CHAPTER 8

REPORTING AND ANALYZING RECEIVABLES

PREVIEW OF CHAPTER 8

In this chapter, we discuss some of the decisions related to reporting and analyzing receivables. As indicated in the Feature Story, receivables are a significant asset on the books of Nike. Receivables are important to companies in other industries as well because a larger portion of sales are made on credit in the United States. As a consequence, companies must pay close attention to their receivables balances and manage them carefully. In this chapter, we will look at the accounting and management of receivables at Nike and one of its competitors, Skechers USA.

The organization and content of the chapter are as follows.

Types of Receivables

The term receivables refers to amounts due from individuals and companies. Receivables are claims that are expected to be collected in cash. The management of receivables is a very important activity for any company that sells goods or services on credit.

Receivables are important because they represent one of a company's most liquid assets. For many companies, receivables are also one of the largest assets. For example, receivables represent 20% of the assets of Nike. Illustration 8-1 lists receivables as a percentage of total assets for five other well-known companies in a recent year.

The relative significance of a company's receivables as a percentage of its assets depends on various factors: its industry, the time of year, whether it extends long-term financing, and its credit policies. To reflect important differences among receivables, they are frequently classified as (1) accounts receivable, (2) notes receivable, and (3) other receivables.

Accounts receivable are amounts customers owe on account. They result from the sale of goods and services. Companies generally expect to collect accounts receivable within 30 to 60 days. They are usually the most significant type of claim held by a company.

Notes receivable are a written promise (as evidenced by a formal instrument) for amounts to be received. The note normally requires the collection of interest and extends for time periods of 60–90 days or longer. Notes and accounts receivable that result from sales transactions are often called trade receivables.

Other receivables include nontrade receivables such as interest receivable, loans to company officers, advances to employees, and income taxes refundable. These do not generally result from the operations of the business. Therefore, they are generally classified and reported as separate items in the balance sheet.

Accounts Receivable

Two accounting issues associated with accounts receivable are:

1. Recognizing accounts receivable.
2. Valuing accounts receivable.

A third issue, accelerating cash receipts from receivables, is discussed later in the chapter.

RECOGNIZING ACCOUNTS RECEIVABLE

Recognizing accounts receivable is relatively straightforward. A service organization records a receivable when it performs service on account. A merchandiser records accounts receivable at the point of sale of merchandise on account. When a merchandiser sells goods, it increases (debits) Accounts Receivable and increases (credits) Sales Revenue.

The seller may offer terms that encourage early payment by providing a discount. Sales returns also reduce receivables. The buyer might find some of the goods unacceptable and choose to return the unwanted goods.

To review, assume that Jordache Co. on July 1, 2014, sells merchandise on account to Polo Company for $1,000, terms 2/10, n/30. On July 5, Polo returns merchandise worth $100 to Jordache Co. On July 11, Jordache receives payment from Polo Company for the balance due. The journal entries to record these transactions on the books of Jordache Co. are as follows. (Cost of goods sold entries are omitted.)

Some retailers issue their own credit cards. When you use a retailer's credit card (JCPenney, for example), the retailer charges interest on the balance due if not paid within a specified period (usually 25–30 days).

To illustrate, assume that you use your JCPenney Company credit card to purchase clothing with a sales price of $300 on June 1, 2014. JCPenney will increase (debit) Accounts Receivable for $300 and increase (credit) Sales Revenue for $300 (cost of goods sold entry omitted), as follows.

Assuming that you owe $300 at the end of the month and JCPenney charges 1.5% per month on the balance due, the adjusting entry that JCPenney makes to record interest revenue of $4.50 ($300 × 1.5%) on June 30 is as follows.

Interest revenue is often substantial for many retailers.

VALUING ACCOUNTS RECEIVABLE

Once companies record receivables in the accounts, the next question is: How should they report receivables in the financial statements? Companies report accounts receivable on the balance sheet as an asset. Determining the amount to report is sometimes difficult because some receivables will become uncollectible.

Although each customer must satisfy the credit requirements of the seller before the credit sale is approved, inevitably some accounts receivable become uncollectible. For example, a corporate customer may not be able to pay because it experienced a sales decline due to an economic downturn. Similarly, individuals may be laid off from their jobs or be faced with unexpected hospital bills. The seller records these losses that result from extending credit as Bad Debt Expense. Such losses are a normal and necessary risk of doing business on a credit basis.

