CHAPTER 8
Accounts and Notes Receivable
Chapter Outline
Introduction to Receivables
3. A subsidiary ledger includes a separate account for each customer.
Objective 1: Design internal controls for receivables
A. Internal control over collections of cash on account is important.
1. Cash-handling duties should be separate from cash-accounting duties.
2. The bookkeeper should not also handle cash receipts. A lock-box accomplishes the same control over receipts of cash.
3. The person posting the accounts receivable subsidiary ledger should not also handle cash receipts.
4. The credit department should not have access to cash.
B. The credit department is responsible for evaluating and approving new credit customers as well as monitoring the payment history of current customers.
C. Decision guidelines discuss controlling, managing, and accounting for receivables.
D. Selling on credit creates both a benefit (more sales) and a cost (some customers will not pay). Uncollectible-account expense results from charge sales that customers cannot or will not pay.
E. Two methods are used for recording this expense, which is a normal expense for any business that sells on credit:
1. The allowance method – preferred because it matches collection losses with revenues in the period in which the sales were made.
2. The direct write-off method – fails to match the expense with the sales revenue.
F. The allowance method of recording uncollectible account (or bad debt) expense is based on estimates of collection losses.
Objective 2: Use the allowance method to account for uncollectibles by the percent-of-sales and aging-of-accounts methods
A. Under the allowance method, there are two ways to estimate uncollectible-account expense: percent-of-sales and aging-of-accounts.
1. The percent-of-sales method (also called the income statement approach) considers the credit sales for the period. If focuses on the amount of expense to be reported on the income statement.
a. The percentage used is an historical percentage based on prior uncollectible accounts and past collection experience. To calculate the uncollectible-account expense, the percentage is multiplied by the credit sales.
b. At the end of each accounting period this adjusting entry is made:
Uncollectible-Account Expense XX
Allowance for Uncollectible Accounts XX
c. This entry adjusts the Allowance account by the amount of expense.
2. The aging-of-accounts method (also called the balance-sheet approach) considers the age and amount of accounts receivable at the end of the period. This method focuses on the amount of net accounts receivable to be reported on the balance sheet.
a. First, the accounts are aged (classified according to the age of the account), as illustrated in Exhibit 8-2.
b. A historical percentage is applied to each age category. This amount represents the estimated amount of uncollectible accounts from each age category. When these amounts are added together, the total is the desired ending balance in the Allowance account.
c. The longer an account goes uncollected, the more likely it is to become a bad debt; therefore a higher percentage of accounts long past due are estimated to become uncollectible.
d. The amounts of uncollectible accounts from each category are added together. This amount is the desired ending balance in the Allowance Account. (See Exhibit 8-2.)
e. To calculate the expense, consider the unadjusted balance in the Allowance account and the desired ending balance, based on the calculation described
above. The expense is the amount that will be added to (or deducted from) the Allowance account to achieve the desired ending balance.
f. At the end of each accounting period this adjusting entry is made:
Uncollectible-Account Expense XX
Allowance for Uncollectible Accounts XX
g. Note that this entry adjusts the Allowance account to the estimated amount of uncollectible accounts.
B. The percent of sales and aging methods may be used together. For interim statements, the percent of sales method is easy to use; at year-end, the aging method is more accurate because it adjusts accounts receivable to the expected realizable value. For a comparison of the two methods, see Exhibit 8-3.
C. An account is written off when it is determined to be uncollectible. No expense is recorded at this time. Instead, the Allowance account is reduced with a debit.
1. The write-off entry when an account is deemed to be uncollectible is:
Allowance for Uncollectible Accounts XX
Accounts Receivable (customer name) XX
2. The write-off of an account has no effect on net income; it does not have any effect on net receivables, as illustrated in Exhibit 8-4. In other words, net receivables are the same before and after the write-off.
Objective 3: Use the direct write-off method to account for uncollectibles
A. When using the direct write-off method of accounting for uncollectible receivables, the company waits until a customer’s account is deemed uncollectible to write off the account.
1. At the time an account is written off, this entry is made:
Uncollectible-Account Expense XX
Accounts Receivable (customer name) XX
2. This method is defective because it does not set up an allowance for uncollectibles, resulting in accounts receivable that may be overstated on the balance sheet.
3. The direct write-off method does not match revenue and uncollectible-account expense. In some cases, the expense may be recorded in a later period than the revenue.
4. However, the direct write-off method is easy to use and will not create significant distortions in income or assets if collection losses are insignificant.
