CHAPTER FIVE

CASH AND RECEIVABLES

5.1 INTRODUCTION
a. Cash
Cash is the one asset that is readily convertible into any other type of asset. It also is easily
concealed and transported, and is highly desired. Because of these characteristics, cash is the
asset most susceptible to fraudulent activities. In addition, because of the large volume of cash
transactions, numerous errors may occur in executing and recording them. To safeguard cash and
to ensure the accuracy of the accounting records for cash, effective internal control over cash is
critical.
i. Meaning of Cash
Cash includes money on deposit in banks and other items that a bank will accept for immediate
deposit. Money on deposit in banks includes checking and saving accounts. Other items such as
ordinary checks received from customers, money orders, coins and currency and petty cash also
are included as cash. Banks do not accept postage stamps, travel advances to employees, notes
receivable or post-dated checks as cash. The following are some of the characteristics of cash:
a) Cash is used as medium of exchange
b) Cash is the most liquid asset
c) Cash is mostly affected by business transactions
d) Cash is used to measure the value of other assets
e) Cash is mostly exposed to embezzlements
ii. Management of Cash
Cash management refers to planning, controlling and accounting for cash transactions and cash
balances. Efficient management of cash is essential to the survival and success of every business
organization. Managing cash requires planning wisely so that there will not be excess cash held
on hand at any point in time; or there is no shortage of cash at any point in time to meet the
business’s needs.
5.2 INTERNAL CONTROL OVER CASH
The need to safeguard cash is crucial in most businesses because cash is mostly exposed to
embezzlement. Firms address this problem through the internal control system. An internal
control system is a set of policies and procedures designed to protect assets, provide accurate
accounting records and evaluate performances. In other words, Internal control consists of all
the related methods and measures adopted within an organization to safeguard its assets, enhance
the reliability of its accounting records, increase efficiency of operations, and ensure compliance
with laws and regulations.
A sound internal control system for cash increases the likely hood that the reported values for
cash are accurate.
Internal control for cash should include the following procedures:
a) The individuals who receive cash should not also disburse (pay) cash
b) The individuals who handle cash should not access accounting records

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 c) Cash receipts are immediately recorded and deposited and are not used directly to make
payments.
d) Disbursements are made by serially numbered checks, only upon proper authorization by
someone other than the person writing the check
e) Bank accounts are reconciled monthly.
The following are the most common elements of cash control and managements: bank account
system, petty cash fund, voucher system, change fund, and cash short and over.
Control of Cash through Bank Accounts
Bank accounts are one of the most important means of controlling cash that provide several
advantages such as:
- Cash is physically protected by the bank,
- A separate record of cash is maintained by the bank,
- And customers may remit payments directly to the bank.
If a company uses a bank account, monthly statements are received from the bank showing
beginning and ending balances and transactions occurring during the month including checks
paid, deposits received, and service charges. These monthly statements (reports) received from
the bank are called bank statements. Bank statements generally are accompanied by checks paid
and charged to the accounts during the month, debit and credited memos, which inform the
company about changes in the cash accounts. For a bank, the depositor’s cash balance is a
liability, the amount the bank owes to the firm. Therefore, a debit memo describes the amount
and nature of decrease is the company’s cash accounts. A credits memo indicates an increase in
the cash balance of the depositor that it has with the bank.
5.3 BANK RECONCILIATION
Monthly reconciling of the bank balance with the depositor’s cash accounts balance is essential
cash control procedure. To reconcile a bank statement means to verify that the bank balance and
the accounting records of the depositor are consistent. The balance shown in a monthly bank
statement seldom equals the balance appearing in the depositor’s accounting records. Certain
transactions recorded by the depositor may not have been recorded by the bank and vice versa.
The most common examples that cause disparity between the two balances are:
a) Outstanding checks:
Checks issued and recorded by the company, but not yet presented to the bank for payment.
b) Deposits in transit:
Cash receipts recorded by the depositor, but not reached the bank to be included in the bank
statement for the current month.
c) Service charges:
Banks often charge a fee for handling checking accounts. The amount of this charge is
deducted by the bank form bank balance and debit memo is issued for the depositor.
d) Charges for depositing NSF- checks:
NSF stands for “Not Sufficient Funds.” When checks are deposited in an account, the bank
generally gives the depositor immediate credit. On occasion, one of these checks may prove
to be uncollectible because the maker of the check does not have sufficient funds in his or
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 her account. In such a case, the bank will reduce the depositor’s account by the amount of
this uncollectible item and return the check to the depositor marked “NSF”.
e) Notes collected by bank:
If the bank collects a note receivable on behalf of the depositor, it credits the depositor’s
account and issues a credit memorandum for the depositor.
When the depositor prepares bank reconciliation, the balances shown in the bank statement and
in the accounting records both are adjusted for any unrecorded transactions. Additional
adjustments may be required to correct any errors discovered in the bank statements or in the
accounting records.
Steps in Preparing Bank Reconciliation
Bank reconciliation is a schedule prepared by the depositor to bring the balance shown in the
bank statement and the balance shown in the depositor’s accounting into agreement.
The steps to prepare bank reconciliation are:
a) The deposits listed on the bank statement are compared with the deposits shown in the
accounting records. Any deposits not yet recorded by the bank are deposits in transit and
should be added to the balance shown in the bank statements.
b) The paid and received checks from the bank are compared with the check stubs. Any
checks issued but not yet paid by the bank are outstanding checks and should be deducted
from the balance reported in the bank statements.
c) Any credit memorandums issued by the bank that have not been recorded by the depositor,
are added to the balance per depositor’s record.
d) Any debit memorandums issued by the bank that have not been recorded by the depositor
are deducted from the balance per depositor’s record.
e) Any errors in the bank statement or depositor’s accounting records are adjusted.
f) The equality of adjusted balance of statement and adjusted balance of the depositor’s
record is compared.
g) Journal entries are prepared to record any items delayed by the depositor.
Illustration of Bank Reconciliation
The January bank statement sent by Awash Bank to JORJO Company shows Br. 4,262.83.
Assume also that on January 31, 2016, the Cash account of JORJO Co. shows a balance of Br.
5,000.17. The accountant of JORJO Company has identified the following items:
1. A deposit of Br. 410.90 made after banking hours on Jan. 31 does not appear on the bank
statement.
2. Two checks issued in January have not yet been paid by the bank:
Check No. 301 Br. 110.25
Check No. 342 607.50
3. A credit memorandum was included in the bank statement, which was for proceeds from
collection of a non-interest bearing note receivable from MAN Company Br. 524.74.
4. Three debit memorandums accompanied the bank statement: Fee charged by bank for
handling collection of notes receivable Br.5; a check of Br. 50.25 received from a

