Week 5

Receivables and Payables

BUSN7008

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Learning Objectives
1. Understand the accounting for receivables
2. Use the allowance and direct write off method to
account for bad debts
3. Account for current liabilities of known amount and
those that must be estimated.
4. Reporting receivables and current liabilities on the
financial statements

• BUSN7008 ignores GST

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Receivables
Ch 9

3
Accounts Receivable
Allow customers to buy goods & services without immediate payments
• Benefits:
– Increase sales (and profit)
• Costs:
– Providing free finance for customers at the seller’s expense
– Risk of customers failing to pay (bad debt expense)

Bad Debts
• Overdue accounts - may (or may not) be recovered later
• Uncollectible accounts
• An expense

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Receivables and sales revenue
Balance Sheet
Asset Liability

Credit sales: Acc Rec 1000

Dr Accounts Receivable 1,000 Equity

Cr Sales Revenue 1,000 Income Statement

Sales Rev 1000

Expenses

If we later learn that we cannot collect part of this $1000 accounts

receivable…

We should undo (part of) that transaction:

1. Reduce Sales (by recognising Bad Debt Expense)
2. Reduce Account receivables (by offsetting using Allowance for Bad
Debts)

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 Two methods to account for Bad Debts

1. Allowance method 2. Direct write-off method

• We make provision for bad debts • Write-off (i.e. cancel) the accounts
before the bad debt events happen. receivable when they are “proven” to
be uncollectible.
Estimation • ATO only accepts this approach for
1.1 - % of Sales 1.2 - Aging of accounts tax deduction purpose

It is an Dr Bad debt expense 10 Dr Bad debt expense 10

expense to Cr Allowance for bad debts 10 (contra-asset) Cr Account receivable 10
us because B/S B/S
we are now Asset Liability Asset Liability
$10 worse Acc Rec 1000 Acc Rec 1000-10
off by All. For Bad debts 10
having $10 Equity Equity
extra
liability all of
a sudden. I/S
I/S
Sales Rev 1000 Sales Rev 1000

Expenses Expenses
Bad debt expenses 10 Bad debt expenses 10

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What do we mean by “providing for” or “allowing
for” bad debts?
• E.g. Our clients owe us $1000 in total. Based on experience, we estimate
that $10 cannot be collected in the future
• Under the allowance method, we go ahead and reduce our net receivables
by $10 (to be conservative) before any of our clients has gone bankrupt or
died etc.
• So that, later on, when any of our clients indeed cannot pay us back, there
will be no (or less) impact on us:

Dr Allowance for bad debts 10 Balance Sheet

Cr Accounts Receivable 10 Asset
Current Asset

Accounts Receivable $1000 990

- Allowance for bad debts (10) (0)
Net Receivables 990 990

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 Allowance method – Percentage of Sales
Method 1.1: Percentage of (credit) sales
• Income statement approach — focuses on the amount of bad debt expense to be
reported on the income statement for this period
• Based on prior experience, calculated as a % of credit sales Example:
Credit sales for the year = $200
• Recorded as an adjusting entry at the end of the period Percentage of sales deemed
uncollectable: 2%
• Add to the balance of the allowance for bad debts account.
i.e. We’ll have $4 of bad debt exp
Dr Bad debt expense 4 ($200 * 2%) for this year, we are also going to
have $4 more Allowance for bad
Cr Allowance for bad debts 4 ($200 * 2%) debts

Before: Adjustments: After:

B/S B/S
Asset Liability Asset Liability
Bad debt expense
Acc Rec 2000 Acc Rec 2000
- All. For Bad debts (10) 0 - All. For Bad debts (14)

Net Receivables 1990 Equity 4 Net Receivables 1986 Equity

I/S I/S
Allowance for bad debts
Sales Rev 200 10 Sales Rev 200
4
Profit
Expenses Expenses

Bad debt expense (4)

 Allowance method – Ageing of accounts
Method 1.2: Ageing of accounts receivable
• Balance sheet approach — focuses on the age of the accounts receivable and on
which determines the ending balance of Allowance for bad debts
• Age – the older is an account (the longer an account is overdue), the more likely is it
uncollectible (i.e. bad debt)
– Mostly likely your clients are in financial difficulties, if they cannot pay you back
• Having estimated the ending balance, comparing the opening balance, we can then
work out the change.
• The change amount is what we need for our journal entries:

Example:
A business gives out 30 days credit period to clients. They decide the following bad debt
likelihood for their accounts receivable according to their age:
Age (days) Amount Bad debt likelihood

