Receivables and Payables
This chapter discusses accounts receivable, uncollectible accounts, bad debts, and accounts payable.
Pay attention to aging schedules, how to write off receivables, and how credit card transactions should be identified and recorded from the business entity's perspective. Various forms of liabilities that a company might incur are described. Since most businesses operate mainly on credit sales, it is important to understand the implications of your credit and collections policies. Liabilities can be strategically important for a business, and are a necessary part of doing business. However, debt increases the risk of a company, and managing liabilites is crucial for business survival.
Analyzing and using the financial results - Accounts receivable turnover
Understanding the learning objectives
• Companies use two methods to account for uncollectible accounts receivable: the allowance method, which provides in advance for uncollectible accounts; and the direct write-off method, which recognizes uncollectible accounts as an expense when judged uncollectible. The allowance method is the preferred method and is the only method discussed and illustrated in this text.
• The two basic methods for estimating uncollectible accounts under the allowance method are the percentage-of-sales method and the percentage-ofreceivables method.
• The percentage-of-sales method focuses attention on the income statement and the relationship of uncollectible accounts to sales. The debit to Uncollectible Accounts Expense is a certain percent of credit sales or total net sales.
• The percentage-of-receivables method focuses attention on the balance sheet and the relationship of the allowance for uncollectible accounts to accounts receivable. The credit to the Allowance for Uncollectible Accounts is the amount necessary to bring that account up to a certain percentage of the Accounts Receivable balance. Either one overall percentage or an aging schedule may be used.
• Credit cards are charge cards used by customers to charge purchases of goods and services. These cards are of two types - nonbank credit cards (such as American Express) and bank credit cards (such as VISA).
• The sale is recorded at the gross amount of the sale, and the cash or receivable is recorded at the net amount the company will receive.
• Liabilities result from some past transaction and are obligations to pay cash, provide services, or deliver goods at some time in the future.
• Current liabilities are obligations that (1) are payable within one year or one operating cycle, whichever is longer, or (2) will be paid out of current assets or create other current liabilities.
• Long-term liabilities are obligations that do not qualify as current liabilities.
• Clearly determinable liabilities are those for which the existence of the liability and its amount are certain. An example is accounts payable.
• Estimated liabilities are those for which the existence of the liability is certain, but its amount can only be estimated. An example is estimated product warranty payable.
• Contingent liabilities are those for which the existence, and usually the amount, are uncertain because these liabilities depend (or are contingent) on some future event occurring or not occurring. An example is a liability arising from a lawsuit.
• A promissory note is an unconditional written promise by a borrower (maker) to pay the lender (payee) or someone else who legally acquired the note a certain sum of money on demand or at a definite time.
• Interest is the fee charged for the use of money through time.
Interest=Principal×Rate of interest×Time.
• Companies sometimes need short-term financing. Short-term financing may be secured by issuing interest-bearing notes or by issuing non interest-bearing notes.
• An interest-bearing note specifies the interest rate that will be charged on the principal borrowed.
• A non interest-bearing note does not have a stated interest rate applied to the face value of the note.
• Calculate accounts receivable turnover by dividing net credit sales, or net sales, by average net accounts receivable.
• Calculate the number of days' sales in accounts receivable (or average collection period) by dividing the number of days in the year by the accounts receivable turnover.
• Together, these ratios show the liquidity of accounts receivable and give some indication of their quality. Generally, the higher the accounts receivable turnover, the better; and the shorter the average collection period, the better.