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 customer, JORJO company, and deposited by JORJO company was charged back as
NSF; and service charge by bank for the month of January amounts to Br. 12.00.
5. Check No. 305 was issued by JORJO Company for payment of telephone expense in the
amount of Br. 85 but was erroneously recorded in the cash payments journal as Br. 58.
The January 31 bank reconciliation for JORJO Company is shown below

Jorjo Company
Bank Reconciliation
January 31, 2016

Balance per bank statement, Jan. 31, 2016 Br. 5,000.17

Add: Deposit of Jan. 31 not recorded by bank 410.90
Subtotal Br. 5,411.07
Deduct: outstanding checks:
No. 301 Br. 110.25
No. 342 607.50 117.75
Adjusted cash balance Br. 4,693.32

Balance per depositor’s record, Jan. 31,2016 Br. 4,262.83

Add: Note Receivable collected by bank 524.74
Subtotal Br. 4,787.57

Deduct: collection fee Br. 5.00

NSF check of Ron Co. 50.25

Service charge 12.00

Error on check stub No. 305 27.00 94.25

Adjusted cash balance Br. 4,693.32

Figure 5.1: Bank Reconciliation

The following are journal entries related to the bank reconciliation.

Jan. 31 Cash 524.74
Notes Receivable 524.74
To record collection of Note Receivable collected by bank

Jan 31 Miscellaneous Expense 17.00

Accounts Receivable-RON Co. 50.25
Utilities Exp. 27.00
Cash 94.25
To record bank service charges, NSF check and error in recording Check No. 305

