Chapter 7 – Receivables & Investments

Accounts Receivable
• Account receivable: a receivable arising from the sale of goods or services with a verbal promise
to pay.
• The most common type of receivable is the one that arises from the sale of goods or services to
customers with a verbal promise to pay within a specified period of time.
• Selling on credit causes two problems: it slows down the inflow of cash to the company, and it
raises the possibility that the customer may not pay its bill on time or possibly ever.

The Use of a Subsidiary Ledger

• Accounts receivable is the asset that arises from a sale on credit.
• The effect of the transaction can be identified and analyzed as follows:

• Subsidiary ledger: the detail for a number of individual items that collectively make up a single
general ledger account (for control purposes).
• Control account: the general ledger account that is supported by a subsidiary ledger.
• In theory, any one of the accounts in the general ledger could be supported by a subsidiary ledger.
• Two other common accounts supported by subsidiary ledgers are Plant and Equipment and
Accounts Payable.
 An accounts payable subsidiary ledger contains a separate account for each of the suppliers or
vendors from which a company purchases inventory.
 A plant and equipment subsidiary ledger consists of individual accounts, along with their
balances, for each of the various long-term tangible assets the company owns.
• A subsidiary ledger does not take the place of the control account in the general ledger.
• At any point in time, the balances of the accounts that make up the subsidiary ledger should total
to the single balance in the related control account.

The Valuation of Accounts Receivable

• The credit department of a business is responsible for performing a credit check on all potential
customers before granting them credit.
• A company believes that all customers will be able to pay their accounts when due, only when:
1. All customers are completely trustworthy
2. Customers have never experienced unforeseen financial difficulties that makes it impossible to
pay on time.
• Bad debts are unpaid customer accounts that a company gives up trying to collect.
• Some companies describe the allowance more fully as the allowance for doubtful accounts or the
allowance for uncollectible accounts – this amount is reduced from gross receivables.
Two Methods to Account for Bad Debts
1. Direct Write-Off Method
• Direct write-off method: the recognition of bad debts expense at the point an account is written
off as uncollectible.
• Problems with using this method are:
− By ignoring the possibility that not all of its outstanding accounts receivable will be collected,
the value of this asset is being overstated.
− By ignoring the possibility of bad debts on sales made during a certain period, the matching
principle is being violated. The problem is one of timing: even though any one particular
account may not prove to be uncollectible until a later period, the cost associated with making
sales on credit (bad debts) should be recognized in the period of sale.

2. Allowance Method
• Allowance method: a method of estimating bad debts on the basis of either the net credit sales of
the period or the accounts receivable at the end of the period.
• Accountants use the allowance method to overcome the deficiencies of the direct write-off
method.
• Bad Debts Expense recognizes the cost associated with the reduction in value of the asset
Accounts Receivable.
• Allowance for doubtful accounts: a contra-asset account used to reduce accounts receivable to its
net realizable value. Alternate term: Allowance for uncollectible accounts.

Write-Offs of Uncollectible Accounts with the Allowance Method

• Like the direct write-off method, the allowance method reduces Accounts Receivable to write off
a specific customer’s account.
• If the account receivable no longer exists, there is no need for the related allowance account; thus,
this account is reduced as well.
• Whether the direct write-off method or the allowance method is used, the adjustment to write
off a specific customer’s account reduces Accounts Receivable. It is the other side of the
adjustment that differs between the two methods:
1. Under the direct write-off method, an expense is increased.
2. Under the allowance method, the allowance account is reduced.
Two Approaches to the Allowance Method of Accounting for Bad Debts
• Because the allowance method results in a better matching, accounting standards require the use
of it rather than the direct write-off method unless bad debts are immaterial in amount.
• Accountants use one of two different variations of the allowance method to estimate bad debts:
1. One approach emphasizes matching bad debts expense with revenue on the income statement
and bases bad debts on a percentage of the sales of the period.
2. The other approach emphasizes the net realizable amount (value) of accounts receivable on
the balance sheet and bases bad debts on a percentage of the accounts receivable balance at
the end of the period.
• The objective with both approaches is the same, however: to use past experience with bad debts
to predict future amounts.

1. Percentage of net Credit Sales Approach

• If a company has been in business for enough years, it may be able to use the past relationship
between bad debts and net credit sales to predict bad debt amounts.
• Net means that credit sales have been adjusted for sales discounts and returns and allowances.
• The company needs to determine whether this estimate is realistic for the current period. For
example, are current economic conditions considerably different from those in prior years? Has
the company made sales to any new customers with significantly different credit terms?

