Fundamentals of Accounting II

Chapter One
Accounting for Receivables
The term receivables refer 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.
The receivables that result from sales on account are normally accounts receivableor notes
receivable. The term receivables includes all money claims against other entities, including
people, companies, and other organizations. Receivables are usually a significant portion of the
total current assets.

Accounts Receivable
The most common transaction creating a receivable is selling merchandise or serviceson account
(on credit). The receivable is recorded as a debit to Accounts Receivable. Such accounts
receivable are normally collected within a short period, such as 30 or 60 days. They are classified
on the balance sheet as a current asset.

Notes Receivable
Notes receivable are amounts that customers owe for which a formal, written instrument of credit
has been issued. If notes receivable are expected to be collected within a year, they are classified
on the balance sheet as a current asset. Notes are often used for credit periods of more than 60
days. For example, an automobile dealer may require a down payment at the time of sale and
accept a note or a series of notes for the remainder. Such notes usually provide for monthly
payments.Notes may also be used to settle a customer’s account receivable. Notes and accounts
receivable that result from sales transactions are sometimes called trade receivables.

Other Receivables
Other receivables include interest receivable, taxes receivable, and receivables from officersor
employees. Other receivables are normally reported separately on the balance sheet. If they are
expected to be collected within one year, they are classified as current assets. If collection is
expected beyond one year, they are classified as noncurrent assetsand reported under the caption
Investments.

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Uncollectible Receivables
Regardless of how careful a company is in granting credit, some credit sales willbe uncollectible.
The operating expense recorded from uncollectible receivables is called bad debt
expense,uncollectible accounts expense, or doubtful accounts expense.
There is no general rule for when an account becomes uncollectible. Some indications that an
account may be uncollectible include the following:
1. The receivable is past due.
2. The customer does not respond to the company’s attempts to collect.
3. The customer files for bankruptcy.
4. The customer closes its business.
5. The company cannot locate the customer.
The two methods of accounting for uncollectible receivables are as follows:
1. The direct write-off method records bad debt expense only when an account is determined
to be worthless.
2. The allowance method records bad debt expense by estimating uncollectible accounts at
the end of the accounting period.
The direct write-off method is often used by small companies and companies withfew
receivables.Generally accepted accounting principles (GAAP), however, requirecompanies with
a large amount of receivables to use the allowance method.

Direct Write-Off Method for Uncollectible Accounts

Under the direct write-off method, Bad Debt Expense is not recorded until the customer’saccount
is determined to be worthless. At that time, the customer’s account receivableis written off.
Example, assume that a $4,200.00 account receivable from D. L. Ross has been determined to
be uncollectible. The entry to write off the account is as follows: May 10, 2019
Bad Debt Expense…………………4,200.00
Account Receivable……………….4,200.00
An account receivable that has been written off may be collected later. In such cases, the account
is reinstated by an entry that reverses the write-off entry. The cash received in payment is then
recorded as a receipt on account.
Example, assume that the D. L. Ross account of $4,200.00 written off on May 10 is later
collected on November 21. The reinstatement and receipt of cash is recorded as follows:
Account Receivable …………………… 4,200.00
Bad Debt Expense ………………….…. 4,200.00

Cash………………………………....……4,200.00
Account Receivable……………………. 4,200.00

Example
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Journalize the following transactions using the direct write-off method of accounting for
uncollectible receivables:
July9. Received $1,200 from Jay Bike and wrote off the remainder owed of $3,900 as
uncollectible.
Oct. 11. Reinstated the account of Jay Bike and received $3,900 cash in full payment.
July9Cash . . .. . . . . . . . . . . . . . . . . . . . … . . . . . . . 1,200.00
Bad Debt Expense . . . . . . . . . . . …. . . . . . . . 3,900.00
Accounts Receivable . . . . . . . . . . . . . . . . . . . . . …. 5,100.00

