UNIT-FOUR

Accounting Receivables

INTRODUCTION

Receivables are claims against other entities. Many companies sell on credit in order to
sell more services or goods. The receivables that result from sales are normally
classified as accounts receivables. The most common transaction creating a receivable
is selling merchandise or service on credit. Accounts receivables are normally informal
claims expected to be collected within a relatively short period, where as notes
receivables are formal, written instruments of credit.

4.1. Nature and valuation of receivables

4.1.1.: Nature of Receivable

Receivables represent a company’s claims to the future collection of cash, other assets
or services. Receivables arising from sale of goods and services on account are called
accounts receivables and often are referred to as trade receivables. Non-trade
receivables are those other than trade receivables and include interest receivables, rent
receivables, loans by the company to other entities and so on.

Accounts receivable arise from credit sales to customers by both retailers and whole
sales. The amount of credit sales has increased in recent years, reflecting several factors
including an efficient banking system and a sound economy. Merchandising businesses
can sell their merchandises either on cash or on credit

Accounts receivable are current assets because by definition, they will be converted to
cash within the normal operating cycle.

When sales are made on account, the entry is:

Accounts receivable ………….XX

Sales revenue………………….XX

4.1.2 Valuing Accounts Receivable

Companies that extend credit to customers know that it is unlikely that all customers
will fully pay their accounts. When a company directly grants credit to its customers,
there are usually some customers who do not pay what they promised. The accounts of
these customers are uncollectible accounts, commonly called bad debts. Bad debt
expense is an inherent cost of granting credit. It is an operating expense incurred to

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 boost sales. The total amount of uncollectible accounts is an expense of selling on
credit.

4.1.3: Methods of Accounting for Bad Debts

Companies usually use two methods to account for uncollectible account. These are:
(A) allowance method and (B) direct write-off method.

(A) Allowance Method

As it is not expected that all accounts receivables will be collected, the balance sheet
should report only the expected net realizable value of the asset. Therefore an estimate
is needed to record bad debt expense and the related reduction of accounts receivable.
In an adjusting entry we debit bad debt expense and reduce accounts receivables
indirectly by crediting a contra account to receivables account called, Allowance for
uncollectible account

The allowance method of accounting for bad debts matches the expected loss from
uncollectible accounts receivable against the sales they produce. We must use expected
losses management because we cannot exactly identify the customers who will not pay
their bills at the time of sale. This means at the end of each period, the allowance
method requires us to estimate the total bad debts expected to result from that period’s
sales. This method has two advantages over the direct write-off method (1) bad debts
expense is charged to the period when the related sales are recognized, and (2) accounts
receivable are reported on the balance sheet at the estimated amount of cash to be
collected.

Example: Assume XYZ Company sells its products offering a 30-day’s credit period.
At the end of the year, it has accounts receivables of Br 305,000 and from experience it
anticipates that 2% of all credit sales will be uncollectible.

The entry is:

Bad debt expense…………….……6,100

Allowance for doubtful account….6, 100

Writing-off a Bad Debt

When the estimated doubtful account is later on determined that all or portion of the
amount will not be collected, it has to be written-off.

Using the allowance method, the write-off is recoded as a debit to allowance for
uncollectible accounts and a credit to accounts receivable.

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 Assume from the previous example that Br 3,100 is proved uncollectible, and then the
entry will be:
Allowance for doubtful account-………3,100

Accounts receivable…………………….3, 100

Recovery of a Bad Debt

Occasionally, a receivable that has been written-off will be collected in part or in full.
When this happens, the receivable and the allowance should be reinstated. In other
words, the entry to write-off the account simply is reversed and the collection is then
recorded as the usual way as debit to cash and a credit to accounts receivable.

For example- assume that in our previous illustration, Br 2000 that was previously
written-off is collected. The following journal entries are required.

Accounts receivable---------2000

Allowance for doubtful account-------2000

(To reinstate the written-off account)

Cash---------------------------2000

Accounts receivable------------2000

(To record the Cash collection)

B) Direct Write-off Method

If uncollectible accounts are not anticipated or are immaterial, or if it is not possible to

reliably estimate uncollectible accounts, an allowance for uncollectible accounts is not
appropriate. In such cases, a direct-write-off method is used.

The direct write-off methods of accounting for bad debts records the loss from an
uncollectible account receivable at the time it is determined to be uncollectible. No
attempt is made to predict uncollectible accounts or bad debts expense. Bad debts
expense is recorded when specific accounts are written off as uncollectible.

