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Understanding Receivables in Accounting

Learn about common types of receivables such as accounts receivable, notes receivable, and other receivables. Explore how credit sales are recorded and methods for accounting uncollectibles.

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Understanding Receivables in Accounting

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  1. Chapter 8Receivables

  2. WHAT ARE COMMON TYPES OF RECEIVABLES, AND HOW ARE CREDIT SALES RECORDED? • A receivable occurs when a business sells goods or services to another party on account (on credit). • A receivable is a monetary claim against a business or an individual. • A receivable is a right to receive cash in the future from a current transaction. • A creditor is the party who receives a receivable. • A debtoris the party to a credit transaction who is obligated to pay later.

  3. Accounts Receivable • Accounts receivable, also called trade receivables, represents the right to receive cash in the future from customers for goods or services performed. • Generally collected within 30 to 60 days • Reported as a current asset on the balance sheet

  4. Notes Receivable • Notes receivable usually have longer terms than accounts receivable. • Notes receivable are sometimes called promissory notes. • A note receivable represents a promise to pay a fixed amount of principle plus interest by a certain due date. • The maturity date is the date on which a note receivable is due.

  5. Other Receivables • Any other type of receivable is considered other receivables. • Receivables are classified as either current or long-term, depending on whether they will be received in one year or less. • Examples include: • Dividends receivable • Interest receivable • Taxes receivable

  6. Recording Sales on Credit Smart Touch Learning provides $5,000 in services to Brown on account and sells $10,000 (sales price) of merchandise inventory to Smith on account on August 8. Ignore Cost of Goods Sold.

  7. Recording Sales on Credit The control account, Accounts Receivable, shows a balance of $15,000. The individual customer accounts in the subsidiary ledger (Accounts Receivable—Brown $5,000 + Accounts Receivable—Smith $10,000) add up to $15,000.

  8. Recording Sales on Credit When the business collects cash from both customers on August 29—$4,000 from Brown and $8,000 from Smith—Smart Touch Learning makes the following entry:

  9. Recording Sales on Credit After posting:

  10. Decreasing Collection Time and Credit Risk • Companies must wait to receive cash from sales on account. • Some accounts are never collected. • Options to decrease collection time while transferring the risk of noncollection to a third party include: • Credit Card and Debit Card Sales • Factoring and Pledging Receivables

  11. Learning Objective 2 Apply the direct write-off method for uncollectibles

  12. HOW ARE UNCOLLECTIBLES ACCOUNTED FOR WHEN USING THE DIRECT WRITE-OFF METHOD? • Bad debts expense arises from failure to collect from some customers who purchase on account. • There are two methods of accounting for uncollectible receivables: • Direct write-off method • Allowance method (GAAP method)

  13. Recording and Writing Off Uncollectible Accounts—Direct Write-off Method • The direct write-off method is a method of accounting for uncollectible receivables in which the company records bad debts expense when a customer’s account receivable is uncollectible. • Primarily used by small, nonpublic companies. • Accounts receivable are written off when the business determines that it will never collect from a specific customer. • Once an account receivable is written off, the company stops pursuing the collection.

  14. Recording and Writing Off Uncollectible Accounts—Direct Write-off Method On August 9, Smart Touch Learning determines that it will not be able to collect $200 from customer Dan King for a sale of merchandise inventory made on May 5.

  15. Recovery of Accounts Previously Written Off—Direct Write-off Method On September 10, Smart Touch Learning unexpectedly receives $200 cash from Dan King.

  16. Limitations of the Direct Write-off Method • The direct write-off method violates the matching principle • Example: A company records sales revenue in 2017 and related bad debts expense in 2018. This results in: • Overstated net income in 2017 • Understated net income in 2018 • Overstated Accounts Receivable in 2017 • The direct write-off method is only acceptable for companies that have very few uncollectible receivables.

  17. Learning Objective 3 Apply the allowance method for uncollectibles and estimate bad debts expense based on the percent-of-sales, percent-of-receivables, and aging-of-receivables methods

  18. HOW ARE UNCOLLECTIBLES ACCOUNTED FOR WHEN USING THE ALLOWANCE METHOD? • Most companies use the allowance method to measure bad debts. • The allowance method is based on the matching principle. • It records bad debts in the same period as the sales revenue. • A contra asset account called Allowance for Bad Debtsreduces the Accounts Receivable to the net realizable value.

  19. Recording Bad Debts Expense—Allowance Method As of December 31, 2019, Smart Touch Learning estimates that $80 of its $4,400 accounts receivable are uncollectible.

  20. Recording Bad Debts Expense—Allowance Method

  21. Writing Off Uncollectible Accounts—Allowance Method • An allowance is established for the estimated uncollectible accounts. • Instead of recording a debit to Bad Debts Expense, the company records a debit to Allowance for Bad Debts. • The entry to write off an account under the allowance method has no effect on net income at the time of entry.

  22. Writing Off Uncollectible Accounts—Allowance Method On January 10, 2020, Smart Touch Learning determines that it cannot collect a total of $25 from its customer Shawn Clark.

  23. Writing Off Uncollectible Accounts—Allowance Method The entry to write off a receivable reduces the amount of the Allowance for Bad Debts account and also the Accounts Receivable account, but it does not affect the net realizable value shown on the balance sheet.