Oct. 11Accounts Receivable . . . . . . . . . . …….. . . . 3,900.00

Bad Debt Expense . . . . . . . . . . . . . . . . . . . . . . . . . . 3,900.00

11Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,900.00
Accounts Receivable.................…. . . . . . . . . . . . . 3,900.00

Allowance Method for Uncollectible Accounts

The allowance method estimates the uncollectible accounts receivable at the end of
theaccounting period. Based on this estimate, Bad Debt Expense is recorded by an
adjustingentry.
To illustrate, assume that ExTone Company began operations August 1. As of the end of its
accounting period on December 31, 2019, ExTone has an accounts receivable balance of
$200,000. This balance includes some past due accounts. Based on industry averages, ExTone
estimates that $30,000.00 of the December 31 accounts receivable will be uncollectible.
However, on December 31, ExTone doesnot know which customer accounts will be
uncollectible. Thus, specific customer accounts cannot be decreased or credited. Instead, a contra
asset account, Allowance for Doubtful Accounts, is credited for the estimated bad debts. Using
the $30,000 estimate, the following adjusting entry is made on December 31:
Bad Debt Expense………………………….. 30,000.0
Allowance for Doubtful Account……………….. 30,000.00
The preceding adjusting entry affects the income statementand balance sheet. On the income
statement, the $30,000.00 of Bad Debt Expense will be matched against the related revenues of
the period. On the balance sheet, the value of the receivables is reduced to the amount that is
expected to be collected or realized.This amount, $170,000.00 ($200,000.00- $30,000.00), is
called the net realizable value of the receivables. After the preceding adjusting entry is recorded,
Account eceivable still has a debit balance of $200,000.00. This balance is the total amount owed
by customers on account on December 31 as supported by the accounts receivable subsidiary
ledger. The accounts receivable contra account, Allowance for Doubtful Accounts, has a credit
balance of $30,000.

Write-Offs to the Allowance Account

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When a customer’s account is identified as uncollectible, it is written off against the
allowanceaccount. This requires the company to remove the specific accounts receivable and an
equal amount from the allowance account.
Example, on January 21, 2020, JohnParkers account of $6,000.00 with ExToneCompany is
written off as follows:
Allowance for Doubtful Account ………………….. 6,000.00
Account Receivable …………………………….. 6,000.00
An account receivable that has been written off against the allowance account maybe collected
later. Like the direct write-off method, the account is reinstated by an entry that reverses the
write-off entry. The cash received in payment is then recorded as a receipt on account.
Example, assume that Nancy Smith’s account of $5,000.00 which was written off on April 2 is
collected later on June 10. ExTone Company records the reinstatement and the collection as
follows:
Account Receivable………………………………5,000.00
Allowance for Doubtful Account ………………….. 5,000.0

Cash……………………………………………...5,000.00
Account Receivable…………………………………5,000.00
Journalize the following transactions using the allowance method of accounting for
uncollectiblereceivables.
July 9. Received $1,200.00 from Jay Burke and wrote off the remainder owed of $3,900.00 as
uncollectible.
Oct. 11. Reinstated the account of Jay Burke and received $3,900 cash in full payment.

July 9Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,200.00

Allowance for Doubtful Accounts . . . . . . . . . . . . . . . . . . . . 3,900.00
Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,100.00

Oct. 11Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,900.00

Allowance for Doubtful Accounts . . . . . . . . . . . . . . . . . . . . 3,900.00

11Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,900.00
Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,900.00

Estimating Uncollectible
The allowance method requires an estimate of uncollectible accounts at the end ofthe period.
This estimate is normally based on past experience, industry averages, and forecasts of the
future.
The two methods used to estimate uncollectible accounts are as follows:
1. Percent of sales method.
2. Analysis of the receivables method.
Percent of SalesMethod

