Example:
On May 1, 2007 X Co. purchased merchandise on account for $5,000 from Y Co. giving a
written promise to pay after 90 days (non-interest bearing note)
a) What is the due date?
Due date: Days remaining in May (31-1) ……… 30
Days in June …………………………30
Days in July to maturity date …………30 (due date)
(date of payment included)
90 days
b) How much is maturity value?
Maturity Value = Face amount = $5,000
Example:
On July 6, 2007 X Co. purchased merchandise on account for $8,000 from ABC trading
signing a 90 day, 12% promissory note.(assume a year of 360 days)
a) Due date: Days remaining in July (31- 6) ……… 25
Days in August ………………………31
Days in September …………………..30
Days in October to maturity date …….4 (due date)
(date of payment included)
90 days
b) Interest = $8,000 x 0.12 × 90/360 = $240
c) Maturity Value = $8,000 + $240 = $8,240
Exercise: Date -------- September 11 Required: a) Due date?
Face Value--- $24,000 b) Interest?
Period----- 120 days c) Maturity value?
Interest rate ------- 12%
Page 1 of 13
Receivables (Recording and Valuing)
Recording Receivable Transactions
- If a customer signs a promissory note in exchange for merchandise, the entry is recorded by
debiting notes receivable and crediting sales.
- Customers frequently sign promissory notes to settle overdue accounts receivable balances.
The conversion of accounts receivable to notes receivable has advantages for the payee:
i. Earns interest on the balance until paid as this allows the customer more time to pay
the balance of the account.
ii. The notes receivable is more liquid as it can be sold to a bank or other financial
institution.
Example:
On April 26, 20X8 Nile Co. sold merchandise on account for $2,500 for Awash Co., term
n/60. On the books of the payee:
a) Record the transaction on April 26, 20X8
b) Assume that on June 25 Awash Co. did not pay for Nile Co. according to their term
of agreement and both agreed to change the open account to notes receivable with an
interest rate of 10% for six months. The change of A/R to N/R is recorded as
follows:
c) Record the receiving of cash on December 25, 20X8.
When a note's maker pays according to the terms specified on the note, the note is
said to be honored. Assuming that no adjusting entries have been made to accrue
interest revenue, the honored note is recorded as follows: (Note that the total interest
on a six-month, 10%, $2,500 note is $125)
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If some of the interest has already been accrued (through adjusting entries that
debited interest receivable and credited interest revenue), then the previously
accrued interest is credited to interest receivable and the remainder of the interest is
credited to interest revenue.
- Adjusting entries that recognize accrued interest are often calculated in terms of days.
Suppose a company holds a four-month, 10%, $10,000 note dated October 19, 20X2. If the
company uses an annual accounting period that ends on December 31, an adjusting entry
that recognizes 73 days of accrued interest revenue must be made on December 31, 20X2.
Notice that when you count days, you omit the note's issue date but include the note's due
date or, in this situation, the date that the adjusting entry is made. Assuming the interest
calculation uses a 365-day year, the accrued interest revenue equals $200.
The adjusting entry debits interest receivable and credits interest revenue.
Interest on long-term notes is calculated using the same formula that is used with short-term
notes, but unpaid interest is usually added to the principal to determine interest in
subsequent years. Remember that any entry to record the subsequent receipt of interest
depends on whether reversing entry was made.
Evaluating Accounts Receivable (Uncollectible Receivables)
- A business that sells its goods or services on credit will inevitably find that some of its
accounts receivables are uncollectible.
- Regardless of how thoroughly the credit department investigates the credit worthiness of each
prospective customer, some uncollectible accounts will arise as a result of one or more of the
following reasons: bankruptcy, closing of the debtor’s business, disappearance of the debtor,
and failure of repeated attempt to collect.
- The operating expense incurred because of the failure to collect receivables is called an
expense or loss from uncollectible accounts, doubtful accounts or bad debts.
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- Companies use two methods to account for bad debts: the allowance method(reserve method)
and the direct write-off(direct charge off) method
Allowance Method.
- Under the allowance method, an adjustment is made at the end of each accounting period to
estimate bad debts based on the business activity from that accounting period.
- The adjusting entry has two purposes:
1. To reduce A/R to its NRV in the balance sheet
2. To match expenses with revenue that helped generate (matching principle) in the income
statement.
Example: A company had total A/R of $100,000 at the end of the fiscal year (Dec.31 20X5). If
the company estimates that $5,000 in accounts receivable will become uncollectible,
the necessary adjusting entry will be as follows:
The bad debt expense is an administrative expense.
