Define and explain common types of receivables and
review internal controls for receivables
Use the allowance method to account for
Uncollectible
Understand the direct write-off method for
Uncollectible
Account for notes receivable
Report receivables on the balance sheet and evaluate a
company using the acid-test ratio, days’ sales in
receivables, and the accounts receivable turnover ratio
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International Financial Accounting
Chapter 7: RECEIVABLES
MA. NguyenQuocNhat –nhatnq.faa@gmail.com 1
Chapter 7:
RECEIVABLES
International Financial Accounting
MA. Nguyen Quoc Nhat
Learning Objectives
Define and explain common types of receivables and
review internal controls for receivables
Use the allowance method to account for
Uncollectible
Understand the direct write-off method for
Uncollectible
Account for notes receivable
Report receivables on the balance sheet and evaluate a
company using the acid-test ratio, days’ sales in
receivables, and the accounts receivable turnover ratio
Chapter’s content
7.1 Receivables: An Introduction
7.2 Accounting for Uncollectible (Bad Debts)
7.3 The Allowance Method
7.4 The Direct Write-Off Method
7.5 Credit-Card and Debit-Card Sales
7.6 Notes Receivable
7.7 Using Accounting Information for Decision
Making
5
You have a receivable when you sell goods or services to
another party on credit.
You also have a receivable when you loan money to
another party. So a receivable is the right to receive cash
in the future from a current transaction. It is something the
business
owns; therefore, it is an asset. Each receivable transaction
involves two parties:
● The creditor, who will collect cash from the customer.
● The debtor, who takes on an obligation/payable (a
liability). The debtor will pay cash later.
7.1 Receivables: An Introduction
RECEIVABLES 6
Types of Receivables
The two major types of receivables are
● accounts receivable, and
● notes receivable.
7.1 Receivables: An Introduction
RECEIVABLES
International Financial Accounting
Chapter 7: RECEIVABLES
MA. NguyenQuocNhat –nhatnq.faa@gmail.com 2
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Accounts receivable, also called trade receivables, are
amounts to be collected from customers from sales made
on credit. Accounts receivable serves as a control account
because it summarizes the total of all the individual
customer receivables.
7.1 Receivables: An Introduction
RECEIVABLES
7.1 Receivables: An Introduction
9
Notes receivable are usually longer in term than accounts
receivable. Notes receivable represent the right to receive
a certain amount of cash in the future from a customer or
other party. The debtor of a note promises to pay the
creditor a definite sum at a future date—called the
maturity date. The maturity date is the date the debt
must be completely paid off. A written document known
as a promissory note serves as the evidence of the
indebtedness and is signed by both the creditor and the
debtor.
7.1 Receivables: An Introduction
RECEIVABLES 10
As we discussed earlier, selling on credit (on
account) creates an account receivable. The creation of
this account receivable is really the first step in the
process. However,
if the company sells only for cash, it has no accounts
receivable and, therefore, no bad debts from unreceived
customer accounts.
7.2 Accounting for Uncollectibles (Bad Debts)
RECEIVABLES
2014
1a Aug 8 Accounts Receivable - Brown 5,000
Service Revenue 5,000
Performed service on account
1b Aug 8 Accounts Receivable - Smith 10,000
Sales Revenue 10,000
Sales Inventory on account
7.2 Accounting for Uncollectibles (Bad Debts)
Greg’s Tunes sells $5,000 in services to customer Brown
on account and also sells $10,000 of inventory to customer Smith
on account on August 8, 2014. The revenue is recorded (ignore
COGS) as follows
2014
2a Aug 29 Cash 12,000
Accounts Receivable - Brown 8,000
Accounts Receivable - Smith 4,000
Collected cash on account
7.2 Accounting for Uncollectibles (Bad Debts)
The business collects cash from both customers on August
29—$4,000 from Brown and $8,000 from Smith. Collecting cash
is the second step in the process and Greg’s makes the following
entry:
International Financial Accounting
Chapter 7: RECEIVABLES
MA. NguyenQuocNhat –nhatnq.faa@gmail.com 3
7.2 Accounting for Uncollectible (Bad Debts) 7.2 Accounting for Uncollectible (Bad Debts)
There are two methods of accounting
for uncollectible receivables:
● the allowance method, ● or, in certain
limited cases, the direct write-off
method.
7.2 Accounting for Uncollectible (Bad Debts)
16
Most companies use the allowance method to
measure bad debts. The allowance method is based on
the matching principle. The offset to the expense is a
contra account called Allowance for uncollectible
accounts or the Allowance for doubtful accounts. The
Allowance account reduces Accounts receivable.
