Cash and Receivables

Part 2
I N T ERMEDIATE ACCOU N T I NG I

CHA PT ER 7
 Measuring and Reporting Accounts Receivable
Recognition Depends on the earnings process; for most credit sales, revenue and the
related receivables are recognized at the point of delivery.

Initial valuation Initially recorded at the exchange price agreed upon by the buyer and
seller.

Subsequent valuation Initial valuation reduced to net realizable value by:

1. Allowance for sales returns
2. Allowance for uncollectible accounts:
- The income statement approach
- The balance sheet approach

Classification Almost always classified as a current asset.

 VALUING ACCOUNTS RECEIVABLE
Accounts Receivable should be reported on the balance
sheet under Current Assets at their net realizable value.
Possible returns and customer nonpayment could cause
subsequent accounts receivable to be less than initial
valuation.
 UNCOLLECTIBLE ACCOUNTS
Uncollectible accounts (or bad debts) must be accounted for by
companies who offer credit.
Two methods exist for accounting for uncollectible accounts:
Direct Write-off Method
Allowance Method
o Income Statement Approach (estimate is a percentage of sales)
o Balance Sheet Approach (estimate is a percentage of accounts
receivable adjusted for previous estimates)
If the estimate for bad debts is material, the allowance method should
be used. The allowance method adheres to the Matching Principle by
attempting to estimate future bad debts and match them with the
related sales revenue in the current accounting period.
 UNCOLLECTIBLE ACCOUNTS:
Allowance Method Income Statement Approach
The Hawthorne Manufacturing Company sells its products offering 30 days credit to its
customers. During 2014, the following events occurred:

Sales on credit $1,200,000

Cash collections from credit customers 895,000
Accounts receivable, end of year $ 305,000

Assume an aging of accounts receivable revealed a required allowance of $25,500, and the
allowance account prior to the adjusting entry was a credit balance of $4,000:
Prepare the journal entry to record the adjustment for uncollectible accounts using the
Income Statement Approach.
Bad debt expense 24,000
Allowance for uncollectible accounts 24,000
(2% x $1,200,000)
 UNCOLLECTIBLE ACCOUNTS:
Allowance Method Balance Sheet Approach
The Hawthorne Manufacturing Company sells its products offering 30 days credit to its customers. During
2014, the following events occurred:
Sales on credit $1,200,000
Cash collections from credit customers 895,000
Accounts receivable, end of year $ 305,000
Allowance for Uncollectible Accounts $4,000 (credit)

Assume that 8% of ending accounts receivable are estimated to be uncollectible.

Prepare the journal entry to record the adjustment for uncollectible accounts.

Calculation: Bad debt expense 20,400

Desired Balance: $305,000 X .08 = $24,400 Allowance for uncollectible accounts 20,400
Desired Balance $24,400
Less: Credit balance in Allowance account (4,000)
Amount of Adjustment $20,400
 Balance Sheet Presentation
Allowance for uncollectible accounts is a contra account (valuation account)
to accounts receivable. On the 2014 balance sheet in the current asset
section, accounts receivable would be reported net of the allowance. If
material, the amount in the Allowance account should be disclosed on the
face of the balance sheet.

The Allowance account may be listed separately, as follows:

Accounts receivable $305,000
Less: Allowance for uncollectible accounts (24,000) Disclosure Notes:
Net accounts receivable $281,000 Details about accounts
receivable including the
Accounts Receivable may also be shown net of the allowance method used for
estimating bad debts
in one line item, as follows: should be included in
Accounts receivable, less allowances for doubtful the notes to the
accounts $24,000 $281,000 financial statements.
WHEN INDIVIDUAL ACCOUNTS ARE DEEMED UNCOLLECTIBLE

Customer accounts may be determined to be uncollectible for a number of

reasons.
Writing off a debt does not legally release the customer from the obligation
to pay. The purpose is to provide more accurate accounting records.
The process of writing off a receivable using the allowance method is
accomplished by debiting the allowance account and crediting accounts
receivable (and the individual customer accounts in the subsidiary ledger).
 WRITING OFF ACCOUNTS RECEIVABLE
Example
Assume that actual bad debts in 2015 were $25,000. Draft the journal entry to
record the write-off.

