Receivables
Study Guide
I. Generally, when organizations sell to customers without collecting cash at the
time of sale, an account receivable is created. The customer is expected to pay
the organization at some point in the future.
II. When non-cash sales are made, accounts receivable are recorded at the time
revenue is recognized in accordance with revenue recognition under U.S. GAAP.
[See the lesson Revenue Recognition in Part 1, Section A, Topic 2.3 for a review
of revenue recognition and special considerations for when the typical pattern of
recognition is disrupted.]
A. Following is the standard accounts receivable entry for a $100 sale made
on account. Note that if the sale was for inventory, a corresponding entry
to cost of goods sold and inventory would also be required.
B. When the $100 cash is collected, the entity records the following entry.
III. Credit risk, also known as default risk, measures the risk that a customer will not
ultimately pay the organization as promised at the time of sale.
A. A customer failing to pay an accounts receivable results in an uncollectible
account, or bad debt, to the selling entity.
B. Organizations must balance the desire for increased sales from selling on
credit with the risk of incurring credit losses related to its customers
uncollectible accounts.
IV. Organizations account for credit losses, or bad debts, in one of two ways.
A. Allowance method—The organization estimates the amount of bad debt it
will incur and records the expense in the same period as the related sales
using an allowance account called Allowance for Credit Losses, or
Allowance for Uncollectible Accounts.
1. Recording an allowance helps an organization match expenses
associated with uncollectible accounts to related revenues.
2. The organization assumes some amount of receivables will not be
collected for purposes of estimating bad debt expense.
3. Under the allowance method, the organization is reducing accounts
receivable without knowing which specific customers will not pay
their debts in the future. The use of a separate account for the
estimate of uncollectible receivables will allow the sum of the
subsidiary (individual customer) ledgers to reconcile to the account
receivable balance.
4. The allowance for uncollectible accounts is subtracted from
accounts receivable when preparing the balance sheet. The
financial statements, therefore, will reflect only the amount that is
expected to be collected, or Net Realizable Value (NRV) of
Accounts Receivable. This amount is commonly referred to as Net
Accounts Receivable.
5. When a specific customer account is identified as uncollectible, the
organization can write off the amount by reducing both the
allowance for uncollectible accounts and accounts receivable. This
adjustment does not change the amount of Net Accounts
Receivable reflected on the balance sheet. The entry to write off the
sale noted above would be:
6. Organizations use two approaches for estimating uncollectible
receivables under the allowance method.
a. Percentage of receivables or balance sheet approach—The
organization assumes a percentage of existing accounts
receivable will not be collectible and adjusts the allowance
account to reflect that percentage each time the financial
statements are prepared.
i. Because this method is based on a percentage of
accounts receivable, a balance sheet account, it is
often referred to as the balance sheet approach.
ii. The accounts receivable aging is often used to
estimate the total amount of uncollectible accounts at
the end of the period. The estimated amount is
compared to the amount remaining in the allowance
account and the necessary adjustment is recorded.
• If the allowance for uncollectible accounts is too
small, bad debt expense is increased and income
goes down.
• If the allowance for uncollectible accounts is too
large, bad debt expense is decreased and income
goes up.
b. Illustration: An organization has the following accounts
receivable aging and estimates for expected uncollectible
percentages at the end of Year 1.
If the current balance in the allowance account is $15,000,
the organization makes the following entry:
If, on the other hand, the current balance in the allowance
account is $17,000, the organization makes the following
entry:
c. Percentage of revenues or income statement approach—
The organization assumes a certain percentage of sales are
uncollectible and records bad debt expense based on that
percentage of revenue in a given period.
i. Because this method is based on a percentage of
revenue, an income statement account, this is often
referred to as the income statement approach.
ii. Periodically, an organization will review its allowance
for uncollectible accounts to ensure that it is sufficient
to cover uncollectible amounts and adjust the balance
as needed. Regular large adjustments to the
allowance would indicate that the percentage of sales
being used for the estimate should be adjusted going
forward.
d. Illustration: An organization has $100,000 of revenues each
month and assumes 1% of all revenues are uncollectible.
The organization makes the following entry each month:
If, at the end of the year, the balance in the allowance
account is $10,500 (after write-offs during the year), and a
review of the accounts receivable aging indicates the need
for a $16,500 allowance, the organization would adjust the
allowance by recording an additional $6,000 in bad debt
expense. In addition, the organization would likely increase
its percentage of sales used for recording bad debt expense
from 1% to 1.5% going forward.
B. Direct write-off method—The organization waits until a specific account is
identified as not collectible and removes the accounts receivable with an
offsetting entry to bad debt expense.
1. Under U.S. tax laws, bad debts are only recorded using the direct
write-off method.
2. The direct write-off method is the simplest method to use.
3. A disadvantage of using the direct write-off method is that the
expense for bad debt is not matched to the revenue associated with
the sale.
