CHAPTER 8

Accounting for Receivables

LECTURE OUTLINE

1. Accounts Receivable
1.1 The term receivables refers to amounts due from individuals and other companies
that are expected to be collected in cash. The most common types of receivables
are accounts receivable and notes receivable.

1.2 The two most common types of receivables are accounts and notes receivable:
Accounts receivable are amounts owed by customers on account resulting from the
sale of goods or services. These receivables are generally expected to be collected
within 30 days or so, and are classified as current assets. Accounts receivable are
usually the most common type of claim held by a company.
Notes receivable are claims for which formal instruments of credit are issued as
proof of the debt. A note has a time period that extends for 30 days or longer and
normally requires the debtor to pay interest. Notes receivable may be current or
long-term assets, depending on their due dates.
Notes and accounts receivable that result from sale transactions are often called
trade receivables.

1.3 Recognizing Accounts Receivable

1.3.1 Accounts receivable are recognized when goods are sold on account or
services are provided on account.

1.3.2 Subsidiary Accounts Receivable Ledger

Most companies who sell on account use a subsidiary ledger to keep track
of individual customer accounts. Each entry affecting accounts receivable
is essentially posted twice – once to the subsidiary ledger and once to the
accounts receivable control account in the general ledger.
Normally, in a manual system, entries to the subsidiary ledger are posted
daily, while entries to the general ledger are summarized and posted
monthly.
Today most companies have computer accounting systems that
automatically update the subsidiary ledger and the general ledger when
the journal entry is recorded.

1.3.3 Credit Card Receivables

Some retailers issue their own credit cards. In many cases these
companies have their own financial divisions that will process the billings
and collections from customers. For these retailers the credit card sale
becomes a type of accounts receivable.

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 1.3.4 Interest Revenue
If a customer does not pay in full by the due date, most companies add an
interest (financing) charge to the balance due. When financing charges
are added, the company recognizes interest revenue.
Interest revenue is included in other revenues in the non-operating
section of the income statement.

Valuing Accounts Receivable

2.1 Valuing receivables involves reporting them at their carrying amount. The carrying
amount is the amount expected to be received in cash.

2.2 Credit losses are considered a normal and necessary risk of doing business on a
credit basis. When receivables are written down to their carrying amount because
of expected credit losses, owner’s equity must also be reduced. Credit losses are
debited to Bad Debts Expense.

2.3 The key issue in valuing accounts receivable is to estimate the amount of accounts
receivable that will not be collected. If the company waits until it knows for sure
that a specific account will not be collected, it could end up recording the bad debt
expense in a different period than the revenue. If credit losses are not recorded
until they occur, the accounts receivable in the balance sheet are not reported at
the amount that is actually expected to be received. In addition, the bad debts
expense will not be matched to sales revenue in the income statement.

2.4 To avoid overstating assets and profit, we do not wait until we know exactly which
receivables are uncollectible. Instead, we must estimate the uncollectible accounts
receivable in the period where the sales occur.

2.5 Because we do not know which specific accounts receivable will need to be written
off, we use the allowance method.

2.6 The Allowance Method of accounting for bad debts involves estimating the
uncollectible accounts at the end of each period. As a result, the bad debt expense
is recorded in the same period as the revenue from credit sales, and the accounts
receivable are reported at their carrying amount on the balance sheet.

2.7 The allowance method is required for financial reporting purposes when bad debts
are material (significant) in amount. It has three essential features:
(1) Recording estimated uncollectibles.
(2) Recording the write off of uncollectible accounts.
(3) Collection of a previously written off account.

2.8 Estimating the Allowance

The most common approach used by companies in estimating the Allowance for
doubtful accounts is called the percentage of receivables approach. This method is
often called the balance sheet approach as it focuses on estimating the collectible
portion of accounts receivable to report on the balance sheet.

