PRACTICAL ACCOUNTING 1

RECEIVABLES – Lecture

1. Nature of receivables – Receivables represents financial asset arising from a contractual right to receive cash
or another financial asset from another company. It falls under one of four categories of financial instruments,
namely Loans and Receivables. Loans and Receivables are non-derivative financial assets with fixed maturity
(including loan assets, trade receivables, investments in debt securities and deposits held by banks) that are not
quoted in an active market other than those classified as “financial assets at fair value”. The reference to fixed
maturity in the definition means a contractual arrangement that defines the amounts and dates of payments to
the holder such as interest and principal payments. For most entities, they comprise trade receivables, loan
assets, investments in debt securities. For banks and similar institutions, they constitute a significant proportion
of their non-trading assets, in particular loans and advances to customers.

2. Classes of Receivables
Trade receivables – are claims arising from sale of merchandise or service in the ordinary course of business
operations; such as the following (a) accounts receivable and (b) notes receivable.

Non-trade receivable – are claims arising from sources other than from sale of goods and services in the
normal course of business; such as the following (a) advances to officers and employees (b) advances to
subsidiaries (c) dividends and interest receivable (d) deposits as a guarantee of performance or payment (e)
deposits to cover potential damages or losses (f) claims for; insurance, tax refunds, lawsuits, merchandise
damaged or lost in transit, returnable items, etc.

3. Presentation of receivables on the face of the balance sheet or in the notes

Receivables are disaggregated into amounts receivable from trade customers, receivables from related parties
prepayments and other amounts (PAS 1 paragraph 75b)

Trade receivables should be presented on the face of the balance sheet as one line item and classified as
current assets but the detail of which will be disclosed in the notes. Non-trade receivables that are currently
collectible should be presented as one line item under the current asset section but the detail of which will be
disclosed in the notes.

4. Valuation of Loans and Receivables:

a. At initial recognition loans and receivables are measured at fair value (transaction price). The fair value is
based on the total expected future cash inflows that an enterprise will realized.

b. Subsequent to initial recognition loans and receivables are measured at amortized cost. The amortized cost
of a financial asset is the amount at which the financial asset is measured at initial recognition minus
principal repayments, plus or minus principal amortization using effective interest method of any
difference between that initial amount and maturity amount and minus any reduction (directly through the
use of allowance account) for impairment or uncollectibility.

Accounts receivable are measured at original exchange price between the firm and the outside party, less
adjustment for cash discount, sales return and allowances, yielding and approximation to fair value which
is the amount expected to be collected.

The issue of bad and doubtful debts will inevitably arise in accounting for trade receivables. There are
currently no approved accounting standards that deal specifically with the measurement of bad and
doubtful debts, the only guide which accountants rely on in practice is the prudence consideration of PAS 1,
which generally requires that known bad and doubtful debts shall be provided for. However, the application
of this prudence consideration on accounting for trade receivables as it is left mostly to the discretion of the
reporting entity.

One view of doubtful debt is based on the direct write-off method, where bad debts expense is recognized
or recorded in the period in which it is determined that a specific trade receivable cannot be collected. This
view that each sale results in a “good” trade receivable and accordingly, the full amount shall be recognized
in the period of sale. In other words, no allowance shall be made in respect of that “good” trade receivable.
When later events proved that certain receivables are uncollectible and are worthless, a direct write-off is
made to recognize the bad debts. From a practical standpoint, this method has been argued as simple and
convenient to apply. Furthermore, the amount written off is based on actual facts rather than estimates
which may need revisions subsequently when facts become known. However, the direct write off method is
theoretically deficient because it usually does not match costs with revenues of the period. This is due to the
fact that trade receivables do not generally become worthless at an identifiable moment of time. As such,
the method does not result in trade receivables being stated at the estimated realizable value on the
balance sheet.
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In practice today, the view that is generally accepted is that bad and doubtful debts shall be provided
immediately when they are known. This is in accordance with the prudence principle which requires that
when the collectability of trade receivables is considered doubtful, adequate allowance shall be made.

Notes receivable should be stated at present value. The present value of a note receivable maybe its face
value (for notes that are short-term and interest bearing long-term notes) or discounted value (for long-
term non-interest bearing and long-term interest bearing but the interest rate is unreasonably low)

A note receivable is said to be interest bearing when specific interest rate is stated in the promissory note.
The stated rate is the “nominal or face rate or coupon rate or contracted rate as part of the note which
usually corresponds to the market rate of interest of similar risk. The market interest rate or effective
interest rate or yield rate is the rate used in the market to determine the value of the note, which is actually
the discount rate to determine present value. When the stated and market rates are equal it means the
notes were selling at face but when the stated and market rates are different it means that the face of the
note differs from the present value of the note. The difference would either be a discount or premium that is
to be amortized over the term of the note using the effective interest method as prescribed by the standard
for financial instruments.

A note is said to be non-interest bearing when there is no specific stated interest rate. The interest rate is
already imbedded in the face of the note and consequently the maturity value of a note is its face amount,
therefore, it is necessary to separate the interest from the note by discounting the note using the prevailing
market interest rate.

5. Impairment of Loans and Receivables:

Assessment and recording of impairment loss – Any entity shall assess at each balance sheet date whether
there is any objective evidence that a financial asset or group of financial assets is impaired. A financial asset or
group of financial assets is impaired and impairment losses are considered, if and only if: (a) there is objective
evidence of impairment as a result of one or more events (loss events) that occurred after initial recognition,
and (b) that the event (loss event) has an impact on the estimated future cash flows of the financial assets that
can be reliably estimated.

