Ch 5: Receivables and Sales - Study Notes
Recognizing Accounts Receivable (LO5–1)
Credit sales (sales on account): sales made to customers who do not pay at the time of sale; seller bears the risk of nonpayment.
At the time of a credit sale:
Accounts receivable (AR) is recorded to represent amounts owed by customers from the sale of goods/services on account.
Revenue or Sales is recorded immediately under accrual accounting when goods/services are provided and collection is probable (Revenue Recognition Principle).
If the sale is for services (not goods), the example focuses on service revenue; for goods, inventory would also be addressed (not in this service-based example).
Key takeaway: Companies record an asset (AR) and revenue on credit sales, with the expectation of future collection; AR is reduced when cash is collected.
Other Types of Receivables (LO5–1, continued)
AR sometimes called “trade” receivables; nontrade receivables originate from sources other than customers (e.g., tax refunds, interest receivable, loans to others).
Notes receivable: formal credit arrangements evidenced by a written debt instrument (notes); typically a loan made to others. Lender records a note receivable; borrower records a note payable.
Concept Check 5–1
Question: Which of the following is generally recorded at the time a company provides services on account?
Correct answer: Accounts receivable, not interest receivable, notes receivable, or tax refund claims.
Note: Nontrade receivables include tax refund claims, interest receivable, and loans by the company to others.
LO5–2: Net Revenues; Returns, Allowances, and Discounts (Learning Objective 2)
Revenues – Gross vs Net:
Net Sales (Net Revenue) is what is typically reported on financial statements.
Contra revenue accounts reduce gross revenue and are used to track reductions to revenue from returns, allowances, and discounts.
Four common contra revenue items (which reduce net revenues):
Trade discounts (reduces sale price directly; no separate contra account used)
Sales returns
Sales allowances
Sales discounts
Net revenues formula:
Important note: When contra revenue accounts increase, net revenues decrease.
FY Eye Scenario (Illustrates Net Sales components)
Scenarios included in the chapter: trade discount price, sale of sunglasses, sale returns, sales allowances, and sales discounts when paid within the discount period.
The scenario is used to illustrate how net sales is modified through various events.
Trade Discounts (LO5–2)
Definition: Reduction in the list price of a product or service; often used for large customers, seasonal promotions, or specific groups.
Recording: The sale is recorded at the discounted price; no contra revenue account is used. The revenue recognized equals the discounted amount.
Example: F.Y.Eye offers laser eye surgery for $3,000 but discount price is $2,400 (March Madness). The sale is recorded at the discounted price ($2,400).
March 1: Debit Accounts Receivable 2,400; Credit Service Revenue 2,400.
Sales Returns and Allowances (LO5–2)
Sales Returns: Customer returns goods purchased on account; refund or reduction to AR if the original sale was on account.
Sales Allowances: Customer is not returning goods but is granted a price reduction due to dissatisfaction or deficiency.
Recording:
Sales Returns: Debit Sales Returns; Credit Accounts Receivable (for a sale on account)
Sales Allowances: Debit Sales Allowances; Credit Accounts Receivable
Note: Services cannot be returned; a sales allowance can be used to resolve customer dissatisfaction with services.
Sales Returns and Allowances (Continued: Example Entries)
Example: March 4 – Customer returns sunglasses purchased on March 2 for $200 on account.
Debit Sales Returns 200; Credit Accounts Receivable 200.
Example: March 5 – Customer receives a $400 sales allowance on the March 1 sale at March Madness price.
Debit Sales Allowances 400; Credit Accounts Receivable 400.
Sales Discounts (2/10, n/30) (LO5–2)
Sales discounts are offered to encourage prompt payment.
Terms like 2/10, n/30 mean:
2% discount if payment is made within 10 days.
If the discount is not taken, full payment is due within 30 days (net 30).
Recording a discounted payment:
If customer pays within the discount period, cash collected is reduced by the discount, and the discount is recorded in a separate Sales Discounts contra-revenue account.
Example: A sale on account of $2,000 with a 2% discount paid within 10 days would result in cash of $1,960 and a $40 Sales Discounts reducing AR.