4. Generally, the direct write-off method is not acceptable for U.S.
GAAP reporting purposes unless the uncollectible amounts are
clearly immaterial or there is no reasonable basis for estimating bad
debts.
Practice Question
Company X has the following accounts receivable aging and
estimates for expected uncollectible percentages at the end of Year
1.
Company X has a current credit balance in its allowance for
uncollectible accounts of $22,000 and bad debt expense of $62,000
before adjusting entries.
1. What is the necessary amount of the adjustment to bad debt
expense?
2. What is the Net Accounts Receivable that will be reflected in the
balance sheet after the adjustment is made?
Answer
1. Allowance for uncollectible accounts needs to be adjusted by
$2,840 and bad debt expense will increase by that amount:
Current credit balance in the allowance for uncollectible accounts
before adjustment is $22,000 so it must increase by $2,840 to bring
the allowance to the required balance of $24,840.
2. After the adjustment, the Net Accounts receivable balance
shown in the balance sheet is $625,160, calculated as follows:
V. Organizations can sell, or factor, accounts receivable to third parties and receive
a percentage of the receivables immediately as cash.
A. There are several advantages and disadvantages to factoring receivables.
1. Advantages
a. It is a quick source of cash.
b. Fees are usually based on the credit quality of the
organization's customers, not the organization itself.
c. The organization can raise cash without incurring any
additional debt.
d. The organization does not have to secure financing with
existing assets.
2. Disadvantages
a. It is a short-term cash solution.
b. Investors and creditors could perceive factoring as a sign of
financial difficulty.
c. Fees and expenses can be very high.
B. Factoring can be done either with recourse or without recourse.
1. With recourse means the organization selling accounts receivable
bears the risk of loss relative to collecting the customers’ balances.
a. Fees are generally lower when factoring with recourse than
without recourse.
b. If the customer does not pay its accounts receivable, the
selling organization is required to compensate the factor for
the loss.
c. The selling organization must estimate the amount of the
recourse obligation and record it at the time of the factoring.
d. Illustration: Company A sells $100,000 of accounts
receivable to Company B with recourse. Company B, the
factor, assesses a 2% finance charge and withholds an
additional 5% to cover possible uncollectible amounts.
Company A estimates the recourse obligation to be $3,500.
Company A makes the following entry to record the
factoring:
The loss on the factoring transaction is the sum of the 2%
finance charge and the estimated recourse obligation
($2,000 + $3,500). The Due from Factor and Recourse
Obligation accounts will be settled once both parties agree
that all collection efforts have been exhausted and the
amount of uncollectible accounts is known.
2. Without recourse means the factor (the organization purchasing the
accounts receivable from the selling organization) bears the risk of
loss relative to collecting the customers’ balances.
a. The organization selling the accounts receivable will
generally receive less cash when factoring without recourse
to compensate for the increased risk to the factor.
b. If the customer does not pay its accounts receivable, the
selling organization is not impacted by this nonpayment.
c. Illustration: Company A sells $100,000 of accounts
receivable to Company B without recourse. Company B, the
factor, assesses a 5% finance charge and withholds an
additional 4% to cover late-paying customers. Company A
makes the following entry to record the factoring:
In this case, the loss on the factoring transaction is simply
the 5% finance charge as there is no estimated recourse
obligation. The Due from Factor will be settled once all
money has been collected from customers or both parties
agree that all collection efforts have been exhausted.
Practice Question
Company Y sells $150,000 of accounts receivable to Company Z with recourse.
Company Z, the factor, assesses a 4% finance charge and withholds an additional 3%
to cover possible uncollectible amounts. Company Y estimates the recourse obligation
to be $7,000.
1. What is the amount of the loss on factoring that Company Y will record upon the
sale of these receivables to Company Z?
2. Assume Company Y wishes to renegotiate the sale of receivables to be without
recourse instead. Is the amount of the finance charge likely to be greater than or
less than 4%? Why?
Answer
1. The loss on factoring will include both the finance charge and the amount of the
recourse obligation:
2. The finance charge is likely to be greater than 4% as Company Z will want
compensation for taking on the risk of loss associated with collectability of the
accounts if the sale is without recourse.
Summary
According to revenue recognition principles under U.S. GAAP, when non-cash sales are
made, accounts receivable are recorded at the time revenue is recognized. Credit risk,
or default risk, is the risk that a customer will ultimately not pay the organization as
promised. There are two methods of accounting for credit losses, also known as bad
debts. The first is the allowance method, which is when the organization estimates the
amount of bad debt it will incur and records the expense in the same period as the
related sales using an allowance account. The second method is the direct write-off
method, which is when an organization waits until a specific account is identified as not
collectible to remove the account receivable using an offsetting entry to bad debt
expense. Organizations sometimes factor, or sell, their accounts receivable to a third
party in order to receive a percentage of the receivables immediately as cash.
