Table of Contents

1. Introduction
2. Accounts Receivable
3. Revenue Recognition Principle
4. Economic Benefits
5. Measuring the Costs of Transaction
6. Notes Receivable
7. Summary

1. Introduction

Receivables are claims that will be collected by the company in cash. These are one of the company's most liquid assets
but are not as liquid as cash and cash equivalents. Receivables that are due within one year or one operating cycle
(whichever is longer) are classified as current assets. Receivables that are due beyond one year or one operating cycle
(whichever is longer) are classified as noncurrent assets.

Receivables comprise accounts receivable, notes receivable and other receivables. Accounts receivable reflects the debt
owed by clients resulting from the sale of goods and services. Notes receivable reflects claims that are documented using
note instruments. These notes require the debtor to pay the principal, as well as an interest, charged to the note-holder.
Other receivables typically include non-salerelated debt such as prepayments and advances, loans, interest and dividend
receivables, and income tax refunds receivable.

Objectives: Receivables

Upon completion of this topic, you should be able to:

describe the principles of controlling and managing receivables

2. Accounts Receivable

You have already learnt that when a company sells goods and services in cash, it debits Cash and it credits Sales Revenues
or Service Revenues. An example is shown below:

Cash US$5,000
Sales Revenues US$5,000

You have also learnt that when a company sells goods and services on account, it debits Accounts Receivable and it credits
Sales Revenues or Service Revenues.

Accounts Receivable US$5,000

Sales Revenues US$5,000

If a customer returns goods, the company reverses the sales entry by debiting Sales Returns (a contra-revenue account) and
crediting Accounts Receivable.

Sales Returns US$5,000

Accounts Receivable US$5,000

In order to avoid sales returns, some companies offer unsatisfied customers sales allowances in order to reduce the sale
price. Sales allowances are recorded by debiting Sales Allowance (a contra-revenue account) and crediting Accounts
Receivable.

Sales Allowance US$200

Accounts Receivable US$200
 Companies also tend to offer customers cash discounts if they pay within a specified time period. Similar to sales
allowances and sales returns, cash discounts are recorded by debiting Sales Discounts (a contra-revenue account) and
crediting Accounts Receivable.

Sales Discounts US$200

Accounts Receivable US$200

While investors and other users of financial statements may find it useful to learn of Sales Returns, Sales Discounts and
Sales Allowances, companies tend to only report net sales revenues in the income statement. It is quite rare for companies
to disclose the breakdown of their net sales revenues in the footnotes to the financial statements.

You have learnt that under the revenue recognition principle, revenue (and hence accounts receivable) is recognised when
it has been earned. But when is revenue earned?

3. Revenue Recognition Principle

According to International Accounting Standard number 18 (IAS 18), of the International Accounting Standards Board
(IASB), revenue should be recognised as earned when all of the following conditions are met:

1. Significant risks and rewards of ownership are transferred to the buyer.

2. Managerial involvement and control have been passed.
3. The amount of revenue can be measured reliably.
4. It is probable that economic benefits will flow to the enterprise.
5. The costs of the transaction (including future costs) can be measured reliably.

The application of the first three criteria (i.e. risks and rewards, managerial involvement and control, and
measurement of revenue) is straightforward. If, for example, a company places its products with a client on
consignment or asks a client to store some of its products in a storage location that belongs to the client, the first
three criteria have not been met. In these cases, the company clearly cannot recognise the consignment or the
storage of goods as a sale transaction and hence Sales Revenue should not be credited and Accounts Receivable
should not be debited. Unfortunately, some companies have been caught doing just that.

4. Economic Benefits

The probability of the flow of expected economic benefits in return for the sale of goods or the provision of services is the
fourth criterion. If the sale transaction is paid in full, in cash, the economic benefits are received and this criterion becomes
irrelevant. However, if the sale transaction is completed on account, economic benefits are in the form of receivables.
Under this criterion, the selling company must show that it is probable that receivables will be collected. If receivables are
not likely to be collected, then the selling company should defer the recognition of the sale revenue.

In general, companies sell their products in good faith and only after checking the credit-worthiness of their customers.
Therefore, it is probable that economic benefits will flow to the selling company. Nevertheless, some customers may still
default on their payments. Companies account for this by creating an allowance for uncollectible accounts at the end of
each reporting period.

