Chapter Five

Accounting for Receivable

6.1. Classifications of receivables

The term receivable refers to amounts due from individuals and other companies. Receivables are claims
that are expected to be collected in cash. They are frequently classified as (1) accounts receivable, (2)
notes receivable, and (3) other receivables.
 Accounts receivable: are amounts owed by customer on account. They result from the sale of
goods and services. Companies generally expect to collect these receivables within 30 to 60 days.
Accounts receivable are the most significant type of claim held by a company.
 Notes receivables are claims for which formal instruments of credit are issued as proof of the
debt. A note receivable normally extends for time periods of 60–90 days or longer and requires the
debtor to pay interest. Notes and accounts receivable that result from sales transactions are often
called trade receivables.
 Other receivables include non-trade receivables. Examples are interest receivable, loans to
company officers, advances to employees, and income taxes refundable. These do not generally
result from the operations of the business. Therefore, companies generally classify and report them
as separate items in the balance sheet.
6.2. Internal control of receivables
The principles of internal control that we saw in chapter 5 are required by organizations to safeguard their
assets from any kind of error and misconduct. These control procedures should apply on receivables
because they are one of the asset elements of the organization. For example, the individual responsible for
sales should be separate from the individual accounting for the receivables and approving credit. By doing
so, the accounting and credit approval functions serve as independent checks on sales. Separation of
responsibility for related functions reduces the possibility of errors and misuse of funds.

6.3. Accounting for uncollectible accounts receivable

Accounts receivable arise from the sale of goods or services on credit. What you may not know is that
some accounts receivable are never collected. There is no general rule for when an account becomes
uncollectible. Some indications that an account may be uncollectible include the following:
 The receivable is past due.
 The customer does not respond to the company’s attempts to collect.
 The customer files for bankruptcy.
 The customer closes its business.
 The company cannot locate the customer.

There are two methods of accounting for uncollectible receivables.

 The allowance method

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  Direct write-off method
6.3.1. Allowance Method
The allowance method of accounting for bad debts involves estimating uncollectible accounts at the end
of each period. This provides better matching on the income statement. It also ensures that companies
state receivables on the balance sheet at their cash (net) realizable value. Cash (net) realizable value is
the net amount the company expects to receive in cash. It excludes amounts that the company estimates it
will not collect. Thus, this method reduces receivables in the balance sheet by the amount of estimated
uncollectible receivables. Based on this estimate, Bad Debt Expense is recorded by an adjusting entry.
Illustration
Assume that ABC-Company has credit sales of $1,200,000 in 2010. Of this amount, $200,000 remains
uncollected at December 31. The credit manager estimates that $12,000 of these sales will be
uncollectible. The adjusting entry to record the estimated uncollectible is:
Bad Debts Expense-------------------------------------12,000
Allowance for Doubtful Accounts------------------------12,000
(To record estimate of uncollectible accounts)
Bad Debts Expense is reported in the income statement as an operating expense (usually as a selling
expense). Thus, the estimated uncollectable are matched with sales in 2010. ABC-Company records the
expense in the same year it made the sales.
Allowance for Doubtful Accounts shows the estimated amount of claims on customers that the company
expects will become uncollectible in the future. Companies’ use a contra account instead of a direct credit
to Accounts Receivable because they do not know which customers will not pay. The credit balance in the
allowance account will absorb the specific write-offs when they occur. The company deducts the allowance
account from accounts receivable in the current assets section of the balance sheet.

6.3.1.1. Write-off of an Uncollectible Account

When a customer’s account is identified as uncollectible, it is written off against the allowance account. This
requires the company to remove the specific accounts receivable and an equal amount from the allowance
account.
Illustration
Assume that the financial vice-president of Kaleb Furniture authorizes a write-off of the $500 balance owed
by ABC-Company on March 1, 2011.The entry to record the write-off is:
March 1 Allowance for Doubtful Accounts----------------------500
2011 A/Receivable ----------------------------------------500
(To write-off uncollectible accounts)

6.3.1.2. Recovery of Uncollectible Accounts

When a customer fails to pay and the account is written-off as uncollectible, his or her credit standing is
jeopardized. To help restore credit standing, a customer may later choose to voluntarily pay all or part of
the amount owed. A company makes two entries when collecting an account previously written-off. The first

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is to reverse the original write-off and reinstate the customer’s account. For example, assume the amount
written-off in the preceding entry is later collected on March 15.
March 15 A/Receivable ----------------------------------------------------500
2011 Allowance for Doubtful Accounts------------------------500
(To reinstate accounts previously written-off)