SLIDES
FLASHCARDS
What is credit risk?
Credit risk is also known as default risk. It measures the risk that a customer will not
ultimately pay the organization what they promised at the time of sale.
Briefly describe the two ways organizations account for credit
losses, or bad debts.
1. Allowance method: The organization estimates the amount of bad debt it will
incur and records the expense in the same period as the related sales using an
allowance account. This method is based on accrual accounting and is used for
GAAP purposes.
2. Direct write-off method: The organization waits until a specific account is
identified as not collectible and removes the accounts receivable with an
offsetting entry to bad debt expense. This method is more like a cash basis and
is used for tax purposes.
What are the two approaches for estimating uncollectible
receivables under the allowance method of accounting for bad
debts?
1. Percentage of receivables or balance sheet approach: The organization
assumes a percentage of existing accounts receivable will not be collectible and
adjusts the allowance account to reflect that.
2. Percentage of revenues or income statement approach: The organization
assumes a certain percentage of sales are uncollectible and records bad debt
expense based on that.
What is factoring a receivable?
When receivables are factored, they are sold for cash immediately, rather than waiting
for the cash to be collected from customers. This usually involves a discount from the
recorded value of the receivables to cover the risk of non-payment by customers.
What does it mean to factor receivables with recourse?
The organization selling accounts receivable bears the risk of loss relative to
collecting the customers’ balances. One advantage to factoring with recourse is that
the fees are typically lower than factoring without recourse. The selling organization
is required to compensate the factor for any loss so they estimate the amount of the
resulting recourse obligation and record it at the time of the factoring.
What does it mean to factor receivables without recourse?
This means that the factor (the organization purchasing the accounts receivable from
the selling organization) bears the risk of loss relative to collecting the customers’
balances. The selling organization typically receives less cash on the sale because the
buyer has increased risk. If the customer does not ultimately pay the factor, the selling
organization is not impacted.
Question 1
aq.rec.001_1802
A company is in its first year of operations and has never written off any accounts
receivable as uncollectible. When the allowance method of recognizing bad debt
expense is used, the entry to recognize that expense:
Increases net income.
Decreases current assets.
Has no effect on current assets.
Has no effect on net income.
This Answer is Correct
This answer is correct. When the allowance method of recognizing bad debt expense
is used, the journal entry is:
Bad debt expense xxx
Allowance for bad debts xxx
The allowance account is a contra account to accounts receivable. Since accounts
receivable is a current asset, current assets will be decreased by the allowance for bad
debts.
Question 2
aq.rec.002_1802
When the allowance method of recognizing bad debt expense is used, the allowance
for doubtful accounts would decrease when a(n):
Specific account receivable is collected.
Bad Debt Expense is recorded using the balance sheet approach.
Bad Debt Expense is recorded using the income statement approach.
Specific uncollectible account is written off.
This Answer is Correct
This answer is correct. When the allowance method of recognizing bad debts is used,
the entry to establish the allowance account is:
Bad Debt Expense xx
Allowance for bad debts xx
The entry to write off a specific uncollectible account is
Allowance for bad debts xx
Accounts Receivable xx
Thus, the allowance is decreased when the account is written off.
Question 3
aq.rec.003_1802
A method of estimating bad debts that focuses on the income statement rather than the
balance sheet is the allowance method based on:
Direct write-off.
Aging the trade receivable accounts.
Credit sales.
The balance in the trade receivable accounts.
You Answered Correctly!
This answer is correct. Estimating bad debts based on credit sales of the period is the
income statement approach in that bad debts are treated as a function of sales.
Question 4
aq.rec.004_1802
When a specific customer's account receivable is written off as uncollectible, what
will be the effect on net income under the allowance method and the direct write-off
method of recognizing bad debt expense?
None, Decreased
Decreased, None
Decreased,
Decreased
None, None
This Answer is Correct
This answer is correct because under the allowance method a bad debt is written off
by making the following entry:
Allowance for doubtful accounts xxx
Accounts Receivable xxx
Since neither of the accounts involved in this entry are income statement accounts,
there can be no income statement effect. Under the direct write-off method, the entry
to write off a bad debt would be
Bad Debt Expense xxx
Accounts Receivable xxx
Since the bad debt expense account is an income statement account, the write-off will
cause net income to decrease.
Question 5
aq.rec.005_1802
Marr Co. had the following sales and accounts receivable balances, prior to any
adjustments at year-end:
Credit sales $10,000,000
Accounts receivable 3,000,000
Allowance for uncollectible accounts 50,000
Marr uses 3% of accounts receivable to determine its allowance for uncollectible
accounts at year-end. By what amount should Marr adjust its allowance for
uncollectible accounts at year-end?