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Since accounts receivable are created by credit sales,uncollectible accounts can be estimated as a
percent of credit sales. If the portion ofcredit sales to sales is relatively constant, the percent may
be applied to total sales ornet sales.
Example, assume the following data for ExTone Company on December 31, 2019,before any
adjustments:
Balance of Accounts Receivable ………………………..$240,000.00
Balance of Allowance for Doubtful Accounts ………...…… 3,250.00 (Cr.)
Total credit sales …………………………………………3,000,000.00
Bad debt as a percent of credit sales 2%
Bad Debt Expense of $60,000.00 is estimated as follows:
BadDebtExpense= CreditSales* BadDebt as a Percent of Credit Sales
Bad Debt Expense = $3,000,000.00* 2% =$60,000.00

The adjusting entry for uncollectible accounts on December 31, 2019, is as follows:

Bad Debt Expense………………………….. 60,000.00

Allowance for Doubtful Account……………….. 60,000.00

After the adjusting entry is posted to the ledger, Bad Debt Expense will have an adjusted balance
of $60,000. Allowance for Doubtful Accounts will have an adjusted balance of $63,250.00
($3,250.00 + $60,000.00).
Under the percent of sales method, the amount of the adjusting entry is the amountestimated for
Bad Debt Expense. This estimate is credited to whatever the unadjusted balance is for Allowance
for Doubtful Accounts.
Example, assume that in the preceding example the unadjusted balance of Allowance for
Doubtful Accounts on December 31, 2019, had been a $2,100.00 debit balance instead of
a$3,250.00 credit balance. The adjustment would still have been $60,000.00. However, the
December 31, 2019, ending adjusted balance of Allowance for Doubtful Accounts would have
been $57,900 ($60,000.00- $2,100.00).
Example, at the end of the current year, Accounts Receivable has a balance of $800,000;
Allowance for Doubtful Accounts has a credit balance of $7,500; and net sales for the year total
$3,500,000. Bad debt expense is estimated at 1⁄2 of 1% of net sales.
Determine A. The amount of the adjusting entry for uncollectible accounts
B. The adjusted balances of Accounts Receivable, Allowance for Doubtful
Accounts and Bad Debt Expense
C. The net realizable value of accounts receivable
Answer
A. $17,500 ($3,500,000 * 0.005)
B. Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $800,000.00
Allowance for Doubtful Accounts ($7,500 + $17,500) . . . . . . . . . . . . . . . . . . . . . . 25,000.00
Bad Debt Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ….. . . . . . . . . . . . . . .. . . 17,500.00
C. $775,000.00 ($800,000.00 - $25,000.00)

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Analysis of Receivables Method
The analysis of receivables method is based on the assumption that the longer an account
receivable is outstanding, the less likely that it will be collected. The analysis of receivables
method is applied as follows:
Step1. The due date of each account receivable is determined.
Step2. The number of days each account is past due is determined. This is the number of days
between the due date of the account and the date of the analysis.
Step3. Each account is placed in an aged class according to its days past due. Typical aged
classes include the following:
Not past due
1–30 days past due
31–60 days past due
61–90 days past due
91–180 days past due
181–365 days past due
Over 365 days past due
Step4. The totals for each aged class are determined.
Step5. The total for each aged class is multiplied by an estimated percentage of uncollectible
accounts for that class.
Step6. The estimated total of uncollectible accounts is determined as the sum of the uncollectible
accounts for each aged class.
The preceding steps are summarized in an aging schedule, and this overall processis called
agingthereceivables.The aging of accounts receivable is the process of listing each customer’s
receivableaccount according to the due date of the account. If the customer’s account is past due,
there is a possibility that the account will not be paid. And that possibilityincreases as the
account extends further beyond the due date. The aging of accountsreceivable helps management
evaluate its credit and collection policies and alerts it topossible problems.
To illustrate, assume that ExTone Company uses the analysis of receivables methodinstead of the
percent of sales method. ExTone prepared an aging schedule for its accounts receivable of
$240,000.00 as of December 31, 2019.
The sum of the estimated uncollectible accounts for each aged class is theestimated uncollectible
accounts on December 31, 2019. This is the desired adjusted balance for Allowance for Doubtful
Accounts. ForExTone Company, this amount is $26,490.00. Comparing the estimate of
$26,490.00 with the unadjusted balance of the allowance account determines the amount of the
adjustment for Bad Debt Expense. For ExTone, the unadjusted balance of the allowance account
is a credit balance of $3,250.00. The amount to be added to this balance is therefore $23,240.00
($26,490.00-$3,250.00). The adjusting entry is as follows:

