Financial Accounting: Chapter Five – Receivables (Mini-Textbook Study Notes)

Receivables in Financial Accounting

This chapter covers the accounting principles and procedures related to receivables, including revenue recognition, control of accounts receivable, estimation of uncollectible accounts, and liquidity analysis. The content is structured according to the main learning objectives for college-level Financial Accounting students.

Learning Objectives

• Apply GAAP for proper revenue recognition

• Account for and control accounts receivable

• Evaluate collectibility using the allowance for uncollectible accounts

• Account for notes receivable

• Show how to speed up cash flow from receivables

• Evaluate liquidity using key ratios

GAAP and Revenue Recognition

Revenue Recognition Principles

Revenue recognition is a fundamental concept in financial accounting, governed by Generally Accepted Accounting Principles (GAAP). Revenue is recognized when it is earned, regardless of when cash is received.

• Revenue is recognized when:

  • Goods are delivered

  • Services are performed

• Amount recorded:

  • Cash received, or

  • Fair market value of assets received in exchange

Revenue Recognition: The Five-Step Model

GAAP requires a five-step process for recognizing revenue from contracts with customers:

1. Identify the contract(s) with a customer

2. Identify the performance obligation(s) in the contract

3. Determine the transaction price

4. Allocate the transaction price to the performance obligations

5. Recognize revenue when (or as) the entity satisfies a performance obligation

Definition: A contract is an agreement between two parties that creates enforceable rights or performance obligations.

Shipping and Credit Terms

• FOB (Free on Board) Shipping Point: Ownership transfers and revenue is recognized when goods leave the seller's shipping dock.

• FOB Destination: Ownership transfers and revenue is recognized when goods are delivered to the customer.

• Credit Terms Example: 2/10, n/30 means a 2% discount is offered if payment is made within 10 days; otherwise, the full amount is due in 30 days.

Example: Revenue Recognition with Discounts

Suppose Apple, Inc. delivers 30,000 iPhones to AT&T Wireless at $100 each, offering a 2% discount if paid within 30 days. The journal entry to record the sale is:

• Accounts Receivable: $2,940,000

• Sales Revenue: $2,940,000

• Explanation: To record sale of 30,000 iPhones for $98 each ($100 - 2% discount)

Accounts Receivable

Nature and Control of Accounts Receivable

Accounts receivable are monetary claims against customers arising from selling goods or services on credit. They are classified as current assets and are among the most liquid assets after cash and short-term investments.

• Trade Receivables: Receivables from customers for goods or services sold on credit.

• Control Account: The general ledger account summarizing total receivables; detailed records are kept in a subsidiary ledger for each customer.

Types of Receivables

• Accounts Receivable: Amounts owed by customers from sales on credit.

• Notes Receivable: Formal written promises to pay a definite sum plus interest at a future date.

• Other Receivables: Includes interest receivable, advances to employees, and miscellaneous claims.

Uncollectible Accounts and the Allowance Method

Allowance for Uncollectible Accounts

Not all receivables will be collected. The allowance method estimates uncollectible accounts and matches the expense to the period in which the related revenue is earned, in accordance with GAAP.

• Allowance for Uncollectible Accounts: A contra-asset account representing the estimated amount of receivables that will not be collected.

• Net Realizable Value: Accounts Receivable minus Allowance for Uncollectible Accounts.

Example:

Accounts Receivable	Less: Allowance for Uncollectible Accounts	Net Accounts Receivable
$10,000	($900)	$9,100

Estimating Uncollectibles

There are two main methods for estimating uncollectible accounts:

• Percent-of-Sales Method: Uncollectible-account expense is computed as a percentage of total credit sales (income statement approach).

• Aging-of-Receivables Method: Specific accounts are analyzed based on how long they have been outstanding (balance sheet approach).

Percent-of-Sales Method Example

• Total revenues: $182,795,000

• Estimated uncollectible rate: 0.04%

• Uncollectible-account expense: $182,795,000 × 0.0004 = $73,118

Journal Entry:

• Debit: Uncollectible Account Expense $73,118

• Credit: Allowance for Uncollectible Accounts $73,118

Aging-of-Receivables Method Example

Receivables are grouped by age, and different percentages are applied to each group to estimate uncollectibles. The sum gives the required ending balance in the allowance account.

Age of Receivable	Amount	Estimated % Uncollectible	Estimated Uncollectible
Current	$10,000	2%	$200
31-60 days	$5,000	5%	$250
61-90 days	$2,000	10%	$200
Over 90 days	$1,000	20%	$200
Total	$18,000		$850

Additional info: Percentages and amounts are illustrative.

Direct Write-Off Method

An alternative to the allowance method, the direct write-off method records expense only when a specific account is deemed uncollectible. This method is not GAAP-compliant because it may overstate assets and does not match expenses with revenues.

Notes Receivable

Accounting for Notes Receivable

Notes receivable are formal written promises to pay a specified amount of money (principal) plus interest at a future date. They are used when a customer requires more time to pay or for loans.

• Payee: The party to whom money is owed (lender)

• Maker: The party that borrowed and owes money (borrower)

• Principal: The amount of money borrowed

• Interest: The cost of borrowing, stated as an annual percentage rate

• Maturity Date: The date when payment is due

• Maturity Value: Principal plus interest

Interest Calculation Formula:

$\text{Interest} = \text{Principal} \times \text{Interest Rate} \times \frac{\text{Time}}{12}$

For periods less than a year, use months/12 or days/365.

Example: Accruing Interest Revenue

• Principal: $1,000

• Interest Rate: 9% per annum

• Time: 4 months

• Interest Revenue: $1,000 × 0.09 × (4/12) = $30

Managing and Accelerating Cash Flow from Receivables

Strategies to Speed Up Collections

• Offer sales discounts for early payment

• Charge interest on overdue accounts

• Adopt effective credit and collection procedures

• Emphasize credit card or bankcard sales

Factoring Receivables

Factoring involves selling receivables to another company (a factor) at a discount. The factor collects from the customer and earns revenue from the difference.

• Benefits: Immediate cash flow

• Drawbacks: Expensive, loss of control over collections

Example: Selling $100,000 of receivables for $95,000 cash; the $5,000 difference is a factoring expense.

Liquidity Analysis Using Receivables

Quick (Acid-Test) Ratio

The quick ratio measures a company's ability to pay current liabilities using its most liquid assets.

$\text{Quick (Acid-Test) Ratio} = \frac{\text{Cash and cash equivalents} + \text{Short-term investments} + \text{Net accounts receivable}}{\text{Total current liabilities}}$

Example: If Apple has $13,844 in cash, $11,233 in short-term investments, $17,460 in net accounts receivable, and $63,448 in current liabilities:

$\text{Quick Ratio} = \frac{13,844 + 11,233 + 17,460}{63,448} = 0.67$

This means Apple has $0.67 in quick assets for every $1 of current liabilities.

Accounts Receivable Turnover and Days Sales Outstanding (DSO)

• Accounts Receivable Turnover: Measures how many times average receivables are collected during the year.

• Formula: $\text{Accounts Receivable Turnover} = \frac{\text{Credit Sales}}{\text{Average Net Accounts Receivable}}$ $\text{Average Net Accounts Receivable} = \frac{\text{Beginning AR} + \text{Ending AR}}{2}$

• Days Sales Outstanding (DSO): Indicates the average number of days it takes to collect receivables. $\text{DSO} = \frac{365}{\text{Accounts Receivable Turnover}}$

A higher turnover or lower DSO indicates faster collection and better liquidity.