Cash andReceivables
Part 2
I N T ERMEDIATE ACCOU N T I NG I
CHA PT ER 7
Measuring and Reporting Accounts Receivable
Recognition
Depends on the earnings process; for most credit sales, revenue and the
related receivables are recognized at the point of delivery.
Initial valuation
Initially recorded at the exchange price agreed upon by the buyer and
seller.
Subsequent valuation
Initial valuation reduced to net realizable value by:
1. Allowance for sales returns
2. Allowance for uncollectible accounts:
- The income statement approach
- The balance sheet approach
Classification
Almost always classified as a current asset.
VALUING ACCOUNTS RECEIVABLE
Accounts Receivable should be reported on the balance
sheet under Current Assets at their net realizable value.
Possible returns and customer nonpayment could cause
subsequent accounts receivable to be less than initial
valuation.
UNCOLLECTIBLE ACCOUNTS
Uncollectible accounts (or bad debts) must be accounted for by
companies who offer credit.
Two methods exist for accounting for uncollectible accounts:
• Direct Write-off Method
• Allowance Method
o Income Statement Approach (estimate is a percentage of sales)
o Balance Sheet Approach (estimate is a percentage of accounts
receivable adjusted for previous estimates)
If the estimate for bad debts is material, the allowance method should
be used. The allowance method adheres to the Matching Principle by
attempting to estimate future bad debts and match them with the
related sales revenue in the current accounting period.
UNCOLLECTIBLE ACCOUNTS:
Allowance Method – Income Statement Approach
The Hawthorne Manufacturing Company sells its products offering 30 days credit to its
customers. During 2014, the following events occurred:
Sales on credit
Cash collections from credit customers
Accounts receivable, end of year
$1,200,000
895,000
$ 305,000
Assume an aging of accounts receivable revealed a required allowance of $25,500, and the
allowance account prior to the adjusting entry was a credit balance of $4,000:
Prepare the journal entry to record the adjustment for uncollectible accounts using the
Income Statement Approach.
Bad debt expense
Allowance for uncollectible accounts
(2% x $1,200,000)
24,000
24,000
UNCOLLECTIBLE ACCOUNTS:
Allowance Method – Balance Sheet Approach
The Hawthorne Manufacturing Company sells its products offering 30 days credit to its customers. During
2014, the following events occurred:
Sales on credit
$1,200,000
Cash collections from credit customers
895,000
Accounts receivable, end of year
$ 305,000
Allowance for Uncollectible Accounts
$4,000 (credit)
Assume that 8% of ending accounts receivable are estimated to be uncollectible.
Prepare the journal entry to record the adjustment for uncollectible accounts.
Calculation:
Desired Balance: $305,000 X .08 = $24,400
Desired Balance
$24,400
Less: Credit balance in Allowance account (4,000)
Amount of Adjustment
$20,400
Bad debt expense
Allowance for uncollectible accounts
20,400
20,400
Balance Sheet Presentation
Allowance for uncollectible accounts is a contra account (valuation account)
to accounts receivable. On the 2014 balance sheet in the current asset
section, accounts receivable would be reported net of the allowance. If
material, the amount in the Allowance account should be disclosed on the
face of the balance sheet.
The Allowance account may be listed separately, as follows:
Accounts receivable
$305,000
Less: Allowance for uncollectible accounts
(24,000)
Net accounts receivable
$281,000
Accounts Receivable may also be shown net of the allowance
in one line item, as follows:
Accounts receivable, less allowances for doubtful
accounts $24,000
$281,000
Disclosure Notes:
Details about accounts
receivable including the
method used for
estimating bad debts
should be included in
the notes to the
financial statements.
WHEN INDIVIDUAL ACCOUNTS ARE DEEMED UNCOLLECTIBLE
• Customer accounts may be determined to be uncollectible for a number of
reasons.
• Writing off a debt does not legally release the customer from the obligation
to pay. The purpose is to provide more accurate accounting records.
• The process of writing off a receivable using the allowance method is
accomplished by debiting the allowance account and crediting accounts
receivable (and the individual customer accounts in the subsidiary ledger).
WRITING OFF ACCOUNTS RECEIVABLE
Example
Assume that actual bad debts in 2015 were $25,000. Draft the journal entry to
record the write-off.
