CHAPTER-6

RECEIVABLES AND TEMPORARY INVESTMENTS

Many companies sell goods on credit in order to sell more services or products.
Selling or providing service on credit or on account creates an Asset account called
account receivable or Note receivable.

Receivables- refers to various types of claims of on entry against other entries or

individuals for money.

Classifications of Receivables
Receivables are majorly classified in to trade and Non-trade receivables.
1. Trade Receivables- are receivable that arises from the major (normal) operational
activities of business such as sales of goods and services on
credit.
The two major types of trade receivables are: Accounts Receivable & Notes
Receivable.
a) A/Receivable- are claims against customers for goods or services sold on credit.

b) N/Receivable- represent claims that are evidenced by formal instruments of

credit.

So, credit sales may be granted either on open account like A/Receivable or on the
basis of a formal written instrument of credit which is usually called Promissory
note

2.  Non -Trade Receivable- are receivables arising from transaction other than credit
sales of goods & services .
Example: Interest receivable (from lending money), Rent receivable, loans or
advances to employees, Commission receivable etc.

Control over receivables

      Like cash, Receivables also needs control system since it will result into future cash
collection.
      Receivable is controlled by designing a clear boundary that separates the tasks of
approving credit sales, record keeping of credit sales, and collection as well as follow up
of receivables. Thus, the employee who handles the accounting for notes & A/Rec should
not be involved in credit approvals or collection of receivable. Separation of these
functions reduces the possibility of errors and embezzlement.

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 Uncollectible Receivables

Uncollectible Receivable- refers to the amount that will not be collected due to
failure of the customers to make payment.
In accounting credit losses (receivables not collected) from customers are debited to
Bad Debts Expense (or Uncollectible Accounts Expense). Such losses are considered a
normal and necessary risk of doing business on a credit basis. From a management point
of view, a reasonable amount of uncollectible amount is evidenced as a sound credit
policy.
Un collectible account expense, an operating expense, must be measured, recorded and
reported. To do so, accountants use: (1) the direct write - off method, or (2) The
allowance method
1. The Direct Write off Method
Under the direct- write -off method of accounting for bad debts, the accountant
recognizes and records bad debts expense at the time when of specific customer's account
is determined to be uncollectible.
As an e.g. of the direct write-off method assume that, during 1994 ABC Trading Co.
made sales on account to several thousand customers. One of them Mr. Yirga declared
bankruptcy, having no cash available to satisfy creditors’ demand (claims). Upon
learning of yirga’s bankruptcy, ABC Co. determined that yirga's account was
uncollectible & at the same time recognized it as a bad debts exp. ABC Co. makes the
following entry to write-off Yirga's account.

1994
June 25 Bad debts exp 550
A/Rec-yirga 550
(To write of a/c of Yirga’s that is Uncollectible)

What if a customer later pays on an account that has been written off ?
If an a/c of a customer written-off in earliest times b/c it was determined to be
uncollectible, unexpectedly make a payment in the future, the cash collection is recorded
by first re-instating his/her account. That is, the previously written -off entry is reversed
first.
For e.g. assume that the a/c for Yirga, which was written off on June 25, is collected
in Sept. 30 of the same accounting period. The entry to re-instate the a/c is as follows:
Sept. 30 A/Rec- Mr. Yirga 550
Bad debts expense 550
(To re-instate a/c written off earlier in the year)

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 Sept. 30 Cash 550
A/Rec.- Mr. Yirga 550
(To record collect of cash on a/c)
The direct write-off method is criticized because of two major limitations:
(a) It violates the matching principle in that it makes no attempt to match revenue and
related expense.
 Expense is recorded and reported in a period different from the period in w/h
the revenue was recorded.
(b) It distorts the amounts of A/Rec. on the B/sheet. This is to mean that A/Rec. is
reported at its gross amount, and the receivable are not stated at its estimated cash
realizable value.
There fore on the basis of the above drawbacks the direct write-off method is not
acceptable for financial reporting purposes unless bad debt losses are insignificant. It's
acceptable, however, if the following conditions are fulfilled.
 Credit sales constitutes small amount.
 Credit sales are made to financially strong companies.