March 15 Cash --------------------------------------500

2011 A/receivable --------------------------------500
(To record full payment of account)

6.3.1.3. Estimating Uncollectible

The allowance method of accounting for bad debts requires an estimate of bad debts expense to prepare
the adjusting entry at the end of each accounting period. How does a company estimate bad debts
expense? There are two common methods. One is based on the Income Statement relationship between
bad debts expense and sales. The second is based on the Balance Sheet relationship between A/R and
the Allowance for Doubtful Accounts. Both methods require an analysis of past experience.
a) Estimating Based on Sales
Accounts receivable are created by credit sales. The amount of credit sales during the period may therefore
be used to estimate the amount of uncollectible accounts expense. The amount of this estimate is added to
whatever balance exists in Allowance for Doubtful Accounts.
Illustration
Assume Wonji PLC has credit sales of birr 500,000 in 2002. Based on past experience and the experience
of other Companies Wonji plc estimated 0.007% of credit sales are uncollectible. Using this prediction, the
adjusting entry for uncollectible accounts at the end of the period, 20X2 is as follows.
Dec. 31 Uncollectable Accounts Exp. (500,000 X 0.007%) -----------------3500
Allowance for Doubtful Accounts-----------------------------------------3500
(To record estimated uncollectable Expense)
This entry doesn’t mean that the Dec. 31, 20X2, balance of Allowance for Doubtful Accounts will be Br.
3500. A Br. 3500 balance results only if the account had a zero balance prior to posting the adjusting entry.

b) Estimate Based on Analysis of Receivables

The longer an A/R remains outstanding, the less likely that it will be collected. Thus, we can base the
estimate of uncollectable accounts on how long the accounts have been outstanding. For this purpose, we
can use a process called Ageing receivables which examines each A/R to estimate the amount of
uncollectable. Receivables are classified by how long they are past their due date. Then, estimates of
uncollectible are made assuming the longer an amount is past due the more likely it is to be uncollectible.

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After the outstanding amounts are classified and analyzed in the Aging schedule the expected balance for
the Allowance for Doubtful Accounts will be estimated.
Let’s assume the amount estimated is Br. 5000. So, do you think this is the adjustment amount required for
the current period? NO!
Because, this estimated amount is the expected balance of the Allowance for Doubtful Accounts after
adjustment rather than the current year provision for Uncollectible Accounts Expense. Therefore, to
determine the current year provision we must take into account the balance before adjustment in the
Allowance for Doubtful Accounts. To illustrate, assume there is as credit Balance of Br. 1200 in the
allowance account before adjustment. The amount to be added to this balance is therefore Br. 3800 (B.r
5000 – Br. 1200) and the adjustment entry is as follows:
Dec. 31 Uncollectible Accounts Expense--------------------------3800
Allowance for Doubtful Accounts-------------------------------3800
(To record Uncollectible expense)

Alternatively, if the Allowance for Doubtful Accounts had an unadjusted debit balance of Br 700, then the
required adjustment is Br. 5700. (Br. 5000 + 700) and the adjustment entry is as follows:
Dec. 31. Uncollectible Accounts Expense---------------------------5700
Allowance for Doubtful Accounts---------------------5700
(To record Uncollectible expense)

6.3.2. Direct write-off method

The Direct Write-off method of accounting for bad debts records the loss from an uncollectible A/R at the
time it is determined to be uncollectible. No attempt is made to predict uncollectible accounts expense. Bad
debt expense is recorded when specific accounts are determined to be worthless. If Wonji Co. uses a direct
write-off method and determines on Feb. 20, it can’t collect from a customer- Home Co. - Br. 500. The entry
to write-off the customer’s account is as follows

Feb. 20 Uncollectible Accounts Expense -----------------------------500

A/R- Home Co. ----------------------------------------------------500
(To write-off Uncollectible accounts)

Sometimes an amount previously written off is later collected. This can be due to factors such as continual
collection efforts or the good fortune of a customer. If the account of Home Co. that was written-off directly
to Bad Debt Expense is later collected in full, the following two entries record this recovery.
Mar. 5 A/R- Home Co. ----------------------------------------------------500
Uncollectible Accounts Expense -------------------500
(To reinstate account)

Mar. 5 Cash ---------------------------------------------500

A/R- Home Co. -----------------------------------500
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 (To record full payment of account)
If the recovery is in the year following the writ-off, there is no balance in the Uncollectible Accounts
Expense account related to the previous year’s write-off and no other write-offs are expected. So the credit
portion of the entry recording the recovery can be made to a Bad Debts Recoveries revenue account.
To conclude this part companies must weigh at least two principles when considering use of the direct
write-off method:
6.4. Accounting for notes receivable
Companies may also grant credit in exchange for a formal credit instrument known as a promissory note. A
promissory note is a written promise to pay a specified amount of money on demand or at a definite time.
Promissory notes may be used:
 when individuals and companies lend or borrow money,
 When the amount of the transaction and the credit period exceed normal limits, or
 In settlement of accounts receivable.
In a promissory note, the party making the promise to pay is called the maker. The party to whom payment
is to be made is called the payee. The note may specifically identify the payee by name or may designate
the payee simply as the bearer of the note.