If ABC determines that it cannot collect Birr 820 owed too it by its customer, the loss is
recognized using the direct write-off method as follows:

Bad debt expense----------820

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 Accounts receivable----------820

The debit in this entry charges the uncollectible amount directly to the current year’s
Bad Debts Expense account. The credit removes the balance of the account receivable
from the subsidiary Ledger and from the controlling account.

Sometimes an account 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 that was
written-off directly to Bad Debts Expense is later collected in full, the following two
entries record this recovery:

Accounts receivable----------------820

Bad debt expense--------------820

(To reinstate account previously written-off)

Cash--------------------820

Accounts receivable-----820

(To record collection)

4.1.4. Estimating Bad Debts Expense

Companies with direct credit sales estimate bad debts expense. They do this to help
them manage their receivables and to set credit policies. The allowance method of
accounting for bad debts also requires an estimate of bad debts expense to prepare the
adjusting entry at the end of each accounting period.

There are two common methods. One is based on the income statement relation
between bad debts expense and sales. The second is based on the balance sheet relation
between accounts receivable and the allowance for doubtful accounts. Both methods
require an analysis of experience.

Percent of sales method

The percent of sales method uses statement relations to estimate bad debts. It is based
on the idea that a given percent of a company’s credit for the period are uncollectible.
The income statement would then report that percent as the amount of bad debts
expense.

To illustrate, assume ABC has credit sales of Birr 500,000 in 2000. Based on past
experience and the experience of similar companies, ABC estimates 0.6% of credit sales
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 are uncollectible. Using this prediction, ABC expect Birr 3,000 of bad debts expense
from 2000’s sales (computed as Birr 500,000x0.006=Birr 3,000). The adjusting entry to
record this estimated expense is:

Bad Debts expense-------------------3000

Allowance for doubtful account--------3000

This entry doesn’t mean the December 31, 2000 balance in Allowance for Doubtful
Accounts will be Birr 3000. A Birr 3000 balance occurs only if the account had a zero
balance prior to posting the adjusting entry. For several reasons, the unadjusted balance
of Allowance for Doubtful Accounts cannot be zero. Unless a company is in its first
period of operations, the allowance account will have a zero balance only if the prior
amounts written-off as uncollectible exactly equal to the prior estimated bad debts

Accounts Receivable method

The accounts receivable methods use balance sheet relation to estimate bad debts,
primarily, the relation between accounts receivable and the allowance amount. It is
based on the idea that some portion of the end-of period account receivable balance is
not collectible. The objective for this bad debts adjusting entry is to make the
Allowance for Doubtful Account balance equal to the portion of outstanding account
receivable estimated as uncollectible. To obtain this required balance for the Allowance
for Doubtful Accounts, we compare its balance before the adjustment with our
estimated balance. Account is done in one of two ways: (1) simple estimates of percent
uncollectible from the total outstanding account receivable and (2) aging account
receivable.

Percent Accounts Receivable method

The percent of accounts receivable approach assumes a given percent of a company’s

outstanding receivable are uncollectible. This estimated percent is based on experience
and the experience of similar companies. Current conditions such as recent economic
trends and difficulties faced by customers do also have impacts on it. The total dollar
amount of all outstanding receivable is multiplied by an estimated percent to get the
estimated dollar amount of uncollectible account. This amount is reported in the balance
sheet as the balance for allowance for Doubtful Accounts, We prepare an adjusting
entry debiting Bad Debts Expense and crediting Allowance for Doubtful Accounts. The
amount of adjustment is the amount necessary to give us the required balance in
Allowance for Doubtful Accounts.

Assume ABC had Birr 50,000 of outstanding accounts receivable on December 31.1999
past experience suggests 5% of outstanding receivable are uncollectible. This means

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 that after the adjusting entry is posted, we want the Allowance for Doubtful Accounts to
show a Birr 2,500 credit balance computed as 5% of Birr 50,000=2500). Before the
adjustment, the account appears as:

Prior to the December 31, 1999 adjustment, the allowance for doubtful account has a
credit balance of Br 200. The Adjusting entry to give the allowance the required Birr
2,500 balance is:

Dec. 31 Bad Debts Expense …………………. 2,300

Allowance for Doubtful Account…… 2,300

Aging of Accounts receivable method

Both the percent of sales (income statement) method and the percent of accounts
receivable (balance sheet) method use information from past experience to estimate the
amount of bad debts expense. Another balance sheet method using receivables
information produces a more precise estimate and uses experience and current
information. The aging of accounts receivable method examines each account
receivable to estimate the amount uncollectible. Receivable are classified by how long
they are past their due dates. Then, estimates of uncollectible amount are made
assuming the longer an amount is past due the more likely it is to be uncollectible.

