- Read: Revsine: Chapters 9, 11
- Read: Chapter 9 – Receivables
- Read: Chapter 11 – Long-Lived Assets
- Watch: Module 4 Presentation https://canvas.liberty.edu/courses/950718/pages/watch-module-4-presentation?module_item_id=90922760
Case Study: IFRS Adoption in the U.S. Assignment
Receivables
Revsine/Collins/Johnson/Mittelstaedt/Soffer: Chapter 9
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Learning Objectives 1 After studying this chapter, you will understand:
How to account for accounts receivable using net realizable value.
How to analyze accounts receivable under net realizable value accounting.
How to evaluate whether or not reported receivables arose from real sales and how to spot danger signals.
How to impute and record interest when notes receivable have either no explicit interest or an unrealistically low interest rate.
How to account for accounts and notes receivable using the fair value option.
How companies use receivables to accelerate cash inflows and how the accounting treatment affects financial statement ratios.
Why receivables are securitized and how the accounting treatment affects financial statement ratios.
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Learning Objectives 2 After studying this chapter, you will understand:
Why receivables are restructured when a customer experiences financial difficulty and how to account for the troubled-debt restructuring.
The key differences between current G A A P and I F R S requirements for receivable accounting.
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Assessing the Net Realizable Value of Accounts Receivable
Accounts receivable are generally reflected in the balance sheet at net realizable value.
Two things must be estimated to determine the net realizable value of receivables:
Credit losses—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 for credit or are allowed a reduction in the amount owed.
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Accounting for Credit Losses 1
Most companies establish credit policies by weighing the expected cost of credit sales against the benefit of increased sales.
Expected cost:
Customer collection and billing costs plus potential bad debts.
This tradeoff illustrates that bad debts are often unavoidable.
Accrual accounting requires that some estimate of uncollectible accounts be offset against current period sales.
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Treatment of Bad Debt Losses
Traditionally, firms referred to losses from uncollectible accounts as bad debt expense and treated them as operating expenses.
However, the final F A S B revenue recognition standard, effective for fiscal years beginning after December 15, 2017, requires that bad debt losses be treated as expenses and include them with other impairment losses.
The impairment losses must be disclosed separately if material.
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Recording and Reporting the Allowance for Credit Losses
Bristol Corporation estimates that bad debt losses arising from first quarter sales are expected to be $30,000.
| D R Credit loss expense | $30,000 | |
| C R Allowance for credit losses | $30,000 |
A contra-asset account subtracted from gross accounts receivable.
If Bristol’s gross accounts receivable and allowance for credit losses before recording this entry were $1,500,000 and $15,000, respectively, then after the entry the balance sheet would show:
| Accounts receivable (gross) | $1,500,000 |
| Less: Allowance for credit losses | (45,000) |
| Accounts receivable (net) | $1,455,000 |
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Approaches to Estimating Uncollectible Accounts: Sales Revenue Approach
Bristol Corporation prepares quarterly financial statements and must estimate the bad debt provision at the end of each quarter. Analyzing past customer payment patterns, Bristol determined that bad debt losses average about 1% of sales. First quarter sales total $3,000,000.
Sales Revenue Approach
Estimate the current period bad debt provision as a percentage of current period sales. For Bristol Corporation, the estimate is:
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Approaches to Estimating Uncollectible Accounts: Gross Receivables Approach
Gross Receivables Approach
Estimate the required allowance account balance as a percentage of gross receivables and then adjust the allowance upward or downward to this figure. For Bristol Corporation, the required allowance account balance is:
Access the text alternative for slide images.
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Writing Off Credit Losses
When a specific account receivable is known to be definitely uncollectible, the amount must be removed from the books.
Assume that Bristol later determines that a $750 receivable from Ralph Company cannot be collected.
| D R Allowance for credit losses | $750 | |
| C R Accounts receivable – Ralph Company | $750 |
Notice that the entry has no effect on income.
The specific account receivable (Ralph Company) is eliminated from the books and the allowance contra-account is reduced, but no credit loss expense is recorded.
This is consistent with the accrual accounting philosophy of recording estimated uncollectibles when the sales is made rather than at a later date when the nonpayment is identified.
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Assessing the Adequacy of the Allowance for Credit Losses Account Balance 1
No matter which method is used to estimate bad debts, management must periodically assess the reasonableness of the allowance for uncollectibles balance.
The F A S B approach uses a current expected credit loss (C E C L) model.
F A S B A S C Topic 326 does not require a specific method, but provides an aging of accounts receivable example.