Recently, when U.S. home prices fell, home foreclosures rose, and the economy in general slowed, lenders experienced huge increases in their bad debt expense. For example, during a recent quarter Wachovia, a large U.S. bank now owned by Wells Fargo, increased bad debt expense from $108 million to $408 million. Similarly, American Express increased its bad debt expense by 70%.

Accounting uses two methods for uncollectible accounts: (1) the direct write-off method, and (2) the allowance method. We explain each of these methods in the following sections.

Direct Write-Off Method for Uncollectible Accounts

Under the direct write-off method, when a company determines receivables from a particular company to be uncollectible, it charges the loss to Bad Debt Expense. Assume, for example, that Warden Co. writes off M. E. Doran's $200 balance as uncollectible on December 12. Warden's entry is:

Under this method, bad debt expense will show only actual losses from uncollectibles. The company reports accounts receivable at its gross amount without any adjustment for estimated losses for bad debts.

Use of the direct write-off method can reduce the usefulness of both the income statement and balance sheet. Consider the following example. In 2014 Quick Buck Computer Company decided it could increase its revenues by offering computers to college students without requiring any money down, and with no credit-approval process. It went on campuses across the country and sold one million computers at a selling price of $800 each. This promotion increased Quick Buck's revenues and receivables by $800,000,000. It was a huge success: The 2014 balance sheet and income statement looked wonderful. Unfortunately, during 2015, nearly 40% of the college student customers defaulted on their loans. The 2015 income statement and balance sheet looked terrible. Illustration 8-2 shows the effect of these events on the financial statements using the direct write-off method.

Under the direct write-off method, companies often record bad debt expense in a period different from the period in which they recorded the revenue. Thus, no attempt is made to match bad debt expense to sales revenues in the income statement. Nor does the company try to show accounts receivable in the balance sheet at the amount actually expected to be received. Consequently, unless a company expects bad debt losses to be insignificant, the direct write-off method is not acceptable for financial reporting purposes.

Allowance Method for Uncollectible Accounts

The allowance method of accounting for bad debts involves estimating uncollectible accounts at the end of each period. This provides better matching of expenses with revenues on the income statement. It also ensures that receivables are stated at their cash (net) realizable value on the balance sheet. Cash (net) realizable value is the net amount a company expects to receive in cash from receivables. It excludes amounts that the company estimates it will not collect. Estimated uncollectible receivables therefore reduce receivables on the balance sheet through use of the allowance method.

Companies must use the allowance method for financial reporting purposes when bad debts are material in amount. It has three essential features:

1. Companies estimate uncollectible accounts receivable and match them against revenues in the same accounting period in which the revenues are recorded.
2. Companies record estimated uncollectibles as an increase (a debit) to Bad Debt Expense and an increase (a credit) to Allowance for Doubtful Accounts through an adjusting entry at the end of each period. Allowance for Doubtful Accounts is a contra account to Accounts Receivable.
3. Companies debit actual uncollectibles to Allowance for Doubtful Accounts and credit them to Accounts Receivable at the time the specific account is written off as uncollectible.

RECORDING ESTIMATED UNCOLLECTIBLES. To illustrate the allowance method, assume that Hampson Furniture has credit sales of $1,200,000 in 2014, of which $200,000 remains uncollected at December 31. The credit manager estimates that $12,000 of these sales will prove uncollectible. The adjusting entry to record the estimated uncollectibles increases (debits) Bad Debt Expense and increases (credits) Allowance for Doubtful Accounts, as follows.

Companies report Bad Debt Expense in the income statement as an operating expense (usually as a selling expense). Thus, Hampson matches the estimated uncollectibles with sales in 2014 because the expense is recorded in the same year the company makes the sales.

Allowance for Doubtful Accounts shows the estimated amount of claims on customers that companies expect will become uncollectible in the future. Companies use a contra account instead of a direct credit to Accounts Receivable because they do not know which customers will not pay. The credit balance in the allowance account will absorb the specific write-offs when they occur. The company deducts the allowance account from Accounts Receivable in the current assets section of the balance sheet, as shown in Illustration 8-3.

The amount of $188,000 in Illustration 8-3 represents the expected cash realizable value of the accounts receivable at the statement date. Companies do not close Allowance for Doubtful Accounts at the end of the fiscal year.