Allowance for Uncollectible Accounts 25,000

Accounts Receivable 25,000

Net realizable value is not directly affected by the write-offs since both the
Allowance account and Accounts Receivable are decreased by the same amount.
 When Previously Written-off Accounts
Are Collected
Assume a $1,200 account that was previously written off is collected.
The following journal entries record the event:

Accounts Receivable 1,200

Allowance for Uncollectible Accounts 1,200

Cash 1,200
Accounts Receivable 1,200

The first journal entry reverses the write-off and re-

establishes the receivable. The second entry receives the
payment on account.
 UNCOLLECTIBLE ACCOUNTS:
Direct Write-Off Method
Under the Direct Write-off Method, uncollectible accounts expense is
recognized only as accounts are written off. No allowance for
uncollectible accounts is made. This method should only be used if
uncollectible accounts are not anticipated or are immaterial.

Example
Assume that actual bad debts in 2015 were $25,000. Draft the journal entry to record
the write-off and recognize bad debt expense.

Bad debt expense 25,000

Accounts Receivable 25,000
 SALES RETURNS
Return of merchandise by a customer is recorded by debiting
Sales Returns & Allowances (a contra-revenue account) and
crediting Accounts receivable (to reduce the amount owed
by the customer.) The returned merchandise must also be
accounted for by debiting Inventory and crediting
Cost of Goods Sold.

If material, sales returns should be anticipated

by subtracting an allowance for estimated returns
from accounts receivable. The adjustment for sales
returns is reduced by the actual returns made
during the fiscal year.
 SALES RETURNS
Example Part 1
During 2015, its first year of operations, the Sales
Hawthorne Manufacturing Company sold Accounts Receivable 2,000,000
merchandise on account for $2,000,000.
This merchandise cost $1,200,000 (60% of Sales 2,000,000
the selling price). Customers returned
$130,000 in sales during 2015, prior to Cost of Goods Sold ($2,000,000 X 60%) 1,200,000
making payment.
Inventory 1,200,000
Draft the entries to record sales and
merchandise returned during the year, Returns
assuming that a perpetual inventory system
is used. Sales returns (actual returns) 130,000
Accounts Receivable 130,000

Inventory ($130,000 X 60%) 78,000

Cost of Goods Sold 78,000
 SALES RETURNS
Example Part 2

Hawthorne Manufacturing Company Sales Returns ([$2,000,000 X 10%]-$130,000 70,000

estimates that 10% of all sales will be Allowance for Sales Returns 70,000
returned.

Assuming this is a material amount, draft Inventory-Estimated Returns 42,000

the entries to record the adjustment at the Cost of Goods Sold ($70,000 X 60%) 42,000
end of the fiscal period.
 NOTES RECEIVABLE
Notes Receivable are formal credit arrangements between a creditor and a
debtor. Notes can be issued for cash, merchandise, or other assets.

Payment of the face amount of the note, or principal, is due at a specified

maturity date.

INTEREST-BEARING NOTES RECEIVABLE

The typical Note Receivable is an interest-bearing note. Interest is calculated
on the face amount of the note based on a stated interest rate.
 Interest Bearing Note
Example 1 Note is Collected Prior to Fiscal Year End
The Stridewell Wholesale Shoe Company manufactures athletic shoes that it sells to retailers.
On May 1, 2016, the company sold shoes to Harmon Sporting Goods. Stridewell agreed to
accept a $700,000, 6-month, 12% note in payment for the shoes. Interest is payable at maturity.
Stridewell would account for the note as follows:

May 1, 2016 - To record the sale of goods in exchange for a note

Notes Receivable 700,000
Sales Revenue 700,000

Nov 1, 2016 To record collection of the note at maturity

Cash ($700,000 + $42,000) 742,000
Interest Revenue ($700,000 X 12% X 6/12) 42,000
Notes Receivable 700,000
 Interest Bearing Note
Example 2 Note is Collected After Fiscal Year End
On August 1, 2016, Stridewell sold shoes to Harmon Sporting Goods agreeing to accept a $700,000,
6-month, 12% note in payment for the shoes. Interest is payable at maturity.