0-30 (not overdue) $1000 1%

31-90 (overdue) $5000 10%

91+ (overdue) $1225 40%

Opening balance of Allowance for bad debts: $200

 Est. Allow. for
Age (days) Amount Bad debt likelihood bad debts
0-30 (not overdue) $1000 1% $10
31-90 (overdue) $5000 10% $500
91+ (overdue) $1225 40% $490
Total = $1000
• To recall, opening balance of Allowance for bad debts = $200
• We estimated the ending balance to be $1000
• There is an increase in a contra-asset (~liability) account of $800
• An net increase in liability = an expense

Dr Bad debt expense 800

Cr Allowance for bad debts 800

Balance Sheet Income Statement

Accounts receivable $10,000 10,000 Sales $10,000
- Allow. for bad debts (200) (1000) Expense:
Net receivables 9,800 9,000 Bad debt expense (800)
Comparing the Percentage of Sales
and Ageing Methods
When predictions come true (some debts turn bad
as predicted)…
• Under the allowance method, we estimate the amount of bad debts
that we may have in the future.
• Say, some time in the future, some clients indeed cannot repay us
($1000):
– The “allowance” (or “provision”) is no longer an allowance.
– Our accounts receivable actually reduces.

Dr Allowance for bad debts 1000

Cr Accounts receivable 1000

• But since we have previously allowed (provided) for this event, the
impact on our financials will be none (or less, at least).
– See the example on slide #6
Method 2: Direct Write-off
• As its name suggests, we directly write off (or cancel) the accounts
receivable whenever we learn that they have become uncollectible.
• Whenever the bad debt event happens, we record that as bad debt
expense.
• E.g. We just learnt that one of our client has died in an accident. The client
owes us $1000.
Dr Bad debt expense 1000
Cr Accounts receivable 1000

• Simple - We do not allow or provide for such event (i.e. do something

before it happens to warn investors), and thus we do not have to predict the
future
•  Overstate asset, underestimate expense - But since bad debt events are
very common. Knowing that it is likely, but not warning investors via
financial reports may be inappropriate.

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Bad debt recovery
Some times, we are lucky…
E.g. The client who owed us $1000 and died in an accident. Their child
unexpectedly took over the business and pay us back!
To account for this recovery, the business must reverse the effect of the
earlier write-off to the Allowance account and record the cash collection:
Allowance method Direct write-off method:
Re-establish Accounts Receivable:
Dr Accounts Receivable Dr Accounts Receivable
Cr Allowance for Bad Debts Cr Bad Debts Expense*
What about the
reversal of
Cash collection: expense under the
Dr Cash at Bank allowance method? Dr Cash at Bank
Cr Accounts Receivable Cr Accounts Receivable
* Assuming that the bad debt event and its recovery
happen in the same period
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Credit & Debit card Sales – No bad debts
• Fees applies for the retailer
– Transferrable to customers
• Essentially, the fee is an insurance premium
against bad debt
– Banks/financial institutions bear the bad debt risks

Recording a $100 credit card sale with a 2.5% To many businesses,

service charge: 2.5% of sales is a
whole lot!
Dr Acc Receivable (credit card) 97.5
Dr Credit Card Charge 2.5
Cr Sales Revenue 100

We do not need to provide for bad debts

Bills Receivable
• Essentially a (short-term) loan
• Very similar to accounts receivable except that:
– Bills receivable are more formally a debt (it matters if your client went bankrupt)
– Bills receivable attracts interest. (trade credits are interest-free)

• May arise from a sale or may be given in settlement of an account

receivable.

• Credit is extended to customers by means of a bill of exchange or

promissory note.
Bills of Exchange (a form of bills receivable)
• Essentially a (short-term) loan but it can be transferrable
• A common example: Cheque (negotiable)
– The one who writes the cheque promises to pay the holder of the cheque (need
not to be the buyer) in some later date

Sometimes, a BoE may be

“accepted” (guaranteed) by a
financial institution
• An “accepted” BoE has (almost)
no risk of bad debt
• E.g. Bank cheque

The seller may “factor” (cash-in) an

BoE with a financial institution
before the bill matures at a discount
• Discount = interest + bad debt
risk + admin fee
Bills Receivable
Example: Interest on a Bill
• Interest = Principal × Rate × Duration

• Principal: $10,000
• Interest: 10% (p.a.)
• Duration: June 1, 2016 to August 30, 2016
90 days

$10,000 × 10% × 90/365 = $246.58

Recording Bills Receivable
• If a bill is drawn on a sale:
Dr Bill Receivable 10,000
Cr Sales Revenue 10,000
OR
• If a bill is drawn for settlement of an account receivable:
Dr Bill Receivable 10,000
Cr Accounts Receivable 10,000

