PROFESSOR S CLASS NOTES FOR UNIT 14 COB 241 Sections 13, 14, 15 Class on November 5, 2018

PROFESSOR S CLASS NOTES FOR UNIT 14 COB 241 Sections 13, 14, 15 Class on November 5, 2018 Accounts Receivable Accounts Receivable are amounts which the company has a legal right to collect from customers. This legal right was created by selling (goods or services) to the customers on credit terms specified in the sales contract. The Importance of the Credit Check The Credit Manager is charged with responsibility of vetting new customers to try to avoid extending credit to customers who may not pay their bills. This is called a Credit Check Before a company makes a sale on account, due care requires that the seller perform a Credit Check on the customer. There are many commercial organizations which compile and gather information on how customers have paid their bills in the past. These organizations can provide reports and credit scores which can serve as a guide to a Credit Manager about whether or not to loan the customer money in the form of extending credit. The Credit Manager usually also supervises the Collections Department, which is responsible for sending customers reminders about overdue bills. These reminders are called Dunning Notices. Interest or Late Fees on A/R Generally, companies do not charge interest on amounts owed by customers as long as the amounts are paid within the payment terms of the sales agreement. The sales agreement must specify exactly how long the customer has before payment is due. Sometimes companies will charge interest and/or fees if the customer does not pay within the time limit specified by the sales terms. Most customers pay on-time. Of the few who do not, many will pay late. If our company charges late fees or interest, this is handled as any other revenue -type transaction; we credit a Late Fee Income or Interest Income account, and debit Accounts Receivable, to show that the customer now owes us even more money. 1

Accounting for Late Fees Example: On April 12, our company sells $1600 of services to Wilson Corporation on account under terms of Net 30. The contract permits assessment of a late fee of 1.5% per month for late payment. At the time of the sale, we credit Revenue, and debit Accounts Receivable. The journal entry is: 12-Apr Accounts Receivable (customer Wilson) 1,600 Revenue 1,600 By May 12, Wilson has still not paid. Typically our company will send a Dunning Notice to Wilson reminding them of the overdue amount. If Wilson still has not paid within 10 days, our company adds the late fee and sends a reminder statement to Wilson including the late fee. The journal entry is: 23-May Accounts Receivable (customer Wilson) 24 Late Payment Fee Income 24 Uncollectible Accounts If a customer refuses to pay after numerous reminders, our company can take legal recourse and resort to the court system to force the buyer to pay. If that avenue does not result in collection, our company may have to give up and write-off the debt. Debts can become uncollectible for a number of reasons, among the most common are the customer goes out of business or files bankruptcy. In some cases, the amount of the debt is not worth the trouble and expense of pursuing legal recourse. The accountants do not determine when to write-off a bad debt. That is the job of the Credit Manager. The Credit Manager is usually judged by how much of the credit he approved ends up being collected. This serves as a disincentive for the Credit Manager to write-off bad debts simply because it the effort involved in collections. 2

Writing-Off a Bad Debt Direct Write-Off Method When the Credit Manager determines that a customer will not be paying a bill, the accountants write-off the account receivable amount by debiting Bad Debt Expense and crediting the Account Receivable. The credit (to A/R) reduces assets, showing that the company no longer considers the debt to be collectible, and therefore lost. Losing an asset is always an expense. Bad Debt Expenses is usually considered to be a Selling Expense, since the whole reason for extending credit in the first place is to obtain sales from customers who would not purchase using cash. Example: A company made a sale to a customer, and several accounting periods later, it becomes obvious that the customer will not be paying. Under the direct write-off method, the accounting entry would be: 30-Oct Bad Debt Expense 1,700 Accounts Receivable -- customer Wilson 1,700 Accrual for Bad Debt The Direct Write-Off Method of accounting for Bad Debts is allowed only when the amount of bad debt suffered by a company is immaterial or very small, or happens only infrequently say a couple of times per year. In practice, companies who extend major amounts of credit to large numbers of customers come to expect that a certain amount of their credit sales will eventually become uncollectible. To follow the matching principle, these companies use one of the accrual methods for accounting for uncollectible accounts. Under the matching principle, the company recognizes the Bad Debt Expense in the same period the sale is recognized. Of course, at that time, the company has no idea which, or even if any, of the accounts will become uncollectible. The company ESTIMATES the portion of sales which will become uncollectible. It charges (debits) expense for this amount, and sets aside an account (by crediting a contra-asset account) called Allowance for Bad Debt. This entry is made as an adjusting entry at the end of the period in which the sales were made. 3