2. Percentage of Accounts Receivable Approach

• Some companies believe that they can more accurately estimate bad debts by relating them to
the balance in the Accounts Receivable account at the end of the period rather than to the sales
of the period.
• The ratio of bad debts to the ending balance in Accounts Receivable over the last couple of
years is used.
• Note the one major difference between this approach and the percentage of sales approach:
1. Under the percentage of net credit sales approach, the balance in the allowance account is
ignored and the bad debts expense is simply a percentage of the sales of the period.
2. Under the percentage of accounts receivable approach, however, the balance in the
allowance account must be considered.

3. Aging of Accounts Receivable

• Aging schedule: a form used to categorize the various individual accounts receivable according
to the length of time each has been outstanding.
• The estimated percentage of uncollectibles increases as the period of time the accounts have
been outstanding lengthens.
The Accounts Receivable Turnover Ratio
• Managers, investors, and creditors are keenly interested in how well a company manages its
accounts receivable.
• One simple measure is to compare a company’s sales to its accounts receivable:
Net Credit Sales
Accounts Receivable Turnover =
Average Accounts Receivable

• If receivables are turning over too slowly, the company’s credit department may not be operating
effectively; therefore, the company is missing opportunities with the cash that isn’t available.
• On the other hand, a turnover rate that is too fast might mean that the company’s credit policies
are too stringent and that sales are being lost as a result.
• Management compares the current year’s turnover rate with that of prior years to see if the
company is experiencing slower or faster collections.
• It is also important to compare the rate with that of other companies in the same industry.

Notes Receivable
• Promissory note: a written promise to repay a definite sum of money on demand or at a fixed or
determinable date in the future.
• Maker: the party that agrees to repay the money for a promissory note at some future date.
• Payee: the party that will receive the money from a promissory note at some future date.
• Note receivable: an asset resulting from the acceptance of a promissory note from another
company.
• Note payable: a liability resulting from the signing of a promissory note.
• Over the life of the note, the maker incurs interest expense on its note payable and the payee
earns interest revenue on its note receivable:
Party Recognizes on Balance Sheet Recognizes on Income Statement
Maker Note Payable Interest Expense
Payee Note Receivable Interest Revenue
• Promissory notes are used for a variety of purposes.
• Banks normally require a company to sign a promissory note to borrow money.

Important Terms Connected with Promissory Notes

• Principal: the amount of cash received, or the fair value of the products or services received, by
the maker when a promissory note is issued.
• Maturity date: the date the promissory note is due.
• Term: the length of time a note is outstanding, that is, the period of time between the date it is
issued and the date it matures.
• Maturity value: the amount of cash the maker is to pay the payee on the maturity date of the note.
• Interest: the difference between the principal amount of the note and its maturity value.
Accelerating the Inflow of Cash from Sales
• To remain competitive, most businesses find it necessary to grant credit to customers, even
though it slows down the process of cash inflow to the company.
• If one company won’t grant credit to a customer, the customer may find another company that
will.

Credit Card Sales

• Most retail establishments as well as many service businesses accept one or more major credit
cards.
• In return for a fee, the merchant passes the responsibility for collection on to the credit card
company. Thus, the credit card issuer assumes the risk of nonpayment.
• Credit card draft: a multiple-copy document used by a company that accepts a credit card for a
sale (also called Invoice).

• Some credit cards, such as MasterCard and VISA, allow a merchant to present a credit card draft
directly for deposit in a bank account, in much the same way the merchant deposits checks, coins,
and currency. Obviously, this type of arrangement is even more advantageous for the merchant
because the funds are available as soon as the drafts are credited to the bank account.
Discounting Notes Receivable
• Discounting: the process of selling a promissory note.
• Promissory notes are negotiable, which means that they can be endorsed and given to someone
else for collection.
• A company can sign the back of a note (just as it would a check), sell it to a bank, and receive cash
before the note’s maturity date. This process, called discounting, is another way for companies to
speed the collection of cash from receivables.
• A note can be sold immediately to a bank on the date it is issued, or it can be sold after it has been
outstanding but before the due date.
• When a note is discounted at a bank, it is normally done “with recourse.” This means that if the
original customer fails to pay the bank the total amount due on the maturity date of the note, the
company that transferred the note to the bank is liable for the full amount.
• Because there is uncertainty as to whether the company will have to make good on any particular
note that it discounts at the bank, a contingent liability exists from the time the note is discounted
until its maturity date.
• The contingency created by the discounting of a note with recourse is not recorded as a liability.
However, a note in the financial statements is used to inform the reader of the existing
uncertainty.
Accounting for Investments
• Some corporations find themselves with excess cash during certain times of the year and invest
this idle cash in various highly liquid financial instruments such as certificates of deposit and money
market funds.
• These investments are included with cash and are called cash equivalents when they have an
original maturity to the investor of three months or less. Otherwise, they are accounted for as
short-term investments.
• Some companies invest in the stocks and bonds of other corporations as well as bonds issued by
various government agencies.
• Equity securities: securities issued by corporations as a form of ownership in the business (also
called Stocks). Because these securities are a form of ownership, they do not have a maturity date.
• Investments in equity securities can be classified as either current or long term depending on the
company’s intent.
• Debt securities: securities issued by corporations and governmental bodies as a form of borrowing
(also called Bonds). The term of a bond can be relatively short, such as 5 years, or much longer,
such as 20 or 30 years.

