Chapter 1 - Cash and Receivables

Principle of
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Accounting II
By Animaw Y. (MBA, BA & BSc) 8/9/2018

Chapter 1: Cash and Receivables
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Outlines are
Internal control over cash
Bank reconciliation
Petty cash and change funds
Classifications of receivables
Internal control of receivables
Accounting for uncollectible accounts
Accounting for notes receivable
Factoring Receivables
Presentation of cash and receivables on the balance sheet
Learning Objectives
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After studying this chapter, you should be able to:
1. Define the internal control in procedures in cash
2. Identify items considered cash.
3. Indicate how to report cash and related items.
4. Define receivables and identify the different types of receivables.
5. Explain accounting issues related to recognition and valuation of accounts
receivable.
6. Explain accounting issues related to recognition & valuation of notes
receivable.
7. Understand special topics related to receivables.
8. Describe how to report and analyze receivables.

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1. Internal control over cash
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 What is Cash?
 Cash is the resource on hand to meet planned
expenditures and emergency situations.
 Most liquid asset
 Standard medium of exchange
 Is used as a basis for measuring and accounting for all
items
 Is classified as Current asset
 Is a financial asset - also a financial instrument.
 Financial Instrument - Any contract that gives rise to a
financial asset of one entity and a financial liability or
equity interest of another entity.
Internal control over cash Cont’d …
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COMPOSITION OF CASH
Cash includes
currency & coins,
amounts on deposit with banks in checking

accounts and savings accounts, and
items ready for deposit such as checks and money

orders received from customers.

7 COMPOSITION OF CASH DIAGRAMATICALLY
Cash
Included in Cash Excluded from Cash
• Coins and currency • Certificates of deposit

• Checking accounts • Bank overdrafts
• Savings accounts • Postdated checks
• Negotiable checks • Travel advances
• Bank drafts • Postage stamps
8 Cash Equivalent
Cash equivalents include short-term, highly liquid
investments that are:
 Easily converted into a known amount of cash.
 Close to maturity.
 Not sensitive to interest rate changes.
Examples are
money market funds,
treasury bills, and
commercial paper.
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Restricted Cash
 When material in amount:

Segregate restricted cash from “regular” cash.
Current assets or non-current assets
Examples, restricted for:
(1) plant expansion,
(2) retirement of long-term debt, and
(3) compensating balances.

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Bank Overdrafts
Company writes a check for more than the amount in its
cash account.
 Generally reported as a current liability.
 Offset against other cash accounts only when
accounts are with the same bank.

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An internal control system is the company’s plan that
encourages adherence to company policies and

procedures,
promotes operational efficiency, minimizes errors and

theft, and
enhances the reliability and accuracy of accounting

data.
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Control of Cash Receipts
Cash is easily susceptible to theft, internal controls over cash are
extremely important.
Separate responsibility for
 handling cash,
 recording cash transactions, and
 reconciling cash balances.
Reconcile cash amounts deposited with cash amounts
received.
Close supervision of cash-handling and cash-recording
activities.
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 The person opening the mail or the sales person using the
cash register should count the receipts immediately.
 All cash receipts are recorded daily in the accounting
records.
 All receipts are deposited daily in the company’s bank
account.
 When duties are separated, there a check and balance
employee or group of employees.
 Effective separation of duties reduces the likelihood of fraud
or theft by employees.
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 Internal control over cash receipts, can best be illustrated in
retail store by both over-the-counter and mail receipts.
 In retail businesses, control of over-the-counter receipts
centers on cash registers that are visible to customers. A
cash sale is entered in a cash register, with the amount
clearly visible to the customer. This activity prevents the
cashier from entering a lower amount and pocketing the
difference.
 Suppose that the cash register tape indicated sales of
$6,956.20 but the amount of cash was only $6,946.10. A
cash shortfall of $10.10 exists. To account for this cash
shortfall and related cash, the entry is.

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Cash 6,946.10
Cash Over and Short 10.10
Sales Revenue 6,956.20
(To record cash shortfall)
Cash Over and Short is an income statement item. It is

reported as miscellaneous expense when there is a cash
shortfall, and as miscellaneous revenue when there is an
overage.

