A credit sale on open account creates an account receivable. A note receivable is a promise in writing (a formal document) to pay (1) a specified amount of money, called the principal, on a definite future date known as the maturity date and (2) a specified amount of interest on one or more future dates.
A sale of merchandise or services on credit in the normal course of business creates a trade receivable. A nontrade receivable arises from transactions other than the normal sale of merchandise or services.
Receivables are classified as either current or noncurrent (short term or long term), depending on when cash is expected to be collected.
LO2 Account for and report the effects of uncollectible accounts.
Under generally accepted accounting principles, companies must use the allowance method to account for uncollectibles.
This method involves two steps:
Estimate and record uncollectibles with an end-of-period adjusting entry that increases Bad Debt Expense (debit) and increases the Allowance for Doubtful Accounts (credit).
Identify and write off specific customer balances in the period when they are determined to be uncollectible by decreasing the specific customer Account Receivable (credit) and decreasing the Allowance for Doubtful Accounts (debit).
The adjusting entry (in 1) reduces net income as well as net accounts receivable. The write-off (in 2) affects neither.
LO3 Use two different methods to estimate uncollectible accounts.
The percentage of credit sales method estimates bad debt expense by multiplying the historical percentage of bad debt losses by the current year's credit sales.
The aging of accounts receivable method estimates bad debts based on the "age" of each amount in accounts receivable. The older and more overdue accounts receivable become, the less likely they are to be collected. Therefore, for each age category, we multiply an estimated bad debt loss percentage by the amount of the accounts receivable in that category. The total amount is the desired ending balance in the Allowance for Doubtful Accounts.
LO4 Compute and report interest on notes receivable.
Calculate interest on a note receivable by multiplying the principal, the interest rate, and the time period (the number of months out of 12). As time passes and interest is earned on the note, accountants record an adjusting entry to accrue the interest revenue receivable on the note.
LO5 Compute and interpret the receivables turnover ratio.
The receivables turnover ratio measures the effectiveness of credit-granting and collection activities. It reflects how many times, on average, a company recorded and collected trade receivables during the period.
Analysts and creditors watch this ratio because a sudden decline may mean that a company is extending payment deadlines in an attempt to prop up lagging sales. Or it may mean that the company is recording sales of merchandise that customers are likely to return later.