RECORDING THE WRITE-OFF OF AN UNCOLLECTIBLE ACCOUNT. Various methods are used to collect past-due accounts. When a company exhausts all means of collecting a past-due account and collection appears unlikely, the company writes off the account. In the credit card industry, it is standard practice to write off accounts that are 210 days past due. To prevent premature or unauthorized write-offs, authorized management personnel should formally approve each write-off. To maintain segregation of duties, the employee authorized to write off accounts should not have daily responsibilities related to cash or receivables.

To illustrate a receivables write-off, assume that the vice president of finance of Hampson Furniture on March 1, 2015, authorizes a write-off of the $500 balance owed by R. A. Ware. The entry to record the write-off is:

The company does not increase Bad Debt Expense when the write-off occurs. Under the allowance method, a company debits every bad debt write-off to the allowance account and not to Bad Debt Expense. A debit to Bad Debt Expense would be incorrect because the company has already recognized the expense when it made the adjusting entry for estimated bad debts. Instead, the entry to record the write-off of an uncollectible account reduces both Accounts Receivable and Allowance for Doubtful Accounts. After posting, the general ledger accounts appear as shown in Illustration 8-4.

A write-off affects only balance sheet accounts. Cash realizable value in the balance sheet, therefore, remains the same before and after the write-off, as shown in Illustration 8-5.

RECOVERY OF AN UNCOLLECTIBLE ACCOUNT. Occasionally, a company collects from a customer after the account has been written off as uncollectible. The company must make two entries to record the recovery of a bad debt: (1) It reverses the entry made in writing off the account. This reinstates the customer's account. (2) It journalizes the collection in the usual manner.

To illustrate, assume that on July 1, R. A. Ware pays the $500 amount that Hampson Furniture had written off on March 1. Hampson makes these entries:

Note that the recovery of a bad debt, like the write-off of a bad debt, affects only balance sheet accounts. The net effect of the two entries is an increase in Cash and an increase in Allowance for Doubtful Accounts for $500. Accounts Receivable and Allowance for Doubtful Accounts both increase in entry (1) for two reasons. First, the company made an error in judgment when it wrote off the account receivable. Second, R. A. Ware did pay, and therefore the Accounts Receivable account should show this reinstatement and collection for possible future credit purposes.

ESTIMATING THE ALLOWANCE. For Hampson Furniture in Illustration 8-3, the amount of the expected uncollectibles was given. However, in “real life,” companies must estimate the amount of expected uncollectible accounts if they use the allowance method. Illustration 8-6 shows an excerpt from the notes to Nike's financial statements discussing its use of the allowance method.

Frequently, companies estimate the allowance as a percentage of the outstanding receivables. Under the percentage-of-receivables basis, management establishes a percentage relationship between the amount of receivables and expected losses from uncollectible accounts. For example, suppose Steffen Company has an ending balance in Accounts Receivable of $200,000, and an unadjusted credit balance in Allowance for Doubtful Accounts of $1,500. It estimates that 5% of its accounts receivable will eventually be uncollectible. It should report a balance in Allowance for Doubtful Accounts of $10,000 (.05 × $200,000). To increase the balance in Allowance for Doubtful Accounts from $1,500 to $10,000, the company debits (increases) Bad Debt Expense and credits (increases) Allowance for Doubtful Accounts by $8,500 ($10,000 − $1,500).

To more accurately estimate the ending balance in the allowance account, a company often prepares a schedule, called aging the accounts receivable. This schedule classifies customer balances by the length of time they have been unpaid.

After the company arranges the accounts by age, it determines the expected bad debt losses by applying percentages, based on past experience, to the totals of each category. The longer a receivable is past due, the less likely it is to be collected. As a result, the estimated percentage of uncollectible debts increases as the number of days past due increases. Illustration 8-7 shows an aging schedule for Dart Company. Note the increasing uncollectible percentages from 2% to 40%.

Total estimated uncollectible accounts for Dart Company ($2,228) represent the existing customer claims expected to become uncollectible in the future. Thus, this amount represents the required balance in Allowance for Doubtful Accounts at the balance sheet date. Accordingly, the amount of bad debt expense that should be recorded in the adjusting entry is the difference between the required balance and the existing balance in the allowance account. The existing, unadjusted balance in Allowance for Doubtful Accounts is the net result of the beginning balance (a normal credit balance) less the write-offs of specific accounts during the year (debits to the allowance account).