2. The Allowance Method (Percentage of credit sales method)

To present accurate financial statements, accountants in Company's with large
credit sales use the allowance method of measuring bad debts. This method records
collection losses based on estimates before the business knows which specific
customers’ account will be uncollectible.
Its essential features are:
1. Uncollectible A/Receivable are estimated & matched against sales in the same
accounting period in which the sales accrued.
2. Estimated Uncollectibles are debited to Bad Debts Expense and credited to
Allowance for doubtful accounts through an adjusting entry at the end of each
period.
3. Actual uncollectibles are debited to Allowance for doubtful account & credited
to A/Receivable at the time the specific account is written off.
The allowance for doubtful accounts often is described as a contra- asset account or a
valuation account.
Recording Estimated Uncollectibles
To illustrate the allowance method, assume that Africa Furniture Company has credit
sales of Br. 200,000 in 1993, of which Br. 20,000 remain uncollected at Dec. 31. The
credit manager estimates that Br. 8,000 of these sales may not be collectible. The
adjusting entry to record the estimated unollectible

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Dec 31 Bad debts exp 8,000
Allow for Doubtful Accts 8,000

Bad debts exp- is reported in the Income statement as an operating expense, usually as a
selling expense.
Allow for doubtful acct is not closed at the end of the fiscal year. It is deducted from
A/Rec in the current asset section of the B/sheet as follows:

Current Asset
Cash Br.250, 000
A/Rec 20,000
Less: Allow for doubtful accts 8,000
Merchandise inventory 310,00
Prepaid insurance 25,000
Total current assets 491,000

The amount of Br. 188,000 represents the expected cash realizable value of the A/Rec.
at the Balance sheet date.
Recording the write -off of an uncollectible Account
When all appropriate means of collecting a past-due account have been exhausted &
collection appears impossible, the account should be written off. To prevent premature
write- off each write-off should be formally approved in writing by authorized
management personnel.
Assume, for e.g., that vice-president of finance of Africa furniture authorizes the
write-off of the Br. 500 liability owed by Mesifn on March 1,994. The entry to record the
write-off is:

Mar-1 Allow for doubtful Accts 500

A/Rec-mesfin 500
Write-off of mesfin account wore

Bad debts exp is not debited when the write-off occurs under the allow method,
every bad debt write- off is debited to the allowance account and not to Bad debts exp.

Recovery of an uncollectible Account.

Occasionally a company collects from a customer offer the account has been written off
as uncollectible Two entries are required to record the recovery of bad debt.
(1) The entry made in writing off the account id reversed to reinstates the
customer's account.
(2) The collection is journalized in the usual manner.
To illustrate, assume that mesfin pays the amount .due in full on July 1. The entries are

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July 1 A/Rec- mesfin 500
Allow. For doubtful Acct 500
(To reverse write -off of mesfin account

1 Cash
A/Rec.- Mesfin 500
(To record collection from mesfin 500

Bases used for estimating uncollectible under Allowance method

Two bases are used to determine the amount of uncollectible amount
How is the amount of uncollectible accounts estimated usually the estimate of
uncollectibles at the end fiscal period is based on past experience of forecast of the future.
1. Percentage of Sales
2. Percentage of Receivables.

1. Percentage of sales method

Under the percentage of sales basis, management establishes a percentage r/ship b/n
the amount of credit sales & expected losses from uncollectible accounts. The percentage
is based on past experience & anticipated credit policy.
To illustrate assume that ABC. Co estimated bad debt expense as a percentage of
credit net sales and thus if expected 1% of net credit sales may become uncollectible. If
total sales for the period is Br. 1,000,000, out of which Br. 800,000 is on credit.
Estimated bad debt exp= 1%x Br.800,000
= Br 8,000

The adjusting entry to record the uncollectible expense at the end of the period is then,
as follow.