Journal entry on payment within discount period:
Debit Cash 1,960; Debit Sales Discounts 40; Credit Accounts Receivable 2,000.
Recording Customer Payment Within and Beyond Discount Period (LO5–2)
Within discount period (example above): cash collected includes discount; AR reduced by full amount.
After discount period: cash collected equals the full amount due (no discount); AR is reduced by the full amount.
Income Statement and Balance Sheet Effects (Contras; End-of-Period) (LO5–2)
Revenue reporting:
Revenue is reported net of returns, allowances, and discounts on the income statement; net revenues reflect the expected cash receipts.
Balance sheet reporting:
Accounts receivable is presented net of the Allowance for Uncollectible Accounts (net realizable value):
Net AR = AR − Allowance for Uncollectible Accounts.
End-of-Period Adjustment for Contra Revenues (LO5–2)
At year-end, adjust for expected returns, allowances, and discounts to reflect cash the company expects to collect.
Adjusting entry generally affects both an income statement account and a balance sheet account (contra asset or contra revenue as appropriate).
Estimating Uncollectible Accounts (Allowance Method) (GAAP) (LO5–3)
Purpose: Recognize that some AR will not be collected; estimate and report this as a contra asset (Allowance for Uncollectible Accounts, AUA).
Key points:
AUA is a contra asset; it reduces the balance of Accounts Receivable on the balance sheet to show net realizable value.
Bad debt expense is recognized in the income statement as the cost of extending credit.
The allowance method requires estimating future uncollectible accounts in the current year.
Net AR on the balance sheet is AR minus the allowance (AR − AUA).
The Allowance Method; End-of-Year Adjustments (LO5–3)
Steps:
At year-end, estimate future uncollectible accounts and record an adjusting entry to update both the income statement (Bad Debt Expense) and the balance sheet (Allowance for Uncollectible Accounts).
Later, write off actual bad debts as uncollectible; write-offs may differ from the estimate.
Repeat this process annually.
Estimating Uncollectible Accounts: End-of-Year Example (AUA) – Kimzey Medical Clinic
Provided data (illustrative):
End-of-year AR: $20 million; estimated uncollectible = 30% of AR in year-end aging approach (example year 2024).
Adjusting entry (example):
Debit Bad Debt Expense … 6
Credit Allowance for Uncollectible Accounts … 6
Rationale: $20M × 30% = $6M estimated uncollectible.
Consequence: AUA balance increases to reflect the estimated uncollectible amount; net AR becomes AR − AUA.
Allowance for Uncollectible Accounts (AUA) – Details
AUA is a contra asset; it represents the portion of AR not expected to be collected.
Balance sheet impact:
Report AR net of the allowance: Net AR = AR − AUA.
The allowance is shown in the asset section of the balance sheet as a reduction to AR.
Typical example: AR $20,000,000; Allowance $6,000,000; Net AR $14,000,000.
Common Mistakes with Allowance Accounts
Misclassifying the Allowance for Uncollectible Accounts as a liability due to its credit balance; it is a contra asset, not a liability.
Illustrative Income Statement and Balance Sheet Effects (Illustration 5–5, 5–9, 5–17, etc.)
Example shows impact of bad debt expense and allowance on both income statement and balance sheet:
Bad debt expense increases (income statement) and increases the allowance (balance sheet) to reflect estimated uncollectibles.
Net income decreases accordingly.
Net AR (AR − Allowance) decreases on the balance sheet.
Writing Off Accounts Receivable as Uncollectible (LO5–4)
When an account is deemed uncollectible:
Debit Allowance for Uncollectible Accounts; Credit Accounts Receivable.
This write-off reduces AR and reduces the allowance; total assets and total income are not affected at the time of write-off.
Example: February 23 – Write off $4,000: Debit Allowance for Uncollectible Accounts 4,000; Credit Accounts Receivable 4,000.
Important: The write-off itself does not affect bad debt expense because the expense was recorded at the time of estimating uncollectibles.
