Chapter 07 – Reporting and Analyzing Receivables
7-7
Chapter Outline
Notes
2. Interest Computation:
Principal of note times the annual interest rate times the time
expressed in years. Note that a year has 360 days for interest
computations (the banker’s rule).
B. Recognizing Notes Receivable: debit Notes Receivable for
principal or face amount of note; credit will vary (depends on
reason note is received). Note that interest is not recorded until
earned.
C. Valuing and Settling Notes
The principal and interest of a note are due on its maturity date.
1. Recording an Honored Note. The maker of the notes usually
honors the note and pays it in full; entry (by the payee) to
record: debit Cash, credit Notes Receivable, credit Interest
Revenue. When a note is dishonored, we remove it from Notes
Receivable and charge it back to an Account Receivable.
2. Recording a Dishonored Note. When the maker does not pay
at maturity, the note is dishonored; entry (by payee) to record:
debit Accounts Receivable (for the principal and interest due),
credit Note Receivable (for principal), credit Interest Revenue.
3. Recording End-of-Period Interest Adjustment. When notes
receivable are outstanding at the end of a period, any accrued
interest earned is computed and recorded. Entry (by payee) to
record: debit Interest Receivable, credit Interest Revenue.
4. Entry to record honoring of a note if interest has been accrued:
debit Cash (for full amount received), credit Interest
Receivable (amount previously accrued), credit Interest
Revenue (amount earned since accrual date), credit Notes
Receivable (face amount of note).
III. Disposing of Receivables
Companies can convert receivables to cash before they are due.
Reasons for this include the need for cash or a desire to not be
involved in collection activities.
A. Selling Receivables
A company can sell all or a portion of its receivables to a finance
company or a bank.
1. Buyer, called a factor, charges the seller a factoring fee and
then takes ownership of the receivables and receives cash
when come due.
2. Entry (by seller of receivables): debit Cash, debit Factoring
Fee Expense, credit Account Receivable.
Chapter 07 – Reporting and Analyzing Receivables
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Chapter Outline
Notes
B. Pledging Receivables
A company can pledge its receivables and/or inventory as security
for a loan.
1. Borrower retains ownership of the receivables.
2. If borrower defaults on the loan, the lender has the right to be
paid from the cash receipts of collections on accounts
receivable.
3. The borrower’s financial statements must disclose the
pledging of the receivables.
IV. Global View
A. Recognition of Receivables – Both GAAP and IFRS have similar
asset criteria that apply to recognition of receivables. Both refer to
the realization principle and an earnings process. Under GAAP,
realization implies an arm’s-length transaction. Under IFRS
realization is applied in terms of reliable measurement and
likelihood of economic benefits. IFRS refers to risk transfer and
ownership reward.
B. Valuation of Receivables – Both GAAP and IFRS require that
receivables be reported net of estimated uncollectibles and both
systems require that the expense for estimated uncollectibles be
recorded in the same period when any revenues from those
receivables are recorded. Both systems require the allowance
method.
C. Disposition of Receivables – both GAAP and IFRS apply similar
rules in recording dispositions of receivables. Under GAAP,
companies disclose Bad Debts Expense as Provision for Bad Debts,
where provision refers to expense. Under IFRS, provision refers to a
liability whose amount or timing is uncertain.
V. Decision Analysis—Accounts Receivable Turnover
A. The accounts receivable turnover ratio measures both the
quality (refers to the likelihood of collection without loss) and
liquidity of accounts receivable; it indicates how often the average
accounts receivable balance was converted to cash during the year.
B. It is calculated by dividing net sales by average accounts
receivable.
C. A high turnover in comparison with competitors suggests that
management should consider using more liberal credit terms to
increase sales. A low turnover suggests management should
consider stricter credit terms and more aggressive collection
efforts.
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VISUAL #7-1
METHODS OF ACCOUNTING FOR BAD DEBTS
DIRECT WRITE-OFF METHOD
Bad debts expense is recorded at the time an
account is determined to be uncollectible.
ALLOWANCE METHOD
Bad debts expense is estimated and recorded
at the end of each accounting period.
Year–end
No adjusting entry
Adjusting entry required:
Bad Debt Expense XXX
Allowance for Uncollectible Accounts XXX
(The amount is an estimate based on a percentage of sales or a
percentage of outstanding accounts receivable. If the estimate is based
on sales, the full estimate is used in the adjusting entry. If the estimate
is based on accounts receivable the allowance account balance is
brought to the amount of the estimate.)