For example, if the unadjusted trial balance shows Allowance for Doubtful Accounts with a credit balance of $528, then an adjusting entry for $1,700 ($2,228 − $528) is necessary:

After Dart posts the adjusting entry, its accounts appear as shown in Illustration 8-8.

An important aspect of accounts receivable management is simply maintaining a close watch on the accounts. Studies have shown that accounts more than 60 days past due lose approximately 50% of their value if no payment activity occurs within the next 30 days. For each additional 30 days that pass, the collectible value halves once again.

Occasionally, the allowance account will have a debit balance prior to adjustment. This occurs because the debits to the allowance account from write-offs during the year exceeded the beginning balance in the account which was based on previous estimates for bad debts. In such a case, the company adds the debit balance to the required balance when it makes the adjusting entry. Thus, if there was a $500 debit balance in the allowance account before adjustment, the adjusting entry would be for $2,728 ($2,228 + $500) to arrive at a credit balance of $2,228 (see T-account in margin).

The percentage-of-receivables basis provides an estimate of the cash realizable value of the receivables. It also provides a reasonable matching of expense to revenue.

The following note regarding accounts receivable comes from the annual report of the shoe company Skechers USA.

Notes Receivable

Companies also may grant credit in exchange for a formal credit instrument known as a promissory note. A promissory note is a written promise to pay a specified amount of money on demand or at a definite time. Promissory notes may be used (1) when individuals and companies lend or borrow money, (2) when the amount of the transaction and the credit period exceed normal limits, and (3) in settlement of accounts receivable.

In a promissory note, the party making the promise to pay is called the maker. The party to whom payment is to be made is called the payee. The promissory note may specifically identify the payee by name or may designate the payee simply as the bearer of the note.

In the note shown in Illustration 8-10, Brent Company is the maker, and Wilma Company is the payee. To Wilma Company, the promissory note is a note receivable. To Brent Company, the note is a note payable.

Notes receivable give the holder a stronger legal claim to assets than do accounts receivable. Like accounts receivable, notes receivable can be readily sold to another party. Promissory notes are negotiable instruments (as are checks), which means that, when sold, the seller can transfer them to another party by endorsement.

Companies frequently accept notes receivable from customers who need to extend the payment of an outstanding account receivable. Companies also often require notes from high-risk customers. In some industries (e.g., the pleasure and sport boat industry), all credit sales are supported by notes. The majority of notes, however, originate from lending transactions.

There are five issues in accounting for notes receivable:

1. Determining the maturity date.
2. Computing interest.
3. Recognizing notes receivable.
4. Valuing notes receivable.
5. Disposing of notes receivable.

We look at each of these issues.

DETERMINING THE MATURITY DATE

The maturity date of a promissory note may be stated in one of three ways: (1) on demand, (2) on a stated date, and (3) at the end of a stated period of time. When it is stated to be at the end of a period of time, the parties to the note will need to determine the maturity date.

When the life of a note is expressed in terms of months, you find the date when it matures by counting the months from the date of issue. For example, the maturity date of a three-month note dated May 1 is August 1. A note drawn on the last day of a month matures on the last day of a subsequent month. That is, a July 31 note due in two months matures on September 30.

When the due date is stated in terms of days, you need to count the exact number of days to determine the maturity date. In counting, omit the date the note is issued but include the due date.

COMPUTING INTEREST

Illustration 8-11 gives the basic formula for computing interest on an interest-bearing note.

The interest rate specified on the note is an annual rate of interest. The time factor in the computation expresses the fraction of a year that the note is outstanding. When the maturity date is stated in days, the time factor is frequently the number of days divided by 360. When counting days, omit the date the note is issued but include the due date. When the due date is stated in months, the time factor is the number of months divided by 12. Illustration 8-12 shows computation of interest for various time periods.

There are different ways to calculate interest. For example, the computation in Illustration 8-12 assumes 360 days for the year. Most financial institutions use 365 days to compute interest. For homework problems, assume 360 days to simplify computations.

RECOGNIZING NOTES RECEIVABLE

To illustrate the basic entry for notes receivable, we will use Brent Company's $1,000, two-month, 8% promissory note dated May 1. Assuming that Brent Company wrote the note to settle an open account, Wilma Company makes the following entry for the receipt of the note.