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Mail receipts should be opened in the presence of at
least two mail clerks. These receipts are generally in
the form of checks.
A mail clerk should endorse each check “For Deposit
Only.” This restrictive endorsement reduces the
likelihood that someone could divert the check to
personal use.
Banks will not give an individual cash when
presented with a check that has this type of
endorsement.
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Control of Cash Disbursements
Control of cash disbursements is just as
important as control of cash receipts.
The control of cash payments should provide
reasonable assurance that:
1. Payments are made for only authorized
transactions.
2. Cash is used effectively and efficiently.
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Control of Cash Disbursements
Separate responsibilities for
 cash disbursement documents,
 check writing,
 check signing,
 check mailing, and
 record keeping.
All disbursements, except petty cash, should be made by
check. By Animaw Y. (MBA, BA & BSc) 8/9/2018
Summary of Internal control
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Internal control is defined as the procedures and processes
used by a company to:
1. Safeguard its assets.
2. Process information accurately.
3. Ensure compliance with laws and regulations.
 controls are important because they deter fraud and
prevent misleading financial statements
 The objectives of internal control are to provide reasonable
assurance that:
1. Assets are safeguarded and used for business purposes.
2. Business information is accurate.
3. Employees and managers comply with laws and
regulations.
Internal control … Cont’d
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Internal control can safeguard assets by
preventing theft,
Fraud - a dishonest act by an employee that results in
personal benefit to the employee at a cost to the employer.
misuse, or
misplacement.
A serious concern of internal control is preventing
employee fraud.
Employee fraud is the intentional act of deceiving an
employer for personal gain.
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Why does fraud occur?
 The three main factors/reason that contribute to fraudulent
activity are depicted by the fraud triangle/elements of fraud.
1. Opportunity - The most important element of the fraud triangle
the workplace environment must provide opportunities, when the
workplace lacks sufficient controls.
2. Financial pressure - personal financial problems caused by too
much debt or to lead a lifestyle that they cannot afford on their
current salary.
3. Rationalization - to justify their fraud, employees rationalize
their dishonest actions. (underpaid as compared to the employer,
deserve to be paid more.
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Elements of Internal Control
1. Control environment
2. Risk assessment
3. Control procedures
4. Monitoring
5. Information and communication
The elements of internal control form an umbrella over

the business to protect it from control threats.

23  Control Procedures
 Control procedures provide reasonable assurance that
business goals will be achieved, including the prevention
of fraud. Control procedures, which constitute one of the
most important elements of internal control, include the
following as shown
1. Competent personnel, rotating duties, and mandatory
vacations
2. Separating responsibilities for related operations
3. Separating operations, custody of assets, and accounting
4. Proofs and security measures
1.2. Bank reconciliation
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What is a Bank?
A bank is a financial institution that offers a variety of
services to its customers’.
Bank Accounts are used for internal control.
The Advantages of using bank accounts:
1. Bank accounts reduce the amount of cash on hand.
2. Bank accounts provide an independent recording of
cash transactions.
3. Use of bank accounts facilitates the transfer of funds
using EFT systems.
Electronic
By Animawfunds transfer
Y. (MBA, BA & BSc) (EFT) moves cash by electronic communication. 8/9/2018
Bank reconciliation Cont’d …
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A primary service offered by banks is the bank checking
account.
A bank checking account is an amount of cash on
deposit with a bank that the bank must pay at the order
of the depositor. It is the credit for the bank.
The depositor is the person (or business) under whose
name the checking account is maintained.
A deposit slip should be prepared when a deposit is
made in a checking account. A deposit slip summarizes
the amount deposited and is the depositor's record of the
deposit.
26 Bank reconciliation Cont’d …
 A check is used to pay money from a checking account.
 A check is recorded in a bound book of checks called
a checkbook by filling in the check stub.
 Checks must be endorsed before they can be deposited or
cashed.
 Banks usually maintain a record of all checking account
transactions. A summary of all transactions, called a bank
statement, is mailed to the company (depositor) or made
available online, usually each month. The bank statement
shows the beginning balance, additions, deductions, and
the ending balance.

27 Bank reconciliation Cont’d …
There are three common forms of endorsement.
1. A blank endorsement is simply a signature on the
back of the check. A check with a blank
endorsement can be cashed by anyone who has
possession of it.
2. A full endorsement specifies the party to whom
the check is being transferred.
3. A restrictive endorsement specifies the purpose
for which money from a check is to be used.