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5.4 PETTY CASH AND CHANGE FUNDS
5.4.1 Petty cash fund
Petty cash fund, which is part of the total cash balance, is used to handle many types of small
payments such as employee transportation costs, purchase of office supplies, purchase of postage
stamps, and delivery charges. Many businesses find it convenient to make minor expenditures
instead of writing checks. The petty cash amount various from Br. 50 or less to more than Br.
1,000, which will cover small expenditures for a period of two or three weeks. Thus, petty cash
fund is the small fund used to make payment for small expenditures. There are three steps
involved in the operation of the petty cash.
1. Establishing the petty cash
2. Making payment from the petty cash.
3. Replenishing (reimbursing) the petty cash.
1) Establishing the petty cash: In establishing the petty cash fund, the first step is to estimate
the amount of cash needed for disbursement of relatively small amounts during certain period,
such as week or a month and appointing the petty cash custodian, the one who is responsible for
the operation of the petty cash fund and for making disbursements from the petty cash fund.
Checks payable to the petty cash fund custodian will be issued.
Petty cash xx
Cash in bank xx
No entree will be made to the petty cash account unless the petty cash fund is changed (increased
or decreased).
2) Making payment from the petty cash: Petty cash receipt: The employee who request for
payment and the petty cash custodian will sign on it. The petty cash custodian will make
payment for the specified employee who request disbursement.
3) Replenishing (reimbursing) the petty cash: When the money in the petty cash fund reaches
a minimum level the fund is replenished (reimbursed). Replenishing the petty cash fund restores
to its original amount. The request for this is initiated by the petty cash custodian. The custodian
will provide the summery of the petty cash payment with the petty cash receipt to the treasurer.
Then the treasurer approves the request and check is prepared to restore the fund to its
established amount. Journal entry will be made to restore the petty cash fund to previously
established amount and to record all expenditures.
Example: If “X” company desires to establish a $100 fund on August 1, the entry will be
August 1/ Petty cash 100
Cash in bank 100
Assume that on August 31, the petty cash custodian request check number 3 for $87. The fund
contains $13 cash and petty cash receipt for postage expense $44, freight in, $38 and
miscellaneous expense, $5. The entry to record the replenishment on August 31 will be:
August 31/ Postage expense 44
Freight in 38
Miscellaneous expense 5
Cash in bank 87
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Voucher System
One method to control cash disbursements is a voucher system. A voucher is a special form,
which contains relevant data about a liability and its payment.
In a voucher system, a voucher is prepared for each expenditure and approved by the designated
officials. Each approved voucher represents liability and recorded in a voucher register, which is
similar to purchases journal. Those registered vouchers are filed according to their payment date
in an unpaid vouchers file. The vouchers and supporting documents then are sent to the treasure
or other official is the finance department before issuing checks. When the checks are signed, the
paid vouchers are recorded in a check register which is similar to cash payments journal. Those
paid vouchers are filed in paid vouchers file according to their serial number for future reference.
5.4.2 Cash Change Funds
Cash change funds are funds of currency or coins separately maintained in order to make
changes when cash is received directly from customers. The fund may be established by drawing
a check for the required amount, debiting the account cash o hand and crediting cash in bank
account.
Example
Check No 45 is issued to establish a cash change fund of $100.
Required: Record the journal entry
Cash on hand (Cash change fund)…………………100
Cash in bank……………………………….100
No additional debit or credit to the fund account is necessary unless the amount of the fund is to
be increased/decreases.
Example
i. Prepare the necessary journal entry assuming the cash change fund in the above example
is increased to $120.
Cash on hand……………………………….20
Cash in bank……………………..20
ii. Assume again that the change fund now is decreased to $85 make the necessary journal
entry
(Changed from $120 to $85)
Cash in bank………………………………..35
Cash on hand……………………35
At the end of each business day the total amount of cash received during the day is deposited and
the original amount of change fund will remain on hand
5.5 CASH SHORT AND OVER
In handling cash receipts from daily sales, a few errors in making changes will occur. These
errors may cause a cash shortage or overage at the end of the day. The account cash short and
over is debited if there is shortage and credited if there is overage. At the end of the period if the
account had a debit balance, it appears in the Income statement as miscellaneous expense; if it
has a credit balance, it is shown as miscellaneous revenue.

