Controlling accounts receivable:

Accounts receivable are valuable primarily because they will result in cash coming into the company. Because they are valuable, they should be controlled so their value does not decrease or become lost completely. From an accounting standpoint, control of accounts receivable is concerned with reasonably stating a company's assets and net income. The following paragraphs present four ways accounts receivable are controlled: (1) analyzing potential credit customers, (2) detailed customer records, (3) accounts receivable aging schedule, and (4) ratios.


Analyzing potential credit customers:

Since accounts receivable are valuable primarily because they result in cash from customers, one important way in which companies control accounts receivable is to analyze the financial impact of selling products on credit to potential customers. This analysis is important because it is a fact of business life that all customers do not pay their bills. Some customers may experience financial difficulties and simply become unable to pay. Other customers may move from the area and simply forget to pay. Other customers may deliberately refuse to pay. The analysis of potential credit customers attempts to determine the financial impact of selling products on credit. If it is unprofitable to sell to credit customers, a company may want to avoid making such sales.

As an example of the analysis of potential credit customers, consider the Kristen Company that has always sold its products for cash. The company expects the products it sells to cost 55% of their sales prices. It expects its other operating expenses (salaries and wages, utilities, etc.) to be 25% of sales revenue. Income taxes expense is expected to be 35% of income before taxes. Presently, the Kristen Company's income statement is as follows.

 

Present
Operations

Sales

$500,000

Cost of Goods Sold (55% of sales)

275,000

Gross Profit

$225,000

Operating Expenses (25% of sales)

125,000

Income Before Taxes

$100,000

Income Taxes Expense (35% of income before taxes)

35,000

Net Income

$65,000

 

As the above income statement shows, at its present level of operations the Kristen Company's net income is expected to be $65,000. The Kristen Company's income statement is a classified income statement, reporting information in separate, important categories. For example, the $225,000 gross profit suggests the company expects to charge customers $225,000 more than it costs the company to purchase the products. Additionally, the company expects its income taxes expense to be $35,000.

The Kristen Company is considering expanding its sales by $30,000 by selling on credit. The company predicts approximately 2% of its credit customers will not pay for the products they buy. Should the company expand its sales by $30,000 by selling on credit?

Based on its estimates, the Kristen Company's projected income statements would be as follows.

 

Present
Operations

New
Credit

Expanded
Operations

Sales

$500,000

$30,000

$530,000

Cost of Goods Sold (55% of sales)

275,000

16,500

291,500

Gross Profit

$225,000

$13,500

$238,500

Operating Expenses

 

 

 

    Other Operating Expenses (25% of sales)

125,000

7,500

132,500

    Uncollectible Accounts Expense (2% of credit sales)

0

600

600

Total Operating Expenses

$125,000

$8,100

$133,100

Income Before Taxes

$100,000

$5,400

$105,400

Income Taxes Expense (35% of income before taxes)

35,000

1,890

36,890

Net Income

$65,000

$3,510

$68,510

 

In the above income statements, it is important to note the uncollectible accounts expense relating to the new $30,000 credit sales. Since the Kristen Company expects 2% of its credit customers to not pay, the company expects to be unable to collect $600 ($30,000 x .02) from such customers. This uncollectible accounts expense is the expected cost of selling to customers who will not pay their bills.

In spite of the $600 uncollectible accounts expense, if the Kristen Company's goal is to increase net income, the company would choose to expand sales by $30,000 because its income would increase by $3,510, from $65,000 to $68,510. Thus, as a result of its analysis of potential credit customers, the Kristen Company would conclude that selling to such customers is desirable. On the other hand, if the analysis had shown the company's net income decreased by selling to such customers, the company would have chosen not to expand sales by $30,000.


Practice Exercise

The Christopher Corporation predicts its sales for the coming year will be $1,100,000. The products it sells are expected to cost the Christopher Corporation $500,000. Operating expenses are expected to be 20% of sales. Income taxes expense is expected to be 35% of income before taxes.

1. Calculate the Christopher Corporationís expected net income for the coming year.

Sales

$1,100,000

Cost of Goods Sold

500,000

Gross Profit

$600,000

Operating Expenses (20% of sales)

220,000

Income Before Taxes

$380,000

Income Taxes Expense (35% of income before taxes)

133,000

Net Income

$247,000

 

2. In addition to the above information, assume the Christopher Corporation expects to be unable to collect cash for 2% of its total sales. Calculate the Christopher Corporationís expected net income for the coming year.

 

Sales

$1,100,000

Cost of Goods Sold

500,000

Gross Profit

$600,000

Operating Expenses (22% of sales)

242,000

Income Before Taxes

$358,000

Income Taxes Expense (35% of income before taxes)

125,300

Net Income

$232,700

 

The Christopher Corporationís operating expenses are 20% plus 2% for uncollectible accounts receivable.

** You now have the background to do text exercise 7.1.

 

Detailed customer records:

Accounts receivable are valuable primarily because they will result in cash being collected from customers. One way in which accounts receivable are controlled is through the use of detailed customer records called the accounts receivable subsidiary ledger. These detailed records are useful in collecting cash from customers and in evaluating customers who are interested in placing additional orders. The accounts receivable subsidiary ledger is composed of all customer accounts receivable accounts, the total of which agrees with the accounts receivable balance in the general ledger. A simplified version of one customer account, the Hamer Corporation, in the accounts receivable subsidiary ledger of the Nicholas Corporation appears below.