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 Keeping cash in a bank account helps control cash for
banks have established practices of safeguarding
customers’ money.
 The documents used to control a bank account include
the:
 Signature card Reconciling the balance of
the cash account in the
 Deposit ticket
company’s records with
 Check the cash balance according
 Bank statement to the bank is an
 Bank reconciliation important control.
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 Signature Card - Banks require each person authorized
to sign on an account to provide a signature card. This
protects against forgery.
 Deposit Ticket - Banks supply standard forms such as
deposit tickets. The customer fills in the amount of each
deposit. As proof of the transaction, the customer keeps
a deposit receipt.
 Check - To pay cash, the depositor can write a check,
which tells the bank to pay the designated party a
specified amount.
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There are 3 parties to a check:
the maker - the person who signs the check
the payee - to whom the check is paid (the
person to receive the check)
the bank - on which the check is drawn

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 Upon paying a check, the bank stamps the check “paid”; a
paid check is sometimes referred to as a canceled check.
 On the statement, the bank also includes memoranda
explaining other debits and credits it made to the depositor’s
account.
 DEBIT MEMORANDUM - Deduct the depositors account as a
result of the service offered during the month.
 Examples - bank service charge, the cost of printing
checks, issuing traveler’s checks, and wiring funds to
other locations, when a deposited check from a customer
“bounces” because of insufficient funds - NSF

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CREDIT MEMORANDUM – it adds (Credits) depositors
account.
Example - Collections
Reconciling the Bank Account
The bank and the depositor maintain independent
records of the depositor’s checking account.
The two balances are do not agree sometimes.
Therefore, it is necessary to make the balance per books
and the balance per bank agree with the correct or true
amount - a process called reconciling the bank
account.
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The need for agreement has two causes:
1. Time lags that prevent one of the parties from
recording the transaction in the same period as the
other party.
2. Errors by either party in recording transactions.

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 Steps in reconciling items;
1. Deposits in transit - are deposits recorded by the depositor that
have not been recorded by the bank are the deposits in transit.
 Add these deposits to the balance per bank.
2. Outstanding checks - Issued checks recorded by the company but
that have not yet been paid by the bank are outstanding checks.
 Deduct outstanding checks from the balance per bank.
3. Errors - All errors made by the depositor are reconciling items in
determining the adjusted cash balance per books. In contrast, all
errors made by the bank are reconciling items in determining the
adjusted cash balance per bank.
4. Bank memoranda. Trace bank memoranda to the depositor’s
records that add and deduct the depositors account accordingly. For
example, the bank service charges deducts where as interest earned
adds to the balance per book.
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36

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 ENTRIES FROM BANK RECONCILIATION
 The reconciling items are the adjustments we consider at
the depositors records are;
 bank collections
 bank fees (bills or charges)
 interest earned on account
 NSF checks
 The company records each reconciling item used to
determine the adjusted cash balance per books.
 If the company does not journalize and post these items,
the Cash account will not show the correct balance.
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39  The bank statement for GAMBY PLC shows a balance per bank of
$15,907.45 on April 30, 2017. On this date the balance of cash per
books is $11,589.45. Using the four reconciliation steps, GAMBY
determines the following reconciling items.
 Step 1. Deposits in transit: April 30 deposit (received by bank on
May 1). $2,201.40
 Step 2. Outstanding checks: No. 453, $3,000.00; no. 457,
$1,401.30; no. 460, $1,502.70.
 Step 3. Errors: GAMBY wrote check no. 443 for $1,226.00 and the
bank correctly paid that amount. However, GAMBY recorded the check
as $1,262.00.
 Step 4. Bank memoranda:
a. Debit—NSF check from J. R. Baron for $425.60.
b. Debit—Charge for printing company checks $30.00.
c. Credit—Collection of note receivable for $1,000 plus interest earned
$50, less bank collection fee $15.00.
40 GAMBY PLC
Bank Reconciliation
April 30,

41 1. The entries involved on Apr. 30 are;
Cash 1,035.00
Miscellaneous Expense 15.00
Notes Receivable 1,000.00
Interest Revenue 50.00
(To record collection of note receivable by bank)
2. Cash 36.00
Accounts Payable - Andrea Company 36.00
(To correct error in recording check no. 443)
3. Accounts Receivable—J. R. Baron 425.60
Cash 425.60
(To record NSF check)
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4. Miscellaneous Expense 30.00
Cash 30.00
(To record charge for printing company checks)
The adjusted balance in cash account can be
illustrated;

1.3. Petty Cash and Change Funds
43  Petty cash is a fund established for making small
payments that are impractical to pay by check.
 The operation of a petty cash fund, often called an Imprest
system/fund, involves;
1. establishing the fund,
2. making payments from the fund, and
3. Replenishing the fund
 A petty cash custodian is designated to have
responsibility for safeguarding & making payments.
 Examples postage due, reimbursement to employees for
small purchases of office supplies, & numerous similar
items.

