Accounting for Accounting for ReceivablesReceivables

Chapter 8Chapter 8

ReceivablesReceivables

Includes all money claims against other entities, including people, business firms, and other organization.

Are usually a significant portion of the total current assets.

Types of ReceivablesTypes of Receivables

Accounts receivable Results from the sale of

merchandise on credit and expected to be collected within a relatively short period, such as 30 or 60 days.

Types of ReceivableTypes of Receivable

Notes receivable: Are amounts that

customer owe, for which a formal written instrument of credit has been issued.

Are usually used for credit periods of more than sixty days.

May be used to settle a customer’s accounts receivable

Uncollectible receivablesUncollectible receivables

When allowing customers to purchase on credit, we run the risk of nonpayment.

Many retail businesses may shift the risk of uncollectible to other companies. Allow only VISA or Mastercard.

Companies may also sell their receivables to other companies. Usually companies issue their own credit cards.

Regardless of the care used in granting credit and the collection procedures used, a part of the credit sales will not be collectible.

Bad debts expenses – operating expense recorded from the uncollectible receivables.

Two methodsTwo methods

Allowance method Required by generally

accepted accounting principles (GAAP)

Estimates the accounts receivable that will not be collected and records bad debt expense for this estimate at the end of each accounting period.

Direct write off method No estimate of

uncollectible Write off as

deemed uncollectible

Allowance MethodAllowance Method

We create a CONTRA ASSET ACCOUNT called Allowance for Bad Debts. It increases with a credit.

Record the total estimate that has not been written off.

Entry is considered an adjusting entry.

Allowance methodAllowance method

Allowance accountAllowance account Records the estimate uncollectible Credit to increase

Bad Debts ExpenseBad Debts Expense Records the annual estimated uncollectible Uncollectible account expense

Adjusting EntryAdjusting Entry

Suppose that accounts receivable have a Balance of $105,000 and it is estimated that$4,000 will go bad. Record the adjusting entry under the allowance method.

Account Debit Credit

Bad Debts Expense $4,000

Allowance for Bad Debts $4,000

Net Realizable ValueNet Realizable Value

Net Realizable Value = Accounts receivable balance – Allowance for bad

debts

What is really expected to be collected!

Write offs to the Allowance Write offs to the Allowance AccountAccount Once that we determine that a particular

customer will be not collectible, we write off the account.

The write off consists of reducing the allowance account by the amount of the write off and removing the uncollectible account from accounts receivable.

Example 2Example 2

Suppose that J Mays account with a balance of $1,200 is uncollectible.

Account Debit Credit

Allowance for Bad Debts $1,200

Accounts Receivable $1,200

Estimating UncollectiblesEstimating Uncollectibles

The allowance method estimates bad debts expense at the end of the period.

Estimate of uncollectibles at the end of a fiscal period is based on past experience and forecasts of the future.

Two methods are used:Two methods are used: Estimated based on percentage of salesEstimated based on percentage of sales Analysis of accounts receivable.Analysis of accounts receivable.

Estimated Based on SalesEstimated Based on Sales

We assume that a percentage of credit sales will go bad and record that as the adjusting entry.

Example 3:Example 3:

Suppose that credit sales for the period were $800,000 of which 1% is expected to be uncollectible. Record the entry.

$800,000 x 1% = $ 8,000

Account Debit Credit

Bad Debts Expense $8,000

Allowance for Bad Debts $8,000

Example 4Example 4

Suppose that the company expects 3% of credit sales to go uncollected. A review of the trial balance shows: Sales $1,000,000 of which 45% are cash

sales. Accounts receivable has a balance of

$70,000. Allowance for bad debts has credit balance

of $2,000.

Example 4Example 4

Credit sales are $1,000,000 x 55% = $550,000Estimate is $550,000 x 3% = $16,500

Allowance for Bad Debts

Debit Credit

$2,000 balance

$16,500 should be balance

Example 4Example 4

As a result of the credit balance in the Allowance account, We will record the entry not for $16,500 but $14,500 ( $16,500 - $2,000).

Account Debit Credit

Bad Debts Expenses $14,500

Allowance for bad debts $14,500

Example 5Example 5

Suppose that the company expects 3% of credit sales to go uncollected. A review of the trial balance shows:

Sales $1,000,000 of which 45% are cash sales.Accounts receivable has a balance of $70,000.

Allowance for bad debts has debit balance of $2,000.

Example 5Example 5

Credit sales are $1,000,000 x 55% = $550,000Estimate is $550,000 x 3% = $16,500

Allowance for Bad Debts

Debit Credit

$2,000 balance

$16,500 should be balance

Example 4Example 4

As a result of the credit balance in the Allowance account, We will record the entry not for $16,500 but $18,500 ( $16,500 + $2,000).

