PART A: RECOGNIZING ACCOUNTS RECEIVABLE

LO5–1 Recognize accounts receivable at the time of credit sales.

Credit Sales and Accounts Receivable
Credit sales
● transfer g/s to a customer today while bearing the risk of collecting payment from them in the future
● also known as sales on account
● credit service transactions: services on account → companies often combine total sales revenues + total
service revenues for reporting total revenues in the income statement
● typically include an informal credit agreement supported by an invoice
● An invoice: a source document that identifies the date of sale, the customer, the specific items sold, the
dollar amount of the sale, and the payment terms
○ Payment terms typically require the customer to pay within 30 to 60 days after the sale
○ Even though no cash is received at the time of the credit sale, the seller records revenue
immediately once g/s are provided to the customer and future collection from the customer is
probable
● Along with the recognized revenue, at the time of sale the seller also obtains a legal right to receive cash
from the buyer. The legal right to receive cash is valuable and represents an asset of the company, which
is referred to as accounts receivable (=trade receivables).
Example: On March 1, a company provides services to a customer for $500. The customer doesn’t pay cash at the
time of service, but instead promises to pay the $500 by March 31. The company records the following at the time
of the service.

When company receives cash:

Benefit and Cost of Extending Credit

● Benefit: seller makes it more convenient for buyer to purchase g/s (long-term → increase company’s
profitability)
● Cost: delay collecting cash from customers/not at all (reduce operating efficiency → lower profitability)

OTHER TYPES OF RECEIVABLES

Nontrade receivables: receivables that originate from sources other than customers
● include tax refund claims, interest receivable, and loans by the company to other entities, including
stockholders and employees
● when receivables are accompanied by formal credit arrangements made with written debt instruments
(or notes), referred to as notes receivable
LO5–2 Calculate net revenues using returns, allowances, and discounts.
Net Revenues
● total revenues less returns, allowances, and discounts
Transactions that reduce the amount of cash a company is entitled to receive:
TRADE DISCOUNTS
● a reduction in the listed price of a good or service
● typically used to provide incentives to larger customers or consumer groups to purchase
● also can be a way to change prices without publishing a new price list/to disguise real prices from
competitors
● e.g. F.Y.Eye typically provides laser eye surgery for $3,000. To help generate new business, the company
offers laser eye surgery in the month of March for only $2,400, which represents a trade discount of 20%
($3,000 × 20% = $600 trade discount). F.Y.Eye provides this discounted service on account to a customer
on March 1.

○ Only can record revenue for $2,400 because it’s the amount they’re entitled to receive
○ trade discount of $600 recorded indirectly by simply recording revenue = the discounted price
(no separate account for trade discounts

SALES RETURNS AND SALES ALLOWANCES

● Sales return: customer returns goods purchased
○ E.g. On March 2, F.Y.Eye sold sunglasses to one of its customers for $200 on account

■ Sales Revenue for sales; Service Revenue for services

○ On March 4 the customer decides she doesn’t want the sunglasses and returns the pair. F.Y.Eye
needs to record the return by reducing accounts receivable and reducing the revenue recorded
on March 2
 ○ Effect of transaction:
■ Reduce revenue for sales returns using a contra revenue account → Sales Returns
○ contra revenue account: an account with a balance that is opposite, or “contra,” to that of its
related revenue account
■ reason we use: to keep a record of the total revenue recognized separate from the
reduction due to subsequent sales returns
● Sales allowance: customer doesn’t return goods, seller reduces customer’s balance owed for g/s provided

(because of deficiency in g/s provided)

○ E.g. The customer having laser eye surgery on March 1 for $2,400 is not completely satisfied with
the outcome of the surgery. F.Y.Eye may allow a $400 reduction in the amount owed by the
customer. In this case, the amount the company is entitled to receive has been reduced to
$2,000, and the $2,400 of revenue previously recognized needs to be reduced by the amount of
the sales allowance.