Petty Cash and Change Funds Cont’d …
44
1. Establishing the Petty Cash Fund.
 Two essential steps in establishing a petty cash fund:
1. appointing a responsible petty cash custodian, and
2. determining the size of the fund.
 To establish the fund, a company issues a check payable to the
petty cash custodian for the stipulated amount
if GAMBY PLC decides to establish a $ 10,000.00 fund on April 1,
the general journal entry is:
Apr. 1 Petty Cash 10,000.00
Cash 10,000.00
(To establish a petty cash fund)

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 The company will make no additional entries to the
Petty Cash account unless management changes the
stipulated amount of the fund.
If GAMBY decides on April 7 to increase the size of
the fund to $ 15,000.00, it would debit Petty Cash $
5,000.00 and credit for Cash $ 5,000.00.
Apr. 7 Petty Cash 5,000.00

Cash 5,000.00
(To increase the petty cash fund to 15,000.00 Birr)

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MAKING PAYMENTS FROM THE PETTY CASH FUND
 Payments are documented on a pre-numbered petty cash
receipt and is kept in the petty cash box until the fund is
replenished.
 Surprise counts are made to check the proper utilization.
 No entry to record a payment when it is made from petty
cash.
 When it reaches a minimum level, all supporting
documentation is stamped “paid”, approves the request
and issues a check to restore the fund to its established
amount.
47  To illustrate, assume that on April 15 GAMBY PLC’s petty
cash custodian requests a check for $ 13,200. The fund
contains $1,800 cash and petty cash receipts for postage $
4,400, freight-out $ 3,800, and miscellaneous expenses $
5,000. The general journal entry to record the check is as
follows.
 Apr. 15 Postage Expense 4,400
Freight-Out 3,800
Miscellaneous Expense 5,000
Cash 13,200
(To replenish petty cash fund)

48  When the total of the cash plus receipts in the petty cash
box does not equal the established amount there is a need
to recognize a cash shortage or overage.
 Assume that GAMBY PLC’s petty cash custodian has only
$1,200 in cash in the fund plus the receipts as listed. The
reimbursement would therefore be for $ 13,800, and
GAMBY PLC would make the following entry.
 Apr. 15 Postage Expense 4,400
Freight-Out 3,800
Miscellaneous Expense 5,000
Cash Over and Short 600
Cash 13,800
(To replenish petty cash fund)
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A company reports a debit balance in Cash Over and
Short in the income statement as miscellaneous
expense.
It reports a credit balance in the account as
miscellaneous revenue.
The company closes Cash Over and Short to Income
Summary at the end of the year.

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Change Fund is an amount of money consisting of
varying denominations of bills and coins that is used
to make changes in cash transactions.
The establishment is the same as that of the petty
cash except the name.
By the same taken it be increased by issuing a check.

1.4. Classifications of receivables
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The term receivables refers Claims held against
customers and others for money, goods, or services.
Receivables includes all money claims against people,
organizations, or other debtors.
The management of receivables is a very important
activity for any company that sells goods or services on
credit.
Receivables are commonly acquired by the sale of
merchandise or services on a credit basis.
 Receivables are important because they represent one
of a company’s most liquid assets.

Classifications of receivables Cont’d
52
 Receivables are usually a significant portion of the total
current assets.
 Credit may be granted in an open account or on the basis
of a formal instrument (Promissory Note - Note).
 Note is a written promise to pay a sum of money on
demand or on a definite time (More than 60 days).
 Is a stronger legal claim than an open account, more
liquid for it can be transferred.
 Receivables can be classified as;
(1) accounts receivable,
(2) notes receivable, and
(3) other receivables.
Classifications of receivables Cont’d
53  Accounts receivable are amounts customers owe on account.
 result from the sale of goods and services.
 Expected to collect accounts receivable within 30 to 60 days.
 are usually the most significant type of claim held by a company.
 Notes receivable are a written promise for amounts to be received.
 requires the collection of interest and extends for time periods of
60–90 days or longer.
Notes and accounts receivable that result from sales transactions are
often called trade receivables.
 Other receivables include nontrade receivables such as interest
receivable, loans to company officers, advances to employees, and
income taxes refundable.
 do not generally result from the operations of the business.
 are classified and reported as separate items in the balance sheet.

