Accounting for Receivables

Chapter 9 provides a discussion of various types of receivables. Although there are many types of receivables described, the bulk of your work in this lesson will concern accounts receivable and notes receivable. An account receivable arises when a customer purchases goods from you. A note receivable may occur in exactly the same way. Sometimes, however, a note Receivable is used when someone borrows cash from you. In such a case, you are behaving like a banker, and can earn interest on the loan.

A debtor owes money to someone else; a creditor is owed money. If Anne borrows $1,000 from Jill, Anne is the debtor, and Jill is the creditor.

Learning Objectives

Our tasks in Chapter 9 are to:

  1. Learn how to account for accounts receivable -- specifically with respect to accounting for bad debts. A bad debt is an account receivable that turns out to be uncollectible.

  2. Learn how to account for notes receivable. A note receivable is promissory note received from someone, in which there is a promise to pay us at some date in the future. A note receivable normally carries interest.

  3. Examine credit card transactions and miscellaneous receivables transactions that may occur.

Accounting for Bad Debts

When a company sells goods or services on credit, a receivable is created. The company extending credit has every expectation of collecting the Account Receivable in the near future -- otherwise, the credit would not have been granted. At the time of the sale, a transaction such as the following one is journalized:

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Occasionally, despite the good-faith efforts of the parties involved, it turns out that the debtor is unable to pay the creditor the amount owed. From the standpoint of the company extending the credit, the account receivable created in the transaction shown above is not collectible, and should not be included in the current assets. In fact, the debt may not represent an asset at all. At the moment that collection becomes doubtful or impossible, the account receivable must be removed somehow.

There are two general methods used to get a receivable off the accounts:

  1. The Direct Write-off Method;

  2. The Allowance Method.

The Direct Write-off Method

The Direct Write-off Method is simple, objective, and is the method preferred for income tax purposes. Using the example above, assume that three months elapse after the sale of the goods, and the $1000 account is determined to be uncollectible. Using the Direct Write-off Method, the entry to write the account off would be:

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Despite its simplicity, the Direct Write-off Method has a conceptual weakness. It violates the matching principle, because the revenue from the sale is earned in one period, and the expense of the bad debt is not recognized until a significant time later. Specifically, the revenue was earned in January, but the expense of the bad debt is recorded in April. It might seem that perfect matching would be an impossible objective, given that we cannot predict which customer accounts will actually become uncollectible, or when.

The Allowance Method

The solution to this problem is to estimate the bad debts each accounting period. As revenues are earned each period, it is highly probable that some receivables will become bad debts, and with experience, management will be able to make a reasonable estimate of the dollar amount. After an estimate is made, we make an adjusting entry each period like the following:

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This adjustment is made at the same time as the other adjustments; in the example above, the assumption is made that the adjustment is made at the end of each year as a prediction of the likely amount of bad debts.  You might think of this entry as parallel to the depreciation entry -- which is also an estimate.

The Allowance for Doubtful Accounts is sort of a "holding tank" for write-offs that are expected to occur in the future. This account is in the Current Assets, and serves as a contra account to Accounts Receivable. Here is an example of how the two accounts might appear in a ledger:

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The relationship between Accounts Receivable and the Allowance for Doubtful Accounts is essentially the same as that between Equipment and its Accumulated Depreciation Account. On the Balance Sheet, Allowance for Doubtful Accounts is subtracted from Accounts Receivable, resulting in a figure called Cash Realizable Value. In the above example, this figure is $21,000, the amount we actually expect to collect from customers.

When we determine that a customer is not likely to pay us (the receivable is past due, the customer's phone has been disconnected, or the customer has disappeared), we make the following entry to remove the account from accounts receivable.

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This entry removes the receivable from the books, and reduces the Allowance account by the same amount. If we update the Accounts Receivable and the Allowance account to reflect the effect of this transaction, we get the following balances:

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Notice that writing off an account does not change the Cash Realizable Value. Rather, the write-off confirms that a portion of our estimate of bad debts has "come true."

If we are very good at estimating bad debts, the Allowance for Doubtful Accounts should approach zero from time to time. If the economy is good, the Allowance account may get somewhat large, causing us to consider reducing the estimate of bad debts each period. Conversely, write-offs can become larger than expected in a bad economy, and we may exhaust the entire Allowance account. Clearly, this is an area where judgment and experience are required, to make a responsible and fair estimate.

Two Ways to Estimate Bad Debts

How should the estimate of Bad Debts Expense be made? There are two methods illustrated in your text:

  1. The Percent of Sales Method;

  2. The Analysis of Receivables Method

Percent of Sales Method

The Percent of Sales Method assumes that bad debts are a function of the level of sales. The higher the sales level, the higher the Bad Debts Expense/Allowance for Doubtful Accounts replenishment will be. Presumably, credit is extended to customers to increase sales. This method ignores any existing balance in the Allowance for Doubtful Accounts at the time of the adjusting entry. As an example, if Sales amount to $100,000 and the uncollectible percentage of sales is 2%, then make the adjustment for $2,000.

General Journal  
Bad Debts Expense  
  Allowance for Doubtful Accounts  

Analysis of Receivables Method

The Analysis of Receivables Method assumes that bad debts are a function of how old the receivables are. If someone has owed you money for ten days, your probability of collecting it is higher than if someone owes you money for 120 days. To age the accounts, sort the Accounts Receivable into pools by age, and multiply each pool by a percentage assumed uncollectible. Note that, as the age increases, the percentage uncollectible is considered to be higher.

These amounts are added and the sum represents the desired balance for the Allowance for Doubtful Accounts. The adjustment is made to force the Allowance account to this balance. Thus, you must look at the existing balance in the Allowance account before making the adjustment.