Since the specific customer accounts that will become uncollectible are not yet
known when the adjusting entry is made, a contra-asset account named allowance
for bad debts (allowance for doubtful accounts), is subtracted from accounts
receivable to show the NRV of accounts receivable on the balance sheet.
Accounts Receivable --------------------------- $100,000
Less: Allow. for Bad Debts -------------------- 5,000
Net Realizable Value --------------------------- $95,000
After the entry shown above is made, the accounts receivable subsidiary ledger still
shows the full amount each customer owes.
Write-off to the Allowance Account
- When a specific customer's account is identified as uncollectible, it no longer qualifies as an
asset and should be written off against the balance in the allowance for bad debts account.
- To write off an A/R is to reduce the balance of the customer’s account to zero.
Example: Continuing with the above example, if a customer named J. Smith fails to pay a
$225 balance, the company records the write-off as follows:
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- Remember, general journal entries that affect a control account must be posted to both the
control account and the specific account in the subsidiary ledger.
- Under the allowance method, a write-off does not change the NRV of accounts receivable. It
simply reduces accounts receivable and allowance for bad debts by equivalent amounts.
Before writing off After writing off
J. Smith's account J. Smith's account
Accounts Receivable $100,000 $99,775
Less: Allow. for Bad Debts (5,000) (4,775)
Net Realizable Value $95,000 $95,000
- Customers whose accounts have already been written off as uncollectible will sometimes pay
their debts. When this happens, two entries are needed to correct the company's accounting
records and show that the customer paid the outstanding balance.
1) The first entry reinstates the customer's accounts receivable balance:
2) The second entry records the customer's payment:
Example: Assume Mr. J. Smith paid his account fully on August 11,20X6
- In the future when management looks at J. Smith's payment history, the account's activity will
show the eventual collection of the amount owed.
Estimating Bad Debts(Uncollectibles)
- Established companies rely on past experience and perhaps modified in accordance with
future business activity to estimate uncollectibles at the end of the fiscal period. But new
companies must rely on published industry averages until they have sufficient experience to
make their own estimates.
- Companies use two methods to estimate uncollectibles
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1. Estimate based on Sales (Sales or Income Statement Method)
Percentage of credit sales method.
- Some companies estimate bad debts as a percentage of credit sales.
- The adjusting entry doesn’t take into consideration the existing balance in the AFD account.
The question to be answered is not “how large uncollectible allowance is needed to reduce our
receivables to NRV?” Instead, the question is stated as “How much uncollectible accounts
expense is associated with this year’s volume of credit sales?”
- This method stresses the relationship between uncollectible account expense and credit sale
rather than the valuation of receivables at the balance sheet date.
Example:
Assume that AFD account for a company had a credit balance of $400 before adjustment. If a
company has $500,000 in credit sales during an accounting period and company records
indicate that, on average, 1% of credit sales become uncollectible, the adjusting entry at the
end of the accounting period will be as follows:
- If AFD account had a debit balance of $400 before adjustment, the entry would be the same.
- If estimates fail to match actual bad debts, the percentage rate used to estimate bad debts is
adjusted on future estimates.
- Notice that companies with small amount of cash sale may base the estimation on total net
sales for the period rather than total credit sale.
2. Estimate Based On Analysis of Receivables (Receivables or Balance Sheet
Method)
Percentage of Total Accounts Receivable Method.
- One way companies derive an estimate for the value of bad debts under the allowance method
is to calculate bad debts as a percentage of the accounts receivable balance.
- Unless actual write-offs during the just-completed accounting period perfectly matched the
balance assigned to the allowance for bad debts account at the close of the previous
accounting period, the account will have an existing balance. If write-offs were less than
expected, the account will have a credit balance, and if write-offs were greater than expected,
the account will have a debit balance.
- The receivables method determines the desired (target) balance in the AFD account. Thus,
unlike the sales method, to have this desired balance the balance in the AFD account before
adjustment must be considered in making the adjustment. If AFD account has debit balance,
the required adjustment is the desired balance plus the debit balance. If AFD account has
credit balance, the required adjustment is the desired balance minus the credit balance.
Example:
Page 6 of 13
A company has $100,000 in accounts receivable at the end of an accounting period and
company records indicate that, on average, 5% of total accounts receivable become
uncollectible.
Required: Make adjusting entry on Dec.31 assuming that the AFD account has a $200 debit
balance before adjustment.
Notice that the required balance is $5,000(5% of $100,000). Thus AFD account must be
adjusted by $5,200 to have a credit balance of $5,000.