Dec, 31 Bad Debts exp 8,000

Allow for doubtful Accts 8,000
(To record estimated bad debts for to year)
Although this approach is fast & simple, it does not give consideration to the
existing balance in the Allow doubtful Accts. It ignores the prior balance in allowance
for uncolledtible accounts.
This basis of estimating uncollectibles emphasizes on the matching of expense
which revenues and thus it is known as an Income statement view.
However, In spite of the matching advantage it disregards the existing balance of
the allowance for doubtful account.

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 2. Percentage Of Receivable

The second popular method of estimating bad debts is called aging of receivable
method. This approaches develops the amount of uncollectibles from the idea that the
longer an A/Rec. remain unpaid, the less likely that it will be collected. Therefore, the
estimate of uncollectible accts is computed according to the length of time that they
have been due (outstanding) or unpaid.
Hence, a schedule (often called on aging schedule is prepared in which customer accts
are classified by the length of time they have been unpaid. So under the percentage of
receivables basis the management establishes a percentage r/ship b/n the amount of
receivable & expected losses from uncollectible accts.

Customer’s Name Not yet 1-30 days Number of 31- Days past due
due 60 days 61-91 days
over 90 days
Mr. Alem Br.20,000
Berne 10,000 10,000
Kaleb 30,000 13,000 3,000 1,000
Dagnew 9,000 12,000 2,000 2,000
Total 69,000 25,000 15,000 3,000
Estimate percentage
Uncollectible 0.1% 1% 5% 90%
Allow. For uncolle
ctible accts Br.69 Br.250 Br.750 Br.2,700

 The Total balance needed in the Allowance a/c is = Br.3, 769

This is the sum of the amounts computed for the various groups
(Br.69+250+750+2,700)
The longer a receivable is past due, the less likely it is to be collected. As a result, the
estimated percentage of uncollectible debts increases as the number of days past due
increases.

Suppose, the allow a/c has a Br. 2,100. Balance from the previous period. Under the
aging method the adjusting entry is designed to adjust this a/c balance from Br.2, 100
to Br. 3,769, the needed amount in allow for doubtful, determined by the aging
schedule.
So to bring the allowance balance to represent the required balance at the B/sheet
date, the following entry is made:

Dec, 31 Bad debts Expense (Br.3, 769-Br 2,100) 1,669

Allow for doubtful accts 1, 669

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It is possible that the allow a/c might have a debit balance at year-end prior to the
adjusting entry. This accours when bad debt write-off during the year could have
exceeded the allowance amount. Suppose the unadjusted allow. for uncollectible accts
balance is a debit amount of Br. 1,500.
In this situation the adj entry would be:
Dec. 31. Bad debt expence (Br. 3,769+1,500) 5,269
Allow for uncollectible Acct 5,269

The aging of A/Rec. approach provides a more reliable estimate of uncollectible accts
b/c of the consideration given to the age and collectibility of specific A/Rec. at the
balance sheet date.

Note Receivable
Credit may also be granted in exchange for a formal credit instrument known as
promissory note. A Promissory Note is a written promise to pay specified amount of
money at a particular future date. It involves two parties: the Maker & the Payee

a. Maker of a note- is the person or business that signs the note & promises to pay
the amount required by the note agreement. The maker is the debtor and thus it is a
liability for him/her.
b. Payee of the note- is the person or business to whom the maker promises future
amount .The payee is the creditor and thus it is an asset for him/her.