The company records the note receivable at its face value, the value shown on the face of the note. No interest revenue is reported when the company accepts the note because the revenue recognition principle does not recognize revenue until the performance obligation is satisfied. Interest is earned (accrued) as time passes.

If a company issues cash in exchange for a note, the entry is a debit to Notes Receivable and a credit to Cash in the amount of the loan.

VALUING NOTES RECEIVABLE

Like accounts receivable, companies report short-term notes receivable at their cash (net) realizable value. The notes receivable allowance account is Allowance for Doubtful Accounts. Valuing short-term notes receivable is the same as valuing accounts receivable. The computations and estimations involved in determining cash realizable value and in recording the proper amount of bad debt expense and related allowance are similar.

Long-term notes receivable, however, pose additional estimation problems. As an example, we need only look at the problems large U.S. banks sometimes have in collecting their receivables. Loans to less-developed countries are particularly worrisome. Developing countries need loans for development but often find repayment difficult. In some cases, developed nations have intervened to provide financial assistance to the financially troubled borrowers so as to minimize the political and economic turmoil to the borrower and to ensure the survival of the lender.

DISPOSING OF NOTES RECEIVABLE

Notes may be held to their maturity date, at which time the face value plus accrued interest is due. In some situations, the maker of the note defaults, and the payee must make an appropriate adjustment. In other situations, similar to accounts receivable, the holder of the note speeds up the conversion to cash by selling the receivables (as described later in this chapter).

Honor of Notes Receivable

A note is honored when its maker pays in full at its maturity date. For each interest-bearing note, the amount due at maturity is the face value of the note plus interest for the length of time specified on the note.

To illustrate, assume that Wolder Co. lends Higley Inc. $10,000 on June 1, accepting a five-month, 9% interest note. In this situation, interest is $375 . The amount due, the maturity value, is $10,375 ($10,000 + $375). To obtain payment, Wolder (the payee) must present the note either to Higley Inc. (the maker) or to the maker's agent, such as a bank. If Wolder presents the note to Higley Inc. on November 1, the maturity date, Wolder's entry to record the collection is:

Accrual of Interest Receivable

Suppose instead that Wolder Co. prepares financial statements as of September 30. The timeline in Illustration 8-13 presents this situation.

To reflect interest earned but not yet received, Wolder must accrue interest on September 30. In this case, the adjusting entry by Wolder is for four months of interest, or $300, as shown below.

At the note's maturity on November 1, Wolder receives $10,375. This amount represents repayment of the $10,000 note as well as five months of interest, or $375, as shown on the next page. The $375 is comprised of the $300 Interest Receivable accrued on September 30 plus $75 earned during October. Wolder's entry to record the honoring of the Higley note on November 1 is:

In this case, Wolder credits Interest Receivable because the receivable was established in the adjusting entry on September 30.

Dishonor of Notes Receivable

A dishonored (defaulted) note is a note that is not paid in full at maturity. A dishonored note receivable is no longer negotiable. However, the payee still has a claim against the maker of the note for both the note and the interest. If the lender expects that it eventually will be able to collect, the two parties negotiate new terms to make it easier for the borrower to repay the debt. If there is no hope of collection, the payee should write off the face value of the note.

Financial Statement Presentation of Receivables

Companies should identify in the balance sheet or in the notes to the financial statements each of the major types of receivables. Short-term receivables are reported in the current assets section of the balance sheet, below short-term investments. Short-term investments appear before short-term receivables because these investments are nearer to cash. Companies report both the gross amount of receivables and the allowance for doubtful accounts.

Receivables represent 53% of the total assets of heavy equipment manufacturer Deere & Company. Illustration 8-14 (page 412) shows a presentation of receivables for Deere & Company from its balance sheet and notes in a recent year.

In the income statement, companies report bad debt expense under “Selling expenses” in the operating expenses section. They show interest revenue under “Other revenues and gains” in the nonoperating section of the income statement.

If a company has significant risk of uncollectible accounts or other problems with its receivables, it is required to discuss this possibility in the notes to the financial statements.

Managing Receivables

Managing accounts receivable involves five steps:

1. Determine to whom to extend credit.
2. Establish a payment period.
3. Monitor collections.
4. Evaluate the liquidity of receivables.
5. Accelerate cash receipts from receivables when necessary.