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 Bad Debt Expense………………………….. 23,240.00
Allowance for Doubtful Account……………….. 23,240.00
After the preceding adjusting entry is posted to the ledger, Bad Debt Expense willhave an
adjusted balance of $23,240.00. Allowance for Doubtful Accounts will have an adjusted balance
of $26,490.00, and the net realizable value of the receivables is $213,510.00($240,000.00-
$26,490.00).
Comparing the Direct Write-off and Allowance Methods

Direct Write-Off Method Allowance Method

Bad debt expensewhen the specific customer Using estimate based on
is recordedaccounts are determined 1. A percent of sales or
to be uncollectible. 2. An analysis of receivables.

Allowance account No allowance account is The allowance account is

used. used

Primary usersSmall companies and large companies and

companies with few those with a large amount of
receivables. receivables.

Notes Receivable
A claim supported by a note has some advantages over a claim in the form of anaccount
receivable. By signing a note, the debtor recognizes the debt and agrees to pay it according to the
terms listed. A note is therefore a stronger 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. It is signed by
the person or firm that makes the promise.
A promissory note is a written promise to pay the face amount, usually with interest, on demand
or at a date in the future. The one to whose order the note is payable is called the payee, and the
one makingthe promise is called the maker.
Characteristics of a promissory note are as follows:
 The maker is the party making the promise to pay.
 The payee is the party to whom the note is payable.
 The face amount is the amount the note is written for on its face.
 The issuance date is the date a note is issued.
 The due date or maturity date is the date the note is to be paid.
 The term of a note is the amount of time between the issuance and due dates.
 The interest rate is that rate of interest that must be paid on the face amount for theterm
of the note.

Due Date
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The date a note is to be paid is called the due date or maturity date. The periodof time between
the issuance date and the due date of a short-term note may bestated in either days or months.
When the term of a note is stated in days, the duedate is the specified number of days after its
issuance.
When the due date is stated in terms of days, you need to count the exact numberof days to
determine the maturity date. In counting, omit the date the note isissued but include the due date.
For example, the maturity date of a 60-day notedated July 17 is September 15, computed as
follows.
Term of note 60 days
Remaining Days in July (31-17) 14 days
Add days in August 31 days
Maturity date September 15 days

The term of a note may be stated as a certain number of months after the issuancedate. In such
cases, the due date is determined by counting the number of months from the issuance date. For
example, a three-month note dated June 5 would be due on September 5. A two-month note
dated July 31 would be due on September 30.
Number of days in each month contains
January ……..31 days May……….31 days September………….30 days
February…….28 days June……….30 days October…………….31 days
March……….31 days July………..31 days November………….30 days
April………...30 days August…......31 days December…………..31 days
Example, The maker of the note is S-Company, and the payee is P-Company. The face value of
the note is $2,000.00, and the issuance date is March 16, 2019. The term of the note is 90 days,
which results in a due date of June 14, 2019, as shown below.
Term of note 90 days
Remaining Days in March (31-16) 15 days
Add days in April 30 days
Add days in May 31 days
Maturity date June 14 days

Interest
Interest is the cost of borrowing money or the return on lending money, depending on whether
one is the borrower or the lender. The amount of interest is based on three factors:
Principal (the amount of money borrowed or lent)
Rate of interest
Length of the loan
The interest on a note is computed as follows:
Interest = Face Amount * Interest Rate * Time
The interest rate is stated on an annual (yearly) basis, while the term is expressed as days. Thus,
the interest on the note is computed as follows:

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Interest = $2,000.00*10% *(90/360) = $50.00
b
The maturity valueis the amount that must be paid at the due date of the note,which is the sum
of the face amount and the interest. The maturity value of the note is $2,050.00 ($2,000.00+
$50.00).