Allowance for Uncollectible Accounts
Accounts Receivable
25,000
25,000
Net realizable value is not directly affected by the write-offs since both the
Allowance account and Accounts Receivable are decreased by the same amount.
When Previously Written-off Accounts
Are Collected
Assume a $1,200 account that was previously written off is collected.
The following journal entries record the event:
Accounts Receivable
1,200
Allowance for Uncollectible Accounts
Cash
Accounts Receivable
1,200
1,200
1,200
The first journal entry reverses the write-off and reestablishes the receivable. The second entry receives the
payment on account.
UNCOLLECTIBLE ACCOUNTS:
Direct Write-Off Method
Under the Direct Write-off Method, uncollectible accounts expense is
recognized only as accounts are written off. No allowance for
uncollectible accounts is made. This method should only be used if
uncollectible accounts are not anticipated or are immaterial.
Example
Assume that actual bad debts in 2015 were $25,000. Draft the journal entry to record
the write-off and recognize bad debt expense.
Bad debt expense
Accounts Receivable
25,000
25,000
SALES RETURNS
Return of merchandise by a customer is recorded by debiting
Sales Returns & Allowances (a contra-revenue account) and
crediting Accounts receivable (to reduce the amount owed
by the customer.) The returned merchandise must also be
accounted for by debiting Inventory and crediting
Cost of Goods Sold.
If material, sales returns should be anticipated
by subtracting an allowance for estimated returns
from accounts receivable. The adjustment for sales
returns is reduced by the actual returns made
during the fiscal year.
SALES RETURNS
Example – Part 1
During 2015, its first year of operations, the
Hawthorne Manufacturing Company sold
merchandise on account for $2,000,000.
This merchandise cost $1,200,000 (60% of
the selling price). Customers returned
$130,000 in sales during 2015, prior to
making payment.
Draft the entries to record sales and
merchandise returned during the year,
assuming that a perpetual inventory system
is used.
Sales
Accounts Receivable
2,000,000
Sales
Cost of Goods Sold ($2,000,000 X 60%)
2,000,000
1,200,000
Inventory
1,200,000
Returns
Sales returns (actual returns)
130,000
Accounts Receivable
Inventory ($130,000 X 60%)
Cost of Goods Sold
130,000
78,000
78,000
SALES RETURNS
Example – Part 2
Hawthorne
Manufacturing
Company
estimates that 10% of all sales will be
returned.
Sales Returns ([$2,000,000 X 10%]-$130,000
Assuming this is a material amount, draft
the entries to record the adjustment at the
end of the fiscal period.
Inventory-Estimated Returns
70,000
Allowance for Sales Returns
Cost of Goods Sold ($70,000 X 60%)
70,000
42,000
42,000
NOTES RECEIVABLE
Notes Receivable are formal credit arrangements between a creditor and a
debtor. Notes can be issued for cash, merchandise, or other assets.
Payment of the face amount of the note, or principal, is due at a specified
maturity date.
INTEREST-BEARING NOTES RECEIVABLE
The typical Note Receivable is an interest-bearing note. Interest is calculated
on the face amount of the note based on a stated interest rate.
Interest Bearing Note
Example 1 – Note is Collected Prior to Fiscal Year End
The Stridewell Wholesale Shoe Company manufactures athletic shoes that it sells to retailers.
On May 1, 2016, the company sold shoes to Harmon Sporting Goods. Stridewell agreed to
accept a $700,000, 6-month, 12% note in payment for the shoes. Interest is payable at maturity.
Stridewell would account for the note as follows:
May 1, 2016 - To record the sale of goods in exchange for a note
Notes Receivable
700,000
Sales Revenue
700,000
Nov 1, 2016 – To record collection of the note at maturity
Cash ($700,000 + $42,000)
Interest Revenue ($700,000 X 12% X 6/12)
Notes Receivable
742,000
42,000
700,000
Interest Bearing Note
Example 2 – Note is Collected After Fiscal Year End
On August 1, 2016, Stridewell sold shoes to Harmon Sporting Goods agreeing to accept a $700,000,
6-month, 12% note in payment for the shoes. Interest is payable at maturity.
The entry to record the sale is the same as that shown in the previous example. In this example, Stridewell
must account for interest accrued at the end of the fiscal year end.
