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Chapter 7
Receivables and
Investments
After studying this chapter, students should be able to:
◼ Explain how to account for accounts receivable, including bad debts (Module 1–LO1).
◼ Explain how information about sales and receivables can be combined to evaluate how efficient a
INSTRUCTOR’S MANUAL
7-2
Chapter Outline
MODULE 1 ACCOUNTING FOR ACCOUNTS RECEIVABLE
Module 1
LO 1
Accounting for Accounts Receivable
Accounts receivable are receivables arising from the sale of goods or services with a verbal promise to pay
within a specified period of time.
The Use of a Subsidiary Ledger
◼ To record a sale on credit, debit Accounts Receivable and credit Sales Revenue.
• This increases assets and revenues, thus increasing net income and stockholders’ equity.
The Valuation of Accounts Receivable
◼ Credit department of a business is responsible for performing a credit check on all potential
customers before granting them credit.
CHAPTER 7 RECEIVABLES AND INVESTMENTS
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◼ Bad debts are unpaid customer accounts that are uncollectible.
◼ Allowance is called allowance for doubtful accounts or the allowance for uncollectible accounts.
Two Methods to Account for Bad Debts
There are two methods to account for bad debts – the direct-write off method and the allowance method.
◼ The direct write-off method (Example 7-1):
• The recognition of bad debts expense at the point an account is written off as uncollectible.
◼ The allowance method (Example 7-2):
• Overcomes the deficiencies of the direct write-off method by estimating the amount of bad
debts before they actually occur.
• A method of estimating bad debts on the basis of either the net credit sales of the period or the
accounts receivable at the end of the period.
• Debit Bad Debt Expense, credit Allowance for Doubtful Accounts to record the estimated bad
debts.
INSTRUCTOR’S MANUAL
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◼ Summary of the two methods:
Two Approaches to the Allowance Method of Accounting for Bad Debts
Because the allowance method results in better matching, accounting standards require it rather than the
direct write-off method unless bad debts are immaterial. Two methods are used to estimate bad debts – the
percentage of net credit sales approach and the percentage of accounts receivable approach.
◼ Percentage of Net Credit Sales Approach
• Emphasizes matching bad debts expense with revenue on the income statement.
• Debit Bad Debt Expense, credit Allowance for Doubtful Accounts for the amount obtained
when multiplying net credit sales by the percentage.
Total assets decrease, total expenses increase, thus causing net income and stockholders’
equity to decrease.
Ignore any balance in the allowance account under this method.
◼ Percentage of Accounts Receivable Approach
• Emphasizes the net realizable value of accounts receivable on the balance sheet.
IMPORTANT: This method does not yield the amount to debit to Bad Debt Expense and
credit to the Allowance for Doubtful Accounts. The amount calculated is the ending
balance of the Allowance account. It is necessary to consider any existing balance to
arrive at the debit to Bad Debt Expense.
To summarize:
CHAPTER 7 RECEIVABLES AND INVESTMENTS
Under the percentage of net credit sales approach, the balance in the allowance account is
ignored and the bad debts expense is simply a percentage of the sales of the period.
Under the percentage of accounts receivable approach, however, the balance in the
allowance account must be considered.
◼ Aging of accounts receivable is a refinement of the percentage of accounts receivable approach
to estimate bad debts. (Exhibit 7-1)
Journal entry to record bad debts is the same as discussed under the allowance method.
Module 1
LO 2
The Accounts Receivable Turnover Ratio
◼ Managers, investors, and creditors are interested in how well a company manages its accounts
receivable.
• One simple measure is to compare a company’s sales to its accounts receivable.
(Example 7-6)
• Compare ratios to other companies in the same industry.
• If receivables are turning over too slowly, company’s credit policies may be too lenient and
they may be selling to customers who may not be able to pay.
• If receivables are turning over too quickly, the company’s credit policies may be too tight and
sales are being lost.
INSTRUCTOR’S MANUAL
7-6
2. Gather the Information From the Financial Statements. Net credit sales are on the income
statement and accounts receivable can be found on the balance sheet at the end of the two
most recent years.
• Using the Business Decision Model:
1. Formulate the Question. If you were a banker, would you loan money to Apple Inc.?
2. Gather Information from the Financial Statements and Other Sources. This information will
come from a variety of sources, not limited to, but including:
3. Analyze the Information Gathered.
Compare inventory turnover ratio with competitors, and industry averages.