In aging accounts receivable outstanding at the end a period, we examine each account
and classify it by how much time has passed since it was due. Classification depends on
the judgment of a company’s management. However, classes are often based on 30-
days (or one-month period). After the outstanding amounts are classified (or aged),
experience is used to estimate the percent of each class that is uncollectible. These
percents are applied to the amount in each class to get the required balance of the
Allowance for Doubtful Account.

Aging of Accounts Receivable

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 Estimated uncollectible

Age Interval Balance Percent Amount

Not past due 75,000 2% = 1500
1-30 days past 4000 5% = 200
due
31-60 days past 3100 10% = 310
due
61-90 days past 1900 20% = 380
due
91-180 days past 1200 30% = 360
due
181-365 days 800 50%= 400
past due
> 365 days past 300 80%= 240
due

Total 86,300 Br 3390

The longer an accounts receivable remains outstanding, the less likely that it will be
collected. In the aging of receivables, an aging schedule is prepared by classifying each
receivable by its due date. Based on the above exhibit, the desired balance for the
allowance for doubtful accounts is estimated as Br 3390. Assume that the unadjusted
balance of the allowance account is credit balance of Br 510. The amount to be added to
this balance is therefore Br 2880 (3390- 510). Then the adjusting entry will be:

Uncollectible accounts expense………2880

Allowance for doubtful account………2880

Estimation of uncollectible accounts expense based on aging of receivables emphasizes

on the current net realizable value of receivables and hence the amount of uncollectible
receivables estimated by aging is the adjusted balance of receivables.

Required adjustment for Accounts Receivable is Br.3390 .

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 Unadjusted balance ………… Birr 510 credit

Required balance ………..…….Birr 2,880 credit

Required adjustment …………Birr 3390 credit

4.2.: Notes Receivable

Promissory notes are used in many transactions, including paying for products and
services, in the lending and borrowing of money, and to pay for accounts receivable. In
this section, we will discuss computations of maturity date and maturity value of a note,
how to record receipt of a note, how to account for discounting of a note before it
matures. We also discuss cases of dishonored note.

4.2.1 Interest bearing

The typical notes receivable requires the payment of a specified face amount, also
called principal, at a specified maturity date or dates. In addition, interest is paid at a
stated percentage of the face amount. Interest is the cost of borrowing money for the
borrower or the profit from lending money for the lender. Unless otherwise stated, the
rate of interest on a note is the rate charged for the use of the principal for one year.

Interest on notes is calculated as:

I= (P) (R) (T)

Where

I=Interest

P=Principal

R=Annual Interest Rate, and

T=Time (Period)

For example-On January 1, 2.007, Ambasel Trading sold fertilizers to cooperatives

agreeing to accept, Br 700,000, 6-month, 12% notes. The note is payable on December
31, 2007

The entry is:

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 Jan-1, 2007 Notes receivable---------700,000

Sales revenue-----------700,000

(To record the ale of fertilizers)

Dec, 31, 2007, Cash------------------------------784,000

Notes receivable----------------------------700,000

Interest income (700,000x12%x1yr) -----84,000

(To record the collection of cash at maturity)

4.2.2 Maturity Date and Period

The maturity date of a note is the day on which the note (principal and interest) must be
repaid. The period of a note is the time from the date of the note to its maturity date.
Many notes mature in less than a full year, and the period covered by then is often
expressed in days. When the time of a note is expressed in days, the maturity date is the
specified number of days after the date of the note. As an example, a five-day not dated
June 15 matures and is due on June 20. A 90-day note dated July 10 matures on
October 8. Thus October 8, due date, is computed as shown below

Maturity Date Computation

Day in July 31
………………………….
Minus the date of the note 10
…
Days remaining in 21
July……………
Add days in August 31
……………….
Add days in September 30
…………..
Days to equal 90 days, or Maturity Date, 8
October Maturit
y

Date

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 Period of the note in days 90

The period of a note is sometimes expressed in months or years. When months are
used, the note matures and is payable in the month of its maturity on the same day of
the month as its original date. A three-month note, dated July 10, for instance, is
payable on October 10. The same analysis applies when years are used.