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Assessing the Adequacy of the Allowance for Credit Losses Account Balance 2
Exhibit 9.1 Bristol Corporation: Allowance for Credit Losses Based on Aging of Receivables
On December 31, 20X1, Bristol Corporation’s gross accounts receivable are $1,600,000, and the balance of the Allowance for uncollectibles is $39,000. Bristol’s normal sales terms require payment within 30 days after the sale is made and the goods are received by the buyer. Bristol determines that the receivables have the following age distribution:
| Current | 31 to 90 days old | 91 to 180 days old | Over 180 days old | Total | |
| Amount | $1,450,000 | $125,000 | $15,000 | $10,000 | $1,600,000 |
Once the receivables have been grouped by age category, a separate estimate of credit losses by category is developed. Based on past experience, Bristol determines the following estimate of expected credit losses by category:
| Current | 31 to 90 days old | 91 to 180 days old | Over 180 days old | ||
| Historical % of credit losses | 2.3% | 5.5% | 18.4% | 36.8% |
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Assessing the Adequacy of the Allowance for Credit Losses Account Balance 3
Exhibit 9.1
Numerous government forecasts predict that economic growth will slow in 20X2. In addition, unemployment rates have increased. Consequently, Bristol estimates that the 20X2 credit loss rates will be approximately 8% higher. Consequently, it uses the following loss percentages to estimate its allowance at December 31, 20X1.
| Current | 31 to 90 days old | 91 to 180 days old | Over 180 days old | ||
| Forecasted % of credit losses | 2.5% | 6.0% | 20.0% | 40.0% |
The required balance in the Allowance for credit losses account would then be as follows:
| Current | 31 to 90 days old | 91 to 180 days old | Over 180 days old | Total | |
| Amount | $1,450,000 | $125,000 | $15,000 | $10,000 | $1,600,000 |
| Estimated % of credit losses | 2.5% | 6% | 20% | 40% | |
| = Allowance for credit losses | $ 36,250 | $ 7,500 | $ 3,000 | $ 4,000 | $ 50,750 |
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Assessing the Adequacy of the Allowance for Credit Losses Account Balance 4
Exhibit 9.1
Because the balance of the Allowance for credit losses is only $39,000 on December 31, 20X1, the account must be increased by $11,750. This is the difference between the $50,750 required balance (as computed) and the existing $39,000 balance. To bring the balance up to the $50,750 figure indicated by the aging, Bristol makes the following adjusting entry:
| D R Credit loss expense | $11,750 | |
| C R Allowance for credit losses | $11,750 |
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Analysis of Uncollectible Accounts Receivable 1
Exhibit 9.2 Mattel, Inc.: Analysis of Accounts Receivable Credit Losses
| ($ in millions) | Dec. 31, 2018 | Dec. 31, 2017 | Dec. 31, 2016 |
| A. Select Reported Amounts | |||
| Revenues | $ 4,510.9 | $ 4,882.0 | $ 5,456.7 |
| Pre-tax income | (419.3) | (505.0) | 409.7 |
| Ending gross accounts receivables | 992.1 | 1,154.0 | 1,136.6 |
| B. Change in Allowance for doubtful accounts | |||
| Balance at beginning of year | $ 25.4 | $ 21.4 | $ 24.4 |
| Provision for doubtful accounts | 40.9 | 17.6 | 9.2 |
| Write-offs | (44.3) | (13.6) | (12.2) |
| Balance at end of year | $ 22.0 | $ 25.4 | $ 21.4 |
| C. Analysis | |||
| Provision for doubtful accounts as a % of sales | 0.91% | 0.36% | 0.17% |
| Provision for doubtful accounts as a % of ending gross receivables | 4.12% | 1.53% | 0.81% |
| Provision for doubtful accounts as a % of ending allowance | 185.91% | 69.29% | 42.99% |
| Allowance as a % of ending gross receivables | 2.22% | 2.20% | 1.88% |
Source: Mattel, Inc. Form 10-Ks.
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Analysis of Uncollectible Accounts Receivable 2
Sales declined over the three-year period.
The provision for doubtful accounts increased substantially over the three year period.
The percentage of, gross receivables, and ending allowance increased substantially over the period as Mattel’s collection experience worsened.
Firms must continually adjust their allowance account as collection experience changes.
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Estimating Sales Returns and Allowances
When goods are returned or a price allowance granted, the customer’s account receivable must be reduced and an income statement charge made.
Assume that Bristol agrees to reduce by $8,000 the price of goods that arrived damaged at Bath Company:
Companies must estimate the expected amount of future returns and allowances arising from receivables currently on the books at the end of each reporting period. If significant, an adjusting entry must be recorded.
| D R Sales returns and allowances | $$$ | |
| C R Allowance for sales returns and allowances | $$$ |
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Analytical Insight: Do Existing Receivables Represent Real Sales?
Generally, the growth rates in sales and in accounts receivable should be roughly equal.
Receivables might grow faster than sales for the following reasons:
Deliberate change in (that is, loosening of) sales terms to attract new customers.
Deteriorating credit worthiness among existing customers.
Firm has changed its financial reporting procedures, which determine when sales are recognized (that is, accelerated revenue recognition.)
Large increases in accounts receivable relative to sales frequently represent a danger signal.