In the textbook example, Accounts Receivable were $240,000 and the Allowance for Uncollectible Accounts was $3,250. After an aging of the accounts, it was determined that an estimated $26,490 of Accounts Receivable were uncollectible. But, since the Allowance for Doubtful Accounts already had a $3,250 balance, the adjustment needed was for $23,240.

General Journal  
Bad Debts Expense  
  Allowance for Doubtful Accounts  

The effect of this entry is a reduction in owner's equity and a reduction in total assets. Bad Debts Expense, like all expenses, reduces net income.

To reiterate a major difference between the two allowance methods, the percent of sales method computes a percent of sales and makes the bad debts expense entry using that figure, while the analysis of receivables method computes a percent of receivables, and forces the allowance account to that figure.

Writing Off a Bad Debt

The discussion so far has been about the adjusting entry for uncollectible accounts. That entry, illustrated above is always a debit to Bad Debts Expense, and a credit to Allowance for Doubtful Accounts. Once again, the purpose of this adjustment is to estimate the bad debts that are likely to arise, based on the current level of sales, or an aging of accounts.

Now, what happens when a customer fails to make payment on their account? We write it off. This means that we get it out of Accounts Receivable, and use up some of the Allowance that has already been established. For example, if Fred Johnson cannot pay us the amount he owes us, $100, we make this entry:

General Journal  
Allowance for Doubtful Accounts  
  Accounts Receivable  

Note that this entry reduces Accounts Receivable, and reduces the Allowance account. Both of these accounts are in the asset category, so there is no effect on total assets, total liabilities or total owner's equity.

Distinguishing Among Three Types of Bad Debt Entries

When doing the homework for this chapter, or when taking a quiz, you should look for clues as to which entry is being described. The adjustment for bad debts involves a regular, recurring debit to Bad Debts Expense and a credit to Allowance for Doubtful Accounts.

The writeoff entry will consist of a debit to Allowance for Doubtful Accounts, and a credit to Accounts Receivable.

There is a third entry that could happen. If Johnson failed to pay his debt to us, and then we wrote it off--and then Johnson came into some money and was able to pay us--we would have to re-establish the Account Receivable, and the Allowance account. In other words, we would reverse the writeoff, so that there would again be a receivable. Then, we would show the debit to Cash and credit to Accounts Receivable upon Johnson's payment.

Notes Receivable

A Note Receivable is a formal promise from a customer or other party, wherein they promise to pay us a certain amount (the principal) on a certain date in the future (the maturity date) plus interest, at an agreed-upon rate. The maturity date may be expressed as a number of days, a number of months, or a number of years.

At the payment date, the principal and interest is due. Interest is calculated as follows: the asterisk (*) means multiply.

Interest = Principal * Rate * Time in Years

A Note with Maturity Quoted in Years

Suppose that, on June 1, you loan someone $1,000 with 10% interest for one year. The amount of interest you would be owed after one year would be $1,000*.10*1=$100. The maturity date would be the same day next year, June 1.

A Note with Maturity Expressed as a Number of Months

Suppose that on September 1, you loan someone $1000 on a note receivable for 3 months at 6%. How much interest would accrue? Answer: it would earn interest of $15.00, computed as follows:

Interest = $1000 * .06 * 3/12 = $15.00

The maturity date would be December 1--simply take the loan date of September 1 and count forward three months.

Note: an interest rate is always the rate for one year. In this example, the rate is 6% per year. The money was loaned out for 3/12 of one year, resulting in total interest of $15. If the money had been loaned out for an entire year, the interest would amount to .06*1000*1=$60.

A Note with Maturity Quoted in Days

Similarly, a $2000 note for 60 days earning an 8% rate would result in interest revenue of $26.67, computed as follows:

Interest = $2000 * .08 * 60/360 = $26.67

The maturity date for a note quoted in days requires that you count the days until maturity. If a 60 day note is received on July 25, you would count the number of days remaining in July (6 days), then add all of the days in August (31) and you will need 23 days in September to make 60 days. Thus, the maturity date for the note would be September 23.

If you are working with a note quoted in days, it is vital that you know how many days there are in each month. Here is a table:

Month Number of Days
January 31
February 28, or 29 in a leap year
March 31
April 30
May 31
June 30
July 31
August 31
September 30
October 31
November 30
December 31

A Note Received on a Sale

A note receivable may arise in a sale of merchandise, as implied by the following transaction:

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At maturity, 60 days later (note the dates), the note is paid off, plus interest:

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If the maker of the note does not honor (pay) the note, it can be converted to an Account Receivable. If no further arrangement can be made for payment, this receivable may have to be written off as a bad debt.

Keep in mind that a note bearing interest may require an adjustment if the note has been running and won't be collected until after the accounting period ends. The adjusting entry would be as follows:

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Credit Cards

A credit card allows a business to sell goods to a customer, and the credit card company assumes responsibility for ultimate collection of the debt. Bank cards, for example, allow the seller of the goods to collect cash from the bank immediately (less a small service charge), which can reduce the risk of bad debts, and accelerate cash collection. A store credit card, on the other hand, establishes an Account Receivable when the customer purchases something on account.

Accounts Receivable Turnover

The Accounts Receivable Turnover is a ratio that measures how many times per year the receivables are collected. The formula is: Accounts Receivable Turnover = Net Sales/Average Accounts Receivable, where the Average Accounts Receivable is calculated as (Beginning Accounts Receivable + Ending Accounts Receivable)/2.

Once the Accounts Receivable Turnover has been computed, a related calculation, Average Collection Period, can be calculated. The Average Collection Period is the number of days it takes to collect the receivables. Average Collection Period = 365/Accounts Receivable Turnover.