6.5. Characteristics of Notes Receivable

A note has some advantages over an account receivable. By signing a note, the debtor recognizes the debt
and agrees to pay it according to its terms. Thus, a note is a stronger legal claim. A promissory note is a
written promise to pay the face amount, usually with interest, on demand or at a date in the future.
Characteristics of a promissory note are as follows:
6.5.1. Maturity Date:
The maturity date is the date on which a promissory note must be paid. This date must be stated on the
note or be determinable from the facts stated on the note. Due date of a short-term note may be stated in
either days or months. When the term on a note is expressed in days, the maturity date is the specified
number of days after the note’s date

Illustration
A five-day note dated January-1 matures and is due on Jannuary-6. A 90-day notes dated March-10,
matures on Jun-8. This due date, June-8, is computed as below: -

Term of the Note--------------------------------------------90

Days in March----------------------------31
Minus the date of the note---------- (10)
Days remaining in March------------------------21
Add days in April---------------------------------30
Add days in May----------------------------------31---- 82
Maturity date (June) -------------------------------------8

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The period of a note is sometimes expressed in months. When months are used, the note matures and is
payable in the month of its maturity on the same date of the month as its original date.

 A three-month note dated March-10, for instance, is payable on June-10.

6.5.2. Interest Computation
Interest is the cost of borrowing money for the borrower. It is the profit from lending money for the lender.
The interest rate on notes is normally stated in terms of per year, regardless of the actual period of time
involved.
The formula for computing interest is as follows: -

Interest = Principal X Annual X Time

(Face Amount of the Note) interest Rate

Illustration
The interest on a Br. 10,000, 12%, 60 day note is computed as:-

Interest = Principal × interest Rate ×Time

=Br. 10,000 X 12% X 60/360

= 200
N.B. To simplify interest computations for notes with periods expressed in days, it is common to treat a
year as having 360 days.

6.5.3. Maturity Value

The amount that is due at the maturity or due date is called the maturity value. The maturity value of a note
is the sum of the face amount and the interest.

MV = FV + I
Where
- MV= Maturity value
- FV = Face value
- I = Interest
Illustration
In the above example, the maturity value will be:
MV = 10,000 + 200= 10,200
6.6. Accounting For Notes Receivable

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Notes Receivable is usually recorded in a single note Receivable account to simplify record keeping. We
need only one account because the original notes are kept on file. This means the maker; rate of interest,
due date, and other information can be learned by examining the actual note.
Illustration
Assume that on Jannuary-10, Nile Co. sales merchandise on account to Tana Co. and receive a Br. 5,000,
90-day, 12% promissory note.
This transaction is recorded as: -
Jan. 10. Notes Receivable ------------------------5000
Sales--------------------------------------5000
The maker of the note usually honors the note and pays it in full. The entry required to record the receipt of
cash by Nile Co. from Tana Co. is as follows:
April-10 Cash-------------------------------------------------------5150
Notes Receivable---------------------------------------------5000
Interest Revenue (500 X 12/100 X 90/360) -------------150
Companies can sometimes accept a note for an overdue customer as a way of granting a time extension
on a past-due account Receivable.
Illustration
Assume that a 60-day, 10% note dated September 5, 2001 is accepted by Awash Co. in settlement of the
account of Happy co, which is past due and has a balance of 10,000. The entry to record the transaction is
as follows:
Sept 5 N/Receivable--------------------------------------10, 000
A/Receivable ----------------------------------------------10,000
(Received a note to settle account)
6.6.1. Recording a dishonored note
When a note’s maker is unable or refuses to pay at maturity, the note is dishonored. The act of dishonoring
a note doesn’t relieve the maker of the obligation to pay. The payee should use every legitimate means to
collect. But how do companies report this event? The balance of the Notes Receivable account normally
includes only those notes that have not matured. When a note is dishonored, we therefore remove the
amount of this note from the Notes Receivable account and charge it back to an Accounts Receivable from
its maker.
Illustration
Assume for instance Nile Co., holds a Br. 1000, 12%, 30-day note of Ato Alemu. At maturity, Alemu
dishonored the note. Nile Co. records this dishonoring of its N/R, on Oct. 25, as follows:
Oct.25 A/R-Ato Alemu -------------------------------------------1010
N/Receivable -------------------------------------1000
Int. Revenue -----------------------------------------10
(To record dishonored note & interest of 1000 X 12% X30/360 =10)