Accounting for Notes Receivable

A promissory note may be received by a company from a customer to replace an account
receivable. In such cases, the promissory note is recorded as a note receivable.
Example, assume that a company accepts a 30-day, 12% note dated November 21, 2019, in
settlement of the account of Beta-Co., which is past due and has a balance of $6,000.00. The
company records the receipt of the note as follows:
Note Receivable……………………6,000.00
Account Receivable………………6,000.00
At the due date, the company records the receipt of $6,060 ($6,000 face amount plus $60.00
interest) as of December 21 is as follows:
Cash……………………….6,060.00
Note Receivable……………….6,000.00
Interest Income…………………….60.00
If the maker of a note fails to pay the note on the due date, the note is a
dishonorednotereceivable. A company that holds a dishonored note transfers the faceamount of
the note plus any interest due back to an accounts receivable account. Forexample, assume that
the $6,000.00, 30-day, 12% note received from Beta-Co. andrecorded on November 21 is
dishonored. The company holding the note transfers thenote and interest back to the customer’s
account as follows:
Account Receivable…………………..… 6,060.00
Note Receivable……………….……….6,000.00
Interest Income……………………….…….60.00
The company has earned the interest of $60.00, even though the note is dishonored.If the account
receivable is uncollectible, the company will write off $6,060.00 against Allowance for Doubtful
Accounts.
A company receiving a note should record an adjusting entry for any accrued interestat the end
of the period. For example, assume that Crawford Company issues a $4,000, 90-day, 12% note
dated December 1, 2019, to settle its account receivable. If the accounting period ends on
December 31, the company receiving the note would record the following entries:
December 01, 2019

Note Receivable……………………4,000.00
Account Receivable………………4,000.00
December 31, 2019
Interest Receivable……………………40.00

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 InterestIncome……………..……….40.00

March 01, 2020

Cash………………………. 4,120.00
Note Receivable………………. 4,000.00
Interest Income…………………….80.00
Interest Receivable…………………40.00

Sale of Notes Receivable

The accounting for the sale of notes receivable is recorded similarly to the sale of accounts
receivable. The accounting entries for the sale of notes receivable are left for a more advanced
course.

Discounting Notes Receivable

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
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 firststep, the
maker receives goods, service or cash from the payee in exchange for the note. In the
secondstep, 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 thirdstep, the maker pays the bank at the
maturity of the note.

Goods (1)
Payee
Maker

Note (2)
Cash less discount

Bank

Cash (3) Note (2)

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Although it is not a common transaction, a company may endorse its notes receivableand transfer
them to a bank. The bank transfers cash (the proceeds) to thecompany after deducting a
discount (interest) that is computed on the maturity value of the note for the discount period.
The discount period is the time that the bank must hold the note before it becomes due.
Toillustrate, assume that a 90-day, 12%, $1,800.00 note receivable from P- Co., dated April 8,
is discounted at the payee’s bank on May 3 at the rate of 14%. The data used in determining the
effect of the transaction are as follows:
Face value of note dated April 8 $1,800.00
Interest on note (90 days at 12%) 54.00
Maturity value of note due July 7 $1,854.00
Discount on maturity value (65 days from
May 3 to July 7, at 14%) 46.87
Proceeds $1,807.13

Cash…………………………. 1,807.13
Note Receivable…………………….. 1,800.00
Interest Income…………………………….7.13

Accounting for 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? 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. For example on September 25, 2020
Mega Co. holds a Br. 10,000.00, 12%, 30-day note of Mr. Wilyam. At maturity, Mr. Wilyam
dishonored the note. Mega Co. records this dishonoring of its N/R, on Oct. 25, 2020 as follows:

Oct.25, Account Receivable --------------- 10,100.00

Note Receivable---------------------------10,000.00

Interest receivable-------------------------100.00

To record dishonored note & interest of 10,000.00 X 12% X

30/360 =100.00

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The above entry records interest of Br. 100.00, which has been earned, even though the note has
been dishonored.

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