The business does not wait to see which customers will
not pay. Instead, it records a
bad debt expense based on estimates developed from past
experience
7.3 The Allowance Method
RECEIVABLES
17
Estimating Uncollectible
So, how are uncollectible receivables estimated?
Companies use their past experience as well as
considering the economy, the industry they operate in, and
other variables. In short, they make an educated guess,
called an estimate. There are two basic ways to estimate
uncollectibles:
● Percent-of-sales
●Aging-of-accounts-receivable
7.3 The Allowance Method
RECEIVABLES
● Percent-of-sales
Based on prior experience, Greg’s
uncollectible account expense is
normally 2% of net credit sales, which
totaled $15,000 for August. The journal
entry records the following at August
31, 2014:
7.3 The Allowance Method
International Financial Accounting
Chapter 7: RECEIVABLES
MA. NguyenQuocNhat –nhatnq.faa@gmail.com 4
After posting, the accounts are ready for the
balance sheet.
7.3 The Allowance Method
2014
1b Aug 31 Uncollectible account expense
($15000 X0.02)
300
Allowance for Uncollectible accounts 300
Recorded Uncollectible expense for
the period
20
Aging-of-Accounts Method
The other approach for estimating uncollectible
receivables is the aging-of-accounts method. This
method is also called the balance-sheet approach
because it focuses on the actual age of the accounts
receivable and determines a target allowance balance
from that age. Assume it is now December 31, 2014, and
Greg’s Tunes has recorded the remainder of the year’s
activity in the accounts such that the accounts now have
the following balances before the year-end adjustments.
7.3 The Allowance Method
RECEIVABLES
7.3 The Allowance Method
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Chapter 7: RECEIVABLES
MA. NguyenQuocNhat –nhatnq.faa@gmail.com 5
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Identifying and Writing Off Uncollectible Accounts
7.3 The Allowance Method
RECEIVABLES 26
Recovery of Accounts Previously Written Off—
Allowance Method
7.3 The Allowance Method
RECEIVABLES
Recall that Greg’s Tunes wrote off the $80
receivable from customer Andrews on January 10,
2015. It is now March 4, 2015, and Greg’s
unexpectedly receives $80 cash from Andrews. To
account for this recovery, the company must
reverse the effect of the earlier write-off to the
Allowance account and record the cash collection.
The entries are as follows:
Summary
1a) Make sales on account.
1b) Establish a pool for future potential
uncollectibility (2%).
2) Collect cash on account.
3) Identify a bad debt.
4) Adjust allowance account to reflect
adjustments to the estimate.
5) Recover previously written off
account.
30
There is another way to account for uncollectible
receivables that is primarily used by small, non-public
companies. It is called the direct write-off method.
Under the direct write-off method, you do not use the
Allowance for uncollectible accounts account to
record the expense based on an estimate.
7.4 The Direct Write-Off Method
RECEIVABLES
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Chapter 7: RECEIVABLES
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The direct write-off method is defective for two reasons:
7.4 The Direct Write-Off Method
RECEIVABLES 32
1. It does not set up an Allowance for uncollectible
accounts account. As a result, the direct write-off method
always reports accounts receivables at their full amount.
Thus, assets are overstated on the balance sheet.
7.4 The Direct Write-Off Method
RECEIVABLES
33
2. It does not match Uncollectible account expense against
revenue very well.
7.4 The Direct Write-Off Method
RECEIVABLES 34
Notes receivable are more formal than accounts
receivable. The debtor signs a promissory note as
evidence of the transaction. Before launching into the
accounting, let’s define the special terms used for notes
receivable:
Promissory note: A written promise to pay a specified
amount of money at a particular future date.
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. The debtor is the company
that must pay the money back.
7.5 Credit-Card and Debit-Card Sales
RECEIVABLES
35
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.
Principal: The amount loaned out by the payee and
borrowed by the maker of the note.
Interest: The revenue to the payee for loaning money.
Interest is 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.
7.5 Credit-Card and Debit-Card Sales
RECEIVABLES 36
Interest rate: The percentage rate of interest specified by
the note. Interest rates are almost always stated for a
period of one year. A 9% note means that the amount of
interest for one year is 9% of the note’s principal.
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.
7.5 Credit-Card and Debit-Card Sales
RECEIVABLES
International Financial Accounting
Chapter 7: RECEIVABLES
MA. NguyenQuocNhat –nhatnq.faa@gmail.com 7
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Identifying Maturity Date
Some notes specify the maturity date. For
example, September 30, 2015, is the maturity date of the
note shown in above Exhibit. Other notes state the period
of the note in days or months. When the period is given in
months, the note’s maturity date falls on the same day of
the month as the date the note was issued.