Types Of Note
1.   Interest Bearing- interest is clearly stated on the face of the note.
2.   Non-interest Bearing- interest is not clearly stated on the face of the note, but it
is included with the amount to be paid in the future.
Advantages of Notes Receivable over A/ Receivable
1. It Possesses strong legal claim
2. It is a Negotiable instrument
3. It earns interest income.
Some important terms of a Note:
(a) Principal- The amount loaned out by the payee & borrowed by the maker of the
note
(b) Interest- Is the revenue to the payee for loaning out the principal and the
expense to the maker for borrowing the principal

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e.g The interest on a Br. 5,000 note at 12% for 60 days is computed as follows:
. Interest= Principal x Rate x Time
Interest= Br 5,000 x 12% x 60/360
=Br 100

(c) Due date (maturity date)- is the date on which final payment of the note is to
made.

 To illustrate, the due date of a note received on Jan. 10 for 90 days will be:

Jan( 31-10) = 21 90 Days

Feb. = 29 OR Days in Jan (31-10) 21
Mar = 31 Remaining 69
81 Days in Feb. 29
April (90 – 81) 9 due date Remaining 40
90 Days in Mar. 31
April 9 Due date
Some businesses specify the period of a note in days, others state in months. When
the period of a note is stated in number of months the due date, is determined by
counting the number of months from the issuance date.
For eg. A three- months note dated (received) April 10 would be due on, July 10
So when the period is given in months, the note’s maturity date falls on the same
day of the month at the date the note was issued.

(d) Maturity Value of a Note- is the sum of principal and interest due at the maturity
date of a note.

Accounting For Notes Receivable

A note may be received for three reasons:
1. Sales of high value assets
2. Extending the payment of an outstanding A/Rec.
3. Lending money for a longer-term or sales of merchandise for an extended period
Recording Note Receivable
Assume that on Dec.1, ABC co. received a 12%, 90- day note from one of its
customers, Alemu, in settlement of an existing account Receivable of Br 30,000 The
entry for receipt of the note is:
Dec. 1 N/Receivable 30,000
A/Receivable-Alemu 30,000
(Accepted (2%-90daynotein settlement of A/Receivable)

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 If the note were received in a sale transaction the credit would have been to sale
At Dec. 31, 2002, the end of the Co.'s fiscal year, the interest earned on the N/Rec.
should be recorded as an adjusting entry as follows:
Interest for 1 month = Br. 30,000 x12% x1/12 = Br. 300
Dec. 31 Interest Receivable 300
Interest income 300
(To record interest earned on Alemu's Note)

On March 1, (90 days after the date of the note), the note matures. The entry to record
collection of the note is:

2003 Cash (Principal, Br. 30,000+interst of Br.900) 30,900

N/Rec. 30,000
Interest Rec 300
Interest Income 600
(To record collection of principal and interest on Alemu note at maturity)

Dishonored N/Receivable
A note that is note paid at maturity date is called a dishonored note. A dishonored
note is no longer negotiable. However, the payee still has a claim against the maker of the
note & usually transfers the claim from the N/Rec. account to A/Rec. The payee records
interest revenue earned on the note & debits A/Rec. for the full maturity value of the
note.
To illustrate, suppose that on March 1, the customer of ABC Co, Alemu had defaulted
on the note used in the previous e.g. In such case, the entry on Mar. 1 would have been.

March 1 A/Rec: Alemu (Principal of Br. 30,000 + Br. 900 30,900

N/Rec 30,000
Interest Rec. 300
Int. Revenue 600
(To record default by Alem on 12% 90-day note)

Notice that the interest earned on the note up to the maturity date is recorder & is
included in the A/Rec. of the maker.
ABC Co. would pursue collection from Alemu as a promissory note default. If the
A/Rec from Alemu can't be collected, it ultimately will write off against the Allowance
for doubtful Accounts. Therefore, the balance in the Allow. for doubtful accounts
Should provide for estimated uncollectible notes as well as uncollectible accounts
receivable.