Dec 31, 2016 - To record the adjusting entry for interest revenue
Interest Receivable
35,000
Interest Revenue ($700,000 X 12% X 5/12)
35,000
Feb 1, 2017 – To record collection of the note at maturity
Cash ($700,000 + $35,000 + $7,000)
Interest Receivable
Interest Revenue ($700,000 X 12% X 1/12)
Notes Receivable
742,000
35,000
7,000
700,000
When the note is collected, Cash is
debited for the full amount of the
principal plus 6 months of interest.
Interest revenue in 2017 is for one
month only. Interest Receivable is
credited for the interest accrued and
recognized in 2016.
NONINTEREST-BEARING NOTES
Sometimes a receivable assumes the form of a so-called noninterest-bearing
note.
• Noninterest-bearing notes actually do bear interest, but the interest is
deducted at the onset (or discounted) from the face amount to determine
the cash proceeds made available to the borrower.
• When interest is discounted from the face amount of a note, the effective
interest rate is higher than the stated discount rate.
• Similar to accounts receivable, if a company anticipates bad debts on shortterm notes receivable, it uses an allowance account to reduce the receivable
to net realizable value.
• The Discount on Note Receivable account is contra to the Note Receivable
account.
NONINTEREST-BEARING NOTES
The preceding note could be packaged as a $700,000 noninterest-bearing note, with a 12% discount rate.
May 1, 2016
Notes Receivable (face amount)
700,000
Discount on Note Receivable ($700,000 X 12% X 6/12)
42,000
Sales Revenue (difference)
658,000
Nov 1, 2016
Cash ($700,000 + $35,000 + $7,000)
700,000
Notes Receivable
Discount on Note Receivable
Interest Revenue
700,000
42,000
42,000
CALCULATING THE EFFECTIVE INTEREST RATE
When interest is discounted from the face amount of a note, the effective interest rate is
higher than the stated discount rate.
Annual Interest at Stated Rate/Sales Price = Effective Annual Interest Rate
$84,000*/$658,000 = .1276595
Stated as a percent rounded to two decimal places = 12.77 %
* $700,000 X .12 = $84,000
ACCRUAL OF INTEREST
If the sale occurs on August 1, the December 31, 2015,
adjusting entry and the entry to record the cash collection on
February 1, 2014, are recorded as follows:
December 31, 2015
Discount on note receivable
35,000
Interest revenue ($700,000 x 12% x 5/12)
35,000
February 1, 2016
Discount on note receivable
7,000
Interest revenue ($700,000 x 12% x 1/12)
7,000
Cash
700,000
Note receivable (face amount)
700,000
DISCOUNTING (selling) A NOTE RECEIVABLE
The transfer of a note receivable to a financial
institution is called discounting. When a note is
discounted to a financial institution, the seller receives
cash in exchange for the note. The proceeds from the
sale are calculated as the maturity value of the note
less the financial institution’s discount rate.
DISCOUNTING A NOTE RECEIVABLE Example
Discounted Note Treated as a Sale
On December 31, 2015, the Stridewell Wholesale Shoe Company sold land
in exchange for a nine-month, 10% note. The note requires the payment of
$200,000 plus interest on September 30, 2016. The company’s fiscal yearend is December 31. The 10% rate properly reflects the time value of
money for this type of note. On March 31, 2016, Stridewell discounted the
note at the Bank of the East. The Bank’s discount rate is 12%.
Because the note has been outstanding for three months before
being discounted at the bank, Stridewell first records the interest
that has accrued prior to being discounted:
March 31, 2014
Interest receivable
5,000
Interest revenue ($200,000 x 10% x 3/12)
5,000
DISCOUNTING A NOTE RECEIVABLE
(continued)
Next, the value of the note if held to maturity is calculated. Then the discount
for the time remaining to maturity is deducted to determine the cash proceeds
from discounting the note:
$200,000
15,000
215,000
(12,900)
$202,100
Face amount
Interest to maturity ($200,000 x 10% x 9/12)
Maturity value
Discount ($215,000 x 12% x 6/12)
Cash proceeds
Cash (proceeds determined above)
202,100
Loss on sale of note receivable (difference)
2,900
Note receivable (face amount)
Interest receivable (accrued interest determined above)
200,000
5,000
Cash and Receivables –
Part 2
I N T ERMEDIATE ACCOU N T I NG I
E N D OF P R ESENTATION