The following procedure illustrates the accounting process for recording allowance for uncollectible accounts:

1. Estimate the percentage of uncollectible accounts receivable

2. Record adjusting entry
3. Debit specific accounts when account is uncollectible

Accounting process for recording allowance for uncollectible accounts:

Step 1: Estimate the percentage of uncollectible accounts receivable

The company uses its experience to estimate the percentage of uncollectible

accounts receivable at the end of each reporting period. Typically, companies assign low percentages to accounts
that are not yet due and assign higher percentages to accounts that are past their due dates. Based on these
percentages, the company computes the estimated amount for uncollectible accounts.
 Step 2: Record adjusting entry

Using the estimated amount computed in Step 1, the company records an adjusting entry at the end of the reporting
period whereby it debits Bad Debt Expense and credits Allowance for Uncollectible Accounts. Bad Debt Expense is
added to other expenses when the company calculates its net income for the period. The Allowance for
Uncollectible Accounts is noted in the balance sheet as a contra-asset account in that it is deducted from gross
accounts receivable balance.

Step 3: Debit specific accounts when account is uncollectible

In future periods, when a company determines that a particular account is uncollectible, it debits the Allowance for
Uncollectible Accounts and credits Accounts Receivable.

View the following animation to see how the process of recording allowance for uncollectible accounts can be
illustrated using a hypothetical example.

Bad Debt Provision

from GlobalNxt University

02:20

5. Measuring the Costs of Transaction

Selling companies are required to reliably estimate and recognise current and future costs associated with their sales. In
accordance with the matching principle, a company must recognise all expenses, current and future, associated with their
sale transactions:

When a company recognises sales revenues, these revenues must be matched with the expenses incurred in
generating the revenues.
In addition to the allowance for uncollectible accounts, future costs may include estimated sales returns and
estimated warranty costs.

If a company is unable to estimate these future costs reliably, it should defer the recognition of the sale revenue
altogether.

Percentage of Completion Method

Measuring the costs of transaction also applies to certain companies that are allowed to recognise partial sale
revenues before the completion of the sale transaction. For example, long-term contractors, such as shipbuilders and
aeroplane manufacturers, have an operating cycle that span many years. These companies recognise a portion of the
sales revenue as specified in the contract based on the percentage of work completed. This is, provided that a
customer is identified, the contract price is specified in advance, the stage of completion can be estimated reliably,
and there is little doubt about the flow of economic benefits to the company. They must also match the recognised
revenues with the corresponding expenses incurred in the reporting period as a percentage of total expenses
 expected to be incurred for the entire contract. Reporting revenues under this method clearly requires a reliable
estimate of the total costs expected for the entire contract. If a company is unable to reliably estimate the total costs
required to fulfil its contractual obligations, it should defer the recognition of the sales revenue.

6. Notes Receivable

A company may have some receivables in the form of notes. Notes receivables are promissory notes that require the
debtor to pay the principal and the interest charge at the maturity date of the note. These notes tend to be used to document
a loan or a sale transaction on account. The recording of these notes is similar to that of accounts receivable. When a
company sells goods in return for a promissory note, it debits Notes Receivable and credits Sales Revenue. Also, when a
company lends a given sum of money in return for a note, it debits Notes Receivable and credits Cash. When cash is
collected at the maturity date of a note, the company debits Cash and credits Notes Receivable.

The main difference between accounting for Accounts Receivable and accounting for Notes Receivable relates to the
recognition of the interest component. The following example can be used to illustrate the accounting process of
promissory notes:

Assume that Hypos Company sells US$10,000 worth of computers to NNN Company on 1 September 2003. In return,
Hypos receives a 10% six-month promissory note. Assume that Hypos' financial year end is 31 December 2003.

The journal entry to record this transaction on 1 September 2003 is:

Notes Receivable US$10,000

Sales Revenue US$10,000

At year end (31 December 2003), in accordance with the accrual basis of accounting,

Hypos records an adjusting entry to accrue the earning of a portion (four months: 1 September-31 December) of the
interest revenue associated with the promissory note.

The interest revenue is calculated as US$10,000 × 10% × (4/12) = US$333.34 The adjusting entry on 31 December 2003
is:

Interest Receivable US$333.34

Interest Revenue US$333.34

On 29 February 2004, Hypos collects the principal US$10,000 and the interest of US$500 for the whole six-month period.
Note that Hypos has already recorded interest revenue for the four-month period up to 31 December 2003.

The journal entry to record this transaction on 29 February 2004 is:

Cash US$10,500
Notes Receivable US$10,000

Interest Receivable US$ 333

Interest Revenue US$ 167

Similar to that of Accounts Receivable, companies record an Allowance for Uncollectible Notes Receivable at year end.
The accounting procedures for recording this allowance are identical to those of Accounts Receivable.

7. Summary

The following are the main points covered in this topic:

Receivables on the balance sheet comprise accounts receivable, notes receivable and others.
Revenue recognition criteria determine the recognition of receivables associated with the sale of goods and the
provision of services.
Receivables are measured on the balance sheet on the basis of their net realisable value after allowing for
uncollectible accounts.
The allowance method for uncollectible accounts results in better matching of revenues and expenses in current and
subsequent periods.
 The main accounting difference between notes receivable and accounts receivable relates to the accounting
recognition of the interest component.

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