method: Describe the two approaches to estimating bad debts

15. Two Approaches to Estimate Bad Debts Allowance Method: • Sales Revenues Approach (Percentage of Sales Method): • Gross Receivables Approach • Composite Rate (Percentage of Receivables): • Aging of Receivables

16. Sales Revenues Approach • Focuses on pastcredit salesto make estimate of bad debt expense. • Emphasizes thematching principleby estimating thebad debt expenseassociated with the current period’s credit sales. Bad debts expense iscomputed as follows:

17. Sales Revenues Approach In 2006, MusicLand has credit sales of $400,000 and estimates that 0.6% of credit sales are uncollectible. What is Bad Debts Expense for 2006? MusicLand computes estimated Bad Debts Expense of $2,400.

18. Gross Receivables Approach • Focuses on the collectability of accounts receivable to make the estimate of uncollectible accounts. • Involves the direct computation of the desired balance in the allowance for uncollectible accounts. • Two Estimation methods: • 1. Composite Rate • 2. Aging Receivable

19. Gross Receivables Approach 1. Composite Rate method:Desired balance in allowance for uncollectible accounts = year-end accounts receivable balance x bad debt expense %

20. Gross Receivables Approach : Composite Rate On Dec. 31, 2006, MusicLand has$50,000 in Accounts Receivableand a$200 credit balance in Allowance for Uncollectible Accounts. Past experience suggests that 5% of receivables are uncollectible. What is MusicLand’s Bad Debts Expense for 2006? Desired balance in Allowancefor Uncollectible Accounts

21. Now, let’s look at the accounts receivable aging approach!

22. Gross receivable approach: Estimated the uncollectibles by using Aging Schedule of Accounts Receivable • An aging of receivables is simply a determination of how long each receivable has been on the books. • Receivables that are long past due often because customers are experiencing financial difficulties and may ultimately become uncollectible. • The aging schedule generates the desire ending balance of “ Allowances for doubtful accounts ”.

23. Aging Schedule of Accounts Receivable :Is the allowance for uncollectibles adequate? • The Allowance for uncollectible accounts has a balance of $39,000 • prior to the adjustments. • The allowance account needs to increase by $11,750. • This is the difference between the desired balance ,$50,750, and the existing • balance $39,000. DRBad debts expense $11,750 CR Allowance for uncollectibles $11,750

24. Accounts receivable disposition:Writing off bad debts • Some time later, Bristol determines that a $750 receivable from Ralph Company cannot be collected. • Note that no bad debt expense is recorded at this time because the estimated expense was previously recorded (matching principle). Allowance for uncollectibles $750 Accounts receivable – Ralph Company $750 So what happens if someone pays after a write-off of the accounts receivable?

25. Collection of PreviouslyWritten-Off Accounts When a customer makes a payment after an account has been written off,twojournal entries are required.

26. Accounts receivable:Understanding receivable disclosures Scotts was taking a more conservative view of receivable collections in 2001. What impact did this conservative view have on the 2001 pre-tax earnings?

27. Sales Returns and Allowances Describe the accounting treatment for merchandise returns

28. Sales Returns and Allowances Sales Returns Sales Allowances Merchandise returned by a customer to a supplier. A reduction in the cost of defective merchandise.

29. Sales Returns & Allowances (FASB 48) A. The amount of sales R&A is not significant Direct method B. The amount of sales R&A is significant and six conditions are not met: Postpone the revenue recognition until all six conditions are met or the return period expired. 29

30. Sales Returns & Allowances (FASB 48) C.The amount of sales R&A is significant and six conditions are met: Allowance method. 30

31. Six Conditions (SFAS No. 48) 1. Sales price is determinable or fixed; 2. Buyers have paid or have the obligation to pay the sales price; 3. The buyer’s obligation would not be changed due to theft or damage of the product after purchase; 4. Sellers are not responsible for the performance of the product; 5. Buyers and sellers are two separate economic entities; 6. The amount of returns can be estimated. 31

32. The Amount of Sales Returns & Allowances Is Significant and Six Conditions Are Met Sales can be recognized in the period in which the sales are made. Also, at the end of the same period, the amount of sales returns would be estimated and recognized. 10/5/2006 A/R 10,000 Sales 10,000 12/31/2006 Sales R&A 1,000 (Adj. entry) Allow. for sale R& A 1,000 (estimate 10% returns) 1/10/2007 Allowance for sales R&A 900 A/R 900 Inventory XXX Cost of Goods Sold XXX Sales returns occurred

33. Learning Objective Do existing receivables represent real sales?

34. Sales Receivables Time Accounts receivable:Do existing receivables represent real sales? • Reasons why receivables might grow faster than sales: • Change in credit policy. • Deteriorating credit worthiness among existing customers. • Firm has changed its financial reporting policy – accelerated revenue recognition.