7.5 Credit-Card and Debit-Card Sales
RECEIVABLES 38
Computing Interest on a Note
The formula for computing the interest is as follows:
7.5 Credit-Card and Debit-Card Sales
RECEIVABLES
Principal x Interest rate x Time = Amount of interest
39
Accruing Interest Revenue
Some notes receivable may be outstanding at the
end of an accounting period. The interest revenue earned
on the note up to year-end is part of that year’s earnings.
Because of the matching principle, we must record the
earnings from the note in the year in which they were
earned.
7.5 Credit-Card and Debit-Card Sales
RECEIVABLES
Accruing Interest Revenue
in the formula, time (period) 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 (x/12) or a fraction of a year in
days (x/360 or x/365). Using the data in
Exhibit 8-5,
Accruing Interest Revenue
Greg’s Tunes computes interest revenue
for one year as follows:
Principal x Interest rate xTime =Amount
of interest ($1,000 X 0.06X12/12 =$60)
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.
International Financial Accounting
Chapter 7: RECEIVABLES
MA. NguyenQuocNhat –nhatnq.faa@gmail.com 8
Accruing Interest Revenue
When the term of a note is stated in
months, we compute the interest based
on the 12-month year. Interest on a
$2,000 note at 10% for nine months is
computed as follows:
$2,000 X 0.10 X 9/12 = $150
Accruing Interest Revenue
When the interest period is stated in
days, we sometimes compute interest
based on a 360-day year rather than on
a 365-day year.1 The interest on a
$5,000 note at 12% for 60 days can be
computed as follows:
$5,000 X 0.12 X 60/360 =$100
Acruring interest revenue
$1,000 X0.06 X 3/12 = $15.00
Greg’s Tunes makes the following
adjusting entry at December 31, 2014:
How much interest revenue does Greg’s
Tunes earn in 2015 (for January 1
through September 30)?
$1,000 X 0.06 X9/12 = $45.00
On the note’s maturity date, Greg’s
Tunes makes the following entry:
Earlier we determined that total interest
on the note was $60 ($1,000 0.06
12/12). These entries assign the correct
amount of interest to each year:
$15 for 2014 + $45 for 2015 = $60 total
interest
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Chapter 7: RECEIVABLES
MA. NguyenQuocNhat –nhatnq.faa@gmail.com 9
Accruing Interest Revenue Accruing Interest Revenue
Consider the loan agreement shown in
Exhibit 8-5. Lauren Holland signs the
note, and Greg’s Tunes gives Holland
$1,000 cash. At maturity, Holland pays
Greg’s Tunes $1,060 ($1,000 principal
plus $60 interest). Greg’s Tunes’ entries
are summarized as shown:
Accruing Interest Revenue
52
The accounting issues for notes receivable are
similar to those for accounts receivable with one
exception. Unlike accounts receivable, which do not
normally incur interest until they become overdue, notes
receivable start incurring interest the day they are created.
7.6 Notes Receivable
RECEIVABLES
53
Notes receivable are more formal than accounts
receivable. The debtor signs a promissory note as
evidence of the transaction. Before launching into the
accounting, let’s define the special terms used for notes
receivable:
7.6 Notes Receivable
RECEIVABLES 54
1. Promissory note: A written promise to pay a specified
amount of money at a particular future date.
7.6 Notes Receivable
RECEIVABLES
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Chapter 7: RECEIVABLES
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2. 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. The debtor is the company that
must pay the money back.
7.6 Notes Receivable
RECEIVABLES 56
3. 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.
7.6 Notes Receivable
RECEIVABLES
57
4. Principal: The amount loaned out by the payee and
borrowed by the maker of the note.
7.6 Notes Receivable
RECEIVABLES 58
5. Interest: The revenue to the payee for loaning money.
Interest is expense to the debtor and revenue to the
creditor.
6. 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.
7.6 Notes Receivable
RECEIVABLES
59
7. Interest rate: The percentage rate of interest specified
by the note. Interest rates are almost always stated for a
period of one year. A 9% note means that the amount of
interest for one year is 9% of the note’s principal.
8. Maturity date: As stated earlier, this is the date when
final payment of the note is due. Also called the due date.
7.6 Notes Receivable
RECEIVABLES 60
As discussed earlier in the text, the balance sheet lists
assets in order of liquidity (closeness to cash).
- Acid-test ratio
- One day’s sales
- Days’ sales in receivables
- Accounts receivable turnover
7.7 Using Accounting Information for Decision Making
RECEIVABLES
International Financial Accounting
Chapter 7: RECEIVABLES
MA. NguyenQuocNhat –nhatnq.faa@gmail.com 11
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End of Chapter 7
RECEIVABLES