○ Record the sales allowance in a contra revenue account → Sales Allowances

○ Effect: reduce Accounts Receivable account & reduce net revenues

● Companies sometimes combine Sales Returns + Sales Allowances → Sales Returns and Allowances (not us)

COMMON MISTAKE
Sales return & sales allowances ≠ expenses; contra revenues have debit balances and reduce the reported net
income, but represent the reduction of revenues (not like expenses: represent the separate costs of generating
revenues)

SALES DISCOUNTS
● a reduction, not in the selling price of a good or service, but in the amount to be received from a credit
customer if collection occurs within a specified period of time
● Discount terms: (2/10, n/30) a shorthand way to communicate the amount of the discount and the time
period within which it’s available → “2/10,” pronounced “two ten,” indicates the customer will receive a
2% discount if the amount owed is paid within 10 days; “n/30,” pronounced “net thirty,” means that if the
customer does not take the discount, full payment net of any returns or allowances is due within 30 days
 ● E.g. F.Y.Eye offers terms of 2/10, n/30. The customer owes $2,000 after the $600 trade discount and the
$400 sales allowance. So, if the customer pays within 10 days, she will receive a sales discount of $40 (=
$2,000 × 2%).
Collection During the Discount Period

● Record sales discount in contra revenue account → Sales Discounts

Partial income statement:

SUMMARY OF ACCOUNTS RECEIVABLE

Collection After Discount Period

● Simply pay

END-OF-PERIOD ADJUSTMENT FOR CONTRA REVENUE

Revenue recognition standard: report revenues equal to the amount of cash the company “expects to be entitled
to receive.”
● E.g. General Health sells medical parts and consultation services of $400,000 on account during 2021. Also
during 2021, some customers return unused parts of $10,000, while others receive allowances of $14,000
and sales discounts of $6,000 for quick payment. To reduce revenues, we debit Sales Returns for $10,000,
Sales Allowances for $14,000, and Sales Discounts for $6,000.
 ● In addition, at the end of 2021 the company must estimate any additional returns, allowances, and
discounts that will occur in 2022 as a result of sales transactions in 2021. The reason is that some
activities associated with sales transactions in 2021 will not occur until 2022 but will affect the final
amount of cash received from customers.
● Continuing our example, suppose the company estimates an additional $2,000 in sales returns, $3,000 in
sales allowances, and $1,000 in sales discounts in 2022 associated with sales in 2021. These estimates
represent a reduction in the cash the company is entitled to receive, so according to the revenue
recognition standard, we need to reduce revenue in 2021 for their amounts as well.

1. Revenues are reported for the amount of cash a company expects to be entitled to receive from
customers for providing goods and services.
2. Total revenues are reduced by sales returns, sales allowances, and sales discounts that occur during the
year.
3. Total revenues are further reduced by an adjusting entry at the end of the year for the estimate of
additional sales returns, sales allowances, and sales discounts expected to occur in the future but that
relate to the current year.

PART B: ESTIMATING UNCOLLECTIBLE ACCOUNTS

Receivables:
● Expect to receive cash within 1 year (from date of balance sheet) → current asset
● Otherwise → long-term asset
Uncollectible accounts = bad debts
LO5-3 Establish an allowance for uncollectible accounts.
Allowance Method (GAAP)
● Reports account receivable for net amount expected to be collected
● How: must estimate the amount of current accounts receivable that will prove uncollectible in the future
& report this estimate as a contra asset to its accounts receivable
● Process:
○ At the end of the initial year, establish an allowance by estimating future uncollectible accounts
○ During the subsequent year, write off actual bad debts as uncollectible (actual write-offs may
differ from the previous year’s estimate)
○ At the end of the subsequent year, once again estimate future uncollectible accounts

ESTABLISHING AN ALLOWANCE FOR UNCOLLECTIBLE ACCOUNTS

In 2021, Kimzey Medical Clinic bills customers $50 million for emergency care services provided. By the end of the
year, $20 million remains due from customers. However, because Kimzey cannot always verify patients’ ability to
pay before administering care, Kimzey’s credit manager decides that 30% of the total year-end accounts receivable
of $20 million is a reasonable estimate of amounts that won’t be collected. To establish an allowance for future
uncollectible accounts of $6 million (= $20 million × 30%), Kimzey records the following:
 ● Effect on financial reports: decrease assets & increase expenses