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For example, assume that the total cash sales recorded during the day amounts to Br. 12,420.
However, the cash receipts in the cash register drawer (actual cash count) total Br. 12,415.
The following entry would be made to adjust the accounting records for the shortage in the cash
receipts:
Cash Short and Over 5.00
Cash 5.00
To record a Br. 5.00 (Br. 12,420 – 12,415) Shortage in cash receipts for the day
5.6 RECEIVABLES
In this section, we emphasize on how companies account for and report receivables. Most of the
companies sell goods and services on credit in order to earn more profits. Receivables represent
claims for money, goods, services, and non-cash assets from other firms.
The term receivable refers to amounts due from individuals and companies. Receivables are
claims that are expected to be collected in cash. The management of receivables is a very
important activity for any company that sells goods or services on credit. Receivables are
important because they represent one of a company’s most liquid assets. For many companies,
receivables are also one of the largest assets.
5.6.1 Classification of Receivables
The relative significance of a company’s receivables as a percentage of its assets depends on
various factors: its industry, the time of year, whether it extends long-term financing, and its
credit policies. To reflect important differences among receivables, they are frequently classified
as (1) accounts receivable, (2) notes receivable, and (3) other receivables.
Accounts receivable are amounts customers owe on account. They result from the sale of goods
and services. Companies generally expect to collect accounts receivable within 30 to 60 days.
They are usually the most significant type of claim held by a company.
Recognizing accounts receivable is relatively straightforward. A service organization records a
receivable when it provides service on account. A merchandiser records accounts receivable at
the point of sale of merchandise on account. When a merchandiser sells goods, it increases
(debits) Accounts Receivable and increases (credits) Sales Revenue.
The seller may offer terms that encourage early payment by providing a discount. Sales returns
also reduce receivables. The buyer might find some of the goods unacceptable and choose to
return the unwanted goods.
To review, assume that Jordache Co. on July 1, 2016, sells merchandise on account to Polo
Company for $1,000, terms 2/10, n/30. On July 5, Polo returns merchandise worth $100 to
Jordache Co. On July 11, Jordache receives payment from Polo Company for the balance due.
The journal entries to record these transactions on the books of Jordache Co. are as follows
July 1 Accounts Receivable—Polo Company 1,000
Sales Revenue 1,000
(To record sales on account)
July 5 Sales Returns and Allowances 100
Accounts Receivable—Polo Company 100
(To record merchandise returned)
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 July 11 Cash ($900 2 $18) 882
Sales Discounts ($900 3 .02) 18
Accounts Receivable—Polo Company 900
(To record collection of accounts receivable)
Notes receivable represent claims for which formal instruments of credit are issued as evidence
of the debt. The credit instrument normally requires the debtor to pay 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. These do not generally result
from the operations of the business. Therefore, they are generally classified and reported as
separate items in the balance sheet.
On the other hand, receivables can be broadly classified into Trade Receivables and No-trade
Receivables. Trade Receivables describe amounts owed to the company for goods and services
sold in the normal course of business. Non-trade Receivable arise from many other sources, such
as advance to employees, interest receivables, rent receivables and loan to affiliated companies.
Unless we indicate otherwise, we will assume that all receivables in this unit are trade
receivables.
As we have seen earlier, Account Receivable refers to amounts due from customers for credit
sales. These receivables are supported by sales invoices or other documents rather than any
formal written promises. Such Account Receivables are normally expected to be collected within
relatively short period, such as 30 or 60 days. They are classified on the balance sheet as a
current asset. On the other hand, Notes Receivable refers to amounts that customers owe, for
which a formal, written instrument of credit has been issued. Notes are usually used for credit
periods of more than sixty days and for transactions of relatively large value. Notes may also be
used in settlement of an open account and in borrowing or lending money.

5.6.2 Internal control over receivables

The principles of internal control that are discussed in chapter 5 are required by organizations to
safeguard their assets from any kind of error and misconduct. These control procedures should
apply on receivables because they are one of the asset elements for the organization. For
example, the individual responsible for sales should be separate from the individual accounting
for the receivables and approving credit. By doing so, the accounting and credit approval
functions serve as independent checks on sales. Separation of responsibility for related functions
reduces the possibility of errors and misuse of funds.

Adequate control over Accounts Receivable begins with the approval of the sales by a
responsible company official or the credit department, after the customer’s credit rating has been
reviewed. Likewise, adjustments of Account Receivable, such as for sales return and allowance,
and sales discount, should be authorized or reviewed by a responsible party. Effective collection

