Receivables Notes

Classification of Receivables

  • Receivables result from sales on account, typically as accounts receivable or notes receivable.
  • Receivables encompass all money claims against other entities (people, companies, etc.).
  • They often constitute a significant portion of a company's current assets.

Accounts Receivable

  • Arise from selling merchandise or services on credit.
  • Recorded as a debit to Accounts Receivable.
  • Normally collected within 30 to 60 days.
  • Classified as current assets on the balance sheet.

Notes Receivable

  • Represent customer debts with a formal, written instrument of credit.
  • Classified as current assets if expected to be collected within a year.
  • Often used for credit periods longer than 60 days.
  • Can be used to settle existing accounts receivable.
  • Notes and accounts receivable from sales are termed trade receivables.

Other Receivables

  • Include interest receivable, taxes receivable, and receivables from officers or employees.
  • Reported separately on the balance sheet.
    • Classified as current assets if expected collection is within one year.
    • Classified as noncurrent assets under "Investments" if collection is expected beyond one year.

Uncollectible Receivables

  • A major issue with credit sales is that some customers will not pay.
  • Companies may transfer this risk to other companies through factoring.
    • Factoring: Selling receivables to a factor to receive immediate cash.
    • Factor: The buyer of the receivables.

Bad Debt Expense

  • The operating expense from uncollectible receivables, also called uncollectible accounts expense or doubtful accounts expense.
  • Indications an account may be uncollectible:
    • Past due.
    • No response from the customer.
    • Customer bankruptcy.
    • Customer closing business.
    • Inability to locate the customer.
  • Companies may use a collection agency.
  • After collection attempts, any remaining balance is considered worthless.
  • Two accounting methods for uncollectible receivables:
    • Direct Write-Off Method: Records bad debt expense only when an account is deemed worthless.
      • Often used by small companies with few receivables.
    • Allowance Method: Estimates uncollectible accounts at the end of the accounting period.
      • GAAP requires companies with significant receivables to use the allowance method.

Direct Write-Off Method for Uncollectible Accounts

  • Bad Debt Expense is recorded when an account is determined to be worthless.

  • The customer's account receivable is written off at that time.

  • Example: Writing off a 4,2004,200 account from D. L. Ross:

    • Debit: Bad Debt Expense
    • Credit: Accounts Receivable

  • If a written-off account is later collected:

    • The account is reinstated by reversing the write-off entry.
    • Cash received is recorded as a receipt on account.

  • Example: D. L. Ross account of 4,2004,200 is collected after being written off.

Reinstatement:
*   Debit: Accounts Receivable
*   Credit: Bad Debt Expense
Cash Receipt:
*   Debit: Cash
*   Credit: Accounts Receivable
  • The direct write-off method is suitable for businesses with mainly cash sales or acceptance of credit cards (Mastercard, Visa).
  • In this scenario, receivables are a small portion of current assets, and bad debt expense is minimal (e.g., restaurants, convenience stores, small retail stores).

Allowance Method for Uncollectible Accounts

  • Estimates uncollectible accounts receivable at the end of the accounting period.
  • Records Bad Debt Expense via an adjusting entry based on the estimated credit losses.
  • Example: ExTone Company estimates 30,00030,000 of its 200,000200,000 accounts receivable will be uncollectible.
  • A contra asset account, Allowance for Doubtful Accounts, is credited.
Adjusting entry:
*   Debit: Bad Debt Expense
*   Credit: Allowance for Doubtful Accounts
  • The adjusting entry impacts both the income statement and balance sheet.
    • Income Statement: Bad Debt Expense is matched against related revenues.
    • Balance Sheet: Reduces the value of receivables to the net realizable value (amount expected to be collected).
  • Net Realizable Value = Accounts Receivable - Allowance for Doubtful Accounts.
  • Example: 200,000 - $30,000 = $170,000 is the net realizable value.
Write-Offs to the Allowance Account

  • When a specific account is deemed uncollectible, it is written off against the allowance account.

  • This involves removing the accounts receivable and an equal amount from the allowance account.

  • Example: John Parker’s account of 6,0006,000 is written off:

    • Debit: Allowance for Doubtful Accounts
    • Credit: Accounts Receivable

  • The Allowance for Doubtful Accounts will usually have an ending balance because it is based on an estimate.

  • Write-offs will rarely equal the beginning balance of the allowance account.