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 Percentage of Receivables Approach
Under the percentage of receivables approach, management uses past experience
to estimate the percentage of receivables that will become uncollectible accounts.
One method is to multiply the total amount of accounts receivable by a percentage
based on an overall estimate of the total uncollectible accounts.
A second method is to use different percentages depending on how long the
accounts receivable have been outstanding. A schedule must be prepared, called an
aging schedule, which shows the age of each account receivable. The longer a
receivable is past due or outstanding, the less likely it is to be collected.
After the ages of the different accounts receivable are determined, the loss from
uncollectible accounts is estimated. This is done by applying percentages based on
past experience to the totals in each category. As the account gets older, the
percentage of uncollectible accounts increases.

The total amount determined as uncollectible (based on the percentage of

accounts receivable method) must equal the final balance in the allowance for
doubtful accounts.
The carrying amount is the difference between gross accounts receivable and
allowance for doubtful accounts and represents the collectible amount of accounts
receivable.

2.9 Determining Bad Debts Expense: Because the balance sheet is emphasized in the
percentage of receivable approach, the existing balance in the allowance account
must be considered when calculating the bad debts expense in the adjusting entry.
Estimated uncollectible accounts are debited to Bad Debts Expense and credited to
Allowance for Doubtful Accounts through an adjusting entry at the end of each
period.
Note that Allowance for Doubtful Accounts is used instead of a direct credit to
Accounts Receivable because we do not know which individual customers will not
pay.
The adjusting entry for the allowance for doubtful accounts appears next. The
existing balance in the Allowance for Doubtful Accounts must be considered before
recording this entry.

If the allowance account has a debit balance, prior to the adjusting entry, the debit
balance is added to the required balance when the adjusting entry is made.

When preparing annual financial statements, all companies must report accounts
receivable at their carrying amount, so companies must estimate the required
allowance. There is a simplified method to calculate bad debts expense, called the
percentage of sales method that some companies use when preparing monthly
financial statements. It estimates bad debts expense as a percentage of net credit
sales based on past experience. The existing balance in the Allowance for Doubtful
accounts is ignored when using the percentage of sales approach. This approach is
often called the income statement approach.

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 Both the percentage of receivable and percentage of sales approaches are
generally accepted. Current accounting standards emphasize the balance sheet and
valuation of assets, liabilities and equity as primary measurements. Therefore, the
percentage receivable approach is most appropriate for reporting accounts
receivable.

2.10 Writing off Uncollectible Accounts

When all of the ways of collecting a past-due account have been tried and
collection appears impossible, the account should be written off. To avoid
premature write offs, each write off should be approved by management.

Bad Debts Expense is not increased when the write off occurs. Only balance sheet
accounts are affected by write offs.
Under the allowance method, every account write off is debited to the Allowance
for Doubtful Accounts rather than to Bad Debts Expense.
A debit to Bad Debts Expense would be incorrect because the expense was already
recognized when the adjusting entry was made for estimated bad debts last year.

2.11 Collection of account previously written off

Occasionally, a company will collect on an account that has previously been
written off.
Two entries are required to record the recovery of the bad debt:
(1) Reverse the entry that originally wrote off the customer’s account, and
(2) Record the receipt of the cash as a collection on account.

3. Notes Receivable
3.1 Recognizing Notes Receivable

3.1.1 Credit may also be granted in exchange for a formal credit instrument
called a promissory note. A promissory note is a written promise to pay a
specified amount of money on demand or at a definite time.

3.1.2 Promissory notes may be used for the following reasons:

(1) When individuals and companies lend or borrow money,
(2) When the amount of the transaction and the credit period are
longer than normal limits, and
(3) In settlement of accounts receivable.

3.1.3 The promissory note provides these details:

(1) The names of the parties,
(2) The amount of the loan,
(3) The loan period,

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 (4) The interest rate,
(5) Whether the interest is repayable monthly or at maturity
along with the principal.
(6) Any other details such as whether any security is pledged
as collateral for the loan and what happens if the maker
defaults.