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procedure should also be established to ensure timely collection of receivables and to minimize
losses from uncollectible accounts.
Characteristics of Notes Receivable
A claim supported by a note has some advantages over a claim in the form of an Account
Receivable. By signing a note, the debtor recognizes the debt and agrees to pay according to the
terms listed. A note is therefore a strong legal claim if there is a court action.
A promissory note is a written promise to pay a sum of money on demand or at a definite time. It
is payable to the order of a person or firm or to the bearer or holder of the note. The person or
firm that makes the promise signs it. The one to whose order the note is payable is called the
payee, and the one making the promise is called the maker.
Notes have several characteristics that affect how they are recorded and reported in the financial
statements. The characteristics are described in the following paragraphs: -
 Due Date
The date a note is to be paid is called the Due Date or Maturity date. The period of time
between the issuance date and the due date of a short-term note may be stated in either days or
months. When the term on a note is expressed in days, the maturity date is the specified number
of days after the note’s date. As an example, a five-day note dated January-1 matures and is due
on January-6. A 90-day notes dated March-10, matures on Jun-8. This due date, June-8, is
computed as below: -
Term of the Note--------------------------------------------90
Days in March---------------------------31
Minus the date of the note-------------10
Days remaining in March------------------------21
Add days in April---------------------------------30
Add days in May----------------------------------31
82
Number of days remaining to equal 90-days
(90 – 82 = 8)------------------------------------------------8
Therefore, Due date is June-8.
The period of a note is sometimes expressed in months. When months are used, the note matures
and is payable in the month of its maturity on the same date of the month as its original date
A three-month note dated March-10, for instance, is payable on June-10.
 Interest Computation
Interest is the cost of borrowing money for the borrower. It is the profit from lending money for
the lender. The interest rate on notes is normally stated in terms of per year, regardless of the
actual period of time involved.
The formula for computing interest is as follows: -

Interest = Principal X Annual X Time

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 (Face Amount interest Rate
Of the Note)
To illustrate the formula, the interest on a Br. 10,000, 12%, 60 day note is computed as:-
Br. 10,000 X 12% X 60/360 = 200
N.B. To simplify interest computations for notes with periods expressed in days, it is common to
treat a year as having 360 days.
 Maturity Value
The amount that is due at the maturity or due date is called the maturity value. The maturity
value of a note is the sum of the face amount and the interest. In the above example, the maturity
value is Br. 10,200 (which is Br. 10,000 face amount plus Br. 200 interest)

I.e. MV = FV + I where MV= Maturity value

FV = Face value
I = Interest

5.6.3 Accounting for Notes Receivable

Notes Receivable are usually recorded in a single note Receivable account to simplify record
keeping. We need only one account because the original notes are kept on file. This means the
maker; rate of interest, due date, and other information can be learned by examining the actual
note.
To illustrate the recording of the receipt of a note, assume that on January-10, Nile Co. sales
merchandise on account to Tana Co. and receive a Br. 5,000, 90-day, 12% promissory note.
This transaction is recorded as: -
Jan. 10. Notes Receivable ------------------------5000
Sales--------------------------------------5000
The maker of the note usually honors the note and pays it in full. The entry required to record the
receipt of cash by Nile Co. from Tana Co. is as follows:
April-10 Cash 5150
Notes Receivable 5000
Interest Revenue (500 X 12/100 X 90/360 150

Companies can sometimes accept a note for an overdue customer as a way of granting a time
extension on a past-due account Receivable. To illustrate, assume that a 60-day, 10% note dated
September 5, 2016 is accepted by Awash Co. in settlement of the account of Happy co, which is
past due and has a balance of 10,000. The entry to record the transaction is as follows:
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September 5 N/R 10, 000
A/R 10,000
Received a note to settle account
Recording a dishonored note
When a note’s maker is unable or refuses to pay at maturity, the note is dishonored. The act of
dishonoring a note doesn’t relieve the maker of the obligation to pay. The payee should use
every legitimate means to collect. But how do companies report this event? The balance of the
Notes Receivable account normally includes only those notes that have not matured. When a
note is dishonored, we therefore remove the amount of this note from the Notes Receivable
account and charge it back to an Accounts Receivable from its maker. Assume for instance Nile
Co., holds a Br. 1000, 12%, 30-day note of Ato Zemen. At maturity, Zemen dishonored the note.
Nile Co. records this dishonoring of its N/R, on Oct. 25, as follows:
Oct.25, A/R Ato Zemen 1010
N/R ______ 1000
Int. Rev. 10
To record dishonored note & interest of 1000 X 12% X 30/360 =10
The above entry records interest of Br. 10, which has been earned, even though the note has been
dishonored.
End-Of-Period Interest Adjustment
When notes receivable are outstanding at the end of an accounting period, accrued interest is
computed and recorded. For example, on December 20, 2016, Nile Co. accepted a Br. 2000, 60-
day, 12% note from a customer in granting an extension of a past-due account. Assuming that the
accounting period ends on Dec. 31, the entries to record the receipt of the note, accrued interest,
and payment of the note at maturity are shown below: -
Dec. 19. N/R 2000
A/R- Customer-X 2000
(Received note in settlement of A\R)
Dec. 31. Interest Receivable 8
Int. Revenue 8
(Adjusting entry for ace need Interest, Br. 2000 X 12% X 12/360 = 8)
Feb. 17. Cash 2040
N/R 2000
Int. Rec 8
Int. Revenue 32
( Received payment of note & interest at maturity)
The adjusting entry above on Dec. 31, 2016, was required to show the interest earned for the
period on the Income Statement.
Converting Receivables to cash before Maturity
Sometimes, companies convert receivables to cash before they are due. Reasons for this include
the need for cash or a desire not to be involved in collection activities. Converting receivable is
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usually done either (1) by selling them, or (2) by using them as security for a loan. The topic of
using notes as security for a loan will be discussed in future courses. Notes Receivable can be
converted to cash by discounting them at a financial institution such as a Bank. The process has
three steps as indicated in the following diagram. In the first step, the maker receives goods,
service or cash from the payee in exchange for the note. In the second step, the payee discounts
the note with a bank and receives the maturity value of the note less a discount (a fee) charged by
the bank. In the third step, the maker pays the bank at the maturity of the note.