EXTENDING CREDIT

Every entrepreneur struggles with financing issues. For example, the very first order that Apple's founders received was 50 circuit boards to a computer hobby shop. To produce the $25,000 order, Steve Jobs and Steve Wozniak needed $15,000 of parts. To purchase the parts, they borrowed $5,000 from friends but then were turned down when they applied for a bank loan for the $10,000 balance. They approached two parts suppliers in an effort to negotiate a purchase on credit, but both suppliers said no. Finally, a third supplier agreed to sell them the parts on 30-day credit after he called the computer hobby shop to confirm that it had, in fact, placed a $25,000 order to purchase goods.

A critical part of managing receivables is determining who should be extended credit and who should not. Many companies increase sales by being generous with their credit policy. However, they sometimes extend credit to risky customers who do not pay. But if your credit policy is too tight, you will lose sales. If it is too loose, you may sell to “deadbeats” who will pay either very late or not at all. One CEO noted that prior to getting his credit and collection department in order, his salespeople had 300 square feet of office space per person, while the people in credit and collections had six people crammed into a single 300-square-foot space. Although this focus on sales boosted sales revenue, it had very expensive consequences in bad debt expense.

Companies can take certain steps to help minimize losses due to bad debts when they decide to relax credit standards for new customers. They might require risky customers to provide letters of credit or bank guarantees. Then, if the customer does not pay, the bank that provided the guarantee will do so. Particularly risky customers might be required to pay cash on delivery. For example, at one time retailer Linens'n Things, Inc. reported that its largest suppliers were requiring cash payment before delivery. The suppliers had cut off shipments because the company had been slow in paying. Kmart's suppliers also required it to pay cash in advance when it was financially troubled.

In addition, companies should ask potential customers for references from banks and suppliers, to determine their payment history. It is important to check references of potential new customers as well as periodically to check the financial health of continuing customers. Many resources are available for investigating customers. For example, The Dun & Bradstreet Reference Book of American Business (www.dnb.com) lists millions of companies and provides credit ratings for many of them.

ESTABLISHING A PAYMENT PERIOD

Companies that extend credit should determine a required payment period and communicate that policy to their customers. It is important that the payment period is consistent with that of competitors. For example, if you require payment within 15 days but your competitors allow payment within 45 days, you may lose sales to your competitors. To match your competitors’ generous terms yet still encourage prompt payment of accounts, you might allow up to 45 days to pay but offer a sales discount for people paying within 15 days.

MONITORING COLLECTIONS

We discussed preparation of the accounts receivable aging schedule earlier in the chapter (pages 404–406). Companies should prepare an accounts receivable aging schedule at least monthly. In addition to estimating the allowance for doubtful accounts, the aging schedule has other uses. It helps managers estimate the timing of future cash inflows, which is very important to the treasurer's efforts to prepare a cash budget. It provides information about the overall collection experience of the company and identifies problem accounts. For example, management would compute and compare the percentage of receivables that are over 90 days past due. Illustration 8-15 contains an excerpt from the notes to Skechers’ financial statements discussing how it monitors receivables.

The aging schedule identifies problem accounts that the company needs to pursue with phone calls, letters, and occasionally legal action. Sometimes, special arrangements must be made with problem accounts. For example, it was reported that Intel Corporation (a major manufacturer of computer chips) required that Packard Bell (at one time one of the largest U.S. sellers of personal computers) exchange its past-due account receivable for an interest-bearing note receivable. This caused concern within the investment community. The move suggested that Packard Bell was in trouble, which worried Intel investors concerned about Intel's accounts receivable.

If a company has significant concentrations of credit risk, it must discuss this risk in the notes to its financial statements. A concentration of credit risk is a threat of nonpayment from a single large customer or class of customers that could adversely affect the financial health of the company. Illustration 8-16 shows an excerpt from the credit risk note from the 2011 annual report of Skechers. Skechers reports that its five largest customers account for 17.8% of its net sales, and two of its customers account for 22.5% of its receivables.

This note to Skechers’ financial statements indicates it has a relatively high concentration of credit risk. A default by any of these large customers could have a significant negative impact on its financial performance.

EVALUATING LIQUIDITY OF RECEIVABLES

Investors and managers keep a watchful eye on the relationship among sales, accounts receivable, and cash collections. If sales increase, then accounts receivable are also expected to increase. But a disproportionate increase in accounts receivable might signal trouble. Perhaps the company increased its sales by loosening its credit policy, and these receivables may be difficult or impossible to collect. Such receivables are considered less liquid. Recall that liquidity is measured by how quickly certain assets can be converted to cash.