4.2.3. Receipt of a Note

Notes receivable is usually recorded in a single notes receivable account to simplify

record keeping. We need only one account because the original notes are kept on file.
This means, that we can understand the maker, rate of interest, due date, and other
information by examining the actual note

To illustrate the recording for the receipt of a note, assume ABC receives a note of the
Birr 1,000. 90-day, 12%. This transaction is recorded as:
July 10 Notes receivable ……………… 1,000
Sales………………………….. 1,000
( Sold merchandise in exchange for a 90-day,
12% note)

Companies also sometimes accept a note from an overdue customer as a way of

granting a time extension on a past-due account receivable. When this occurs, a
company may collect part of the past-due balance in cash. This partial payment forces a
concession from the customer, reduces the customer’s debt and produces a note for a
smaller amount. ABC, for instance, agreed to accept Birr 400 in cash and a Birr 600,
60-day, 15% note to settle its Birr 1000 past-due account. ABC made the following
entry to record receipt of this cash and note:
Oct. 5 Cash……………………..….. 400
Note Receivable…………… 600
Accounts Receivable……… 1000
Received cash and note to settle account

Honoring and dishonoring a Note

The principal and interest of a note are due on its maturity date. The maker of the note
usually honors the note and pays it in full. But sometimes a maker dishonors the note
and does not pay it at maturity.
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 4.2.4. Recording an Honored Note

We use the ABC note transaction above to illustrate the honoring of a note. When ABC
collects a note on its due date, It records its receipt as:
4 Cash……………………….. 615
Notes receivable…….600
Interest earned………5
Collected note with interest of
Birr 600 x 15% x 60/360.

Interest Earned, also called Interest Revenue, is reported on the current period’s income
statement.

Recording a Dishonored Note

When a maker of a note is unable or refuses to pay at maturity, the note is said to be
dishonored. The act of dishonoring a note does not relieve the maker of the obligation
to pay. The payee should use every legitimate means to collect.

The balance of the Notes Receivable account normally includes only those notes that
have not been matured. When a note is dishonored, we, therefore, remove the amount
of this note from the notes receivables account and charge it back to an account
receivable from its maker. For instance, Geni holds a Birr 800, 12%, 60-day note of
Tigist. At maturity, Tigist dishonored the note. Geni records this dishonoring of its
notes receivable as follows:
Accounts receivable-Geni……. 816
Interest earned …………… ….16
Notes receivable………………800
To charge account of Geni for a dishonored note and
interest of Birr 800 x 12% x 60/360

Charging dishonored note back to the account of its maker serves two purposes. First, it
removes the amount of the note from the notes receivable account, leaving in the
accounts that have not been matured. It also records the dishonored note in the maker’s
account.

Second, and more important, if the maker of the dishonored note applies for credit in
the future; his or her account will show all past dealings, including the dishonored note.

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 Restoring the account also reminds the company to continue collection efforts. Note
that Geni owes both principal and interest. The above entry records the full amount
owed in Geni’s account and credits the interest earned. This ensures that interest is
included in efforts to collect from Geni.

4.2.5. End-of-Period Interest Adjustment

When notes receivable are outstanding at the end of an accounting period, accrued
interest is computed and recorded. This recognizes both the interest revenue when it is
earned and the added asset (interest receivable) owned by the holder of the note. For
instance, on December 16, ABC accepted a Birr 3,000, 60-days, 12% note from a
customer in granting an extension on a past-due account. When ABC’ accounting
period ends on December 31, Birr 15 of interest has accrued on this note (Birr 3,000 x
12% x 15/360). The following adjusting entry records this revenue:
Dec. 31 Interest receivable………………….15
Interest earned ……………………………15
To record accrued interest adjustment.

This adjusting entry means interest earned appears on the balance sheet as a current
asset.

4.3. Presentation of receivables in the balance sheet

Accounts receivables are current assets because they will be converted in to cash with in
the current accounting period. Hence, it is reported as current asset in the balance sheet
section. However notes receivables may be classified as current or non-current asset
depending on the expected payment dates.

Receivables are reported in the balance sheet at net realizable value. Allowance for
doubtful account is a contra account to accounts receivable. In the current asset section
of the balance sheet, accounts receivable would be reported net of the allowance as
follows

Accounts receivable…...........................450,000

Less: allowance for doubtful account…...50,000

Balance…………………………………….. 400,000
4.4 Uses of Receivables as a Source of Cash

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 Business enterprises raise cash needed for current operation through the collection of
receivables. This can be accelerated by :

i. Pledging receivables as a collateral for loans

ii. Selling receivables
iii. Assigning receivables

Enterprises engaged in buying of receivables are called factors, and the process of selling
receivables is called factoring. Factors buy receivables outright, i.e. without recourse.
Alternatively, factors or other lenders may buy receivable with recourse, or may lend money to
the owner of the receivable under a legal agreements known as an assignment. In such cases
customers are instructed to make payments to the factors.