Customer: Hamer Corporation

Customer Number: 1023

Date

Description

Debits

Credits

Balance

6/1

Balance

 

 

3,000

6/7

Sales invoice 988

2,300

 

5,300

6/15

Payment received

 

800

4,500

 

The Hamer Corporation's account in the accounts receivable subsidiary ledger shows the Hamer Corporation owed the Nicholas Corporation $3,000 at the beginning of June. On June 7, the Hamer Corporation made additional purchases of $2,300 and on June 15, Hamer Corporation paid $800 of the amount owed. On June 15, the Hamer Corporation still owed $4,500 to the Nicholas Corporation.

In order to collect cash from credit customers, companies usually find it necessary to remind them of the amounts they owe and when payments are due. To remind customers, companies usually send them reports, called statements of accounts. A statement of account is a summary of a customer's recent credit purchases and cash payments activity, and an indication of the dollar amount owed to the company. For example, using the information from the Hamer Corporation's account in the accounts receivable subsidiary ledger, the Nicholas Corporation would send a statement of account to the Hamer Corporation reminding it that it owes $4,500 and suggesting payment by a certain date.

A second use of the information in the accounts receivable subsidiary ledger is in evaluating customer requests for additional products. For example, assume that on June 18 the Hamer Corporation requested $1,800 of additional products from the Nicholas Corporation. Based on the information in the Hamer Corporation's account in the accounts receivable subsidiary ledger, the Nicholas Corporation might agree to the request only if the Hamer Corporation pays a significant amount of the $4,500 already owed.

As an example of the relationships between the general ledger and the accounts receivable subsidiary ledger, assume the Nicholas Corporation's credit customers owe the company the following amounts on June 1.

Customer

Accounts Receivable Balance, June 1

Hamer

$3,000

Powell

$600

Sayer

$1,200

Total

$4,800

 

On June 1, the Nicholas Corporation's general ledger would show accounts receivable as follows.

 

Accounts Receivable

$4,800

 

 

On June 1, the Nicholas Corporation's accounts receivable subsidiary ledger would be as follows.

 

Hamer Corporation

 

Powell Company

 

Sayer Inc.

$3,000

 

 

$600

 

 

$1,200

 

 

Notice the $4,800 accounts receivable balance in the general ledger is equal to the total of all customer accounts balances in the accounts receivable subsidiary ledger ($3,000 + $600 + $1,200 = $4,800).

Assume the Nicholas Corporation made the following credit sales to its customers during June.

Customer

Credit Sales During June

Hamer

$2,300

Powell

$1,900

Sayer

$1,500

Total

$5,700

 

During June, the Nicholas Corporation would correctly record the credit sales as a $5,700 debit to accounts receivable and a $5,700 credit to sales. Once the journal entry is posted to the general ledger, the Nicholas Corporation's general ledger would show accounts receivable as follows.

 

Accounts Receivable

$4,800

 

$5,700

 

$10,500

 

 

In addition to the journal entry being posted to the general ledger, the detail supporting the journal entry would be posted to the accounts receivable subsidiary ledger, which would appear as follows.

 

Hamer Corporation

 

Powell Company

 

Sayer Inc.

$3,000

 

 

$600

 

 

$1,200

 

$2,300

 

 

$1,900

 

 

$1,500

 

$5,300

 

 

$2,500

 

 

$2,700

 

 

Notice the $10,500 accounts receivable balance in the general ledger is equal to the total of all customer accounts balances in the accounts receivable subsidiary ledger ($5,300 + $2,500 + $2,700 = $10,500).

Assume the Nicholas Corporation made the following cash collections from its credit customers during June.

Customer

Cash Collections During June

Hamer

$800

Powell

$600

Sayer

$0

Total

$1,400

 

During June, the Nicholas Corporation would correctly record the cash collections as a $1,400 debit to cash and a $1,400 credit to accounts receivable. Once the journal entry is posted to the general ledger, the Nicholas Corporation's general ledger would show accounts receivable as follows.

 

Accounts Receivable

$4,800

 

$5,700

 

 

$1,400

$9,100

 

 

In addition to the journal entry being posted to the general ledger, the detail supporting the journal entry would be posted to the accounts receivable subsidiary ledger, which would appear as follows.

 

Hamer Corporation

 

Powell Company

 

Sayer Inc.

$3,000

 

 

$600

 

 

$1,200

 

$2,300

 

 

$1,900

 

 

$1,500

 

 

$800

 

 

$600

 

 

 

$4,500

 

 

$1,900

 

 

$2,700

 

 

Again, notice the $9,100 accounts receivable balance in the general ledger is equal to the total of all customer accounts balances in the accounts receivable subsidiary ledger ($4,500 + $1,900 + $2,700 = $9,100).

As mentioned previously, the information in the accounts receivable subsidiary ledger can be used for billing purposes and for evaluating future sales to current customers. For example, at the end of June the Powell Company's accounts receivable balance of $1,900 would be used by the Nicholas Corporation when it sends a statement of account reminding the Powell Company to pay $1,900. Similarly, if Sayer Inc. attempts to purchase more items, the Nicholas Corporation might allow them to only if they pay all or part of the $2,700 they currently owe. Since Sayer Inc. did not make any cash payments to Nicholas Corporation in June, additional sales to them would be evaluated carefully.
 
 

** You now have the background to do text exercise 7.2.

 

 

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