Maker Goods (1) Payee

Note (2)
Cash (3) cash less discount
Bank
Note (2)
Figure: 5.2: Converting Receivable in to Cash
Notes Receivable are discounted with or without recourse. When a note is discounted without
recourse, the bank assumes the risk of a bad debt loss and the original payee doesn’t have a
contingent liability. A contingent liability is an obligation to make a future payment if and only if
an uncertain future event occurs. A note discounted without recourse is like an outright sale of an
asset. If a note is discounted with recourse and the original maker of the note fails to pay the
bank when it matures, the payee of the note must pay for it. This means a company discounting a
note (an endorser) with recourse has a contingent liability until the bank is paid. A Co. should
disclose contingent liabilities in the accompanying notes to its financial statements.
To illustrate, assume that a 90-day, 12%, Br. 20,000 N/R from Hiwot Co. dated Jan.1, 2016 is
discounted at the payee’s bank on February 12, 2016 at the discount rate of 15%. The steps to
determine the proceeds (-the amount to be received by the payee from the bank upon
discounting) are as follows:
Step 1 – Determine the maturity date & maturity value.
MD = April –1 & MV = FV + I = 20,000 + [20,000 X 12% X 90/360]
= 20,600
Step 2 – Determine the Bank Discount (Bank discount is an interest that is charged by the bank
and is computed based on the maturity value of the note for the discount period. Discount
Period is the time the bank must hold the note) before it becomes due.

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  Bank Discount = MV X DR X DP where MV = Maturity value (20,600)
DR = Discount Rate (15%)
discount = 20,600 x 15% x 48/360 dp = discount period ( from february 12 to april 1)
= 412
Step 3- Determine proceed (proceed is the amount of cash paid to the endorser after
deducting discount)
i.e. proceed = MV – D
= 20,600 – 412 = 20188
Step 4 – Record the necessary journal entry at the date of discount. (Here, record interest
revenue which is the excess of proceeds from the face value or record interest expense
when the proceed is less than the face value of the note)
Feb 12. Cash 20,188
N/R 20,000
Interest Receivable 188.00
Discounted Br. 20,000, 90-day, 12% note at 15%
The length of the discount period and the difference between the interest rate and the discount
rate determine whether interest expense or interest revenue will result from discounting.
When a discounted Notes Receivable is dishonored, the bank notifies the endorser and asks for
payment if there is no statement that limits the responsibility of the endorser. In some cases, the
bank may charge a protest fee of notifying the endorser that a note has been dishonored. The
entire amount paid to the bank by the endorser, including the interest and protest fee, should be
debited to the A/R of the maker. For example, assume that the maker, Hiwot Co, dishonored the
above discounted note at maturity. The bank charges a protest fee of Br. 25. The endorser’s entry
to record the payment to the bank is as follows:
April 2. A/R Hiwot Co 20,625
Cash 20, 625
Paid dishonored, discounted note

Accounting for Uncollectible Accounts Receivable

When credit is extended, some amount of uncollectible receivables is generally inevitable
regardless of the care taken in granting credit and the control procedures used. The operating
expense incurred because of the failure to collect receivables is called Uncollectible Accounts
Expense or Bad Debts Expense or Doubtful Accounts Expense.
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When does an account as a note become uncollectibles? There is no general rule for determining
when an account receivable becomes uncollectible. The fact that a debtor fails to pay an account
receivable according to a sales contract or fails to pay a note on the due date does not necessarily
mean that the account receivable will be uncollectible. The debtor’s bankruptcy is one of the
most significant indications of partial or complete uncollectibility. Other indications include the
closing of the customer’s business and the failure of repeated attempts to collect.