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The above entry records interest of Br. 10, which has been earned, even though the note has been
dishonored.
6.6.2. End-Of-Period interest Adjustment
When notes receivable are outstanding at the end of an accounting period, accrued interest is computed
and recorded. For example, on December 20, 20x1, Nile Co. accepted a Br. 2000, 60-day, 12% notes from
a customer in granting an extension of a past-due account. Assuming that the accounting period ends on
Dec. 31, the entries to record the receipt of the note, accrued interest, and payment of the note at maturity
are shown below: -
Dec. 19. N/Receivable -------------------------------------2000
A/R- customer-X ---------------------------------2000
(Received note in settlement of A\R)
Dec. 31. Interest Receivable-------------------------8
Int. Revenue------------------------------------8
Adjusting entry for ace need
Interest, Br. 2000 X 12% X 12/360 = 8
Feb. 17. Cash----------------------------------------2040
N/Receivable ---------------------------------------------2000
Int. Receivable-------------------------------------------------8
Int. Revenue--------------------------------------------------32
(Received payment of note & interest at maturity)
The adjusting entry above on Dec. 31, 20X1, was required to show the interest earned for the period on the
Income Statement.
6.6.3. Converting Receivables to cash before Maturity
Sometimes, companies convert receivables to cash before they are due. Reasons for this include the need
for cash or a desire not to be involved in collection activities. Converting receivable is usually done either
(1) by selling them, or (2) by using them as security for a loan. The topic of using notes as security for a
loan will be discussed in future courses. Notes Receivable can be converted to cash by discounting them at
a financial institution such as a Bank. The process has three steps:
 In the first step, the maker receives goods, service or cash from the payee in exchange for the
note.
 In the second step, the payee discounts the note with a bank and receives the maturity value of the
note less a discount (a fee) charged by the bank.
 In the third step, the maker pays the bank at the maturity of the note.
Notes Receivable is discounted with or without recourse. When a note is discounted without recourse, the
bank assumes the risk of a bad debt loss and the original payee doesn’t have a contingent liability. A
contingent liability is an obligation to make a future payment if and only if an uncertain future event occurs.
A note discounted without recourse is like an outright sale of an asset. If a note is discounted with recourse
and the original maker of the note fails to pay the bank when it matures, the payee of the note must pay for

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it. This means a company discounting a note (an endorser) with recourse has a contingent liability until the
bank is paid. A Co. should disclose contingent liabilities in the accompanying notes to its financial
statements.
Illustration
To illustrate, assume that a 90-day, 12%, Br. 20,000 N/R from Hiwot Co. dated Jan.1, 2002 is discounted at
the payee’s bank on February 12, 20x2 at the discount rate of 15%.
Solution
The steps to determine the proceeds (-the amount to be received by the payee from the bank upon
discounting) are as follows:
Step 1 – Determine the maturity date & maturity value.
MD = April –1
MV = FV + I
= 20,000 + [20,000 X 12% X 90/360]
= 20,600

Step 2 – Determine the Bank Discount (Bank discount is an interest that is charged by the bank and is
computed based on the maturity value of the note for the discount period. Discount Period is the time the
bank must hold the note) before it becomes due.

Bank Discount = MV X DR X DP
Where MV = Maturity value
DR = Discount Rate
DP = Discount period
Discount = 20,600 X 15% X 48/360
= 412
Step 3- Determine proceed (proceed is the amount of cash paid to the endorser after deducting discount)

Proceed = MV – D

Where, MV = Maturity value

D = Discount
= 20,600 – 412
= 20,188

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Step 4 – Record the necessary journal entry at the date of discount. (Here, record interest revenue which is
the excess of proceeds from the face value or record interest expense when the proceed is less than the
face value of the note)
Feb 12. Cash------------------------------------------------20,188
N/Receivable -----------------------------------------20,000
Interest Revenue -----------------------------------------188
(Discounted Br. 20,000, 90-day, 12% note at 15%)
The length of the discount period and the difference between the interest rate and the discount rate
determine whether interest expense or interest revenue will result from discounting.

When a discounted Notes Receivable is dishonored, the bank notifies the endorser and asks for payment if
there is no statement that limits the responsibility of the endorser. In some cases, the bank may charge a
protest fee of notifying the endorser that a note has been dishonored. The entire amount paid to the bank
by the endorser, including the interest and protest fee, should be debited to the A/R of the maker. For
example, assume that the maker, Hiwot Co, dishonored the above discounted note at maturity. The bank
charges a protest fee of Br. 25. The endorser’s entry to record the payment to the bank is as follows:
April 2. A/R Hiwot Co----------------- 20,625
Cash-----------------------------------20,625
(Paid dishonored, discounted note)

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