● Allowance for Uncollectible Accounts: contra asset account → normal credit balance (not liability!!)
○ To estimate future bad debts
○ Reduces accounts receivable indirectly
○ Balance sheet: reported in assets section (but reduces balance of accounts receivable)
○ Net accounts receivable → difference between total accounts receivable & AUA

● Bad Debt Expense: the cost of estimated future bad debts that is reported as an expense in the current
year’s income statement, along with other expenses (the offsetting debit in the entry to establish the

allowance account)
LO5-4 Write off accounts as uncollectible.
WRITING OFF ACCOUNTS RECEIVABLE
On February 23, 2022, Kimzey received notice that a former patient (Bruce) has filed for bankruptcy and therefore
is unlikely to pay his account of $4,000.

● No effect on total amounts reported in balance sheet or income statement

COLLECTING ON ACCOUNTS PREVIOUSLY WRITTEN OFF

On September 8, 2022, after liquidating all assets, Bruce is able to pay each of his creditors 25% of the amount due
them. So, when Kimzey receives payment of $1,000 (= $4,000 × 25%), it makes the following two entries.

● 1st part: reverses write off; 2nd part: records collection of accounts receivable
● No effect on total assets & no effect on net income

LO5-5 Adjust the allowance for uncollectible accounts in subsequent years.

ADJUSTING THE ALLOWANCE IN SUBSEQUENT YEARS
● Establishing AUA:
○ Percentage-of-receivables method (balance sheet method): a single estimated percentage based
on current economic conditions, company history, industry guidelines
 ○ Aging method: older accounts have higher percentage

● Adjustment for 2023

● Balance sheet: 7 million

● Income statement: only 5 million

● If estimate too low → AUA ends in debit balance

LO5-6 Contrast the allowance method and direct write-off method when accounting for uncollectible accounts.
Direct Write-Off Method (Not GAAP)
● Write off bad debts only when they actually become uncollectible
● Primarily used for tax reporting
● Assets overstated & operating expenses understated in previous year

PART C: NOTES RECEIVABLE AND INTEREST

Notes receivable:
● Similar to accounts receivable but are more formal credit arrangements evidenced by a written debt
instrument (note)
● Typically arise from: loans to other entities (including affiliated companies); loans to stockholders and
employees; and occasionally the sale of merchandise, other assets, or services
LO5-7 Account for notes receivable and interest revenue.
Accounting for Notes Receivable
● Assets → normal debit balance
● Classification: current or noncurrent → depends on expected collection date (time to maturity >1 year =
long-term asset)
● E.g. On February 1, 2021, Kimzey Medical Clinic provides services of $10,000 to a patient, Justin Payne,
who is not able to pay immediately. In place of payment, Justin offers Kimzey a six-month, 12%
promissory note. Because of the large amount of the receivable, Kimzey agrees to accept the promissory
note as a way to increase the likelihood of eventually receiving payment. In addition, because of the delay
in payment, Kimzey would like to charge interest on the outstanding balance. A formal promissory note
provides an explicit statement of the interest charges.

● Another use: replace existing accounts receivable → Justin received services on account but Kimzey

realized he wouldn’t be able to pay quickly so they required him to sign a note.
○ No impact on the accounting equation; simply reclassifying assets
 ● Justin records:

INTEREST CALCULATION
Interest = Face Value x Annual interest rate x Fraction of the year

COLLECTION OF NOTES RECEIVABLE

ACCRUED INTEREST
$10,000 face value, 12% six-month note ($600), on Nov 1, 2021

● Dec adjusting entry:

● May full payment:

ANALYSIS: RECEIVABLES ANALYSIS

LO5-8 Calculate key ratios investors use to monitor a company’s effectiveness in managing receivables.
APPENDIX: PERCENTAGE-OF-CREDIT-SALES METHOD
LO5-9 Estimate uncollectible accounts using the percentage-of-credit-sales method.