5.6.4 Accounting for Uncollectible Accounts Receivable

When credit is extended, some amount of uncollectible receivables is generally inevitable
regardless of the care taken in granting credit and the control procedures used. The operating
expense incurred because of the failure to collect receivables is called Uncollectible Accounts
Expense or Bad Debts Expense or Doubtful Accounts Expense.
When does an account as a note become uncollectibles? There is no general rule for determining
when an account receivable becomes uncollectible. The fact that a debtor fails to pay an account
receivable according to a sales contract or fails to pay a note on the due date does not necessarily
mean that the account receivable will be uncollectible. The debtor’s bankruptcy is one of the
most significant indications of partial or complete uncollectibility. Other indications include the
closing of the customer’s business and the failure of repeated attempts to collect.
There are two methods of accounting for uncollectible receivables. The allowance method,
which provides an expense for uncollectible receivables in advance of their write-off (removal
from the ledger) and the direct write-off method, which recognizes the expense only when
accounts receivable is judged to be worthless. We will discuss each of these methods next.

[Link] Allowance Method

The allowance method of accounting for bad debts matches the expected loss from uncollectibles
A/R against the sales they helped produce. We must use expected losses since management
cannot exactly identify the customers who won’t pay their bills at the time of sale. This means at
the end of each period the allowance method requires us to estimate the total bad debts expected
to result from that period’s sales. An allowance is then recorded for this expected loss. This
method has two advantages over the direct write-off method:
(1) Bad debt expense is charged to the period in which the related sales are recognized, and
(2) A/R is reported on the Balance Sheet at the estimated amount of cash to be collected.
The allowance method estimates bad debt expense at the end of each accounting period and
records it through an adjusting entry. To illustrate this method, assume the A/R account has a
balance of Br. 50,000 and based on careful study of the experience of other companies, Nile Co.
estimates that a total of Br. 2000 will be uncollectibles.
This estimated expense is recorded through the following adjusting entry.
Dec. 31 Uncollectibles Accounts Expense 2000
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 Allowance for Doubtful Accounts 2000
To record estimated bad debts
The amount Br. 2000 is an estimated reduction in A/R; but it cannot be credited to specific
customer accounts or to the A/R controlling account. Instead, a contra asset account entitled
Allowance for Doubtful Accounts is credited.
As with all periodic adjustments the above entry serves two purposes. First, it reduces the value
of the receivable to the amount of cash expected to be realized in the future. This amount, which
is Br. 48,000 (Br. 50,000 – Br. 2,000), is called the Net Realizable value of the receivables.
Second, the adjusting entry matches the Br. 2000 expense of uncollectibles account with the
related revenues of the period.
Write-off to the Allowance Account
When specific accounts are identified as uncollectibles, they are written-off against the
Allowance for Doubtful Accounts. Assume after spending some time trying to collect from
Shalla Co., Nile Co. decides that Shalla’s Br. 200 accounts receivable is uncollectible and makes
the following entry to writ-it off.
Jan. 25 Allowance for Doubtful Accounts 200
A/R-Shalla Co. 200
To write-off uncollectible accounts.
Note two aspects of this entry and its related accounts
Before Write-off After Write-off
A/R 50,000 49,800
Less Allowance for D. a/cs 2,000 1,800
Net Realizable Value 48,000 48,000

Neither total assets nor net income are affected by the Write-off of a specific account. But both
total assets and net income are affected by the recognized bad debts expense for the year in the
adjusting entry.

Recovery of Uncollectibles Accounts

When a customer fails to pay and the account is written-off as uncollectibles, his or her credit
standing is jeopardized. To help restore credit standing, a customer may later choose to
voluntarily pay all or part of the amount owed. A company makes two entries when collecting an
account previously written-off. The first is to reverse the original write-off and reinstate the
customer’s account.