If the AFD account had a $300 credit balance instead of a $200 debit balance, a $4,700
adjusting entry would be needed to give the account a credit balance of $5,000. If it had
zero balance, the adjusting would be made by $5,000
Aging Method.
- The process of analyzing the receivable accounts in terms of the length of time they are past
due is sometimes referred to as Aging the Receivables. The base point to determine age is the
due date.
- A past-due A/R will not necessarily be uncollectible but is always viewed with some
suspicion. The fact that a receivable is past due suggests that the customer is either unable or
unwilling to pay. The question “How long past due?” is pertinent. In general, the longer an
account balance is overdue, the less likely the debt is to be paid.
- Each category's overall balance is multiplied by an estimated percentage of uncollectibility for
that category, and the total of all such calculations serves as the estimate of bad debts (desired
balance).
Example: The accounts receivable aging schedule shown below includes five categories for
classifying the age of unpaid credit purchases.
Page 7 of 13
Required: Make adjusting entry on Dec.31 assuming that the AFD account has an existing
credit balance of $400 before adjustment.
- The desired (target) balance is $5,000. So the adjustment required is only for $4,600.
- The information in the aging schedule may be useful to management for purposes other
than estimating uncollectible accounts. If the age of many customer accounts that are
past due has increased
i. Collection efforts must be strengthened
ii. The company may have to find other sources of cash to pay debts within
discount period and to finance other activities
iii. Change credit policies
Direct Write-Off Method.
- This method does not maintain any provision for uncollectbility. So there is no estimation and
adjustment at the end of each accounting period. We have to wait the time in which a
customer’s account is determined to be uncollectible (worthless). Before determining that an
account balance is uncollectible, a company generally makes several attempts to collect the
debt from the customer.
- Recognizing the bad debt requires a journal entry that increases a bad debts expense account
and decreases accounts receivable from a specific customer.
Example: When a customer named J. Smith fails to pay a $225 balance, the company records
the write-off as follows:
Remember, general journal entries that affect a control account must be posted to both the
control account and the specific account in the subsidiary ledger.
Recovery of Cash under Direct Write-Off Method
- Customers whose accounts have already been written off as uncollectible will sometimes pay
their debts. When this happens, two entries are needed to correct the company's accounting
records and show that the customer paid the outstanding balance as discussed earlier.
Entry 1--- to reinstate the account
Entry 2--- to record the collection
Page 8 of 13
Example: Consider the above example and assume that on August 11, 20X6, J. Smith paid
his account which was written off earlier.
20X6 Accounts Receivable- [Link] ---------- 225
Aug. 11 Bad Debt Expense ------------------- 225
To reverse J. Smith write-off
20X6 Cash ------------------------------------ 225
Aug. 11 Accounts [Link]--- 225
Received payment from J. Smith write-off
- Note that if the write of and the recovery occur in the same accounting period, the
reinstatement is just the reverse of the write off.
- But if both occur in different accounting periods, it may be reinstated similar to the above
condition. An alternative is to credit some appropriately tilted account, such as Recovery of
Uncollectible Accounts Written off or Other Income.
Example: Consider the above example and assume that J. Smith paid his account on January
21, 20X7. The entries to reinstate and to record collection of cash would be as
follows:
20X7 Accounts Receivable- [Link] ---------- 225
Jan. 21 Recovery of accounts
written off(Or Other income
(Or Bad Debt Expense) ------------------- 225
To reverse J. Smith write-off
Recovery of accounts written of is deducted from Bad Debt Expense account in the
income statement
20X7 Cash ------------------------------------ 225
Jan. 21 Accounts [Link]-------- 225
Received payment from J. Smith write-off
- Since several months may pass between the time that a sale occurs and the time that a
company realizes that a customer's account is uncollectible, the matching principle, which
requires that revenues and related expenses be matched in the same accounting period, would
often be violated if the direct write-off method were used. Thus it violates GAAP. It overstates
A/R and revenue (profitability in the year of sale). Unless a company's uncollectible accounts
represent an insignificant percentage of their sales, companies may not use the direct write-off
method for financial reporting purposes.
- It is more appropriate when:
i. Estimation with reasonable accuracy is impossible
ii. Credit sales are insignificant compared to total revenue. This is because bad
debt expense should be small as its receivables are small.
Discounting Notes Receivable
- Since a note is a negotiable instrument (transferable to another party), it must be paid
regardless of who holds it at maturity, as long as the holder obtained it legally.
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- Discounting is the act of selling (transferring) a note receivable to a bank by endorsement.(i.e.,
the holder of the note endorse the back of the note, as endorsing checks, and delivers it to the
bank.