54 1.5. Internal control of receivables
The internal control principles include
The separation of the business operations and the
accounting for receivables
The accounting records serve as an independent
check for the operations
The employee who account for notes and accounts
receivable should be separate
The credit approval or collections of receivables
should be separate

1.6. Accounting for uncollectible accounts
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Regardless of how careful a company is in granting
credit, some credit sales will be uncollectible.
The operating expense incurred because of the failure
to collect receivables is called an expense or a lose
from uncollectible accounts, bad debt expense,
uncollectible accounts expense, or doubtful
accounts expense.
no general rule for when an account becomes
uncollectible.

Accounting for uncollectible accounts Cont’d …
56
Some indications that an account may be
uncollectible include the following:
1. The receivable is past due.
2. The customer does not respond to the
company’s attempts to collect.
3. The customer files for bankruptcy.
4. The customer closes its business.
5. The company cannot locate the customer.

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The two methods of accounting for uncollectible
receivables are:
1. The direct write-off method (direct charge of
method) records bad debt expense only when an
account is determined to be worthless.
2. The allowance method (reserve method) records
bad debt expense by estimating uncollectible
accounts at the end of the accounting period (GAAP).

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1. Allowance Method for Uncollectible Accounts
 The advance provision is made by adjusting entry at the end.
 Eg. GAMBY at December 31, 2009, has an A/R balance of
$200,000. Based on industry averages, it estimated that
$30,000 uncollectible.
 The adjusting entry was made on December 3, 2009 as:
Bad Debt Expense 30,000
Allowance for Doubtful Accounts 30,000
To record Uncollectible accounts estimate.
 The adjusting entry reduced receivables to their net realizable
value and matched the uncollectible expense with revenues.

Allowance Method for Uncollectible Accounts Cont’d …
59
 The adjusting entry affects income statement & balance sheet.
 In income statement, the Bad Debt Expense of $30,000
matched against the related revenues.
 On the balance sheet, the value of the receivables is reduced to
the amount that is expected to be collected or realized to
$170,000 ($200,000 - $30,000), called the net realizable value.
 Accounts Receivable still has a debit balance of $200,000 as
supported by the accounts receivable subsidiary ledger.
 The accounts receivable contra account, Allowance for Doubtful
Accounts, has a credit balance of $30,000.

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Reporting the adjusting entry at the end of the
accounting period
GAMBY PLC
Balance Sheet (partial)
For the year Dec, 31, 2009
Current assets
- Cash $ 14,800
- Accounts receivable $200,000
- Less: Allowance for doubtful accounts 30,000 170,000
- Inventory 310,000
- Supplies 25,000
Total current assets $ 519,800

61
Write-Offs to the Allowance Account
 When a customer’s account is identified as uncollectible, it is
written off against the allowance account.
 This requires the company to remove the specific accounts
receivable and an equal amount from the allowance account
(aggregate accounted in advance).
Eg. on January 21, 2010, Ayalsew’s account of $6,000 with GAMBY PLC
is certain to be uncollectible and is written off as follows:
Allowance for Doubtful Accounts 6000
Accounts Receivable – Ayalsew 6000

62  An account receivable that has been written off against the
allowance account may be collected later.
 Like the direct write-off method, the account is reinstated by
an entry that reverses the write-off entry.
 The cash received in payment is then recorded as a receipt on
account.
To illustrate, assume that Belaynesh’s account of $5,000 which was
written off on April 2 is collected later on June 10. GAMBY PLC records
the reinstatement and the collection as follows:
Accounts Receivable – Belaynesh 5000
To re-instate the written of
Cash 5000
Accounts Receivable – Belaynesh 5000
To record Collection
Direct Write-Off Method for Uncollectible Accounts
63
 Under this method, Bad Debt Expense is not recorded
until the customer’s account is determined to be worthless.
 At that time, the customer’s account receivable is written
off.
 To illustrate, assume that a $4,200 account receivable
from Dr. Abera has been determined to be uncollectible.
 The entry to write off the account is as follows:
Bad Debt Expense 4200
Accounts Receivable - Dr. Abera 4200