MODULE 2 ACCOUNTING FOR NOTES RECEIVABLE
Module 2
LO 3
Accounting for Notes Receivable
A note receivable is an asset resulting from accepting a promissory note from another entity.
CHAPTER 7 RECEIVABLES AND INVESTMENTS
7-7
• Has a note payable and interest expense.
• Note payable – a liability resulting from the signing of a promissory note.
◼ Promissory notes are issued:
Important Terms Connected With Promissory Notes
◼ Principal – the amount of cash received or the fair value of the products or services received by the
maker when promissory note is issued.
◼ Maturity date – the date the promissory note is due.
• Principal x rate x time = interest
◼ Accounting for a Note Receivable (Example 7-7):
• To record the receipt of the note for a sale, Debit Notes Receivable and credit Sales Revenue.
• To record the receipt of principal and interest on the maturity date:
Debit Cash, credit Notes Receivable (principal amount), credit Interest Revenue and
credit Interest Receivable (if an adjustment was made at the end of the period). Entry
increases stockholders’ equity and net income.
INSTRUCTOR’S MANUAL
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Module 2
LO 4
Accelerating the Inflow of Cash from Sales
Credit card sales and discounting a note receivable allow a company to accelerate the inflow of cash.
Credit Card Sales (Exhibit 7-2)
◼ Most merchants find that they must honor at least one or more types of credit cards (VISA,
MasterCard) to remain competitive.
• This increases assets and revenues. Stockholders’ equity and net income are therefore
increased.
◼ When reimbursement is transmitted to the company, a collection fee (an expense for the company)
is generally deducted.
• Debit Cash and Collection Fee Expense, and credit Accounts Receivable.
Discounting Notes Receivable
◼ Promissory notes are negotiable, which means that they can be endorsed, sold to the bank, and the
company can then receive cash before the maturity.
• Discounting is the processing of selling a promissory note.
CHAPTER 7 RECEIVABLES AND INVESTMENTS
• Contingency is not recorded as a liability but is stated in a footnote to the financial statements
because it is not an actual liability until maker defaults on the note.
MODULE 3 ACCOUNTING FOR INVESTMENTS
Module 3
LO 5
Accounting for Investments
Companies invest idle cash in a variety of financial instruments.
◼ Cash equivalents are highly liquid financial instruments that have an original maturity to the
investor of three months or less.
• Bond investments have a maturity date.
◼ Classification as current or noncurrent depends on management’s intent.
Investments in Highly Liquid Financial Instruments
◼ Seasonal nature of most businesses leads to a potential cash shortage during certain times of the
year and an excess of cash during other times.
• Interest is calculated for the time invested, usually a fraction of a year.
I = P × R × T
• Adjusting entry for interest may be needed if year-end comes between purchase and maturity.
INSTRUCTOR’S MANUAL
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Investments in Stocks and Bonds
Investments are either in debt securities (bonds) or equity securities (stocks). The company that invests is
the investor and the company whose stocks or bonds are purchased is the investee.
◼ No Significant Influence
• No significant influence exists if investor primarily interested in interest, dividends, capital
appreciation.
◼ Significant influence
• A company buys a relatively large percentage of the common stock of the investee in order to
secure significant influence over the company’s policies.
◼ Control
• Buy stock in another company with the purpose of obtaining control over the other entity.
• Normally requires ownership of more than 50% of investee’s stock.
◼ Accounting for an investment in bonds (Example 7-10):
• When bonds are purchased at face value, debit Investment in Bonds and credit Cash.
This increases and decreases assets. No impact on stockholders’ equity or net income.
CHAPTER 7 RECEIVABLES AND INVESTMENTS
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• If interest is not received at the end of an accounting period, company must accrue interest
earned but not yet received.
◼ Accounting for an investment in stock when there is no significant influence (fair value method)
(Example 7-11):
• Recorded initially at cost, including brokerage fees, commissions or other fees paid to acquire
the shares.
Debit the Investment in Stock and credit Cash.
• This increases and decreases assets by the same amount. Therefore, no impact on
stockholders’ equity or net income.
Valuing and Reporting Investments on the Financial Statements
◼ Whether investment is a current asset or a noncurrent asset depends on the investor’s intent.
• If company intends to sell the investments within the next year, they are current assets.
