CHAPTER 9

1. Explain how companies recognize accounts receivable.

Types of Receivables
The term receivables 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.
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.
Notes receivable are a written promise (as evidenced by a formal instrument) for amounts to
be received. The note normally requires the collection of interest and extends for time periods of
60–90 days or longer.
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.
Recognizing Accounts Receivable
Recognizing accounts receivable is relatively straightforward. A service organization records
a receivable when it performs 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.
 2. Describe how companies value accounts receivable and record their
disposition.
Each customer must satisfy the credit requirements of the seller before the credit sale is
approved. Inevitably, though, some accounts receivable become uncollectible.
Two methods are used in accounting for uncollectible accounts: (1) the direct write-off method
and (2) the allowance method.
DIRECT WRITE-OFF METHOD FOR UNCOLLECTIBLE ACCOUNTS
Under the direct write-off method, when a company determines a particular account to be
uncollectible, it charges the loss to Bad Debt Expense.

Under the direct write-off method, companies often record bad debt expense in a period different
from the period in which they record the revenue. The method does not attempt to match bad
debt expense to sales revenue in the income statement.
 Consequently, unless bad debt losses are insignificant, the direct write-off method is not
acceptable for financial reporting purposes.
ALLOWANCE METHOD FOR UNCOLLECTIBLE ACCOUNTS
The allowance method of accounting for bad debts involves estimating uncollectible accounts at
the end of each period. This provides better matching on the income statement.
It also ensures that companies state receivables on the balance sheet at their cash (net) realizable
value. Cash (net) realizable value is the net amount the company expects to receive in cash. It
excludes amounts that the company estimates it will not collect. Thus, this method reduces
receivables in the balance sheet by the amount of estimated uncollectible receivables.
This method has three essential features:
1. Companies estimate uncollectible accounts receivable. They match this estimated expense
against revenues in the same accounting period in which they record the revenues.
2. Companies debit estimated uncollectibles to Bad Debt Expense and credit them to Allowance
for Doubtful Accounts through an adjusting entry at the end of each period. Allowance for
Doubtful Accounts is a contra account to Accounts Receivable.

3. When companies write off a specific account, they debit actual uncollectibles to Allowance for
Doubtful Accounts and credit that amount to Accounts Receivable.
Companies do not close Allowance for Doubtful Accounts at the end of the fiscal year
RECOVERY OF AN UNCOLLECTIBLE ACCOUNT
The company makes two entries to record the recovery of a bad debt.
(1) It reverses the entry made in writing off the account. This reinstates the customer’s
account.
(2) It journalizes the collection in the usual manner.

ESTIMATING THE ALLOWANCE

In “real life,” companies must estimate that amount when they use the allowance method. Two
bases are used to determine this amount: (1) percentage of sales and (2) percentage of
receivables.
Both bases are generally accepted. The choice is a management decision.
In the percentage-of-sales basis, management estimates what percentage of credit sales will be
uncollectible. This percentage is based on past experience and anticipated credit policy.
The company applies this percentage to either total credit sales or net credit sales of the current
year. To illustrate, assume that Gonzalez Company elects to use the percentage-of-sales basis. It
concludes that 1% of net credit sales will become uncollectible. If net credit sales for 2017 are
$800,000, the estimated bad debt expense is $8,000 (1% x $800,000). The adjusting entry is as
follows.

This basis of estimating uncollectibles emphasizes the matching of expenses with revenues.
 As a result, Bad Debt Expense will show a direct percentage relationship to the sales base on
which it is computed.

Under the percentage-of-receivables basis, management estimates what percentage of

receivables will result in losses from uncollectible accounts. The company prepares an aging
schedule, in which it classifies customer balances by the length of time they have been unpaid.
Total estimated bad debts for Dart Company ($2,228) represent the amount of existing customer
claims the company expects will become uncollectible in the future. This amount represents the
required balance in Allowance for Doubtful Accounts at the balance sheet date. The amount of
the bad debt adjusting entry is the difference between the required balance and the existing
balance in the allowance account. If the trial balance shows Allowance for Doubtful Accounts
with a credit balance of $528, the company will make an adjusting entry for $1,700 ($2,228 x
$528), as shown here.

Disposing of Accounts Receivable

Companies sell receivables for two major reasons. First, they may be the only reasonable
source of cash. When money is tight, companies may not be able to borrow money in the usual
credit markets. Or if money is available, the cost of borrowing may be prohibitive.
A second reason for selling receivables is that billing and collection are often time-consuming
and costly. It is often easier for a retailer to sell the receivables to another party with expertise in
billing and collection matters. Credit card companies such as MasterCard, Visa, and Discover
specialize in billing and collecting accounts receivable.
SALE OF RECEIVABLES
A common sale of receivables is a sale to a factor. A factor is a finance company or bank that
buys receivables from businesses and then collects the payments directly from the customers.
The factor charges a commission to the company that is selling the receivables. This fee ranges
from 1–3% of the amount of receivables purchased.

