Principles of Accounting

Chapter 7: Receivables
Types of Receivables

Amounts due from individuals and other companies that are expected to be
collected in cash.

Amounts owed by Claims for which formal “Nontrade” (interest,

customers that result instruments of credit loans to officers,
from the sale of goods are issued advances to employees,
and services. as proof of debt. and income taxes
refundable).

Accounts Notes Other

Receivable Receivable Receivables
Accounts Receivables

Three accounting issues:

• Recognizing accounts receivable.

• Valuing accounts receivable.

• Disposing of accounts receivable.

Accounts Receivables

Recognizing accounts receivable

Illustration 1: Assume that Jordache Co. on July 1, 2010, sells

merchandise on account to Polo Company for $1,000 terms 2/10,
n/30. Prepare the journal entry to record this transaction on the
books of Jordache Co.

Jul. 1 Accounts receivable 1,000

Sales 1,000
Accounts Receivables

Recognizing accounts receivable

Illustration 2: On July 5, Polo returns merchandise worth $100 to

Jordache Co.

Jul. 5 Sales returns and allowances 100

Accounts receivable 100
Accounts Receivables

Recognizing accounts receivable

Illustration 3: On July 11, Jordache receives payment from Polo

Company for the balance due.

Jul. 11 Cash 882

Discount Allowed (900*0.02) 18
Accounts receivable 900
Accounts Receivables

Valuing accounts receivable

 Are reported as a current asset on the balance sheet.

 Are reported at the amount the company thinks they will be able to
collect.

 Sales on account raise the possibility of accounts not being collected.

 The application of the concept of prudence would require that there should be
an adjustment to reflect the fact that there are some receivables which the
business thinks that it will not recover.
Accounts Receivables

Valuing accounts receivable

There are two categories of problem receivables for which

adjustment might be required:

• Bad debts (also known as irrecoverable debts or receivables)

• Doubtful debts
Accounts Receivables

Valuing accounts receivable – Bad debts

A bad debt is an amount owed by a customer that the business believes it will
never be able to collect.

Examples of circumstances that might lead to the conclusion that a receivable is

irrecoverable include:
• The bankruptcy or insolvency of a customer.
• The death of a customer who has left insufficient assets to pay off his debts.
• A dispute with a customer over whether a contract has been fulfilled or not.
• The dishonesty of a customer (where a person has obtained goods on credit
with no intention to pay).
Accounts Receivables

Valuing accounts receivable – Doubtful debts

A doubtful debt is an amount owed by a customer that the business believes

might prove difficult to collect but they still hope to do so.

Examples of circumstances that might lead to the conclusion that a receivable is

doubtful include:

• A customer experiencing cash flow problems.

• A customer taking an unusually long time to settle a debt.

• A customer experiencing operational difficulties which might lead to financial

problems (for example, strikes, natural disasters disrupting production etc.).
Accounts Receivables

Valuing accounts receivable

Bad debts and doubtful debts are accounted for differently, although
there is often just a single bad and doubtful debts expense account in
the general ledger.
Accounts Receivables

Accounting for bad debts

Bad debts are receivables that an entity is owed, but that it now does
not expect to collect.
When a specific debt (receivable) is considered bad or irrecoverable, it
is written off. This means that it is removed from the accounting
system and supporting records.
Accounts Receivables

Accounting for bad debts

Accounts Receivables

Accounting for bad debts

Accounts Receivables

Accounting for bad debts – Bad debts recovered

On rare occasions cash in respect of a debt that had been written off
as bad in a previous year is subsequently received in a later period.
The double entry for recording the recovery of a bad debt is:
Accounts Receivables

Accounting for doubtful debts

Note that the allowance account might also be called the

provision for doubtful debts account.
Accounts Receivables

Accounting for doubtful debts

The allowance is a credit balance which is then set against the carrying amount of
the receivables in the statement of financial position.
Accounts Receivables

Accounting for doubtful debts – Measurement of the Allowance

• Specific debtor
• General allowance based on historical data
Accounts Receivables

Accounting for doubtful debts – Measurement of the Allowance

Example
The Kasur Cotton Company has receivables at the year-end of Rs.1,500,000.
It has carried out a year-end review of its receivables and discovered that a
customer owing Rs.75,000 has suffered a fire at their factory which will stop
production for 3 months. The chief accountant believes that this casts doubt on
their ability to pay their debt.
In addition, it is the Company policy to recognise an allowance for 5% of its
receivables. This is based on experience and the treatment has been approved by
the company’s auditor.
Accounts Receivables

Accounting for doubtful debts – Measurement of the Allowance

The Kasur Cotton Company would recognise the following allowance:
Accounts Receivables

Accounting for doubtful debts – Changes in the allowance account

A business will recognise an allowance balance at each year end.
The movement on the allowance is recognised as an expense.
Accounts Receivables