Direct Write-Off Method for Uncollectible Accounts Cont’d …
64  An account receivable that has been written off may be
collected later.
 In such cases, the account is reinstated by an entry that
reverses the write-off entry. The cash received in payment
is then recorded as a receipt on account.
 To illustrate, assume that the Dr. Abera’s account of
$4,200 written off on May 10 is later collected on
November 21. The reinstatement and receipt of cash is
recorded as follows:
Accounts Receivable -Dr. Abera 4200
Cash 4200
Accounts Receivable -Dr. Abera 4200
Estimating Un-collectibles
65
 The allowance method requires an estimate of uncollectible
accounts at the end of the period.
 This estimate is normally based on
 past experience,
 industry averages, and
 forecasts of the future.
The two methods used to estimate uncollectible accounts are as follows:

1. Percent of sales method.
2. Analysis of the receivables method.

Estimating Un-collectibles Cont’d …
66
1. Percent of Sales Method (Income Statement Approach)-
Since accounts receivable are created by credit sales,
uncollectible accounts can be estimated as a percent of credit
sales.
 If the portion of credit sales to sales is relatively constant, the
percent may be applied to total sales or net sales.
 To illustrate, assume the following data for GAMBY PLC on
December 31, 2010,before any adjustments:
 Balance of Accounts Receivable $240,000
 Balance of Allowance for Doubtful Accounts 3,250 (Cr.)
Total credit sales 3,000,000
 Bad debt as a percent of credit sales ¾%
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Bad Debt Expense of $22,500 is estimated as
follows:
 Bad Debt Expense = Credit Sales x Bad Debt as a Percent of Credit Sales
 Bad Debt Expense = $3,000,000 x3/4% = $22,500
 The adjusting entry for uncollectible on December 31,
2010, is as follows:
To record Uncollectible accounts estimate.
($3,000,000 x 0.0075 = $22,500)

68 2. Analysis of Receivables Method – This method is
based on the assumption that the longer an account
receivable is outstanding, the less likely that it will be
collected.
 The aging of accounts receivable is the process of
listing each customer’s receivable account according to
the due date of the account.
 Often called balance sheet method.
 The analysis of receivables method is applied as follows:

69
Steps in applying an aging are;
1. The due date of each account receivable is determined.
2. The number of days each account is past due is
determined. This is the number of days between the
due date of the account and the date of the analysis.
3. Each account is placed in an aged class according to
its days past due.

70
Typical aged classes include the following:
Not past due
1–30 days past due
Over 365 days past due
4. The totals for each aged class are determined.
5. The total for each aged class is multiplied by an
estimated percentage of uncollectible accounts for
that class.
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6. The estimated total of uncollectible accounts is
determined as the sum of the uncollectible accounts
for each aged class
assume that GAMBY uses the analysis of receivables
method instead of the percent of sales method. It
prepared an aging schedule for its accounts
receivable of $240,000 as of December 31, 2010, as
shown.

72

73  For GAMBY PLC, the unadjusted balance of the allowance
account is a credit balance of $3,250.
 Comparing the estimate of $26,490 with the unadjusted
balance of the allowance account determines the amount
of the adjustment for Bad Debt Expense.
 The amount to be added to this balance is therefore
$23,240 ($26,490 - $3,250).
 The adjusting entry is as follows:
Bad Debt Expense 23,240
Allowance for Doubtful Accounts 23,240
To record the Uncollectible accounts estimate ($26,490 – $3,250)

74 E.g. 2. At the end of the current year, Accounts Receivable
has a balance of $800,000; Allowance for Doubtful Accounts
has a credit balance of $7,500; and net sales for the year
total $3,500,000. Using the aging method, the balance of
Allowance for Doubtful Accounts is estimated as $30,000.
Determine;
a) the amount of the adjusting entry for uncollectible
accounts;
b) the adjusted balances of Accounts Receivable, Allowance
for Doubtful Accounts, and Bad Debt Expense; and
c) the net realizable value of accounts receivable.

75
Answer for illustrative example 2
a. $22,500 ($30,000 - $7,500)
b. Adjusted Balance
Accounts Receivable . . . . . . . . . . . . $800,000
Allowance for Doubtful Accounts . … 30,000
Bad Debt Expense . . . . . .. . . .. . . .. . 22,500
c. $770,000 ($800,000 $30,000)

76
Comparing Estimation Methods

Comparing Direct Write-Off & Allowance Methods
77
COMPARING THE DIRECT WRITE-OFF AND ALLOWANCE METHODS
Direct Write-Off Method Allowance Method

Bad debt When the specific customer Using estimate based on
expense is accounts are determined to
recorded be uncollectible. (1) a percent of sales or
(2) an analysis of receivables.
Allowance No allowance account is The allowance account is used
account used
Primary Small companies and Large companies and those
users companies with few with a large amount of
receivables receivables.