• Collection at maturity:
Dr Cash at Bank 10,246.58
Cr Bill Receivable 10,000
Cr Interest Revenue 246.58
 Accruing Interest Revenue
If the accounting period ended June 30:
90 days

1-Jun 30-Jun 30-Aug

30 days 60 days
Year end: Payment day:
recognize interest recognize interest revenue (60 days)
revenue (30 days) Collect principal
• Interest earned as of June 30 Collect interests payment (60+30)
= $10,000 × 10% × (30* ÷ 365) = $82.19

* 30 days from June 1 to June 30

Dr Interest Receivable 82.19
Cr Interest Revenue 82.19

• Collection on maturity
Dr Cash 10,246.58
Cr Bill Receivable 10,000.00
Cr Interest Receivable 82.19
Cr Interest Revenue 164.39
Discounting a Bill Receivable (factoring)
• The drawer (who will receive the money) may sell a bill (at discount)
to a financial institution so as to receive money now, rather than at
maturity.

Continue with the previous example:

• The firm discounts the bill after 20 days on June 21, discount rate
applied by the finance company is 12% (p.a.).
– The discount rate reflects: interest + bad debt risk + admin fees

Discount = maturity value x discount rate x disc. period

= $10,246.58 × 12% × 70*/ 365 = $235.81
(*70 days between June 21 and August 30)
Discounting a Bill Receivable
The seller of the bill may receive the discounted amount now:
• = Amount at maturity - discount
• = $10,246.58 - $235.81 = 10,010.77

To record the discounting:

June 21
Dr Cash 10,010.77
Cr Bill Receivable 10,000.00
Cr Interest Revenue 10.77
Record the factoring of and the interest on a bill
Payables
Ch 11 pp.501-509

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Current Liabilities
1. Accounts payable
– amounts owed to suppliers for goods or services purchased on
account
– do not bear interest expense for the debtor

2. Short-term Bills Payable

– Promissory notes, bill of exchange, payable within 1 year
– Business must pay interest expense and record interest payable
if any interest expense is accrued at the end of the period
Current Liabilities
3. GST payable
– Firms are collection agencies for the Australian Tax Office
– GST amounts owed to ATO

4. Accrued Expenses & Unearned Revenue

5. Current Liabilities that must be estimated

Payroll
• Two pay amounts are important for accounting purposes:
– gross pay
– net pay

• Gross pay is the total amount of salary, wages,

commission and bonus earned by an employee during a
pay period
• Net pay is the amount the employee gets to keep
• Payroll deductions are the difference between gross
pay and net pay

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Dr. Salary expense 1000
Cr. Employee income tax payable 190
Employee superannuation contribution 60
Salary payable to employees 750

To record salary expense

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Estimating Current Liabilities
The matching principle demands that the company recognises expense
that are associated with the revenue earned for the same period

E.g. Warranty is offered on goods sold this period

• Provide (allow) for warranty
• Recognise some warranty liability before warranty events happen

Other examples:
• Sick leave provision
• Annual leave provision
• Long service leave provision
Example: Estimating Warranty Provision
Based on experience, 1% of goods sold is faulty and returned for fixing
under the 12-month warranty offered. We sold 1,000 products this year,
cost of fixing a product = $500.

Before any product is returned for warranty, we “provide for” it, we

estimate that we have a our liability for warranty to be 1% x 1000 x
$500 = $5000

Assume we have already recognized some Warranty Provision in the

past, opening balance = $1000

Dr Warranty Expense 4000

Cr Warranty Provision 4000

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Contingent Liability
• A contingent liability is a potential liability that does not appear on
the balance sheet
• For an item to appear on balance sheet, it needs to pass two
criteria:
– Probability, AND
– Reliable measurement
• Contingent liability fails either or both of them

• E.g. an outstanding lawsuit

• The AASB137 requires details of a contingent liability must be

disclosed in the notes to the financial statements
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Lecture exercise
The following information pertains to Prime Technology:
1. Accounts Receivable (as at 30 September) – debit balance $28,000
2. Allowance for Bad Debts (as at 30 September) – credit balance $1,600
3. Sales for October $187,000
– Credit Sales: $120,000
– Cash Sales: $ 67,000
4. Cash Collected in October $91,000
5. Write-offs of bad debts in October totalled $1,070
6. Bad debts expense estimated as 2% of credit sales

Requirements
• Prepare journal entries to record sales, collections, bad debts
expense by the allowance method based on % of sales method and
write-offs of bad debts during October.