Allowable Methods for Expensing and Accruing for Bad Debt There are three allowable methods for determining the amount of expense allowed under GAAP: percentage of sales, percentage of A/R, and aged A/R. Percentage of Sales Method Under the percentage of sales method of accruing for Bad Debt, the company expenses a given percentage of the sales it recorded during the period. A typical amount might be 1% or 2% of Net Sales. A company which sells to high-risk customers or who has extended credit to questionable customers as a gamble to increase sales, or a company who historically has had trouble collecting from customers might expense 3%, 5%, or even more. An adjusting entry is made at the end of each month to set aside an allowance for Bad Debt. This way, the company expenses the Bad Debt expense associated with the current period s sales immediately, thus following the matching principle. Example: Say a company made $250,000 in Net Sales in February, and uses the Percentage of Sales method for accruing for Bad Debt. Company management has approved a rate of 2% of Sales as the estimate for how much of February s sales might eventually become uncollectible. At the end of the month, the adjusting entry will debit (increase) the expense account for 2% of the Net Sales figure, and increase (credit) the contra-asset account Allowance for Bad Debts by the same amount. 28-Feb Bad Debt Expense 5,000 Allowance for Bad Debt 5,000 In March, the company records Sales of $300,000. The entry at the end of March would be: 28-Feb Bad Debt Expense 6,000 Allowance for Bad Debt 6,000 Because of its simplicity, a majority of companies use the Percentage of Sales method to determine how much to expense each period for Bad Debt. GAAP requires the percentage to remain relatively stab le over periods of time, to avoid management s temptation to use it to manipulate earnings by over-expensing in good months and underexpensing in bad months. -- It is important to note that by making the accrual to the Allowance for Bad Debt account, we are NOT writing off any account receivable amount. We are simply anticipating that contingency. The A/R account is not involved. 4

Problems with the Percentage of Sales Method One drawback to the Percentage of Sales method is that if the percentage estimate is not made very carefully, the amount accrued might be incorrect, either too high or too low. Over time, this can result in a major over- or under-accrual, especially since GAAP does not permit management to adjust the percentage on a period-to-period basis. If management realizes that too much has been accrued, management s common response is to correct the balance by skipping the accrual for one or more periods. This results in a blip in the financial statements for the period, and violates the matching principle. If management realizes too little has been accrued, management might correct the balance by suddenly recognizing more expense. Again, this violates the spirit of the matching principle and causes a blip in the financials. Percentage of Accounts Receivable One way of avoiding the problems inherent in the Percentage of Sales method is to use the Percentage of Receivables method for determining how much to write-off each month. Under the Percent of A/R method, the adjusting entry made at the end of each period adjusts the Allowance Account to a given percentage of the ending A/R balance. Under this method, the percentage is still an estimate, but this way and adjusting is being made every period rather than letting the error in estimation accumulate.. Example: Assume a company had a May 31 ending balance of Accounts Receivable of $700,000, and assume that management has agreed that about 4% of A/R will ultimately become uncollectible. Since 4% of $700,000 is $28,000, the Allowance for Bad Debt account should have $28,000 in it. From prior periods activity, the Allowance for Doubtful Accounts has a balance of $5,000 on May 31. On May 31, the adjusting entry would be: DATE DEBIT CREDIT 31-Mar Bad Debt Expense $ 23,000 Allowance for Doubtful Accounts $ 23,000 As with the percentage of sales method, is important to note that by making the accrual to the Allowance for Bad Debt account, we are not actually writing off any account receivable amount yet. There is no credit to the A/R T-account. We are simply anticipating that contingency, and making the entry to satisfy the matching principle. 5