The ratio that analysts use to assess the liquidity of receivables is the accounts receivable turnover, computed by dividing net credit sales (net sales less cash sales) by the average net accounts receivable during the year. This ratio measures the number of times, on average, a company collects receivables during the period. Unless seasonal factors are significant, average accounts receivable outstanding can be computed from the beginning and ending balances of the net receivables.¹

A popular variant of the accounts receivable turnover is the average collection period, which measures the average amount of time that a receivable is outstanding. This is done by dividing the accounts receivable turnover into 365 days. Companies use the average collection period to assess the effectiveness of a company's credit and collection policies. The average collection period should not greatly exceed the credit term period (i.e., the time allowed for payment).

The following data (in millions) are available for Nike.

Illustration 8-17 (page 416) shows the accounts receivable turnover and average collection period for Nike and Skechers, along with comparative industry data. These calculations assume that all sales were credit sales.

Nike's accounts receivable turnover was 7.2 times in 2011, with a corresponding average collection period of 50.7 days. This was slightly faster than its 2010 collection period. It was slower than the industry average collection period of 29.9 days and slightly higher than Skechers, which was 50 days. What this means is that Nike turned its receivables into cash more slowly than most other companies in its industry. Therefore, it was less likely to pay its current obligations than a company with a quicker accounts receivable turnover (all else equal) and is more likely to need outside financing to meet cash shortfalls.

In some cases, accounts receivable turnover may be misleading. Some large retail chains that issue their own credit cards encourage customers to use these cards for purchases. If customers pay slowly, the stores earn a healthy return on the outstanding receivables in the form of interest at rates of 18% to 22%. On the other hand, companies that sell (factor) their receivables on a consistent basis will have a faster turnover than those that do not. Thus, to interpret accounts receivable turnover, you must know how a company manages its receivables. In general, the faster the turnover, the greater the reliability of the current ratio for assessing liquidity.

ACCELERATING CASH RECEIPTS

In the normal course of events, companies collect accounts receivable in cash and remove them from the books. However, as credit sales and receivables have grown in size and significance, the “normal course of events” has changed. Two common expressions apply to the collection of receivables: (1) “Time is money”—that is, waiting for the normal collection process costs money. (2) “A bird in the hand is worth two in the bush”—that is, getting the cash now is better than getting it later or not at all. Therefore, in order to accelerate the receipt of cash from receivables, companies frequently sell their receivables to another company for cash, thereby shortening the cash-to-cash operating cycle.

There are three reasons for the sale of receivables. The first is their size. In recent years, for competitive reasons, sellers (retailers, wholesalers, and manufacturers) often have provided financing to purchasers of their goods. For example, many major companies in the automobile, truck, industrial and farm equipment, computer, and appliance industries have created companies that accept responsibility for accounts receivable financing. Caterpillar has Caterpillar Financial Services, General Electric has GE Capital, and Ford has Ford Motor Credit Corp. (FMCC). These companies are referred to as captive finance companies because they are owned by the company selling the product. The purpose of captive finance companies is to encourage the sale of the company's products by assuring financing to buyers. However, the parent companies involved do not necessarily want to hold large amounts of receivables, so they may sell them.

Second, companies may sell receivables because they may be the only reasonable source of cash. When credit is tight, companies may not be able to borrow money in the usual credit markets. Even if credit is available, the cost of borrowing may be prohibitive.

A final reason for selling receivables is that billing and collection are often time-consuming and costly. As a result, it is often easier for a retailer to sell the receivables to another party that has expertise in billing and collection matters. Credit card companies such as MasterCard, Visa, American Express, and Discover specialize in billing and collecting accounts receivable.

Sale of Receivables to a Factor

A common way to accelerate receivables collection is a sale to a factor. A factor is a finance company or bank that buys receivables from businesses for a fee and then collects the payments directly from the customers.

Factoring was traditionally associated with the textiles, apparel, footwear, furniture, and home furnishing industries. It has now spread to other types of businesses and is a multibillion dollar industry. For example, Sears, Roebuck & Co. (now Sears Holdings) once sold $14.8 billion of customer accounts receivable. McKesson has a pre-arranged agreement allowing it to sell up to $700 million of its receivables.