    • Credit balance: Write-offs are less than the beginning balance.
    • Debit balance: Write-offs exceed the beginning balance.

  • After the end-of-period adjusting entry, the Allowance for Doubtful Accounts should always have a credit balance.

  • If an account written off against the allowance account is later collected:

    • The account is reinstated by reversing the write-off entry.
    • Cash received is recorded as a receipt on account.

  • Example: Nancy Smith’s account of 5,0005,000 is collected after being written off:

    • Debit: Accounts Receivable
    • Credit: Allowance for Doubtful Accounts (reinstatement)
    • Debit: Cash
    • Credit: Accounts Receivable (collection)

Estimating Uncollectibles

  • The allowance method requires estimating uncollectible accounts at the end of the period.
    • Estimates based on past experience, industry averages, economic conditions, and future forecasts.
  • Two main methods:
    • Percent of Sales Method
    • Analysis of Receivables Method
Percent of Sales Method
  • Estimates uncollectible accounts as a percentage of credit sales.
  • If the credit sales portion is constant, the percentage can be applied to total sales.
  • Example Data:
    • Accounts Receivable Balance: 240,000240,000
    • Allowance for Doubtful Accounts Balance: 3,2503,250 (Credit)
    • Total Credit Sales: 3,000,0003,000,000
    • Bad Debt as a Percent of Credit Sales: 3/43/4%
  • The formula for Bad Debt Expense = Credit Sales × Bad Debt as a Percent of Credit Sales

Bad Debt Expense = $3,000,000 × 0.75% = $22,500

  • Adjusting entry would be to debit Bad Debt Expense and credit Allowance for Doubtful Accounts.
  • After the adjustment, Allowance for Doubtful Accounts will have adjusted balance 3,250 + $22,500= $25,750
    • Under the percent of sales method, the amount of the adjusting entry is the amount estimated for Bad Debt Expense.
Analysis of Receivables Method
  • Assumes the longer an account receivable is outstanding, the less likely it is to be collected.
  • Steps:
    1. Determine the due date of each account receivable.
    2. Determine the number of days each account is past due.
    3. Place each account in an aged class.
    4. Determine the totals for each aged class.
    5. Multiply each aged class total by an estimated uncollectible percentage for that class.
    6. Determine the estimated total of uncollectible accounts by summing the uncollectible amounts for each aged class.
  • The aging schedule summarizes these steps, and the overall process is known as aging the receivables.
  • The sum of estimated uncollectible accounts for each aged class is the estimated uncollectible accounts.
    • This provides the desired adjusted balance for the Allowance for Doubtful Accounts.
  • Amount to be added to Allowance for Doubtful Accounts = Estimated Uncollectible Balance − Unadjusted Allowance Balance
  • Using the example from before, the company has an unadjust allowance balance of 3,2503,250 and the aging schedule determined the uncollectible accounts to be 26,49026,490, therefore:

Amount \, to \, be \, added = $26,490 - $3,250 = $23,240

  • After the adjusting enteries are posted:
    • Bad Debt Expense will have an adjusted balance of 23,24023,240
    • Allowance for Doubtful Accounts will have an adjusted balance of 26,49026,490
    • Net Realizable value of the receivables is 240,000 - $26,490 = $213,510

Comparing Estimation Methods

  • Percent of Sales Method
    • Focuses on Bad Debt Expense.
    • Emphasizes matching revenues and expenses, thus prioritizing the income statement.
  • Analysis of Receivables Method
    • Focuses on Allowance for Doubtful Accounts.
    • Emphasizes net realizable value of receivables, thus prioritizing the balance sheet.

Comparing Direct Write-Off and Allowance Methods

  • Allowance Method uses an estimate based on:
    • a percent of sales or
    • an analysis of receivables.
  • Bad Debt Expense is recorded:
    • Direct Write-Off Method: When the specific customer accounts are determined to be uncollectible.
    • Allowance Method: Through Allowance account
  • The allowance usage:
    • Direct Write-Off Method: No allowance account is used.
    • Allowance Method: The allowance account is used.
  • Primary users type of companies:
    • Direct Write-Off Method: Small companies and companies with few receivables.
    • Allowance Method: Large companies and those with a large amount of receivables.

Notes Receivable – Advantages

  • A note has some advantages over an account receivable.