Account Debit Credit

Bad Debts Expense $18,500

Allowance for bad debts $18,500

RuleRule

When the Allowance Account at the end of the year:

Has a debit balance we underestimated the bad debts last period.

Has a credit balance we overestimated the bad debts last period.

Notes on Allowance methodNotes on Allowance method

If allowance account has prior balance then at end of year should equal estimated uncollectible

Analysis of ReceivablesAnalysis of Receivables

Actually looking at each individual account and determining probability of collect ability

Aging of receivables

Aging ScheduleAging ScheduleAge Interval Balance Percent Amount

Not past due $75,000 2% $1,500

1 –30 4,000 5% 200

31 – 60 3,100 10% 310

61 – 90 1,900 20% 380

91 – 180 1,200 30% 360

181 – 365 800 50% 400

Over 365 300 80% 240

Total 86,300 3,390

EntryEntry

Date Account Debit Credit

May 21

Bad debts Expense 3,390

Allowance account 3,390

Direct write off MethodDirect write off Method

There is no estimated uncollectible No allowance account Only when specific customer goes bad

will it be written off to the expense account

Direct Write offDirect Write off

Example 5: Suppose that Haby’s account goes bad with a balance of $8,000

Date Account Debit Credit

May 21 Bad debts Expense $8,000

Accounts receivable $8,000

Reinstatement of write offsReinstatement of write offs

Allowance method Example 6: Suppose Habys pays the amount

due.

Date Account Debit Credit

May 21 Accounts receivable $8,000

Allowance account $8,000

Reinstatement of write offsReinstatement of write offs

Direct Write off method

Date Account Debit Credit

May 21 Accounts receivable $8,000

Bad Debts expense $8,000

Notes Receivable Notes Receivable CharacteristicsCharacteristics

Promissory note – is a written promise to pay a sum of money on demand or at a definite time.

Payee – the person to whom the note is payable to

Maker – one making the note and owing the money

Due date – when the note is due

Maturity value = principal + interest

Sample NoteSample Note

I, Chris owe Odalys $10,000 payable in 60 days plus 12% interest.

Signed Chris

May 1, 2007

Maker Payee

Principal Time

Interest rate

Computation of Due DateComputation of Due Date

The length of time that the note is open is usually stated in days or months.

Use 360 day year for easy of computation in class but in real life we use 365 day year.

Before calculators easier to use 360 days to make calculations

Example 7Example 7

Suppose that a note is issued on May 1st for 60 days when is the note due.

Days in note 60 daysDays in month note is issued 31 days Day note is issued 1Days available in month 30Days for next month 30Days in next month June 30

Note due on June 30th

Example 8Example 8

Use information in the sample note

Computation of InterestComputation of Interest

Principal X Rate X Time = InterestPrincipal X Rate X Time = Interest

Amount due on note

Interest rate on note Days in note

360 days

Amount due

Computation of InterestComputation of Interest

Example: Suppose that face or principal of note is $30,000, interest rate is 10% for 60 days.

Principal X Rate X Time = Interest $30,000 X 10% X 60/360 = $500 Maturity value = Principal + Interest = $30,000 + $500 = $30, 500

Example 8Example 8

Suppose that a note for $20,000 with 12% is issued on June 5 for 90 days. Compute the due date, interest, and maturity value of the note.

Accounting for Notes Accounting for Notes ReceivablesReceivables

A customer may use a note to replace an account receivable. This causes the creation of a note

receivable and the removal of the outstanding accounts receivable.

Example 9Example 9

Suppose that the account for Mister is past due. Mister converts the receivable to a note for 60 days at 10%. The balance is $6,000.

Date Account Pr

Debit Credit

May 21

Notes receivable $6,000

Accounts receivable $6,000

Example 9Example 9

Mister pays amount due on the date.

Date Account Pr

Debit Credit

Cash $6,100

Notes receivable $6,000

Interest revenue $100

Note that is paid on due date is said to be HONORED

Dishonored NotesDishonored Notes

When the maker does not pay the maturity value on the due date, the note is said to be DISHONORED

At this time, the note ceases to exist, the maturity value of the note is reported again as an Accounts Receivable.

We include the interest computed as income earned but not yet received.

Example 9Example 9

Suppose that the account for Mister is past due. Mister converts the receivable to a note for 60 days at 10%. The balance is $6,000. On the due date, the note becomes dishonored

Date Account Pr Debit Credit

Accounts receivable $6,100

Notes receivable $6,000

Interest revenue $100

Notice that the difference is that we debit accounts receivables instead of cash.