The entry to record the sale is the same as that shown in the previous example. In this example, Stridewell
must account for interest accrued at the end of the fiscal year end.
Dec 31, 2016 - To record the adjusting entry for interest revenue
Interest Receivable 35,000
Interest Revenue ($700,000 X 12% X 5/12) 35,000

When the note is collected, Cash is

Feb 1, 2017 To record collection of the note at maturity debited for the full amount of the
Cash ($700,000 + $35,000 + $7,000) 742,000 principal plus 6 months of interest.
Interest revenue in 2017 is for one
Interest Receivable 35,000
month only. Interest Receivable is
Interest Revenue ($700,000 X 12% X 1/12) 7,000 credited for the interest accrued and
Notes Receivable 700,000 recognized in 2016.
 NONINTEREST-BEARING NOTES
Sometimes a receivable assumes the form of a so-called noninterest-bearing
note.

Noninterest-bearing notes actually do bear interest, but the interest is

deducted at the onset (or discounted) from the face amount to determine
the cash proceeds made available to the borrower.
When interest is discounted from the face amount of a note, the effective
interest rate is higher than the stated discount rate.
Similar to accounts receivable, if a company anticipates bad debts on short-
term notes receivable, it uses an allowance account to reduce the receivable
to net realizable value.
The Discount on Note Receivable account is contra to the Note Receivable
account.
 NONINTEREST-BEARING NOTES
The note from the preceding example could be packaged as a $700,000 noninterest-
bearing note, with a 12% discount rate.

May 1, 2016
Notes Receivable (face amount) 700,000
Discount on Note Receivable ($700,000 X 12% X 6/12) 42,000
Sales Revenue (difference) 658,000

Nov 1, 2016
Cash ($700,000 + $35,000 + $7,000) 700,000
Notes Receivable 700,000

Discount on Note Receivable 42,000

Interest Revenue 42,000
 CALCULATING THE EFFECTIVE INTEREST RATE
When interest is discounted from the face amount of a note, the effective interest rate is
higher than the stated discount rate.

Annual Interest at Stated Rate/Sales Price = Effective Annual Interest Rate

$84,000*/$658,000 = .1276595

Stated as a percent rounded to two decimal places = 12.77 %

* $700,000 X .12 = $84,000

 ACCRUAL OF INTEREST

If the sale occurs on August 1, the December 31, 2015, adjusting entry and the entry to
record the cash collection on February 1, 2016, are recorded as follows:

December 31, 2015

Discount on note receivable 35,000
Interest revenue ($700,000 x 12% x 5/12) 35,000

February 1, 2016
Discount on note receivable 7,000
Interest revenue ($700,000 x 12% x 1/12) 7,000

Cash 700,000
Note receivable (face amount) 700,000
 DISCOUNTING (selling) A NOTE RECEIVABLE

The transfer of a note receivable to a financial institution is

called discounting. When a note is discounted to a financial
institution, the seller receives cash in exchange for the note.
The proceeds from the sale are calculated as the maturity value
of the note less the financial institutions discount rate.
 DISCOUNTING A NOTE RECEIVABLE
Example
Discounted Note Treated as a Sale
On December 31, 2015, the Stridewell Wholesale Shoe Company sold land in exchange for
a nine-month, 10% note. The note requires the payment of $200,000 plus interest on
September 30, 2016. The companys fiscal year-end is December 31. The 10% rate
properly reflects the time value of money for this type of note. On March 31, 2016,
Stridewell discounted the note at the Bank of the East. The Banks discount rate is 12%.
Because the note has been outstanding for three months before being
discounted at the bank, Stridewell first records the interest that has
accrued prior to being discounted:
March 31, 2016
Interest receivable 5,000
Interest revenue ($200,000 x 10% x 3/12) 5,000
 DISCOUNTING A NOTE RECEIVABLE
(continued)

Next, the value of the note if held to maturity is calculated. Then the discount
for the time remaining to maturity is deducted to determine the cash proceeds
from discounting the note:

$200,000 Face amount

15,000 Interest to maturity ($200,000 x 10% x 9/12)
215,000 Maturity value
(12,900) Discount ($215,000 x 12% x 6/12)
$202,100 Cash proceeds
Account Debit Credit
Cash (proceeds determined above) 202,100
Loss on sale of note receivable (difference) 2,900
Note receivable (face amount) 200,000
Interest receivable (accrued interest determined above) 5,000
Cash and Receivables
Part 2
I N T ERMEDIATE ACCOU N T I NG I

E N D OF P R ESENTATION