1.7. Accounting for notes receivable
78
Companies may also grant credit in exchange for a
formal credit instrument known as a promissory
note.
A promissory note is a written promise to pay a
specified amount of money on demand or at a definite
time.
A note has some advantages over an account
receivable.
Thus, a note is a stronger legal claim.

Accounting for notes receivable Cont’d …
79
 Promissory notes may be used
(1)when individuals and companies lend or borrow money,
(2)when the amount of the transaction and the credit period
exceed normal limits, or
(3)in settlement of accounts receivable.
 In a promissory note, the party making the promise to pay is
called the maker.
 The party to whom payment is to be made is called the payee.
 The note may specifically identify the payee by name or may
designate the payee simply as the bearer of the note.

80
 Like accounts receivable, notes receivable can be readily
sold to another party.
 Promissory notes are negotiable instruments (as are
checks), which means that they can be transferred to
another party by endorsement.
 The basic issues in accounting for notes receivable are the
same as those for accounts receivable:
1. Recognizing notes receivable.
2. Valuing notes receivable.
3. Disposing of notes receivable.

81
Characteristics of Notes Receivable
Characteristics /features/ of a promissory note are as
follows:
1. The face amount is the amount the note is written for on
its face.
2. The issuance date is the date a note is issued.
3. The due date or maturity date is the date the note is to be
paid.
4. The term of a note (duration of a note) is the amount of
time between the issuance and due dates.
5. The interest rate is that rate of interest that must be paid
on the face amount for the term of the note.
82
Determining the Maturity Date
1. When the life of a note is expressed in terms of months,
you find the date when it matures by counting the
months from the date of issue.
 For example, the maturity date of a three-month note
dated May 1 is August 1.
 A note drawn on the last day of a month matures on the
last day of a subsequent month.
 That is, a July 31note due in two months matures on
September 30.

Determining the Maturity Date cont’d …
83
2. When the due date is stated in terms of days, you
need to count the exact number of days to determine
the maturity date. In counting, omit the date the
note is issued but include the due date.
 For example, the maturity date of a 60-day note
dated July 17 is September 15, computed as follows.
Term of note 60 days
July (31-17) 14
August 31 45
Maturity date: September 15
84
To illustrate, assume that a company accepts a 30-
day, 12% note dated November 21, 2010, in
settlement of the account of W. A. Bunn Co., which is
past due and has a balance of $6,000. The company
records the receipt of the note as follows:
Nov. 21
Notes Receivable—W. A. Bunn Co. 6,000
Accounts Receivable—W. A. Bunn Co 6,000
Received 30 day note interest bearing dated Nov. 21

85
At the due date, the company records the receipt of
$6,060 ($6,000 face amount plus $60 interest) as
follows:
Dec. 21
Cash 6,060
Notes Receivable - W. A. Bunn Co. 6,000
Interest Revenue 60
To record collection of 30 day note
$6,060 = [$6,000 + ($6,000 x 12% x 30/360)].

86
 A company that holds a dishonored note transfers the face
amount of the note plus any interest due back to an
accounts receivable account.
 For example, assume that the $6,000, 30-day, 12% note
received from W. A. Bunn Co. and recorded on November
21 is dishonored. The company holding the note transfers
the note and interest back to the customer’s account as
follows:
Nov 21 Accounts Receivable—W. A. Bunn Co. 6060
Notes Receivable—W. A. Bunn Co. 6000
Interest Revenue 60
87
If the maker of a note fails to pay the note on the due
date, the note is a dishonored note receivable.
A dishonored (defaulted) note is a note that is not
paid in full at maturity.
A dishonored note receivable is no longer negotiable.
The company has earned the interest of $60, even
though the note is dishonored.
If the account receivable is uncollectible, the company
will write off $6,060 against Allowance for Doubtful
Accounts.
88
A company receiving a note should record an adjusting
entry for any accrued interest at the end of the period.
For example, assume that Crawford Company issues a
$4,000, 90-day, 12% note dated December 1, 2010, to
settle its account receivable. If the accounting period
ends on December 31, the company receiving the note
would record the following entries:
Notes Receivable—Crawford Company 4000
Dec 1 Accounts Receivable—Crawford Company 4000

89
2010
Interest Receivable 40
Dec 31 Interest Revenue 40
Accrued interest ($4,000 x 12% x 30/360)
2011
March 1 Cash 4120
N/R - Crawford Company 4000
Interest Receivable 40
Interest Revenue 80
Total interest of $120 ($4,000 x 12% x 90/360)

Discounting Notes Receivable
90
A company may endorse a note receivable and
transfer it to a bank in return for cash.
This is called discounting notes receivable. The bank
pays cash (the proceeds) to the company after
deducting a discount (interest).
The discount is computed using a discount rate on
the maturity value of the note for the discount period.
The discount period is the time that the bank must
hold the note before it becomes due.

