Chapter 8: Receivables

Introduction

Management of receivables is a crucial issue for companies. In this chapter, we mainly provide general information regarding receivables, especially accounts receivables and notes receivables. We also briefly discuss practical issues, which International Financial Reporting Standards deal with. More precisely, we explain valuation and expense methods of uncollectible accounts receivables. Further, we discover how to analyze receivables. Finally, we consider recognition of notes receivables and calculation of interest.

Receivables

Receivable is an accounting term associated with the amounts that are owed to the business by other parties, mainly its customers.

Receivables can be classified with respect to the nature of the transaction or with respect to their maturity structures.

Generally, receivables are classified into three main categories:

1. Accounts Receivables
2. Notes Receivables
3. Other Receivables

Receivables can be also classified as current (short-term) and non-current (long-term) receivables with respect to their maturity structures.

Receivables are one of the main categories within current assets of a company. Management of receivables is so important that if managers do not pay sufficient attention to handle it, the company may have to bear the risk of default of customers.

Accounts Receivable

Accounts receivable is the amount owed to a company by customers as a result of delivering goods or services.

There are three main accounting issues with respect to the accounting of receivables. They are:

1. Recognition of accounts receivable
2. Valuation of accounts receivable
3. Disposition of accounts receivable

Recognition of Accounts Receivable: Accounts receivable arises when a company sells goods or services to its customer on credit in its normal course of business. When the company sells its goods or services on cash basis, there would be no need to consider for accounts receivables. In such a case, cash account is debited; the sales revenue account is credited.

Sales returns and allowances reduce the amount of accounts receivables since the customer delivers back the goods or the company waives a portion of its claim due to product defects.

Trade discount is the reduction in the catalogue price or listed price of the goods. Trade discounts reduce the final sales price and are not affected by the date of payment.

Cash discounts are intended to encourage the customer to make their payment earlier.

Valuation of Accounts Receivables; After recording the receivables in the accounts, the accounts will be reflected in the financial statements, i.e. income statement and balance sheet.

Uncollectible Accounts Receivable (Bad Debts)

In order to ensure that account receivables are not overstated on the balance sheet, they are reported in their cash (net) realizable value . This value deducts the amounts that the business expects it might not be able to get from its receivables.

Bad debt expense is an income statement account that shows the losses incurred due to uncollectible receivables.

Uncollectible accounts receivables are treated under the allowance method or the direct write-off method.

Allowance method is used for company’s financial reporting objectives when the uncollectible debts are significant in nature. This means they are in material amount.

One important issue regarding allowances is how to record the written-off uncollectible account receivables. Whenever a company becomes sure that a particular customer will not be able to repay and hence that account receivable would be uncollectible, then that particular account receivable will no longer be categorized as an asset, so it has to be written off from the books. This write-off means to deduct the receivables balance of that specific customer’s account to nil.

Percent-of-Sales Approach: In a situation where a company has been in a business for a long time, it might be able to use historical relationships between bad debts and net credit sales to estimate bad debts amount. This approach is based on historical or past experience and forecasted credit policies.

Aging Approach: Firms often believe that they are able to forecast bad debts if they relate them to the balance in the Account Receivable account at the end of the period instead of the sales of that period. Under the percentage of Account receivable approach, companies establish a percentage relationship between the amount of account receivables and forecasted losses from bad debts accounts.

Direct Write-off Method: It is mainly used by relatively small and private companies. Under this method, a company does not estimate bad debts losses and does not use allowance account for the expenses based on estimates. Instead, when a specific receivable is considered to be uncollectible or worthless, the loss amount is charged directly to the uncollectible account expense.

Disposing of Accounts Receivable

Normally, companies collect account receivables in cash and remove it from the books simultaneously. However, in recent years as credit sales and receivables have grown considerably, some companies have started to sell their receivables to other companies in order to accelerate receipt of cash from receivables.

Selling Receivables: The most practiced method to sell receivables is the sale to a factor, also called as factoring. Factoring is the business of purchasing receivables from companies upon a fee for the services performed to manage and collect receivables.

Credit Card Sales: Credit card companies are not providing these benefits for free. They are charging a commission fee of 1% to 5% normally on a sale. This means the businesses are not getting 100% of the face value of their sale.

Debit Card Sales: Using a debit card is similar to paying with cash, except that the customers will not have to carry cash with them. When debit card is swapped by retailer at the point of sale terminal (POS) or cash counter, the bank balance of the customer is automatically reduced and the amount is transferred to retailer’s account.

Analyzing the Accounts Receivable

Managers, investors and financial analysts are keenly interested to know how well a company manages and controls its account receivables. One simple measure or ratio to evaluate a company’s ability to analyze its receivables is accounts receivable turnover ratio.

Accounts Receivable Turnover Ratio measures the liquidity of accounts receivable and is calculated as net credit sales divided by net accounts receivable.

Another type of accounts receivable analysis receivable is a trend line of the proportion of customer sales that are paid at the time of sale, noting the payment type used. Changes in a company’s sales policies may shift sales toward or away from up-front payments, which therefore has an impact on the amount and characteristics of accounts receivable.

Notes Receivable

Notes receivable is a type of claim of a company that holds a formal written promise from another party to collect a specific amount of cash in near future. It is recorded as an asset in the books of a company that is entitled to receive the amount.

Promissory note is a written agreement or a commitment to pay a particular amount of promised money at a particular period of time.

A company that receives a promissory note from another party has an asset called “ notes receivable ” and the company that sends or makes the promissory note has a liability called “ notes payable ”.

Maker is the writer of a note, promises to pay.

Payee is the receiver of a note, to get the payment.

Determining the Maturity Date: If the life of a promissory note is in months, then the due date of that note is calculated by counting the months from that date on which it is issued. If the maturity of the note is stated in number of days, then the exact days will be counted to ensure exact maturity date.

Recognition of Notes Receivable: Notes receivables are recorded at its face value, the value that is stated on the face of the note. When the note is accepted, no interest revenue is reported because according to the revenue recognition concept of accounting, revenue is not recognized until it is earned. In this case, interest is earned as time passes.

Valuation of Notes Receivable: Valuation of notes receivables is very similar to the valuation of accounts receivables. First, just as in the case of accounts receivables, the difference between the sales price and the cash equivalent price should be treated as deferred income as a contra-asset account, which should be allocated to the profit/loss accounts in each accounting period.

Disposition of Notes Receivable: Notes receivable may be held until maturity date, when both the face value and the accrued interest are due. However, in some cases the issuer or writer of the note defaults and appropriate adjustments have to be made simultaneously.