ACT 2100 Lecture 8

ACCOUNTING FOR RECEIVABLES

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.
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.
Types of Receivables

The relative significance of a company’s receivables as a

percentage of its assets depends on various factors: its
industry, the time of year, whether it extends long-term
financing, and its credit policies. To reflect important
differences among receivables, they are frequently
classified as (1) accounts receivable, (2) notes
receivable, and (3) other receivables.
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.
Types of Receivables

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. Notes and accounts receivable that result
from sales transactions are often called trade
receivables.
Types of Receivables

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.
Accounts Receivable

Three accounting issues associated with accounts

receivable are:
1. Recognizing accounts receivable.
2. Valuing accounts receivable.
3. Disposing of accounts receivable.
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.
Valuing Accounts Receivable

Once companies record receivables in the accounts, the

next question is: How should they report receivables in
the financial statements? Companies report accounts
receivable on the balance sheet as an asset. But
determining the amount to report is sometimes difficult
because some receivables will become uncollectible.
Companies record credit losses as debits to Bad Debt
Expense (or Uncollectible Accounts Expense). Such losses
are a normal and necessary risk of doing business on a
credit basis.
Two methods are used in accounting for uncollectible
accounts: (1) the direct write-off method and (2) the
allowance method.
Valuing Accounts Receivable

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 this method, Bad Debt Expense will
show only actual losses from uncollectibles. The
company will report accounts receivable at its gross
amount. Although this method is simple, its use can
reduce the usefulness of both the income statement
and balance sheet.
Valuing Accounts Receivable

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 revenues in the
income statement. Nor does the direct write-off
method show accounts receivable in
the balance sheet at the amount the company
actually expects to receive. Consequently, unless
bad debt losses are insignificant, the direct write-off
method is not acceptable for financial reporting
purposes.
Valuing Accounts Receivable

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.
Valuing Accounts Receivable

GAAP requires the allowance method for financial reporting

purposes when bad debts are material in amount. 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.
Valuing Accounts Receivable

Allowance for Doubtful Accounts shows the estimated

amount of claims on customers that the company
expects will become uncollectible in the future.
Companies use a contra account instead of a direct
credit to Accounts Receivable because they do not
know which customers will not pay. The credit
balance in the allowance account will absorb the
specific write-offs when they occur.
Bad Debts

Bad Debts are debts for which payment is not expected to

be received which are therefore written off against profit.

 Because a large proportion of businesses’ sales are

credit sales, they are taking the risk that some of the
customers may never pay for the goods sold to them
on credit. This is a normal business risk and such bad
debts are a normal business expense.

 When a debt is found to be ‘bad’, the asset as shown

by the debt in the receiveable’s account is worthless. It
must be eliminated from the account.
Bad Debts

There are a range of possible scenarios that may exist concerning a

bad debt.

 the debtor may be refusing to pay one of a number of invoices;

 the debtor may be refusing to pay part of an invoice;

 the debtor may owe payment on a number of invoices and has

indicated that only a proportion of the total amount due will ever
be paid because the debtor’s business has failed;

 the debtor’s business has failed and nothing is ever likely to be

received.
How can Bad Debts be minimized
by Businesses?

Bad debts can be avoided by not allowing sales to be made on

credit. Minimizing the risk of bad debts will involve implementing
a system of credit control.

Steps in a reliable system of credit control could involve the

following:

 Asking for references from a business before allowing credit.

 Offering sufficient cash discounts to encourage prompt

payment.
How can Bad Debts be minimized
by Businesses?

 Chasing up outstanding debts when credit periods are

exceeded.

 Using a debt factor (a debt factoring business specializes in

collecting debts and will purchase outstanding debts at a
discounted price from some businesses if there is a chance the
debts can be collected).

 Only allowing a certain credit limit.

 Only allowing regular customers credit.

Provisions for Doubtful Debts

What is a Provision?

A provision is ‘a liability of uncertain timing or amount’.

Why provisions are needed?

When we are drawing up our financial statements, we want to achieve the following objectives:

 to charge as an expense in the profit and loss account for that year an amount
representing debts that will never be paid;

 to show in the balance sheet a debtors figure as close as possible to the true value of debtors at
the balance sheet date.
Provisions for Doubtful Debts

It is impossible to determine with absolute accuracy at the

year end what the true amount is in respect of debtors who
will never pay their accounts.

So, how do you decide how much to provide as a provision

against the possibility of some of the remaining debts (after
removing those which have been written off as bad) proving
bad in a future period?