Investments in Highly Liquid Financial Instruments

• The seasonal nature of most businesses leads to a potential cash shortage during certain times of
the year and an excess of cash during other times.
• Companies typically deal with cash shortages by borrowing on a short-term basis either from a
bank in the form of notes or from other entities in the form of commercial paper. The maturities
of the bank notes or the commercial paper generally range anywhere from 30 days to six months.
• These same companies use various financial instruments as a way to invest excess cash during
other times of the year.
• The most common type of highly liquid financial instrument is a certificate of deposit (CD).

• The basic formula to compute interest is as follows:

Interest (I) = Principal (P) x Interest Rate (R) x Time (T)
Because interest rates are normally stated on an annual basis, time is interpreted to mean the
fraction of a year that the investment is outstanding.
Investments in Stocks and Bonds
• Corporations frequently invest in the securities of other businesses; these investments take two
forms: debt securities (bonds) and equity securities (stocks).
• The following chart summarizes the accounting by an investor for investments in the common
stock of another company:

• The company that invests is the investor, and the company whose stocks or bonds are purchased
is the investee.
• Stocks and bonds are purchased as a way to invest cash over the long run. Often, these types of
investments are made in anticipation of a need for cash at some distant point in the future – no
significant influence over the investee.
• The investor may be interested primarily in periodic income in the form of interest and dividends,
in appreciation in the value of the securities, or in some combination of the two.
• If a company buys a relatively large percentage of the common stock of the investee, it may be
able to secure significant influence over this company’s policies – significant influence over the
investee.
• When an investor is able to secure influence over the investee, the equity method of accounting
is used. According to current accounting standards, this method is appropriate when an investor
owns at least 20% of the common stock of the investee.
• A corporation may buy stock in another company with the purpose of obtaining control over that
other entity. Normally, this requires an investment in excess of 50% of the common stock of the
investee.
• When an investor owns more than half the stock of another company, accountants normally
prepare a set of consolidated financial statements.
• An investor with an interest of more than 50% in another company is called the parent, and the
investee in these situations is called the subsidiary.

Accounting Entries for No Significant Influence

Valuation and Reporting for Investments on the Financial Statements
• Investments in other companies’ bonds and stocks are reported on a company’s balance sheet as
assets.
• Whether the investments are reported as current assets or noncurrent assets depends on the
company’s intent.
 If the company intends to sell the investments within the next year, they are normally classified
as current assets.
 All other investments are classified on the balance sheet as noncurrent.
• Investments could be reported at their cost, or because most investments in other companies’
bonds and stocks are actively traded, they could be reported at their market, or fair, value.
• Investments are generally reported on the balance sheet at their fair value.
• However, the question still remains as to when any gains or losses from recognizing the changes
in the fair value of investments should be recorded on the income statement – this is for advanced
levels of accounting.
How Liquid Assets Affect the Statement of Cash Flows
• Cash equivalents are combined with cash on the balance sheet. These items are very near maturity
and do not present any significant risk of collectibility. Because of this, any purchases or
redemptions of cash equivalents are not considered significant activities to be reported on a
statement of cash flows.
• The purchase and sale of investments are considered significant activities and therefore are
reported on the statement of cash flows.
• Cash flows from purchases, sales, and maturities of investments are usually classified as investing
activities.
• The collection of either accounts receivable or notes receivable generates cash for a business and
affects the Operating Activities section of the statement of cash flows.
• Most companies use the indirect method of reporting cash flows and begin the statement of cash
flows with the net income of the period. Net income includes the sales revenue for the period.
 A decrease in accounts receivable or notes receivable during the period indicates that the
company collected more cash than it recorded in sales revenue. Thus, a decrease in accounts
receivable or notes receivable must be added back to net income because more cash was
collected than is reflected in the sales revenue number.
 An increase in accounts receivable or notes receivable indicates that the company recorded
more sales revenue than cash collected during the period. Therefore, an increase in accounts
receivable or notes receivable requires deduction from the net income of the period to arrive
at cash flow from operating activities.