Accounting for doubtful debts – Changes in the allowance account

Accounts Receivables

Accounting for doubtful debts – Changes in the allowance account

Accounts Receivables

Accounting for doubtful debts – Changes in the allowance account

Accounts Receivables

Accounting for doubtful debts – Changes in the allowance account

Journal entry:
Accounts Receivables

Accounting for doubtful debts – Changes in the allowance account

Journal entry:
Accounts Receivables

Accounting for doubtful debts – Changes in the allowance account

Accounts Receivables

Accounting for doubtful debts – Changes in the allowance account

Practice Qs:
A business has trade receivables of Rs. 75,000.
It identifies that Rs. 5,000 of these debts are irrecoverable and should be written
off.
An allowance for irrecoverable debts of Rs. 2,000 should be created. It is the first
time that the business has opened such an account.
Accounts Receivables

Accounting for doubtful debts – Changes in the allowance account

Accounts Receivables

Accounting for doubtful debts – Changes in the allowance account

Accounts Receivables

Accounting for doubtful debts – Changes in the allowance account

Practice Qs (continued into year 2):
In year 2, credit sales were Rs.200,000, receipts from customers were Rs.185,000
and bad debts written off were Rs.8,000.
The allowance for irrecoverable debts is to be reduced from Rs.2,000 to Rs.1,500.
Accounts Receivables

Accounting for doubtful debts – Changes in the allowance account

Accounts Receivables

Accounting for doubtful debts – Changes in the allowance account

Accounts Receivables

Accounting for doubtful debts – Changes in the allowance account

Accounts Receivables – Question
Accounts Receivables – Solution
Accounts Receivables

Accounting for doubtful debts – Aged Receivables Analysis

This is an analysis for each individual credit customer of their total debtor balance,
showing how long each invoice has been outstanding.
A typical format for an aged receivables analysis is given below:

If a customer has old amounts outstanding, these should be investigated and an

attempt should be made to collect payment.
Accounts Receivables

Accounting for doubtful debts – Aged Receivables Analysis

Accounts Receivables

Disposing of Accounts Receivable

Companies sell receivables (factoring) for two major reasons:
• Receivables may be the only reasonable source of cash.
• Billing and collection are often time-consuming and costly.
Accounts Receivables

Sale of Receivables
A factor buys receivables from businesses and then collects the payments directly
from the customers.
Typically the factor charges a commission to the company that is selling the
receivables.
The fee ranges from 1-3% of the amount of receivables purchased.
Accounts Receivables

Sale of Receivables
Illustration: 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 is as follows:

($600,000 x 2% = $12,000)

Cash 588,000
Service charge expense 12,000
Accounts receivable 600,000
Notes Receivable

Companies may grant credit in exchange for a promissory note.

A promissory note is a written promise to pay a specified amount of money on
demand or at a definite time.
Promissory notes may be used:
• when individuals and companies lend or borrow money,
• when amount of transaction and credit period exceed normal limits, or
• in settlement of accounts receivable.
Notes Receivable

To the Payee, the promissory note is a note receivable.

To the Maker, the promissory note is a note payable.
Notes Receivable

Illustration: Assuming that Calhoun Company wrote $1,000, two-month, 12%

promissory note to settle an open account, Wilma Company makes the following
entry for the receipt of the note:

Notes receivable 1,000

Accounts receivable 1,000
Notes Receivable

Valuing Notes Receivable

Like accounts receivable, companies report short-term notes receivable at their
cash (net) realizable value.
Estimation of cash realizable value and bad debts expense are done similarly to
accounts receivable.
Allowance for Doubtful Accounts is used.
Notes Receivable

Disposing of Notes Receivable

1. Notes may be held to their maturity date.
2. Maker may default and payee must make an adjustment to the account.
3. Holder speeds up conversion to cash by selling the note receivable.

Honor of Notes Receivable

A note is honored when its maker pays it in full at its maturity date.
Dishonor of Notes Receivable
A dishonored note is not paid in full at maturity.
Notes Receivable

Honor of Notes Receivable

Illustration: Assume that Betty Co. lends Wayne Higley Inc. $10,000 on June 1,
accepting a five-month, 9% interest-bearing note. Assuming that Betty Co.
presents the note to Wayne Higley Inc. on the maturity date, Betty Co.’s entry to
record the collection is:

Nov. 1 Cash 10,375

Notes receivable 10,000
Interest revenue 375
Notes Receivable

Honor of Notes Receivable

Illustration (Continued): If Betty Co. prepares financial statements as of
September 30, it must accrue interest. Betty Co. would make an adjusting entry to
record 4 months’ interest.

Sept 30 Interest receivable 300

Interest revenue 300

Now the entry at maturity (Nov 1) would be:

Nov. 1 Cash 10,375

Notes receivable 10,000
Interest receivable 300
Interest revenue 75
Notes Receivable

Dishonor of Notes Receivable

Illustration: Assume that Wayne Higley Inc. on November 1 indicates that it
cannot pay at the present time. If Betty Co. does expect eventual collection, it
would make the following entry at the time the note is dishonored (assuming no
previous accrual of interest):

Nov. 1 Accounts receivable 10,375

Notes receivable 10,000
Interest revenue 375
Presentation

Identify in the balance sheet or in the notes each major type of

receivable.

B/S Report short-term receivables as current assets.

Report both gross amount of receivables and allowance for
doubtful account.
Report bad debts expense and service charge expense as
selling expenses.
I/S
Report interest revenue under “Other revenues and gains.”