The Aged Accounts Receivable Method The third way of determining the amount of Bad Debt Expense for a period is to sort the individual customer Accounts Receivable amounts by date of their sale (invoice date). The amounts are categorized into columns based on how overdue the amount is. See the example Aged Accounts Receivable Report below. AGED ACCOUNTS RECEIVABLE REPORT as of August 31 Overdue Overdue Overdue Overdue Date of Sale Invoice Customer Not yet Due 1-30 days 30-60 Days 60-90 Days Over 90 Days 29-Aug 567 Wilson $5,600 29-Aug 566 Yu $1,544 27-Aug 565 San-Tah $2,401 22-Aug 564 Brown $3,622 18-Aug 563 Southern $1,689 16-Aug 562 Wilson $4,688 16-Aug 561 Creighton $1,112 12-Aug 550 Abram $5,411 10-Aug 549 Benton $10,325 6-Aug 545 Carlton $2,303 4-Aug 541 Simon $7,842 2-Aug 540 Banford $6,305 1-Aug 535 Helios $9,470 28-Jul 513 Jafar $299 27-Jul 505 Heidon $8,391 16-Jul 491 Wango-Dubi $6,793 12-Jul 486 Anahli $29 5-Jul 470 Grubert $6,352 30-Jun 461 King $8,059 22-Jun 452 Wilson $3,874 9-Jun 444 Hygro $1,730 3-Jun 439 Listz $8,073 28-May 431 Bremen $5,010 5-May 392 Jackson $9,899 2-May 390 Hondu $442 15-Apr 380 Czerniak $1,570 18-Mar 355 Jing-Lin $2,686 2-Mar 337 Kravitz $3,408 TOTAL BY AGE $36,392 $25,920 $21,864 $21,736 $23,015 GRAND TOTAL $128,928 6

Usually, there is one column for A/R amounts which are not yet due, another column for those that are overdue, but less than 30 days from the due date, yet another column for those which are 30 days overdue but not yet 60 days overdue, another column for those overdue between 60 and 90 days, and a final column for those which are overdue more than 90 days. The idea behind this method of accrual is that accounts which are less than 90 days old might still be collectible given enough collections effort. Those more than 90 days past due, however, have historically been those where the customer has no intention of paying. In this method, an adjusting entry is made at the end of each period such that the Allowance for Bad Debt account has a balance equal to the total of the Over-90-Days invoices. Example: Assume the company shown in the report above has a balance in the Allowance for Bad Debt T-account of $16,000 as of August 31 before adjusting entries are made.. The adjusting entry made on August 31 is shown below. This entry will bring the allowance account up to the total of the Over-90-Days overdue column, or $23,015. DATE DEBIT CREDIT 31-Aug Bad Debt Expense $ 7,015 Allowance for Doubtful Accounts $ 7,015 Actual Determination of Write-Off The three accrual methods described above (Percentage of Sales, Percentage of A/R, and Aged A/R) are used to calculate the amount of Bad Debt Expense to recognize in a given period, and to add to the Allowance for Bad Debt T-account. At the time those entries are made, the company is NOT, repeat NOT, writing off any Bad Debt. The company is merely anticipating one or more of the amounts becoming uncollectible at a later time. The purpose of the accruals described above is to better match the expense (of making a sale to a customer who might end up not paying) with the revenue. The actual write-off of the Account Receivable happens at a later date, when the credit manager finally throws in the towel, gives up collections efforts, and declares the account uncollectible. 7

Accounting for the Actual Write-Off Regardless of which of the three accrual methods is used to estimate the Allowance for Bad Debts, the actual write-off is handled the same. First, we credit Accounts Receivable for the amount of the invoice(s) which the Credit Manager determined will never be paid. Next, we debit the Allowance for Bad Debt Account. Example: during the months of September, October, and November, the company has been accruing for Bad Debt based on the --- method. (remember, the method doesn t matter!) As of December 5, the following T-accounts have the balances shown: Allowance for Accounts Receivable Bad Debt $215,000 $21,000 One of the accounts in Accounts Receivable is a balance of $15,000 owed by the Dedbeet Company. On December 6, the credit manager determines that the Dedbeet Company has gone bankrupt, and will not be paying their balance. Remember, the expense has been recognized in prior periods. The funding of the write-off is sitting in the Allowance for Bad Debt accounts. We reduce (credit) accounts receivable by the amount of the uncollectible account ($15,000), and reduce (debit) the allowance account by $15,000. 6-Dec Allowance for Bad Debt 15,000 Accounts Receivable (customer Dedbeet) 15,000 After posting this entry, the Accounts Receivable will have a balance of $200,000, since the Dedbeet invoice have been removed. The Allowance for Bad Debt will have only $6,000 remaining. ($21,000 - $15,000 = $6,000). Notice that the expense accounts are not affected. The expense was deducted from Net Income (and folded into Retained Earnings) in prior periods, closer to when the sales to Dedbeet were made. 8

