College Accounting – Chapter 9
Receivables
1. WHAT ARE COMMON TYPES OF RECEIVABLES AND HOW ARE CREDIT SALES
RECORDED?
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A receivable occurs when a business sells goods or services to another party on
account (on credit).
A receivable is the right to receive cash in the future from a current transaction.
Each receivable transaction involves two parties:
o The creditor, who receives a receivable (an asset). The creditor will collect cash
from the customer or borrower.
o The debtor, the party to a credit transaction who takes on an obligation/payable
(a liability). The debtor will pay cash later.
a. Types of Receivables:
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Accounts Receivable – the right to receive cash in the future from customers for goods
sold or for services performed.
Notes Receivable – a written promise that a customer will pay a fixed amount of
principal plus interest by a certain date in the future.
o Maturity date – is the date when a note is due.
Other Receivables – a miscellaneous category that includes any other type of
receivable where there is a right to receive cash in the future. (dividends receivable,
interest receivable, taxes receivables)
b. Exercising Internal Control over Receivables
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Businesses that sell goods or services on account receive cash (check payments) by
mail or an online payment (EFT), so internal control over collections is important.
c. Recording Sales on Credit
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Selling on account (on credit) creates an account receivable. Businesses must maintain
a separate accounts receivable account for each customer in order to account for
payments received from the customer and amounts still owed.
The sum of all balances in subsidiary accounts receivable equals a control account
balance – Accounts Receivable.
d. Recording Credit Card and Debit Card Sales
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By accepting credit and debit cards, businesses are able to attract more customers.
Credit cards offer the customer the convenience of buying something without having to
pay cash immediately.
Debit cards reduce the customer’s bank account immediately but allow the customer to
pay electronically instead of with currency or by writing a check.
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Companies hire a third-party processor to process credit and debit card transactions.
Transactions are usually entered into an electronic terminal (card scanner) that the
company either purchases or rents from the processor.
The following are tow common methods of deposits of proceeds:
o Net – the total sale less the processing fee assessed equals the net amount of
cash deposited by the processor, usually within a few days of the sale date.
o Gross – the total sale is deposited daily within a few days of the actual sale date.
The processing fees for all transactions processed for the month are deducted
from the company’s bank account by the processor, often on the last day of the
month.
e. Factoring and Pledging Receivables
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One of the many drawbacks of accepting sales on account is that the company must
wait for the receipt of cash.
Pledging of receivables is another option for businesses that need cash immediately. In
a pledging situation, a business uses its receivables as security for a loan. The
business borrows money from a bank and offers its receivables as collateral.
2. HOW ARE UNCOLLECTIBLE ACCOUNTED FOR WHEN USING THE DIRECT WRITEOFF METHOD?
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Selling on account brings both a benefit and a cost:
o The benefit to a business is the potential increase revenues and profits by
making sales to a wider range of customers.
o The cost, however, is that some customers do not pay, creating uncollectible
receivables.
Bad Debts Expense is the cost to the seller of extending credit, it arises from the failure
to collect from some credit customers.
There are two methods of accounting for uncollectible receivables and recording the
related bad debts expense:
o Direct write-off method
o Allowance method
a. Recording and Writing Off Uncollectible Accounts - Direct Write-Off Method
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The direct write-off method of account for uncollectible receivables is primarily used
by small, non-public companies.
Accounts receivable are written-off and bad debts expense is recorded when the
business determines that it will never collect from a specific customer.
"Bad Debt Expense" is the debited account.
"Accounts Receivable-Company's name" are the credited accounts.
Once an account is written off, the company stops pursuing the collection.
b. Recovery of Accounts Previously Written Off - Direct Write-Off Method
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Occasionally after a company writes off an account, the customer will decide to make
payment. To account for this recovery, the company must reverse the earlier write-off.
"Accounts Receivable-Company's name" are the debited accounts.
"Bad Debt Expense" is the credited account.
Then "Cash" is the debited account. and..
"Accounts Receivable - Company's name" can be credited again.
c. Limitations of the Direct Write-Off Method
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This method violates the matching principle. The matching principle requires that the
expense of uncollectible accounts be matched with the related revenue.
3. HOW ARE UNCOLLECTIBLES ACCOUNTED FOR WHEN USING THE ALLOWANCE
METHOD?
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The allowance method is based on the matching principle; thus, the key concept is to
record bad debts expense in the same period as the sales revenue.
The offset to the expense is a contra account called Allowance for Bad Debts or the
Allowance for Doubtful Accounts.
a. Recording Bad Debts Expense - Allowance Method
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When using the allowance method, companies estimate bad debts expense at the end
of the period and then record an adjusting entry.
"Bad Debt Expense" is the debited account.
"Allowance for Bad Debt" is the credited account.
Net realizable value is the net value the company expects to collect from its accounts
receivable (Accounts Receivable less Allowance for Bad Debts).
b. Writing Off Uncollectible Accounts - Allowance Method
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When using the allowance method, companies still write off accounts receivable that are
uncollectible. However, instead of recording a debit to Bad Debt Expense (as done
when using the direct write-off method), the company will record a debit to Allowance for
Bad Debts.
c. Recovery of Accounts Previously Written Off - Allowance Method
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A business will need to reverse the write-off to the Allowance for Bad Debts account
and then record the receipt of cash, if the company's account had previously been
written-off.
d. Estimating and Recording Bad Debts Expense - Allowance Method
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There are 3 ways to estimate uncollectibles:
o Percent-of-sale: the percent-of-sale computes bad debts expense as a
percentage of net credit sales. This method is also called the income-statement
approach because it focuses on the amount of expense that is reported on the
income statement. Bad Debts Expense = Net credit sales X % (normally 0.5%).
o Percent-of-receivable: A method of estimating uncollectible receivables by
determining the balance of the Allowance for Bad Debts account based on a
percentage of accounts receivable.