It may not be possible to identify a single discrete event that caused the impairment. The combined effect of
several events that could have caused the impairment should be considered. Losses expected as a result of
future events, no matter how likely, are not recognized. Objective evidence that a financial asset or group of
financial assets such as receivables is impaired includes observable date that come to the attention of the
holder of the financial asset about the following loss events:

a. Significant financial difficulty of the debtor, issuer or obligor.

b. Default or delinquency in interest or principal payments.
c. The creditor granting the debtor a concession that the creditor would not otherwise consider.
d. Probability that the borrower will enter bankruptcy or other financial reorganization or restructuring.
e. Disappearance of an active market for that financial asset because of financial difficulties.
f. Indication that there is a measurable decrease in the estimated future cash flows from the group of
financial assets including:
1. Adverse changes in the payment status of the borrower in the group (e.g. increase number of delayed
payments).
2. National or local economic conditions that correlate with difficulties on the assets in the group
(example, increase in the unemployment rate, decrease in proper price for mortgages in the relevant
areas, adverse changes in industry conditions affect the borrower in the group).

If there is objective evidence that the receivables are impaired an impairment loss should be recognized.
The amount of the loss is the difference between the asset’s carrying amount and the present value of
estimated future cash flows discounted at the financial asset’s original affective interest rate. The carrying
amount of the receivables shall be reduced either directly or through use of an allowance account and the
amount of the loss shall be recognized in profit or loss.

6. Transfer of receivables:
a. Pledging of Account receivable
1. Continue to recognize and report the receivable with appropriate disclosure.
2. Recognize the proceeds as a liability rather than as income.
3. Charge interest on the carrying value of the liability.
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b. Assignment of Account receivable
1. Transfer the account receivable to account receivable assigned.
2. Recognize the proceeds as a liability and charge the interest on the carrying value of the liability.
3. Changes in the value of the assigned receivable such as, returns, write-offs and collections with-in or
after the discount period are accounted the usual way with a corresponding credit to the account
“Account Receivable Assigned”.
4. Any balance in the Account Receivable Assigned is reported and classified in the same manner for
outstanding accounting receivables.
c. Factoring of Accounts receivable
The receivables are sold to a factor, which then collects the cash from the customers. The factor makes a
profit either by charging a fee, charging interest, or by paying below face value for the receivables. The
company selling its receivables is nearly always referred to as the seller, even if the receivables have not
been sold in the eyes of accounting theory.

Typical arrangement might include the following the terms:

1. The seller will assign (sell) some or all of its receivables to the factor.
2. The factor will then advance a percentage of the amount factored. The amount advanced will typically
be about 70% - 90% of the face value of the receivables.
3. The factor can be repaid in a number of ways:
a. The factor may collect in all the cash from the customers, and then pass on the balance to the
seller (less any charges).
b. The seller may repay the advance after a specified period of time (plus any charges).
4. The factor may charge the seller a fee based upon the length of time that it takes to collect in the
receivables.
5. Receivables may be factored with recourse (hybrid method) or without recourse (continuing
agreement method).
a. With recourse means that the seller has to reimburse the factor for any unpaid receivables.
Sometimes this is limited to a fixed amount.
b. Without recourse means that the factor bears the cost of unpaid receivables. There will obviously
be a higher charge for this service to compensate the factor for the higher risks taken.
6. The factor may also administer the sales ledger for a separate fee. This will have no effect on the
accounting treatment.

Accounting for factoring of receivables:

1. If the receivables have been sold, then they will be removed from the balance sheet and replaced by
cash. However, if the seller retains significant risks and benefits relating to the receivable like, slow
payment risks (time value of money), non-payment risks and the benefit of being paid more or sooner
than expected, the seller should continue to recognize the asset and the proceeds of sale will be
recognized as a liability in the balance sheet.
2. If all the benefits and risks have been disposed of, then there has been a genuine sale and the
receivables will be derecognized. The difference between the net proceeds plus any amount retained
by the factor and the amortized cost a (face – allowances for returns, discounts and bad debts, if any)
of the receivable factored will be charged to profit or loss. Any amount retained by the factor (e.g.
Factors’ holdback or Receivable from factor) is recognized and reported as current asset.

d. Discounting of Notes Receivable – generating cash out of the note prior to maturity, the discounting may
be recorded as a borrowing or as a sale. It is to be recorded as a borrowing when the payee has the option
to repurchase the note or if the entity retains substantially all the risks and rewards of ownership of the
financial asset. An entity has retained substantially all the risk and rewards of ownership of a financial asset
if its exposure to the verifiability in the present value of the future net cash flows from the financial asset
does not change significantly as a result of the transfer (example – because the company has sold the
financial asset but subject to an agreement to buy it back at a fixed price or the sales price plus a lenders
return).

Most discounting of note receivables are treated as a sale, and a sale of financial asset requires
derecognition from the accounting records since there has been a transfer of contractual rights to receive
the cash flows of the financial asset, any gain or loss on derecognition is reported in the current period
profit or loss. The gain or loss is determined by the difference of the selling price (net proceeds) and the
carrying value of the financial asset. The carrying value of the financial asset (note receivable) is the
combined amount of the present value or amortized cost of the note and any accrued interest on the date
of sale.