Summary of Bad Debt Accruals The Direct Write-Off method is not an accrual system. Under Direct Write-off method, a company recognizes the expense of uncollectible accounts at the time the decision is made that the money will never be collected. GAAP frowns upon this method unless the write-offs a company makes are small, or very rare. Instead, GAAP requires that a company expense an uncollectible amount in a period close to when the sale is made. Since it cannot be determined at the time of the sale exactly which account(s) will become uncollectible, GAAP allows companies to estimate the amount and accrue for it in a contra-asset account. The company must expense the estimated uncollectible amount in the earlier period. That way, when then account ultimately becomes uncollectible, the reduction in A/R does not result in an expense in that period. Danger of Earnings Manipulations Estimates are very susceptible to manipulation by management. That is, management can tinker with Net Income by deliberately making bad estimates, and then correcting them in later periods. Example: Management has forecast a Net Income figure for January of $4 million. If management has a bad month, and it appears that January s Net Income might be less than $4 million, management might be tempted to expense a smaller-than-prudent amount for bad debt, justifying the smaller expense by claiming that they expect all customers to pay their bills. Later, when a very good month occurs, management may expense more than necessary, to build up a reserve to draw upon later. By accumulating huge amounts in the Allowance for Bad Debt account, management can manipulate Net Income from period to period. This is called Income Smoothing, and is considered fraud. Auditors check estimated amounts carefully, and require that management justify their estimated amounts each period. Notes Receivable Notes Receivable are more formal than Accounts Receivable. Accounts Receivable are generated by sales contracts. Notes Receivable are loans the company makes to outsiders or insiders. For example, a company that has a current excess amount of cash in the bank might loan a local merchant a few thousand dollars to open a new store, in the hopes that the merchant will later become a larger customers. The interest paid by the merchant will be more than the company could earn by investing in a bank note or CD. 9

Other Uses of Notes Receivable If our company has a customer who has not paid a significant amount of overdue invoices, we may request that the customer sign a promissory note, secured by collateral, and possibly even carrying interest. This way, the customer gains more time to repay, our company gets interest, and if the customer goes bankrupt, we will receive the collateral. For example, a customer might owe our company $250,000 in overdue invoices. The customer agrees to put up its truck fleet as collateral, so that if the customer declares bankruptcy and is liquidated, our company is in line to gain title to the truck fleet without having to wait on the other assets to be liquidated, a legal procedure which might take years, compared to gaining title to secured property which usually takes only a few months. Accounting for Notes Receivable When a company issues the note, it debits (increases) Notes Receivable. Notes Receivable is an asset, which can be either short-term or long-term, depending on the length of the loan). Example 1: Our company loans $100,000 cash to a local merchant, who signs a formal Note which is recorded at the county registrar s office. The merchant promises to pay back the note (plus interest) in 60 days. When the note is issued, we make the following entry: 15-Jun Notes Receivable -- Harland Company 100,000 Cash 100,000 As the merchant uses the money, interest is accrued. 15-Aug Notes Receivable -- Harland Company 500 Interest Income -- Note due from Harland 500 When the merchant repays the loan, the Note is removed from our books. 16-Aug Cash 100,500 Note Receivable -- Harland Company 100,500 10

Credit Card Sales A company dealing with consumers often finds it quite bothersome to extend credit itself. The hassles of credit checks on hundreds or thousands of individual customers can far outweigh the profits to be made from those customer s sales. Also, consumers are much more likely than companies to end up not paying their debts. To avoid this, a niche market developed in the 1970s: universally-accepted credit cards. These are credit cards which are issued by large banks and companies, such as Chase, First Union, American Express, and Diner s Club International. These cards are accepted by merchants who display the Visa, Mastercard, American Express, Dixover, Diner s Club, and other logos. If a merchant desires to accept such cards in lieu of cash, the merchant signs up with one or more of these credit card issuers. The issuer installs equipment in the merchant s place of business (the familiar card-swipe or chip-reader point-of-sale terminal). The credit card company in return gets a percentage of the sales made through that machine. Usually, the credit card company charges 1% or 2%, or perhaps a flat amount, per transction. When a consumer makes a purchase with a credit card, the merchant accepts the card instead of cash. The consumer swipes his or her card, and the equipment communicates with the card issuer to ensure the card is valid and not stolen, and that the consumer has sufficient available credit to cover the sale. From the merchant s point of view, the merchant has made a sale (crediting revenue) for the full amount of the consumer s purchase. But remember, the credit card issuer charges a fee for each transaction. This fee is a selling expense an expense incurred in an attempt to serve customers. The remainder (sale amount less the fee) is deposited in the merchant s bank account. Thus, the entry to record a credit card sale to a consumer for $100.00 (with no sales tax) would be recorded as: 18-Sep Cash 98.00 Credit Card Fee Expense (selling expense) 2.00 Revenue 100.00 11