Collecting on Accounts Previously Written Off (LO5–4)
If a customer previously written off later pays:
Step 1: Reverse the write-off: Dr Accounts Receivable; Cr Allowance for Uncollectible Accounts.
Step 2: Collect the cash: Dr Cash; Cr Accounts Receivable.
Example: On September 8, 2025, receive $1,000 from a customer whose account was written off.
Reverse: Dr Accounts Receivable 1,000; Cr Allowance for Uncollectible Accounts 1,000.
Collect: Dr Cash 1,000; Cr Accounts Receivable 1,000.
Net effect: No change in total assets or net income as a result of the write-off and subsequent collection.
End-of-Year: Adjusting the Allowance in Subsequent Years (LO5–5)
At year-end 2025, suppose credit sales = $80 million and year-end AR = $30 million.
Use the allowance method to determine the ending balance for the allowance account (AUA).
The adjusting entry should reflect the estimated uncollectibles for the current year and update both income statement and balance sheet accounts accordingly.
Percentage-of-Receivables Method (Balance Sheet Method) (LO5–9, Appendix)
Purpose: Estimate uncollectible accounts based on the percentage of accounts receivable expected not to be collected.
Characteristics:
Based on a balance sheet account (AR).
The percentage may be informed by current conditions, company history, and industry guidelines.
Aging method is often more precise than applying a single percentage to all AR because older accounts are less likely to be collected.
Aging Method versus Percentage-of-Receivables (LO5–9)
Aging method: Classifies AR by age (e.g., 0–60 days, 61–120 days, 120+ days) and applies higher estimated uncollectible percentages to older buckets.
The aging method yields a more accurate total estimated uncollectible accounts than a single percentage.
Journal entry (example form): Bad Debt Expense (Debit) and Allowance for Uncollectible Accounts (Credit) for the total estimated uncollectibles.
Kimzey’s Accounts Receivable Aging Schedule (Illustration 5–6)
Aging buckets and totals (illustrative):
0–60 days: Not yet due; $16,000,000
1–60 days: $9,000,000
61–120 days: $4,000,000
Over 120 days: $1,000,000
Total AR: $30,000,000
Estimated percent uncollectible by bucket: 10%, 30%, 50%, 70%
Estimated uncollectible amounts by bucket: $1,600,000; $2,700,000; $2,000,000; $700,000; Total $7,000,000
Ending balance for Allowance: $7,000,000
Balance sheet impact: Net AR = $30,000,000 − $7,000,000 = $23,000,000 (illustrative).
Adjusting the Allowance to the Desired Ending Balance (Illustration 5–7)
If the year-end estimated uncollectible is $7 million, the Allowance for Uncollectible Accounts should have an ending balance of $7 million.
Determine the current balance of Allowance and compute the required year-end adjustment to reach $7 million.
Balance Sheet Presentation: Accounts Receivable Portion (Illustration 5–8)
Balance sheet (partial) as of December 31, 2025:
Current assets:
Accounts receivable: $30 million
Less: Allowance for uncollectible accounts: $(7) million
Net accounts receivable: $23 million
Bad Debt Expense in the Income Statement (Illustration 5–9)
Example presentation (2025):
Revenue from credit sales: $80 million
Expenses: Bad debt expense $5; Other operating expenses $50
Net income: $25 (illustrative)
Ending Balance and Nature of the Allowance (Key Points)
The end-of-year adjusting entry for future uncollectible accounts is affected by the current balance of the Allowance for Uncollectible Accounts before adjustment.
The current balance before adjustment equals the beginning-of-year balance (end of last year) minus write-offs during the year.
The allowance is a contra asset; increases to the allowance reduce net AR.
Concept Check 5–7: Aging Method vs Percentage Method
The aging method recognizes that older accounts are less likely to be collected; it should provide a more accurate estimate of total uncollectible accounts than using a single percentage.
Concept Check 5–8 to 5–9: Balance Sheet and Adjustments (AR AUA)
If AR = $100,000 and Allowance for Uncollectible Accounts has a credit balance of $2,000, with 20% of AR estimated uncollectible:
Ending Allowance should be $20,000 (credit balance).