  24. Recovery of Accounts Previously Written Off—Allowance Method Recall that Smart Touch Learning wrote off the $25 receivable from Shawn Clark on January 10, 2020. It is now March 4, 2020, and Smart Touch Learning unexpectedly receives $25 cash from Clark.

  25. Estimating and Recording Bad Debts Expense—Allowance Method • Companies estimate bad debts expense based upon: • Past experience • The industry in which they operate • Other variables • There are three methods to estimate uncollectibles using the allowance method: • Percent-of-sales • Percent-of-receivables • Aging-of-receivables

  26. Percent-of-Sales Method • The percent-of-sales method computes bad debts expense as a percentage of net credit sales. • Some companies use all sales, not just credit sales. • This method is also called the income-statement approach.

  27. Percent-of-Sales Method Smart Touch Learning uses the percent-of-sales method to account for uncollectibles. Past experience suggests that 0.5% of credit sales will be uncollectible, which amounted to $60,000.

  28. Percent-of-Sales Method At December 31, Smart Touch Learning records the following adjusting entry to recognize bad debts expense for the year:

  29. Percent-of-Sales Method After posting the adjusting entry, Smart Touch Learning has the following balances in its accounts. Ignore the previously recorded reversal of the write-off and assume collections on account during the year are $58,000:

  30. Percent-of-Receivables Method • The percent-of-receivables method computes bad debts expense as a percentage of accounts receivable.

  31. Percent-of-Receivables Method On December 31, 2020, Smart Touch Learning’s unadjusted Accounts Receivable balance is $6,375, and 4% of accounts receivable is estimated to be uncollectible. The Allowance for Bad Debts account has a credit balance of $55, so the adjustment is $200.

  32. Percent-of-Receivables Method Smart Touch Learning records the following adjusting entry on December 31 to recognize bad debts expense for the year:

  33. Percent-of-Receivables Method After posting the adjusting entry, Smart Touch Learning has the following balances:

  34. Percent-of-Receivables Method Martin’s Music has a debit balance in its Allowance for Bad Debts account of $150. It estimates uncollectible accounts will be 2% of $40,000 of Accounts Receivable.

  35. Aging-of-Receivables Method • The aging-of-receivables method is similar to the percent-of-receivables method. • In the aging method, businesses group individual accounts based on how long the receivable has been outstanding. • Different percentages are applied to each category. • Takes into account the fact that the longer a receivable is outstanding, the greater the likelihood that it will be uncollectible.

  36. Aging-of-Receivables Method

  37. Aging-of-Receivables Method The procedure for recording the year-end adjusting entry under the aging-of-receivables method is similar to the percent-of-receivables method.

  38. Aging-of-Receivables Method Smart Touch Learning knows the target balance of the Allowance for Bad Debts account is $185.

  39. Aging-of-Receivables Method After posting the adjusting entry, Smart Touch Learning has the following balances in its balance sheet and income statement accounts:

  40. Comparison of Accounting for Uncollectibles

  41. Learning Objective 4 Account for notes receivable including computing interest and recording honored and dishonored notes

  42. HOW ARE NOTES RECEIVABLE ACCOUNTED FOR? • Promissory note—A written promise to pay a specified amount of money at a particular future date, usually with interest. • Maker of the note (debtor)—The entity that signs the note and promises to pay the required amount. • The maker of the note is the debtor. • Payee of the note (creditor)—The entity to whom the maker promises future payment; the payee of the note is the creditor. • The creditor is the company that loans the money.

  43. HOW ARE NOTES RECEIVABLE ACCOUNTED FOR? • Principal—The amount loaned by the payee and borrowed by the maker of the note. • Interest—The revenue to the payee for loaning money. • Interest is an expense to the debtor and revenue to the creditor. • Interest period—The period of time during which interest is computed. • It extends from the original date of the note to the maturity date. • Also called the note term.

  44. HOW ARE NOTES RECEIVABLE ACCOUNTED FOR? • Interest rate—The percentage rate of interest specified by the note. • Interest rates are almost always stated for a period of one year. • Maturity date—As stated earlier, this is the date when final payment of the note is due. • Also called the due date. • Maturity value—The sum of the principal plus interest due at maturity. • Maturity value is the total amount that will be paid back.

  45. HOW ARE NOTES RECEIVABLE ACCOUNTED FOR?

  46. HOW ARE NOTES RECEIVABLE ACCOUNTED FOR? Smart Touch Learning lends Lauren Holland $1,000 on September 30, 2019, for one year, at an annual rate of 6%.

  47. Computing Interest on a Note The formula for computing the interest is as follows: In the formula, time represents the portion of a year that interest has accrued on the note. • It may be expressed as a fraction of a year in months (number of months/12) • Or a fraction of a year in days (number of days/365)

  48. Computing Interest on a Note Using the data in Exhibit 8-4, Smart Touch Learning computes interest revenue for one year as follows: • The maturity value of the note is $1,060 ($1,000 principal + $60 interest). • The time element is 12/12 or 1 because the note’s term is one year.

  49. Computing Interest on a Note Interest on a $2,000 note at 10% for nine months is computed as follows: The interest on a $5,000 note at 12% for 60 days can be computed as follows:

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