Factoring arrangements vary widely, but typically the factor charges a commission. It ranges from 1% to 3% of the amount of receivables purchased. To illustrate, assume that Hendredon Furniture factors $600,000 of receivables to Federal Factors, Inc. Federal Factors assesses a service charge of 2% of the amount of receivables sold. The following journal entry records Hendredon's sale of receivables on April 2, 2014.

If the company usually sells its receivables, it records the service charge expense as a selling expense. If the company sells receivables infrequently, it may report this amount under “Other expenses and losses” in the income statement.

National Credit Card Sales

Approximately one billion credit cards were in use recently—more than three credit cards for every man, woman, and child in this country. A common type of credit card is a national credit card such as Visa and MasterCard. Three parties are involved when national credit cards are used in making retail sales: (1) the credit card issuer, who is independent of the retailer; (2) the retailer; and (3) the customer. A retailer's acceptance of a national credit card is another form of selling—factoring—the receivable by the retailer.

The use of national credit cards translates to more sales and zero bad debts for the retailer. Both are powerful reasons for a retailer to accept such cards. Illustration 8-18 shows the major advantages of national credit cards to the retailer. In exchange for these advantages, the retailer pays the credit card issuer a fee of 2% to 4% of the invoice price for its services.

The retailer considers sales resulting from the use of Visa and MasterCard as cash sales. Upon notification of a credit card charge from a retailer, the bank that issued the card immediately adds the amount to the seller's bank balance. Companies therefore record these credit card charges in the same manner as checks deposited from a cash sale.

To illustrate, Morgan Marie purchases $1,000 of compact discs for her restaurant from Sondgeroth Music Co., and she charges this amount on her Visa First Bank Card. The service fee that First Bank charges Sondgeroth Music is 3%. Sondgeroth Music's entry to record this transaction on March 22, 2014, is:

Illustration 8-19 (page 420) summarizes the basic principles of managing accounts receivable.

Summary of Learning Objectives

1. Identify the different types of receivables. Receivables are frequently classified as accounts, notes, and other. Accounts receivable are amounts customers owe on account. Notes receivable represent claims that are evidenced by formal instruments of credit. Other receivables include nontrade receivables such as interest receivable, loans to company officers, advances to employees, and income taxes refundable.
2. Explain how accounts receivable are recognized in the accounts. Companies record accounts receivable when they perform a service on account or at the point-of-sale of merchandise on account. Sales returns and allowances, and cash discounts reduce the amount received on accounts receivable.
3. Describe the methods used to account for bad debts. The two methods of accounting for uncollectible accounts are the allowance method and the direct write-off method. Under the allowance method, companies estimate uncollectible accounts as a percentage of receivables. It emphasizes the cash realizable value of the accounts receivable. An aging schedule is frequently used with this approach.
4. Compute the interest on notes receivable. The formula for computing interest is: Face value of note × Annual interest rate × Time in terms of one year.
5. Describe the entries to record the disposition of notes receivable. Notes can be held to maturity, at which time the borrower (maker) pays the face value plus accrued interest and the payee removes the note from the accounts. In many cases, however, similar to accounts receivable, the holder of the note speeds up the conversion by selling the receivable to another party. In some situations, the maker of the note dishonors the note (defaults), and the note is written off.
6. Explain the statement presentation of receivables. Companies should identify each major type of receivable in the balance sheet or in the notes to the financial statements. Short-term receivables are considered current assets. Companies report the gross amount of receivables and allowance for doubtful accounts. They report bad debt and service charge expenses in the income statement as operating (selling) expenses, and interest revenue as other revenues and gains in the nonoperating section of the statement.
7. Describe the principles of sound accounts receivable management. To properly manage receivables, management must (a) determine to whom to extend credit, (b) establish a payment period, (c) monitor collections, (d) evaluate the liquidity of receivables, and (e) accelerate cash receipts from receivables when necessary.
8. Identify ratios to analyze a company's receivables. The accounts receivable turnover and the average collection period both are useful in analyzing management's effectiveness in managing receivables. The accounts receivable aging schedule also provides useful information.
9. Describe methods to accelerate the receipt of cash from receivables. If the company needs additional cash, management can accelerate the collection of cash from receivables by selling (factoring) its receivables or by allowing customers to pay with bank credit cards.