91
 To illustrate, assume that on May 3 a note receivable from
Pryor & Co is discounted by Deacon Company at its bank.
The related data are as follows:

92
Interest Rates
Note Issued at
Stated rate = Market rate Face Value
Stated rate > Market rate Premium
Stated rate < Market rate Discount

93
Deacon Company records the receipt of the proceeds
as follows:
May 3
Cash 1,807.13
Notes Receivable 1,800.00
Interest Revenue 7.13
Discounted $1,800, 90-day, 12% note at 14%.
If the proceeds had been less than the face amount,
Deacon Company would have recorded the excess of
the face amount over the proceeds as interest expense.

94  For example, if the proceeds had been $1,785, Deacon
Company would have recorded interest expense of $15 ($1,800
- $1,785).
 The length of the discount period, interest rate, and discount
rate determine whether interest expense or interest revenue is
recorded.
 Without a statement limiting responsibility, Deacon Company
must pay the maturity value of the note if the maker defaults.
This potential liability is called a contingent liability.
 If the maker pays the maturity value, the contingent liability
ceases to exist.
 If, on the other hand, the maker dishonors the note, the
contingent liability becomes a liability that must be paid.

95  If a discounted note receivable is dishonored, the bank
notifies the company and asks for payment & may
charge a protest fee on dishonored notes.
 The entire amount paid to the bank, including the
maturity value and protest fee, is debited to the account
receivable of the maker.
 To illustrate, assume that Pryor & Co. dishonors the
$1,800, 90-day, 12% note that was discounted on May
3. The bank charges a protest fee of $12. Deacon
Company’s entry to record the payment to the bank is as
follows:

96
July 7
Accounts Receivable––Pryor & Co. 1,866
Cash 1,866
Paid dishonored, discounted note (maturity value of $1,854

plus protest fee of $12).
NB. Print page 451 Principle of accounting 11ed

97 1.8. Factoring Receivables
A common sale of receivables is a sale to a factor.
A factor is a finance company or bank that buys
receivables from businesses and then collects the
payments directly from the customers.
The factor charges a commission to the company
that is selling the receivables.

Factoring Receivables Cont’d …
98
To illustrate, assume that Hendredon Furniture
factors $600,000 of receivables to Federal Factors.
Federal Factors assesses a service charge of 2% of
the amount of receivables sold. The journal entry to
record the sale by Hendredon Furniture on April 2,
2014, is as follows.
Apr. 2 Cash 588,000
Service Charge Expense (2% x $600,000) 12,000
Accounts Receivable 600,000
(To record the sale of accounts receivable)
1.9. Presentation of cash & receivables on the
99 balance sheet
 Cash and all receivables (expected to be realized in cash within
a year) are reported in the Current Assets section of the balance
sheet.
 Current assets are normally reported in the order of their
liquidity, beginning with cash and cash equivalents.

Presentation Cont’d …
100
Other disclosures related to receivables are reported
either on the face of the financial statements or in the
financial statement notes.
Disclosures include
the market (fair) value of the receivables.
the nature of the risks are disclosed.
For example, if the majority of the receivables are due
from one customer or are due from customers located
in one area of the country or one industry, these
facts are disclosed.

Summary Questions
101
 Net sales for the month are $800,000, and bad debts are
expected to be 1.5% of net sales. The company uses the
percentage-of-sales basis. If Allowance for Doubtful Accounts
has a credit balance of $15,000 before adjustment, what is
the balance after adjustment?
a. $15,000. c. $23,000.
b. $27,000. d. $31,000.
Which of the following approaches for bad debts is best
described as a balance sheet method?
a. Percentage-of-receivables basis.
b. Direct write-off method.
c. Percentage-of-sales basis.
d. Both a and b.

Chapter 1 - Cash and Receivables

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