    • By signing a note, the debtor recognizes the debt and agrees to pay it according to its terms.
    • A note is a stronger legal claim.

Characteristics of Notes Receivable

  • A promissory note is a written promise to pay the face amount, usually with interest, on demand or at a date in the future.
  • Parts of a promissory note:
    1. The maker is the party making the promise to pay.
    2. The payee is the party to whom the note is payable.
    3. The face amount is the amount for which the note is written on its face.
    4. The issuance date is the date a note is issued.
    5. The due date or maturity date is the date the note is to be paid.
    6. The term of a note is the amount of time between the issuance and due dates.
    7. The interest rate is the rate of interest that must be paid on the face amount for the term of the note.
  • The interest on a note is computed as follows:

Interest=FaceAmount×InterestRate×(Term÷360days)Interest = Face Amount × Interest Rate × (Term ÷ 360 days)

  • The interest rate is stated on an annual (yearly) basis, while the term is expressed as days.
  • To simplify, 360 days per year will be used.
  • In practice, companies such as banks and mortgage companies use the exact number of days in a year, 365.
  • The maturity value is the amount that must be paid at the due date of the note, which is the sum of the face amount and the interest.

Accounting for Notes Receivable

Receipt:
  • A promissory note may be received by a company from a customer to replace an account receivable.
  • In such cases, the promissory note is recorded as a note receivable.
Example:

  • A company journalizes the receipt of a 30-day, 12% note dated November 21 in settlement of the account of W. A. Bunn Company, which is past due and has a balance of 6,0006,000 as follows:

    • Debit: Notes Receivable
    • Credit: Accounts Receivable
At the due date:

  • The company journalizes the receipt of 6,0606,060 (6,0006,000 face amount plus 6060 interest) as:

    • Debit: Cash
    • Credit: Notes Receivable
    • Credit: Interest Revenue

  • If the maker of a note fails to pay the note on the due date, the note is a dishonored note receivable.

  • A company that holds a dishonored note transfers the face amount of the note plus any interest due back to an accounts receivable account.

  • Example: The 6,0006,000, 30-day, 12% note received from W. A. Bunn Co. and recorded on November 21 is dishonored. The company holding the note transfers the note and interest back to the customer’s account as follows:

    • Debit: Accounts Receivable
    • Credit: Notes Receivable
    • Credit: Interest Revenue
Adjusting enteries:

  • A company receiving a note should record an adjusting entry for any accrued interest at the end of the period.

    • Debit: Interest Receivable
    • Credit: Interest Revenue

  • The receipt of the maturity value of the note on its due date is recorded as follows:

    • Debit: Cash
    • Credit: Interest Receivable
    • Credit: Notes Receivable
    • Credit: Interest Revenue

  • The interest revenue account is closed at the end of each accounting period.

  • The amount of interest revenue is normally reported in the “Other revenue and expense” section of the income statement.

Reporting Receivables on the Balance Sheet

  • All receivables that are expected to be realized in cash within a year are reported in the “Current assets” section of the balance sheet.
  • Current assets are normally reported in the order of their liquidity, beginning with cash and cash equivalents.
  • A company may choose to subtract the allowance for doubtful accounts from accounts receivable on the balance sheet to report the net realizable value of receivables.
  • Other disclosures, such as unusual credit risks within the receivables, are reported in the financial statement notes.

Analysis for Decision Making: Accounts Receivable Turnover and Days’ Sales in Receivables

  • Two financial measures that are useful in evaluating efficiency in collecting receivables are the following:
    • accounts receivable turnover
    • days’ sales in receivables
  • The accounts receivable turnover measures how frequently during the year the accounts receivable are being converted to cash.

Accounts Receivable Turnover=SalesAverage Accounts ReceivableAccounts \, Receivable \, Turnover = \frac{Sales}{Average \, Accounts \, Receivable}

  • The average accounts receivable can be determined by adding the beginning and ending accounts receivable balances and dividing by 2.
  • The days’ sales in receivables is an estimate of the length of time the accounts receivable have been outstanding.
  • With credit terms of n/30, the days’ sales in receivables should be about 30 days. It is computed as follows:

Days′ Sales in Receivables=Average Accounts ReceivableAverage Daily SalesDays' \, Sales \, in \, Receivables = \frac{Average \, Accounts \, Receivable}{Average \, Daily \, Sales}

  • Average daily sales are determined by dividing sales by 365 days.