- There are three parties:
The maker― the party that writes the notes
Endorser― the party that accepts the note and sells it to a financial institution
Bank(financial institution)— that buys the note
- Discounting can be made with recourse or without recourse. If it is with recourse, the
company discounting the note agrees to pay the financial institution if the maker dishonors the
note.
- If discounting is made with recourse, the endorser is contingently liable for potential
obligations that will become actual liabilities if the maker of the note defaults. This contingent
liability must be disclosed in the financial statements.
- The cash proceed from discounting a N/R is computed as follows:
- The discount (interest), which is the fee that the financial institution charges, is computed as
follows:
Discount rate― the annual percentage rate that the financial institution charges for buying a
note and collecting the debt.
Discount period― the length of time between a note's sale and its due date.
Example: Suppose on January 15, a company accepts a 90-day, 9%, $5,000 note. If the
company immediately discounts with recourse the note to a bank that offers a
15% discount rate:
a) Compute the cash proceeds
b) Record the discounting of the note
a) Computing the Proceeds
First, compute Maturity Value:
Second, compute the bank's discount:
Third, compute the cash proceeds:
Maturity Value $5,110.96
Discount (189.04)
Discounted Value of Note $4,921.92
b) Record the discounting of the note
Any excess of the face value over the proceeds is recorded as interest expense
Page 10 of 13
Any excess of proceeds over face value is recorded as interest revenue
Example: Suppose the company discounted the note on March 16,20X1.
a) Compute the cash proceeds
b) Record the discounting of the note
a) Cash Proceeds
First, compute maturity value(see above)
Second, compute discount. We have a different result since the discounting period is only 30
days.
Third, compute cash proceeds.
Maturity Value $5,110.96
Discount (63.01)
Discounted Value of Note $5,047.95
b) Record the discounting of the note
Interest revenue = Cash Proceeds − Face value
$5,047.95 − $5,000 = $47.95
Note that this net interest revenue resulted because the company has earned interest revenue
of $73.97($5000 × 0.09 × 60/365) for 60 days.
The company records discounting transaction as follows:
Dishonored Notes
- When the maker of a promissory note fails to pay, the note is said to be dishonored.
- The dishonored note may be recorded in one of two ways, depending upon whether or not the
payee expects to collect the debt
Page 11 of 13
1) If payment is expected, the company transfers the principal and interest to accounts
receivable, removes the face value of the note from notes receivable, and recognizes the
interest revenue.
Example: Assuming Awash Co. dishonors the note but payment is expected, Nile
Company records the event as follows:
2) If Awash Co. dishonors the note and Nile company believes the note is bad debt the note
is recorded as follows:
No interest revenue is recognized because none will ever be received.
If interest on a bad debt had previously been accrued, then a correcting entry is needed to
remove the accrued interest from interest revenue and interest receivable (by debiting
interest revenue and crediting interest receivable). Although interest revenue would have
been overstated in the accounting periods when the interest was accrued and would be
understated in the period when the correcting entry occurs, efforts to amend prior statements
or recognize the error in footnotes on forthcoming statements are not necessary except in
rare situations where the bad debt changes reported revenue so much that the judgment of
those who use financial statements is materially affected by the correcting entry.
When a Discounted Note is Dishonored
- When a discounted N/R(with recourse) is dishonored the holder usually notifies the endorser
of such fact and asks for payment. The bank collects the maturity value from the endorser,
who in turn, can try to collect from the maker.
Example:
Suppose on January 15, 20X1, Nile company accepts a 90-day, 9%, $5,000 note from
Awash Co. and discounted the note on March 16,20X1 at a bank. On April 15, 20X1(due
date), the maker of the note failed to pay to the bank. Record the dishonored note.
April 15 Accounts Receivable- Awash Co.---------------- 5,110.96
20X1 Cash -------------------------------------------- 5,110.96
Page 12 of 13
If the bank has incurred protest fees (a fee for notarized statement of the facts of the
dishonor) it is collected from the endorser. Assuming a protest fee of $50 was charged by
the bank, we will have the following journal entry:
April 15 Accounts Receivable- Awash Co.---------------- 5,160.96
20X1 Cash -------------------------------------------- 5,160.96
If the dishonored note is later collected on May 15, 20X1 plus interest for 30 days at 10% on
the total amount charged to Awash Co. on April 15, we will have the following journal
entry:
May 15 Cash -------------------------------------------- 5,203.38
20X1 Accounts Receivable- Awash Co.---------------- 5,160.96
Interest income (5160.96 × 0.1x30/365) ---------- 42.42
Page 13 of 13