B. If an account written off (or charged off) is later collected, two entries are required: one entry to reverse the original write-off of that account and a second entry to record the cash collection.
Accounts Receivable (customer name) XX
Allowance for Uncollectible Accounts XX
To reverse previous write-off.
and, Cash XX
Accounts Receivable (customer name) XX
To record collection of account receivable.
C. Credit-card and bankcard sales benefit both consumers and retailers.
2. The retailer receives cash almost immediately for the sale (rather than having to wait until the customer is billed) and does not have to check a customer’s credit or send bills.
a. The retailer’s entry when there are credit-card sales is:
Accounts Receivable – Discover XX
Credit-Card Discount Expense XX
Sales Revenue XX
b. When the retailer collects the discounted amount:
Cash XX
Accounts Receivable – Discover XX
c. The retailer’s entry when there are bankcard sales such as VISA is:
Cash XX
Bankcard Discount Expense XX
Sales Revenue XX
D. Debit cards do not require a third party (such as VISA). When the buyer uses the card, his cash account is immediately decreased and the vendor’s cash is immediately increased.
Objective 4: Account for notes receivable
A. A note receivable represents a written promise to pay a specific sum of money on a particular date. Key terms related to notes are illustrated in Exhibit 8-5 and given below:
2. The maker of the note is the debtor; the payee is the creditor.
3. The interest is the borrower’s cost of using the creditor’s money. It is always stated on an annual basis unless specified. The text uses a 360-day year. Interest is calculated as:
Principal x Rate x Time = Interest
4. Maturity value (principal plus interest) is due on the maturity date. To determine maturity date, count the exact days or months from the issue date of the note. Be sure to begin counting on the day following the date of the note.
5. Various features of a promissory note are illustrated in Exhibit 8-5.
B. Accounting for notes receivable is illustrated below:
1. A note receivable can be received for cash, for a sale, or in settlement of an account. The entry is:
Note Receivable – Maker XX
Cash (or Sales Rev. or Accounts Rec.) XX
Interest Receivable XX
Interest Revenue XX
Cash XX
Note Receivable XX
Interest Receivable XX
Interest Revenue XX
C. If a note receivable is not paid at maturity, the maker of the note is said to dishonor or default on the note. The payee records interest revenue earned on the note and debits Accounts Receivable for the full maturity value of the note.
Objective 5: Report receivables on the balance sheet
A. A business usually reports its accounts receivable at net realizable value and discloses the allowance account parenthetically.
B. Alternately, the firm may report net realizable value for receivables on the balance sheet and include details in the footnotes.
Objective 6: Use the acid-test ratio and days’ sales in receivables to evaluate a company’s financial position
A. Key ratios can help managers and owners make decisions about the liquidity of a business.
B. The balance sheet in Exhibit 8-6 is used to illustrate the two ratios: acid test and days’ sales in receivables.
1. The acid-test (or quick) ratio measures a company’s ability to pay current liabilities. In general, an acid-test ratio of 1.0 is considered safe. The computation is:
Acid-test ratio = Cash + Short-term investments + Net current receivables
Total current liabilities
2. The days’ sales in receivables (or collection period) indicates how many days it takes to collect the average level of receivables. The number of days should be very near the days in the credit period. There are two steps to the computation:
a. One day’s sales = Net sales
365 days
b. Days’ sales in average accounts = Average net accounts receivable
receivable One day’s sales
C. A meaningful analysis of financial information is best achieved by calculating many ratios over a number of years.
D. Decision guidelines summarize the accounting for receivables and using ratios related to receivables.
Appendix to Chapter 8
A. Notes receivable may be discounted (or sold) by the payee for cash prior to maturity date.
1. Often, present value calculations are used to determine the discounted price of a note receivable that is sold to a bank prior to maturity.
2. The bank calculates the interest (or discount) based on the maturity value of the note, the bank’s holding period, and the bank’s discount rate.
3. The maturity value less the bank’s discount equals the proceeds or discounted value.
4. The payee records receipt of the proceeds of a discounted note with this entry:
Cash (proceeds) XX
Interest Expense XX
Note Receivable XX
5. Note: the entry may instead require a credit to Interest Revenue (rather than a debit to Interest Expense) if the interest included in the maturity value is greater than the bank’s discount.
6. The steps to discounting a note receivable are illustrated in Exhibit 8A-1.
B. A contingent liability is a potential liability that exists on a discounted note from the discount date until the maturity date. The contingency is not reported on the balance sheet, but rather in the footnotes.
1. If the maker pays the maturity value to the bank, the contingent liability no longer exists.