35. Do existing receivables represent real sales? (contd.) • Large increases in receivables relative to sales represent a danger signal. • Revenue recognition irregularities are often connected to the disparity of the growth rates of receivables and sales. • Sales of receivables can conceal the real increase of receivables.

36. Accounts receivable:Bausch & Lomb illustration Receivables are growing faster than sales 8-36

37. Accounts receivable:Bausch & Lomb’s changing DSO DSO Receivables by Quarter Days Sales Outstanding 8-37

38. Notes to the Case of Bausch & Lomb • In the 4th quarter of 1993, the company shifted responsibility for the sale and distribution of a portion of the US contact lens business to optical distributors. • Thus, revenue was recognize upon the shipment of lenses to these distributors rather than waiting until lenses were sold to final consumers. • The top-down pressure to achieve sales and profit goals caused the company to loose its credit policy (i.e., extend the payment period) and pressured the distributors to take unwanted goods. This practice lasted from Q4 of 1992 to early 1994.

39. Accounts receivable:Sunbeam Corporation illustration 18.7% sales growth 36.4% receivable growth 1 2 8-39

40. Accounts receivable:Clues available to the analyst • Receivable growth at Sunbeam greatly exceeded sales growth (a disparity in growth rates of sales and receivables). • “Bill and hold” sales raise the possibility that some of this disparity occurs because sales were booked too early—thus generating receivables that won’t be collected quickly (if ever).

41. Accounts receivable:Clues available to the analyst • Had Sunbeam not sold about $59 million of receivables, the receivable growth rate would have been much higher than 36.4% in 1997. • This makes it even more likely that some “channel stuffing” was occurring. * Channel stuffing ( Trade loading): abusiness practice where a company inflates its sales by forcing more products through a distribution channel than the channel is capable of selling .

42. Learning Objective Derive and record the impute interests of notes receivable when the notes receivable either carry no interest or lower interest than the market rate

43. Notes Receivable • Short–term notes receivable: Reported at the net realizable value (i.e., the face minus the allowance for uncolletibles) • Long-term notes receivable: Initial Recording Net present value. • End of Period: Net present value. • Companies can also choose the fair value option for the reporting of the long-term notes receivable. Cash and Receivables

44. Imputed interest: Non-interest bearing note • Suppose Monson Corp. sells a machine to Davenport Products and accepts a note for $5 million due in three years. The note bears no explicit interest. • Suppose the cash selling price is $3,756,600…then the effective borrowing rate must be 10%. Interest accumulates at 10% on the unpaid balance 8-44

45. Journal Entries for Monson’s Case At the sale of the equipment: Note Receivable 5,000,000

46. Imputed interest: Stated rate is below prevailing borrowing rate • Quinones Corp. sells a machine to Linda Manufacturing in exchange for a $4 million, three-year, 2.5% note. At the time, the interest rate normally charged to companies with Linda’s credit rating is 10%. • What is the implied (cash) sales price of the machine? Prevailing rate Stated rate 8-46

47. Imputed interest:Calculating interest income for Quinones 8-47

48. Journal Entries for Quinones Corp (see Exhibit 8.7)

49. Additional Examples on Long-Term N/RExample A • Receiving a 2-year note on sales of goods on 1/1/x1. The face amount of this note is $100,000 and the annual interest of the note is 10%. The interests are paid annually and the market interest rate (i.e., the imputed interest)is 12%. Present value of the note: $100,000 0.79719 + 10,000 1.69005 =96,620 Cash and Receivables

50. Long-Term N/RExample A (contd.) 1/1/x1 Notes Receivable 100,000 Sales Revenue 96,620 Discounts on N/R 3,380 • Effective Interest of 20x1 = PV of note on 1/1/x1  12% = ($100,000 - 3,380)  12% = 11,594.4 Cash and Receivables