When an
account is
determined to
be uncollectible
Write-off entry required:
Bad Debts Expense XXX
Accounts Receivable/Customer XXX
(The amount is the balance of the uncollectible account.)
Write-off entry required:
Allowance for Uncollectible Accounts XXX
Accounts Receivable/Customer XXX
(The amount is the balance of the uncollectible account.)
When an
account
previously
written off is
recovered
1. Reinstate account by reversing write-off:
Accounts Receivable/Customer XXX
Bad Debts Expense XXX
(Amount is the account balance that was written off.)
2. Record collection on account normally:
Cash XXX
Accounts Receivable/Customer XXX
(Amount is the amount collected.)
1. Reinstate account by reversing write-off:
Accounts Receivable/Customer XXX
Allowance for Uncollectible Accounts XXX
(Amount is the account balance that was written off.)
2. Record collection on account normally:
Cash XXX
Accounts Receivable/Customer XXX
(Amount is the amount collected.)
Advantages:
• Does not require adjusting entry.
• Does not require year-end estimating of
uncollectibles.
• Matches expense against related revenues.
• Reports the net realizable accounts receivable on the
balance sheet (a more accurate reporting of assets).
Disadvantages:
• Violates matching, therefore only allowed
if qualified under materiality principle.
(May be used by a business that
anticipates an immaterial amount of
uncollectibles.)
• Requires adjusting entry.
• Requires year-end estimating of uncollectibles.
Chapter 07 – Reporting and Analyzing Receivables
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VISUAL #7-2
PROMISSORY NOTE
(6) $2,000.00 April 15, 2013 (1)
Amount Date
For value received, I promise to pay to the order of
Plexi-Plus Supply Co. (2)
Tobay, New York
(7)
Two thousand and no/100 ——————-Dollars
on June 14, 2013 (3)
plus interest at the annual rate of 9 percent. (4)
Scott Cooke (5)
for Tobay Surfer Inc.
Chapter 07 – Reporting and Analyzing Receivables
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Chapter 7 – Alternate Demonstration Problem #1
At the end of the year, the M. I. Wright Company showed the following
selected account balances:
Sales (all on credit) ………………………………………………………………….$300,000
Accounts Receivable ………………………………………………………………. 800,000
Allowance for Doubtful Accounts …………………………………………….. 38,000
Required:
1. Assume the company estimates that 1% of all credit sales will not be
collected.
a. Prepare the proper journal entry to recognize the expense
involved.
b. Present the balances in Accounts Receivable and Allowance for
Doubtful Accounts as they would appear on the balance sheet.
Also show the net realizable Accounts Receivable.
2. Assume the company estimates that 5% of its accounts receivable
will never be collected.
a. Prepare the proper journal entry to recognize the expense
involved.
b. Present the balances in Accounts Receivable and Allowance for
Doubtful Accounts as they would appear on the balance sheet.
Also show the net realizable Accounts Receivable.
3. Under each of the two assumptions (described in #1 and #2 above),
prepare the proper journal entry for the following event.
June 3 John Shifty, who owes us $500, informs us that he is
broke and cannot pay. We believe him.
Chapter 07 – Reporting and Analyzing Receivables
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Solution: Chapter 7 – Alternate Demonstration Problem #1
1A. Bad Debts Expense …………………………………… 3,000
Allowance for Doubtful Accounts ………….. 3,000
($ 300,000 X 1 %)
1B. Accounts Receivable …………………………………$800,000
Less: Allowance for Doubtful Accounts …….. 41,000
Estimated Realizable A/R …………………………..$759,000
2A. Bad Debts Expense …………………………………… 2,000
Allowance for Doubtful Accounts ………….. 2,000
($ 800,000 X 5 % less $38,000)
2B. Accounts Receivable …………………………………$800,000
Less: Allowance for Doubtful Accounts …….. 40,000
Estimated Realizable A/R ………………………….$760,000
3. Both assumptions 1 and 2 above represent the allowance method of
accounting for uncollectibles. The only difference is in the approach
to estimating uncollectibles. Therefore the entry to write–off the
customer account would be the same under either assumption.
June 3 Allowance for Doubtful Accounts …………. 500
Accounts Receivable, John Shifty……. 500