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 Discounting Notes Receivable

To get cash quickly, payees sometimes sell a note receivable to another party before
the note matures. The payee endorses the note and hands it over to the note purchaser,
often a bank, which collects the maturity value of the note at the maturity date. Selling a
note receivable before maturity value is called discounting a N/Rec. because the payee of
the note receives less than its maturity value.
 What happens if the maker of the note fails to pay the bank at maturity ?
There are two types of agreement b/n the holder of the note & the bank as to what to
do when the maker of the note fails to pay the bank at maturity.
(a) With recourse- here the bank requires the original payee to make
reimbursement of   the money. That is, the endorser is
obliged to pay for the note at maturity to the bank in case the
maker failed to pay for it.
     (b) Without Recourse- If the note is discounted with out recourse, the endorser is not
obliged to pay for the note at maturity when the maker failed
to pay the money.
Important terms related to discounting of a note
Proceeds- refers to the amount of cash obtained from the bank by discounting a note.
Discount- refers to the difference b/n the amount that the holder of the note receives
from the bank & the maturity value of the note.
The Co. discounting the note recognizes any difference b/n the proceeds & the
carrying value of the note as interest revenue or interest expense.
              If Proceeds > Principal = interest income
If Proceeds < Principal = interest expense
Discount Period- is the period (number of days) from the date of discounting to the date
of maturity. It is the period in which the bank will hold the note.

Steps in Computing the Proceeds:

1st - Determine the MV (MV= FV+I)
2nd- Determine the discount period
3rd- Determine the discount amount (discount= MV x Discount Rate x Discount
period)
        4th- Determine the proceeds= (proceeds = MV- discount)
        5th- Determine interest income or interest expense

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 Example:- Assume that, omedad received a 90- days, 8%, Br. 15,000 note from Sun
Set stationary on cot. 20, 1994. Omedad discounted the note with recourse at Dashen
Bank on Dec. 9, 1994. Dashen Bank charged 9% discount rate. The maturity value of the
note & the proceeds received by omedad are calculated as follows:

Maturity Value of the note:

Face Value Br. 15,000
Add: Interest for the life of the note (Br. 15,000 x 0.08x 90/36o) 300
Maturity Value Br. 15,147
Proceed of the discounting
Maturity value Br. 15, 300
Less: Discount charged by Dashen (Br. 15,300 x o.09 x 40/360) 153
Proceeds received by omedad Br. 15, 147
Interest income/ expenses:
Proceeds Br. 15, 147
Face value 15,000
Interest income Br 147.

Entries to record receipt of Note.

1994
Oct. 20 N/Receivable 15,000
Sales 15,000
(To record sale to Sun Set Stationary & receipt of 90- days, 8% note)

1994
Dec 9 Cash 15,147
N/Receivable 15,000
Interest income 147
(To record discounting Sun Set Station. note with recourse at Dashen Bank)

Dishonored Discounted Notes Receivable

The maker may dishonor a note after it has been has discounted by the original payee

Example:- Suppose, Sun Set Stationery dishonors its note i.e. unable to pay the bank
(maturity value, Br. 15,300). Since the agreement was with course, Omedad Co. has the
obligation to pay the full maturity value to the bank. The entry to record the payment of
this note in the event of Sun Set Stationery’s default is as follows:

Jan. 18 A/Rec.- Sun Set Stationary 15,300

Cash 15,300

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 Temporary Investment

Many businesses experience widely fluctuating cash balances during the year. During
some seasons of the year, most of their cash may be involved in made. Inventory;
during other seasons most of the goods may be sold, inventory may be low, and there
will be a surplus of cash in the Company's checking (bank) account.

Surplus cash is the cash that is not needed for the current day- to- day operation
of the business, instead of keeping this surplus cash in a checking account which earns
little or no interest, businesses may prefer to invest it in securities that can be quickly
sold when ever cash is needed. The investment that a company makes with a
temporary cash surplus is called temporary investments or marketable securities.
Temporary investments in securities include stocks & bonds. Stocks are equity
securities issued by corporations and bonds are debt securities issued by corporations
and various gov't agencies.

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