That requires a credit balance adjustment of $22,000 (to move from $2,000 debit? credit confusion resolved: the note states the adjustment is a $22,000 increase in the allowance balance to reach $20,000 credit).
Journal: Bad Debt Expense $20,000; Allowance for Uncollectible Accounts $20,000 (example under percentage-of-receivables or aging methodology; actual numbers in the book vary by scenario).
Direct Write-Off Method vs Allowance Method (LO5–6)
Direct Write-Off Method (Not GAAP):
Bad debts are written off only when they become uncollectible; not allowed for financial reporting under GAAP.
Sometimes used for tax reporting or when uncollectibles are immaterial.
Allowance Method (GAAP):
Estimate bad debts in advance and establish a valuation account (Allowance for Uncollectible Accounts).
Bad debt expense is recognized in the period of estimation; actual write-offs reduce AR and the allowance.
Example of Direct Write-Off: If a $2,000 uncollectible account is written off in year 2025, entry is Dr Bad Debt Expense $2,000; Cr Accounts Receivable $2,000 (not GAAP for most financial reporting).
Example: Writing Off and Reversing in the Direct Write-Off Method (Illustration 5–12)
Year-end with allowance method vs actual write-offs:
Allowance Method: Debit Bad Debt Expense; Credit Allowance for Uncollectible Accounts (estimate).
Direct Write-Off: Debit Bad Debt Expense when actual uncollectible occurs; AR is written down then.
The key difference is timing: Allowance anticipates bad debts; Direct Write-Off recognizes them when they occur.
Notes Receivable and Interest (Part C) (LO5–7)
Notes receivable are assets; classified as current or noncurrent depending on expected collection date. If maturity > 1 year, it is a long-term asset.
Note example: $10,000 note payable from Justin Payne; 6 months; 12% interest; due date August 1; Interest = Face value × annual rate × fraction of year.
Interest calculation formula:
For a 6-month note at 12%, Interest =
Recording Notes Receivable; Reclassifying AR to NR (Illustrations 5–13 to 5–14)
Initial entry when providing services and accepting a note receivable:
Debit Notes Receivable 10,000; Credit Service Revenue 10,000.
No interest is recorded at the date of recording the note (interest is recognized as it accrues).
Reclassifying an existing AR to NR when the customer signs a note: Debit Notes Receivable 10,000; Credit Accounts Receivable 10,000.
Interest Revenue on Notes Receivable (LO5–7)
Interest revenue is recognized over time as the note accrues interest.
Example: A six-month note with face value $10,000 at 12% annual rate yields $600 total interest; if interest is accrued during the year, record an adjusting entry for interest receivable and interest revenue.
Collection at maturity:
Example: On August 1, 2024, collect cash of $10,600: Debit Cash 10,600; Credit Notes Receivable 10,000; Credit Interest Receivable 200; Credit Interest Revenue 400 (depending on accruals) to reflect principal and interest collected.
Accruing Interest Revenue (End of Year) (Illustration 5–14; 5–15)
If interest accrues before cash collection, an adjusting entry is required:
Debit Interest Receivable; Credit Interest Revenue for the amount accrued in the current period.
Example: If 2 months of interest accrues on a note issued on November 1 (year-end December 31), accrue: .
Calculating Interest Revenue Over Time (Illustration 5–14)
The same note can generate interest revenue in multiple periods; interest revenue increases in each period according to the fraction of the year the note is outstanding.
When the note matures, the full interest is recorded along with the collection of principal.
Concept Check 5–10: Interest Revenue Allocation (Example)
A note receivable of $5,000 with 6% annual interest maturing in 10 months:
2024 interest revenue:
2025 interest revenue:
Receivables Analysis: Tenet vs. CVS Health (LO5–8)
Receivables Turnover Ratio = Net Credit Sales / Average Accounts Receivable
Average Collection Period = 365 / Receivables Turnover
Example comparison:
Tenet Healthcare: Receivables Turnover ≈ 6.9; Average Collection Period ≈ 52.9 days
CVS Health: Receivables Turnover ≈ 13.8; Average Collection Period ≈ 26.4 days
Interpretation:
Higher turnover and shorter collection period indicate more efficient collection of cash from receivables.