 Determine the target balance of Allowance of Bad Debts.
 Target balance = Ending balance of accounts receivable X %
 Determine the amount of bad debts expense by evaluating the allowance
account.
 Bad debts expense = Target balance - unadjusted credit balance of
Allowance for Bad Debts OR
 Bad debts expense = Target balance + unadjusted debit balance of
Allowance for Bad Debts
o Aging-of-receivables: A method of estimating uncollectible receivables by
determining the balance of the Allowance for Bad Debts account based on the
age of individual accounts receivable.
 Determine the target balance of Allowance for Bad Debts by using the age
of each account.
 Determine the amount of bad debts expense by evaluating the allowance
account.
 Bad debts expense = Target balance - unadjusted credit balance of
Allowance for Bad Debts OR
 Bad debts expense = Target balance + unadjusted credit balance of
Allowance of Bad Debts
e. Comparison of Accounting for Uncollectibles
DIRECT WRITE-OFF METHOD
ALLOWANCE METHOD
Write-off of an uncollectible account:
Bad Debts Expense
Allowance for Bad Debts
25
25
Accounts Receivable- Co Name
Accounts
ReceivableCo
Name
25
25
Wrote off an uncollectible account.
Wrote off an uncollectible account.
Recovery of accounts previously written off:
Accounts Receivable- Co Name
Accounts Receivable- Co Name
25
Bad Debts Expense
Allowance for Bad Debts
25
Reinstated previously written off accts
Cash
Accounts Receivable- Co Name
Collected cash on account
25
25
Reinstated previously written off accts.
25
25
Cash
Accounts Receivable - Co Name
Collected cash on account
25
25
Adjusting entry to recognize bad debts:
No adjusting entry recorded
300
Bad Debts Expense
300
Allowance for Bad Debts
Recorded bad debts expense for the period.
4. HOW ARE NOTES RECEIVABLE ACCOUNTED FOR?
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Promissory note - a written promise to pay a specified amount of money at a particular
future date.
Maker of the note (debtor) - the entity that signs the note and promises to pay the
required amount; the maker of the note is the debtor.
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Payee of the note (creditor) - the entity to whom the maker promises future payment;
the payee of the note is the creditor. The creditor is the company that loans the money.
Principal - the amount loaned out by the payee and borrowed by the maker of the note.
Interest - the revenue to the payee for loaning money. Interest is an expense to the
debtor and revenue to the creditor.
Interest period - the period to time during which interest is computed. It extends from
the original date of the note to the maturity date. Also called the note term.
Interest rate - the percentage rate of interest specified by the note. Interest rates are
almost always stated for a period of one year.
Maturity date - as stated earlier, this is the date when final payment of the note is due.
Also called the due date.
Maturity value - the sum of the principal plus interest due at maturity. Maturity value is
the total amount that will be paid back.
a. Identifying Maturity Date
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A 180-day note dated February 16, 2015, matures on August 15, 2015, as shown here:
Month
Number of Days:
Cumulative Total:
Feb. 2015
28-16 = 12
12
Mar. 2015
31
12 + 31 = 43
Apr. 2015
30
43 + 30 = 73
May 2015
31
73 + 31 = 104
Jun. 2015
30
104 + 30 = 134
Jul. 2015
31
134 + 31 = 165
Aug. 2015
15
165 + 15 = 180
Only 15 days is needed in August to fulfill the maturity period, so it matures on August 15.
b. Computing Interest on a Note:
Amount of Interest = Principal X Interest Rate X Time
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In the formula, time (period) represents the portion of a year that interest has accrued
on the note. It may be expresses as a fraction of a year in months (x/12) or a fraction of
a year in days (x/360 or x/365).
c. Accruing Interest Revenue and Recording Honored Notes Receivable
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Some notes receivable may be outstanding at the end of an accounting period.
The interest revenue earned on the note up to year-end is part of that year's earnings.
"Interest Receivable" is the debited account and 'Interest Revenue" is the credited
account.
d. Recording Dishonored Notes Receivable
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If a maker of a note does not pay at maturity, the maker dishonors a note (also called
defaulting on a note). Because the note has expired, it is no longer in force.
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"Accounts Receivable-Co Name" is the debited account and "Notes Receivable-Co
Name" is the credited account.
5. HOW DO WE USE THE ACID-TEST RATIO, ACCOUNTS RECEIVABLE TURNOVER
RATIO, AND DAYS' SALES IN RECEIVABLES TO EVALUATE BUSINESS
PERFORMANCE?
a. Acid-Test (or Quick) Ratio
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.
Acid-Test
Ratio =
𝐶𝑎𝑠ℎ 𝑖𝑛𝑐𝑙𝑢𝑑𝑖𝑛𝑔 𝑐𝑎𝑠ℎ 𝑒𝑞𝑢𝑖𝑣𝑎𝑙𝑒𝑛𝑡𝑠 + 𝑆ℎ𝑜𝑟𝑡−𝑡𝑒𝑟𝑚 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡𝑠 + 𝑁𝑒𝑡 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠
𝑇𝑜𝑡𝑎𝑙 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
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An acid-test ratio of 1.0 is considered safe.
b. Accounts Receivable Turnover Ratio
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Accounts Receivable turnover ratio =
c. Days' Sales in Receivable
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Days' sales in receivable =
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𝑁𝑒𝑡 𝑐𝑟𝑒𝑑𝑖𝑡 𝑠𝑎𝑙𝑒𝑠
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑛𝑒𝑡 𝑎𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒
365 𝑑𝑎𝑦𝑠
𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑟𝑎𝑡𝑖𝑜
Days' sales in receivables, also called the collection period, indicates how many days it
takes to collect the average level of accounts receivable.