Account Receivable * Percentage Of Allowance - Allowance for uncollectible
accounts
$0
$ 40,000
$ 90,000
$140,000
You Answered Correctly!
This answer is correct because the allowance for uncollectible amounts should be
equal to $90,000, and it is currently $50,000. Therefore the required adjustment is
$40,000 ($90,000 − $50,000).
Question 6
aq.rec.006_1802
Elsa Fashions wants to eliminate its credit department. It also wants to get cash
immediately and continue all operational activities directly with the customers. Which
of the following approaches would be the best to fulfill the company's objectives?
Factor without recourse
Securitization
Sale with recourse
Special investment
vehicle
This Answer is Correct
This answer is correct. Companies that use factor without recourse get immediate cash
and can eliminate their credit department, because the factor takes over these tasks.
The company continues all operational activities directly with the customers, such as
order placement and fulfillment.
Question 7
aq.rec.007_1802
Rue Co.’s allowance for uncollectible accounts had a credit balance of $12,000 at
December 31, Year 1. During Year 2, Rue wrote off uncollectible accounts of
$48,000. Using the balance sheet approach, the aging of accounts receivable indicated
that a $50,000 allowance for uncollectible accounts was required at December 31,
Year 2. What amount of uncollectible accounts expense should Rue report for Year 2?
$48,000
$50,000
$60,000
$86,000
This Answer is Correct
This answer is correct. An examination of the T-account indicates the beginning
balance in allowance for uncollectible accounts has a credit balance of $12,000. When
an account is written off, a debit entry is made to the allowance for uncollectible
accounts. If the aging schedule indicates that a $50,000 allowance is required, then the
ending balance in the Allowance for uncollectible accounts must be $50,000.
Therefore, this answer is correct because $86,000 ($12,000 − $48,000 − $50,000) must
be debited to bad debt expense and credited to the allowance for uncollectible
accounts.
Allowance for uncollectible accounts
12,000
48,000
86,000
50,000
Question 8
aq.rec.008_1802
Wren Company had the following account balances at December 31, Year 1:
Accounts receivable $ 900,000
Allowance for doubtful accounts (before any provision for Year 1 doubtful accounts $16,000
expense)
Credit sales for Year 1 $1,750,000
Wren is considering the following methods of estimating doubtful accounts expense
for year 1:
Based on credit sales at 2%
Based on accounts receivable at 5%
What amount should Wren charge to doubtful accounts expense under the percentage
of credit sales method and the percentage of accounts receivable method,
respectively?
$53,000,
$45,000
$53,000,
$29,000
$35,000,
$45,000
$35,000,
$29,000
This Answer is Correct
This answer is correct. When doubtful accounts expense is estimated based on sales,
any balance in the allowance account is ignored when computing the expense. The
formula to determine the expense is
(Net sales) × (Bad debt rate) = Expense
$1,750,000 × 2% = $35,000
When doubtful accounts expense is estimated based on accounts receivable, the
balance in the allowance account must be considered. This is correct because the
formula is used to compute the desired ending balance in the allowance account, not
the doubtful accounts expense.
(Accts. Receivable) × (Bad debt rate) = Allowance
$900,000 × 5% = $45,000
Since the allowance account already has a credit balance of $16,000, doubtful
accounts expense of $29,000 must be recorded to bring the allowance up to $45,000
($45,000 − $16,000 = $29,000).
Question 9
aq.rec.009_1802
Steve's Igneous Rock store has generous credit terms, so it has significant amounts of
accounts receivable (AR) outstanding. It has created the following aging analysis of
its accounts receivable at year-end:
Term < 30 Days 31–60 Days 61–90 Days 91 + Days
Amount $120,000 $60,000 $20,000 $10,000
Percent Est. Uncollectible 2.00% 5.00% 10.00% 26.00%
In the past, Steve used the aging analysis to estimate bad debts but he is considering a
change to the sales method in order to save time. This year, Steve had sales of
$250,000, with an estimated 5% uncollectible. Steve's G&A expense is 6% of sales.
The current balance in the allowance for doubtful accounts is a $1,000 credit balance.
If Steve adopted the sales method, how much higher (lower) would its bad debt
expense be than under the allowance method?
$4,000
$3,500
$1,500
$12,500
You Answered Correctly!
This answer is correct. This answer calculates the bad debt expense under the sales
method as $12,500 = $250,000 × 5%.
The bad debt expense under the aging method is computed properly. The ending
balance under the aging method is $10,000 = $120,000 × 2% + $60,000 × 5% +
$20,000 × 10% + $10,000 × 26%. Given the beginning $1,000 credit balance, an
expense of $9,000 ($10,000 − $1,000) is needed to have the ending balance equal
$10,000.
Thus, the difference between the two is calculated as $3,500 = $12,500 − $9,000.