Concept Check 5–11: Interpretation of Receivables Ratios
If accounts receivable turnover is 10, the average collection period is 36.5 days (365 / 10).
Efficient collection depends on credit terms; net terms of 30 days would be more favorable with a 36.5-day collection period than a longer period.
Appendix: Percentage-of-Credit-Sales Method (LO5–9)
This method estimates uncollectible accounts using a percentage of credit sales (income-statement focus).
Key idea: Bad Debt Expense = Percentage × Credit Sales.
Entering the adjustment:
Debit Bad Debt Expense; Credit Allowance for Uncollectible Accounts.
Example formulation:
If credit sales in the year are $80 million and the chosen percentage is 10%, then Bad Debt Expense = $8 million; entry: Debit Bad Debt Expense $8,000,000; Credit Allowance for Uncollectible Accounts $8,000,000.
Percentage-of-Receivables Method vs Percentage-of-Credit-Sales Method (Illustration 5–16, 5–17)
Percentage-of-Receivables Method (balance sheet method):
Estimate uncollectibles as a percentage of the ending AR balance; adjust the allowance to that ending balance.
Journal entry: Bad Debt Expense and Allowance for Uncollectible Accounts to reach the target allowance balance.
Effect: Adjusts the net AR directly in the balance sheet.
Percentage-of-Credit-Sales Method (income statement method):
Estimate uncollectibles as a percentage of current period credit sales, ignoring the existing allowance balance.
Journal entry: Bad Debt Expense (current period) and Increase in Allowance for Uncollectible Accounts by the same amount.
Effect: Impacts the income statement more than the ending allowance balance.
Income Statement and Balance Sheet Effects of Estimating Uncollectible Accounts (Illustration 5–17)
Percentage-of-Receivables Method:
Bad debt expense = 6 (illustrative)
Net AR = $80 - $6 = $74 (illustrative)
Percentage-of-Credit-Sales Method:
Bad debt expense = 8 (illustrative)
Net AR after adjustment = $80 − $10 = $70 (illustrative)
Note: These figures are schematic; actual numbers depend on specific data in the exercise.
Key Points: Net Realizable Value and Implications (LO5–9)
When applying estimates of uncollectible accounts, the goal is to report AR at its net realizable value (amount expected to be collected).
Bad debt expense is recognized in the income statement; the allowance reduces AR in the balance sheet.
The aging method is typically more precise than applying a single percentage to total AR because it accounts for the increasing likelihood of noncollection with time.
Subsidiary Ledgers (LO5–4)
A subsidiary ledger contains a group of individual accounts related to a general ledger control account (e.g., AR subsidiary ledger tracks all customer accounts; their balances sum to the AR control account in the general ledger).
End-of-Chapter Summary and Key Equations
Revenue recognition: Revenues are earned when goods/services are provided; revenues are recorded at the amount the company is entitled to receive and reasonably expects to collect.
Net revenues vs gross revenues:
AR and AUA:
AR is reduced by collections and write-offs; net AR is AR − AUA.
AUA is a contra asset; normal credit balance; it reduces AR on the balance sheet.
Writing off uncollectibles:
Write-off entry: Debit Allowance for Uncollectible Accounts; Credit Accounts Receivable.
Collection after write-off: Reverse write-off, then collect cash; no net effect on total assets or net income from the write-off process itself.
Notes receivable:
Notes receivable are assets; interest revenue is recognized over time using the formula
Interest receivable is accrued if not yet collected; on collection, principal and accrued interest are recorded.
Receivables ratios:
Receivables Turnover =
Average Collection Period =
End-of-Chapter 5 (5–100)
End of chapter note: The chapter consolidates recognition, measurement, estimation, and analysis of receivables, including AR, notes receivable, contra revenues, and related ratios.