3.1.4 The party promising to pay is called the maker. The party who is to
receive the payment is called the payee.

3.1.5 There are similarities between notes and accounts receivable:

 Both are credit instruments,
 Both are reported on the balance sheet at their carrying amount,
 Both can be sold to another party.

3.1.6 Accounting issues are the same for notes receivable as those are for
accounts receivable.

3.1.7 Recognizing Notes Receivable

The journal entry in which an account receivable is converted to a note
receivable is provided.
The note receivable is recorded at its principal value.
Interest will be recorded as time passes.

3.1.8 Recording Interest

The formula for calculating interest is:
Principal amount of note × Annual interest rate × Time in terms of one
year
Time is the number of months within the period (not to exceed a year)
divided by 12.

An example of a journal entry for interest receivable calculated on a note

receivable is provided.

3.1.9 Valuing Notes Receivable

Notes receivable are reporting at their carrying amount, just like accounts
receivable are reported. The allowance account is called Allowance for
Doubtful Accounts. The estimations involved in determining the carrying
amount in recording the bad debt expense and related allowances are
similar.

3.2 Disposing of Notes Receivable

3.2.1 Honouring of Notes Receivable

A note is honoured when it is paid in full at its maturity date. For an
interest-bearing note, the amount due at maturity is the principal plus
interest.

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 3.2.2 Dishonouring of Notes Receivable
A dishonoured note is a note that is not paid in full at maturity. The entry
to record the dishonour of a note depends on whether eventual collection
is expected.
If the debtor is expected to pay, an Accounts Receivable is recognized for
the face value of the note plus accrued interest.
If there is no hope of collection, no interest revenue is recorded as it is not
realizable and the face value of the note should be written off along with
any interest receivable that had been accrued at an earlier date by
debiting Allowance for Doubtful Accounts.

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 4. Statement Presentation and Management of Receivables
4.1 Presentation
Each of the major types of receivables should be identified in the balance sheet or
in the notes to the financial statements. Other receivables include interest
receivable, loans or advances to employees. Notes receivable may be classified as
either current assets or long-term assets, depending on their due dates.
Short-term receivables are reported in the current asset section of the balance
sheet following cash and temporary investments, if the balance sheet is presented
in order of decreasing liquidity. Although only the net amount of receivables must
be disclosed, it is helpful if both the gross amount of receivables and allowance for
doubtful accounts are disclosed.
In the income statement, Bad Debts Expense is reported an operating expense.
Interest Revenue is shown under other revenues in the non-operating section.

4.2 Analysis
The receivables turnover is a useful measure for assessing a company’s efficiency
in converting credit sales into cash. The higher the ratio, the more liquid are the
company’s receivables

Net Credit Sales ÷ Average Gross Accounts Receivable

The collection period is determined by dividing 365 days by the receivables

turnover ratio. As a general rule, the collection period should not greatly exceed
the credit terms offered.

The combination of the collection period and days sales in inventory is a useful
way to measure the length of a company’s operating cycle.

4.3 Accelerating Cash Receipts from Receivables

4.3.1 There are two typical ways to collect cash more quickly from receivables:
(1) Using the receivables to secure a loan, and
(2) Selling the receivables.

4.3.2 Loans Secured by Receivables

Companies can go to the banks to secure a loan when in the need of cash
and use accounts receivable as collateral.
The loan can be repaid as the receivables are collected.
Generally banks are willing to finance up to 75% of accounts receivable
that are less than 90 days old.

4.3.3 Sale of Receivables

Companies frequently sell their receivables to another company for cash.

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 Many companies do not want to hold large amounts of receivables. Many
companies have created wholly owned finance companies that accept
responsibility for accounts receivable financing.

Receivables may be sold because they may be the only source of cash for
the company
Many companies do not want to spend the time with billing and
collections so they would rather sell its receivables to another company
with expertise in this area.

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