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Notes Receivable 1
When a note bears an interest rate that approximates prevailing borrowing and lending rates, the accounting is straightforward.
Michele Corporation sells a machine to Texas Products Company for $5 million. Michele accepts a three-year, $5 million interest-bearing note signed with 10% interest per annum to be paid in quarterly installments each year.
| D R Note receivable—Texas Products Company | $5,000,000 | |
| C R Sales revenue | $5,000,000 |
Interest income accrues each quarter.
| D R Accrued interest receivable | $125,000 | |
| C R Interest income | $125,000 |
To accrue three months’ interest = [$5,000,000 × 0.10]/4.
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Notes Receivable 2
Upon receipt of the cash payment, the accrued interest receivable is reduced.
| D R Cash | $125,000 | |
| C R Accrued interest receivable | $125,000 |
To record receipt of the interest payment.
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Accounting for Credit Losses 2
Firms use the Current Expected Credit Loss (C E C L) model to assess the collectability of notes receivable and an appropriate allowance.
Methods may include a discounted cash flow method, a loss-rate method, or a probability-of-default method.
Significant credit quality information must be disclosed by type of receivable including:
Credit quality indicator.
Amortized cost for prior five years and in total.
How expected loss estimates are determined.
Changes in risk factors, policies, or methodologies.
Amount of significant sale of receivables.
Roll-forward of the allowance for credit losses.
Aging analysis of amortized cost by receivable type for past due receivables.
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Imputing Interest on Notes Receivable: Interest Rate not Stated 1
A complication arises for a note that does not state an interest rate.
Monson Corporation sells equipment it manufactured to Davenport Products in exchange for a $5 million non-interest-bearing note due in three years. The note bears no explicit interest. It says only that the entire $5 million is to be paid at the end of three years. Monson’s published cash selling price for the equipment is $3,756,600.
The difference between the $5 million note and the $3,756,600 cash price is the imputed interest.
The implied interest rate equates the present value of the $5 million payment to the cash price of $3,756,600.
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Imputing Interest on Notes Receivable: Interest Rate not Stated 2
Although the $5 million note itself does not contain any mention of interest, Monson will earn a return of 10% per year for financing Davenport’s long-term credit purchase.
Exhibit 9.3 Monson Corporation Effective Interest Table
| (a) Interest Income—10% of Column (d) Balance for Prior Year | (b) Cash Interest Received | (c) Increase in Present Value of Note: (a) Minus (b) | (d) End-of-Year Present Value of Note | |
| 1/1/20X1 | — | — | — | $ 3,756,600 |
| 12/31/20X1 | $ 375,660 | $ 0 | $ 375,660 | 4,132,260 |
| 12/31/20X2 | 413,226 | 0 | 413,226 | 4,545,486 |
| 12/31/20X3 | 454,514* | 0 | 454,514 | 5,000,000 |
| Total | $1,243,400 |
* Rounded.
Interest accumulates at 10% on the unpaid balance.
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Imputing Interest on Notes Receivable: Interest Rate not Stated 3
Monson Corporation records the sale and note receivable as:
| D R Note receivable—Davenport | $3,756,600 | |
| C R Sales revenue | $3,756,600 |
Over the next three years, the note receivable is increased and interest income recognized.
At the end of Year 1, the entry is:
| D R Note receivable—Davenport | $375,660 | |
| C R Interest income | $375,660 |
At the end of Year 3, Monson receives a $5 million payment, which consists of the cash sales price ($3,756,600) plus interest ($1,243,400 = $375,660 + $413,226 + $454,514).
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Imputing Interest on Notes Receivable: Interest Rate not Stated 4
| D R Cash | $5,000,000 | |
| C R Note receivable—Davenport.. | $5,000,000 |
This process of allocating the proceeds of the note between sales revenue and interest income is called imputed interest.
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Imputing Interest: Stated Rate Is Less than Prevailing Rate 1
Another complication arises when the stated interest rate is lower than prevailing rates for loans of similar risk.
Quinones Corp. sells a machine to Linda Manufacturing in exchange for a $4 million, three-year, 2.5% (Stated rate) note. At the time, the interest rate normally charged to companies with Linda’s credit rating is 10% (Prevailing rate).
The implied (cash) selling price of the machine is $3,253,966, as computed on the following slide’s exhibit.
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Imputing Interest: Stated Rate Is Less than Prevailing Rate 2
Exhibit 9.4 Quinones Corporation: Computation of Implied Sales Price for a Note with a Below-Market Interest Rate
Calculation of Present Value at 10% Effective Interest Rate
Present value of $4,000,000 principal repayment on 12/31/20X3 at 10%:
| $4,000,000 | × | 0.75132 | = | $3,005,280 |
Present value of three interest payments of $1,000,000 (that is, $4,000,000 × 0.025), each at 10%:
| 12/31/20X1 | $ 100,000 | × | 0.90909 | = | 90,909 |