In order to arrive at a figure for doubtful debts, a business must

first consider that some debtors will never pay any of the
amount they owe, while others will pay a part of the amount
owing only, leaving the remainder permanently unpaid.
Provisions for Doubtful Debts

The estimated figure can be made:

 by looking at each debt, and deciding to what

extent it will be bad;

 by estimating, on the basis of experience, what

percentage of the total amount due from the
remaining debtors will ultimately prove to be bad
debts.
Provisions for Doubtful Debts

Most businesses don’t go to this level of detail. Instead,

they apply a percentage to the overall debtor
balance (after deducting the bad debts). The
percentage will be one the business has established
over the years as being the most appropriate.
Aging Schedule for Doubtful
Debts

It is well known that the longer a debt is owing, the

more likely it is that it will become a bad debt. Some
businesses draw up an ageing schedule, showing how
long debts have been owing. Older debtors need
higher percentage estimates of bad debts than do
newer debtors. The percentages chosen should reflect
the actual pattern of bad debts experienced in the
past.
Accounting Entries

The accounting entries needed for the provision for

doubtful debts are:
Year in which provision is first made:

 Debit the profit and loss account with the amount of

the provision (i.e. deduct it from gross profit as an
expense).

 Credit the Provision for Doubtful Debts Account

(Balance Sheet).
Bad Debts Recovered

Sometimes, a debt written off in previous years is recovered.

When this happens, you:

1. Reinstate the debt by making the following entries:

 Dr Receiveables’s account
 Cr Bad debts recovered account

2. When payment is received from the debtor in settlement of

all or part of the debt:
 Dr Cash/bank
 Cr Debtor’s account with the amount received.
Increasing the provision

Provisions for doubtful debts in the statement of

comprehensive income
Reducing the provision

Provisions for doubtful debts in the statement of

comprehensive income
Disposing of Accounts
Receivable

In the normal course of events, companies collect

accounts receivable in cash and remove the
receivables from the books. However, as credit sales
and receivables have grown in significance, the
“normal course of events” has changed. Companies
now frequently sell their receivables to another
company for cash, thereby shortening the cash-to-
cash operating cycle. 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.
Disposing of
Accounts Receivable

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.
Disposing of 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. Factoring is a
multibillion dollar business.
Disposing of
Accounts Receivable

CREDIT CARD SALES

Over one billion credit cards are in use in the
United States—more than three credit cards for
every man, woman, and child in this country. Visa,
MasterCard, and American Express are the national
credit cards that most individuals use. Three parties
are involved when national credit cards are used in
retail sales: (1) the credit card issuer, who is
independent of the retailer; (2) the retailer; and (3)
the customer. A retailer’s acceptance of a national
credit card is another form of selling (factoring) the
receivable.
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.
In a promissory note, the party making the promise to pay
is called the maker. The party to whom payment is to be
made is called the payee. The note may specifically
identify the payee by name or may designate the payee
simply as the bearer of the note.
Notes Receivable

Notes receivable give the holder a stronger legal claim

to assets than do accounts receivable. Like
accounts receivable, notes receivable can be
readily sold to another party. Promissory notes are
negotiable instruments (as are cheques), which
means that they can be transferred to another
party by endorsement. Companies frequently
accept notes receivable from customers who need
to extend the payment of an outstanding account
receivable. They often require such notes from high-
risk customers.
Notes Receivable

The basic issues in accounting for notes receivable are

the same as those for accounts receivable:
1. Recognizing notes receivable.
2. Valuing notes receivable.
3. Disposing of notes receivable.
Disposing of Notes Receivable

Notes may be held to their maturity date, at which time

the face value plus accrued interest is due. In some
situations, the maker of the note defaults, and the
payee must make an appropriate adjustment. In other
situations, similar to accounts receivable, the holder of
the note speeds up the conversion to cash by selling
the receivables.

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 noteplus interest for
the length of time specified on the note.
Disposing of Notes Receivable

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 Account 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. Short-term investments appear before short-
term receivables because these investments are
more liquid (nearer to cash). Companies report both
the gross amount of receivables and the
allowance for doubtful accounts.
Statement Presentation
and Analysis

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.
Statement Presentation and
Analysis

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. This ratio measures the number of times,
on average, the company collects accounts
receivable during the period. It is computed by dividing
net credit sales (net sales less cash sales) by the
average net accounts receivable during the year.
Unless seasonal factors are significant, average
net accounts receivable outstanding can be
computed from the beginning and ending balances of
net accounts receivable.
End of Lecture