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For example, assume the amount written-off in the preceding entry is later collected on February
15.
On Feb. 15- The entries to record this recovery are:
Feb. 15- A/R Shalla Co. 200
Allowance for Doubtful Accounts 200
To reinstate accounts previously written-off
Feb. 15- Cash 200
A/R-Shalla Co. 200
To record full payment of account
Estimating Uncollectibles
The allowance method of accounting for bad debts requires an estimate of bad debts expense to
prepare the adjusting entry at the end of each accounting period. How does a company estimate
bad debts expense? There are two common methods. One is based on the Income Statement
relationship between bad debts expense and sales. The second is based on the Balance Sheet
relationship between A/R and the Allowance for Doubtful Accounts. Both methods require an
analysis of past experience.
a. Estimating Based on Sales
Accounts receivable are created by credit sales. The amount of credits sales during the period
may therefore be used to estimate the amount of uncollectible accounts expense. The amount of
this estimate is added to whatever balance exists in Allowance for Doubtful Accounts. To
illustrate, assume Wonji Co. has credit sales of Br. 500,000 in 2016. Based on past experience
and the experience of other Cos, Wonji Co. estimated 0.007% of credit sales are uncollectible.
Using this prediction, the adjusting entry for uncollectible accounts at the end of the period, 2016
is as follows.
Dec. 31 Uncollectibles Accounts Exp. (500,000 X 0.007%) 3500
Allowance for Doubtful Accounts 3500
To record estimated Uncoll. Exp.
This entry doesn’t mean that the Dec. 31, 2016, balance of Allowance for Doubtful Accounts
will be Br. 3500. A Br. 3500 balance results only if the account had a zero balance prior to
posting the adjusting entry. For example, assume that Allowance for Doubtful Accounts has a
credit balance of Br. 1000 before adjustment. Now, what will be the balance of Allowance for
Doubtful Accounts be at the end of 2016? It will be Br. 4500. If there had been a debit balance of
Br. 500 in the Allowance for Doubtful Accounts before the year-end adjustment, and the amount
of adjustment. would still have been Br. 3500. What will have been the end balance of
Allowance for Doubtful Accounts at the end of 2016?

b. Estimate Based on Analysis of Receivables

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The longer an A/R remains outstanding, the less likely that it will be collected. Thus, we can
base the estimate of uncollectibles accounts on how long the accounts have been outstanding.
For this purpose, we can use a process called Ageing receivables which examines each A/R to
estimate the amount of uncollectibles. Receivables are classified by how long they are past their
due date. Then, estimates of uncollectibles are made assuming the longer an amount is past due
the more likely it is to be uncollectible. After the outstanding amounts are classified and
analyzed in the Aging schedule the expected balance for the Allowance for Doubtful Accounts
will be estimated. Let’s assume the amount estimated is Br. 5000. So, do you think this is the
adjustment amount required for the current period? NO!
Because, this estimated amount is the expected balance of the Allowance for Doubtful Accounts
after adjustment rather than the current year provision for Uncollectible Accounts Expense.
Therefore, to determine the current year provision we must take in to account the balance before
adjustment in the Allowance for Doubtful Accounts. To illustrate, assume there is as credit
Balance of Br. 1300 in the allowance account before adjustment. The amount to be added to this
balance is therefore Br. 3800 (B.r 5000 – Br. 1200) and the adjustment entry is as follows:
Dec. 31 Uncollectible Accounts Expense 3800
Allowance for Doubtful Accounts 3800
To record Uncollectible expense.
Alternatively, if the Allowance for Doubtful Accounts had an unadjusted debit balance of Br.
700, then the required adjustment is Br. 5700. (Br. 5000 + 700) and the adjustment entry is as
follows:
Dec. 31. Uncollectible Accounts Expense 5700
Allowance for Doubtful Accounts 5700
To record Uncollectible expense.

[Link] The Direct- Write-Off Method

The Direct Write-off method of accounting for bad debts records the loss from an uncollectible
A/R at the time it is determined to be uncollectible. No attempt is made to predict uncollectible
accounts expense. Bad debt expense is recorded when specific accounts are determined to be
worthless. If Wonji Co. uses a direct write-off method and determines on Feb. 20, it can’t collect
from a customer- Home Co.- Br. 500. The entry to write-off the customer’s account is as follows
Feb. 20 Uncollectible Accounts Expense 500
A/R- Home Co. 500
To write-off Uncollectible accounts

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Sometimes an amount previously written off is later collected. This can be due to factors such as
continual collection efforts or the good fortune of a customer. If the account of Home Co. that
was written-off directly to Bad Debit Expense is later collected in full, the following two entries
record this recovery.
Mar. 5 - A/R- Home Co. 500
Uncollectible Accounts Expense 500
To reinstate account
Mar. 5 - Cash 500
A/R- Home Co. 500
To record full payment of account
If the recovery is in the year following the writ- off, there is no balance in the Uncollectible
Accounts Expense account related to the previous year’s write-off and no other write-offs are
expected. So the credit portion of the entry recording the recovery can be made to a Bad Debts
Recoveries revenue account.
To conclude this parts companies must weight at least two principle when considering use of the
direct-write of method :(1)matching principles and (2) materiality principle.

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