Sales of Receivables without recourse

The purpose of selling receivables without recourse is to shift the purchaser of the receivables
the risk of credit losses, the effort of collection, and the waiting period that result from granting
credit.

Sales of Receivables with recourse

When receivables are sold with recourse, the seller (transferor) guarantees the receivables, and
the purchaser (transferee) is reimbursed for failure of debtors to pay the full amounts anticipated
at the time of sale. The proceeds received under this sale method is less than the face amount of
the receivables sold.

Example receivable with face value of $20,000 has a carrying amount of $19,400 is sold for
$18,500. Record the entry.

Cash ……………………………………18,500
Allowance for doubtful accounts…………..600
Loss on sale of Accounts receivables ……...900
Accounts receivable…………………………..20,000

However the sale installment receivable that bear a higher interest rate than the discount rate
used to compute proceeds on sale would result in a gain.

Example consider a fully collectible installment receivable, which has 1.5% per month payable
at a rate of $723 a month for 36 months was sold for a discount amount of 1% . Record the sale
of the installment, collection of the receivable from the customer show whether there is gain or
loss.

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Solution

36 X $723 = $26,026
Present value of ordinary annuity of 36 payments of $723 a month at 1.5% interest is
$723 x 27.660684 = $20,000
The difference between them is $26026-20,000 = $6,026 is deferred interest revenue.
Present value of ordinary annuity of 36 payments of $723 a month at 1% interest is
$723 x 30.107505 = $21768.

Cash. ……………………….. 21,768

Deferred interest revenue……..6,026
Installment receivable…………………26,026
Gain on sale of installment receivable….1,768
To record sale installment receivable on a recourse basis
The buyer of the receivable will record the following entry for acquisition and the first
collection.

Installment receivable…………………26,026
Deferred interest revenue……………………4,260
Cash ………………………………………..21,768

To record acquisition of installment receivable on a recourse basis to yield 1% a month.

Cash. ……………………….. 723

Deferred interest revenue……..218
Installment receivable………………723
Interest revenue……………………..218
To record receipt of first monthly installment

A sale of receivable with recourse has a characteristic of borrowing collateralized by the

receivables. Transfer of receivables with recourse is recognized as a sale if the following
conditions are met:

1. The transferor surrenders control of the future economic benefit in the receivables
2. The transferor obligation under the recourse provision can be reasonably estimated.
3. The transferee can not require the transferor to purchase the receivables.

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 If any of this condition is not met, the proceeds from the transfer of receivables is reported as
a liability resulting from borrowing.

Assignment of Receivables

Instead of selling receivables, a business may borrow money using the receivables as collateral.
The proceeds from collection of receivables must be used to retire the loan. Alternatively,
receivables must be assigned under a formal arrangement where a borrower (assigner) pledges
the receivables to a lender (assignee) and signs a promissory note payable. Assignee gives the
assignee the same right to bring action to collect the receivables that the assignor posses. The
risk is absorbed by the assignor and makes collection efforts to make good any receivables that
can not collected.
The assignor has some equity in the assigned receivable because the financing company
advances less than 100% of the face amount of the receivables assigned. Assigned receivables
are recorded in as a separate ledger account.

Example:- assume that on Jan.1 Admass co. assigned receivables of $50,000 to Fincha co. and
received $45,000 less a fee of 2% on the amount advanced. Interest 1% of the unpaid balance of
the loan was to be paid monthly. Make entries to record assignment and subsequent transactions
if Admass co. collected $30,150 on Jan.31, and $17,000 on Feb.28. Remember the proceeds
from collection of receivables must be used to retire the loan

Jan. 1 Assigned accounts receivable ………50,000

Accounts receivable …………………………...50,000

Cash ………………………...44,100
Interest expense ………………..900
Notes payable to Fincha.co……………45,000
To record assignment and cash receipt.

Jan.31. Cash ………………………….30,150

Assigned accounts receivable………….30,150
To record cash collection from the customer.

Notes payable to Fincha.co……………29,700

Interest Expense (45,000 x 1%)………………450
Cash……………………………………30,150
To record cash payment to Fincha co.

Feb.28 Cash ………………………….17,000

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 Assigned accounts receivable………….17,000
To record cash collection from the customer.

Notes payable to Fincha.co…………………15,300

Interest Expense ([45,000 -29,700] x 1%)……..153
Cash…………………………………………15,300
To record cash payment to Fincha co.
Feb.28. Accounts receivable………….2,850
Assigned accounts receivable………..2,850

50,000- [30,150+17,00]= 2,850

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