CREDIT CARD SALES

The retailer generally considers sales from the use of national credit card sales as cash sales. The
retailer must pay to the bank that issues the card a fee for processing the transactions
The retailer pays the credit card issuer a fee of 2–6% of the invoice price for its services.

3. Explain how companies recognize notes receivable.

Companies may also grant credit in exchange for a formal credit instrument known as a
promissory note. A promissory note is a written promise to pay a specified amount of money on
demand or at a definite time.
Promissory notes may be used (1) when individuals and companies lend or borrow money,
(2) when the amount of the transaction and the credit period exceed normal limits, or (3) in
settlement of accounts receivable.
Like accounts receivable, notes receivable can be readily sold to another party. Promissory notes
are negotiable instruments (as are checks), which means that they can be transferred to another
party by endorsement.
Determining the Maturity Date
In counting,
omit the date the
note is issued but
include the due
date.
Computing Interest
The basic formula for computing interest on an interest-bearing note.

Most financial instruments use 365 days to compute interest. For homework problems, assume
360 days to simplify computations.
Recognizing Notes Receivable
To illustrate the basic entry for notes receivable, we will use Calhoun Company’s $1,000, two-
month, 12% promissory note dated May 1. Assuming that Calhoun Company wrote the note to
settle an open account, Wilma Company makes the following entry for the receipt of the note.

The company records the note receivable at its face value, the amount shown on the face of the
note. No interest revenue is reported when the note is accepted because the revenue recognition
principle does not recognize revenue until the performance obligation is satisfied. Interest is
earned (accrued) as time passes.
4. Describe how companies value notes receivable, record their disposition, and
present and analyze receivables.
Valuing Notes Receivable
Valuing short-term notes receivable is the same as valuing accounts receivable.
Like accounts receivable, companies report short-term notes receivable at their cash (net)
realizable value.
The notes receivable allowance account is Allowance for Doubtful Accounts.
Disposing of Notes Receivable
HONOR OF NOTES RECEIVABLE
A note is honored when its maker pays in full at its maturity date. For each interest-bearing
note, the amount due at maturity is the face value of the note plus interest for the length of
time specified on the note.
To illustrate, assume that Wolder Co. lends Higley Co. $10,000 on June 1, accepting a five-
month, 9% interest note. In this situation, interest is $375 ($10,000 x 9% x 5/12). The amount
due, the maturity value, is $10,375 ($10,000 1 $375). To obtain payment, Wolder (the payee)
must present the note either to Higley Co. (the maker) or to the maker’s agent, such as a bank. If
Wolder presents the note to Higley Co. on November 1, the maturity date, Wolder’s entry to
record the collection is as follows.

ACCRUAL OF INTEREST RECEIVABLE

To reflect interest earned but not yet received, Wolder must accrue interest on September 30. In
this case, the adjusting entry by Wolder is for four months of interest, or $300, as shown below.

At the note’s maturity on November 1, Wolder receives $10,375. This amount represents
repayment of the $10,000 note as well as five months of interest, or $375, as shown below. The
$375 is comprised of the $300 Interest Receivable accrued on September 30 plus $75 earned
during October. Wolder’s entry to record the honoring of the Higley note on November 1 is as
follows.

DISHONOR OF NOTES RECEIVABLE

A dishonored (defaulted) note is a note that is not paid in full at maturity. A dishonored note
receivable is no longer negotiable. However, the payee still has a claim against the maker of the
note for both the note and the interest.
 Therefore, the note holder usually transfers the Notes Receivable account to an Accounts
Receivable account.

If instead on November 1 there is no hope of collection, the note holder would write off the
face value of the note by debiting Allowance for Doubtful Accounts.
SALE OF NOTES RECEIVABLE
The accounting for the sale of notes receivable is recorded similarly to the sale of accounts
receivable.
Statement Presentation and Analysis
PRESENTATION
Companies should identify in the balance sheet or in the notes to the financial statements each
of the major types of receivables.
Short-term receivables appear in the current assets section of the balance sheet.
In a multiple-step income statement, companies report bad debt expense and service charge
expense as selling expenses in the operating expenses section. Interest revenue appears under
“Other revenues and gains” in the nonoperating activities section of the income statement.
ANALYSIS
Investors and corporate managers compute financial ratios to evaluate the liquidity of a
company’s accounts receivable. They use the accounts receivable turnover to assess the
liquidity of the receivables.

A variant of the accounts receivable turnover that makes the liquidity even more evident is its
conversion into an average collection period in terms of days.

This means that it takes Cisco 47 days to collect its accounts receivable.
 Companies frequently use the average collection period to assess the effectiveness of a
company’s credit and collection policies.
 The general rule is that the collection period should not greatly exceed the credit
term period (that is, the time allowed for payment).