UNIT-FOUR

Accounting Receivables

INTRODUCTION

Receivables are claims against other entities. Many companies sell on credit in
order to sell more services or goods. The receivables that result from sales are
normally classified as accounts receivables. The most common transaction
creating a receivable is selling merchandise or service on credit. Accounts
receivables are normally informal claims expected to be collected within a
relatively short period, where as notes receivables are formal, written
instruments of credit.

4.1. Nature and valuation of receivables

4.1.1.: Nature of Receivable

Receivables represent a company’s claims to the future collection of cash,

other assets or services. Receivables arising from sale of goods and services on
account are called accounts receivables and often are referred to as trade
receivables. Non-trade receivables are those other than trade receivables and
include interest receivables, rent receivables, loans by the company to other
entities and so on.

Accounts receivable arise from credit sales to customers by both retailers and
whole sales. The amount of credit sales has increased in recent years,
reflecting several factors including an efficient banking system and a sound
economy. Merchandising businesses can sell their merchandises either on
cash or on credit

Accounts receivable are current assets because by definition, they will be

converted to cash within the normal operating cycle.

When sales are made on account, the entry is:

Accounts receivable ………….XX

Sales revenue………………….XX

4.1.2 Valuing Accounts Receivable

Companies that extend credit to customers know that it is unlikely that all
customers will fully pay their accounts. When a company directly grants
credit to its customers, there are usually some customers who do not pay
what they promised. The accounts of these customers are uncollectible
accounts, commonly called bad debts. Bad debt expense is an inherent cost of

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 granting credit. It is an operating expense incurred to boost sales. The total
amount of uncollectible accounts is an expense of selling on credit.

4.1.3: Methods of Accounting for Bad Debts

Companies usually use two methods to account for uncollectible account.

These are: (A) allowance method and (B) direct write-off method.

(A) Allowance Method

As it is not expected that all accounts receivables will be collected, the balance
sheet should report only the expected net realizable value of the asset.
Therefore an estimate is needed to record bad debt expense and the related
reduction of accounts receivable. In an adjusting entry we debit bad debt
expense and reduce accounts receivables indirectly by crediting a contra
account to receivables account called, Allowance for uncollectible account

The allowance method of accounting for bad debts matches the expected loss
from uncollectible accounts receivable against the sales they produce. We
must use expected losses management because we cannot exactly identify the
customers who will not pay their bills at the time of sale. This means at the
end of each period, the allowance method requires us to estimate the total bad
debts expected to result from that period’s sales. This method has two
advantages over the direct write-off method (1) bad debts expense is charged
to the period when the related sales are recognized, and (2) accounts
receivable are reported on the balance sheet at the estimated amount of cash
to be collected.

Example: Assume XYZ Company sells its products offering a 30-day’s credit
period. At the end of the year, it has accounts receivables of Br 305,000 and
from experience it anticipates that 2% of all credit sales will be uncollectible.

The entry is:

Bad debt expense…………….……6,100

Allowance for doubtful account….6, 100

Writing-off a Bad Debt

When the estimated doubtful account is later on determined that all or portion
of the amount will not be collected, it has to be written-off.

Using the allowance method, the write-off is recoded as a debit to allowance

for uncollectible accounts and a credit to accounts receivable.

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 Assume from the previous example that Br 3,100 is proved uncollectible, and
then the entry will be:
Allowance for doubtful account-………3,100

Accounts receivable…………………….3, 100

Recovery of a Bad Debt

Occasionally, a receivable that has been written-off will be collected in part or

in full. When this happens, the receivable and the allowance should be
reinstated. In other words, the entry to write-off the account simply is reversed
and the collection is then recorded as the usual way as debit to cash and a
credit to accounts receivable.

For example- assume that in our previous illustration, Br 2000 that was
previously written-off is collected. The following journal entries are required.

Accounts receivable---------2000

Allowance for doubtful account-------2000

(To reinstate the written-off account)

Cash---------------------------2000

Accounts receivable------------2000

(To record the Cash collection)

B) Direct Write-off Method

If uncollectible accounts are not anticipated or are immaterial, or if it is not

possible to reliably estimate uncollectible accounts, an allowance for
uncollectible accounts is not appropriate. In such cases, a direct-write-off
method is used.

The direct write-off methods of accounting for bad debts records the loss
from an uncollectible account receivable at the time it is determined to be
uncollectible. No attempt is made to predict uncollectible accounts or bad
debts expense. Bad debts expense is recorded when specific accounts are
written off as uncollectible.

If ABC determines that it cannot collect Birr 820 owed too it by its customer,
the loss is recognized using the direct write-off method as follows:

Bad debt expense----------820

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 Accounts receivable----------820

The debit in this entry charges the uncollectible amount directly to the current
year’s Bad Debts Expense account. The credit removes the balance of the
account receivable from the subsidiary Ledger and from the controlling
account.

Sometimes an account written-off is later collected. This can be due to factors

such as continual collection efforts or the good fortune of a customer. If the
account that was written-off directly to Bad Debts Expense is later collected in
full, the following two entries record this recovery:

Accounts receivable----------------820

Bad debt expense--------------820

(To reinstate account previously written-off)

Cash--------------------820

Accounts receivable-----820

(To record collection)

4.1.4. Estimating Bad Debts Expense

Companies with direct credit sales estimate bad debts expense. They do this
to help them manage their receivables and to set credit policies. The
allowance method of accounting for bad debts also requires an estimate of bad
debts expense to prepare the adjusting entry at the end of each accounting
period.

There are two common methods. One is based on the income statement
relation between bad debts expense and sales. The second is based on the
balance sheet relation between accounts receivable and the allowance for
doubtful accounts. Both methods require an analysis of experience.

Percent of sales method

The percent of sales method uses statement relations to estimate bad debts. It
is based on the idea that a given percent of a company’s credit for the period
are uncollectible. The income statement would then report that percent as the
amount of bad debts expense.

To illustrate, assume ABC has credit sales of Birr 500,000 in 2000. Based on
past experience and the experience of similar companies, ABC estimates 0.6%

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 of credit sales are uncollectible. Using this prediction, ABC expect Birr 3,000
of bad debts expense from 2000’s sales (computed as Birr 500,000x0.006=Birr
3,000). The adjusting entry to record this estimated expense is:

Bad Debts expense-------------------3000

Allowance for doubtful account--------3000

This entry doesn’t mean the December 31, 2000 balance in Allowance for
Doubtful Accounts will be Birr 3000. A Birr 3000 balance occurs only if the
account had a zero balance prior to posting the adjusting entry. For several
reasons, the unadjusted balance of Allowance for Doubtful Accounts cannot
be zero. Unless a company is in its first period of operations, the allowance
account will have a zero balance only if the prior amounts written-off as
uncollectible exactly equal to the prior estimated bad debts

Accounts Receivable method

The accounts receivable methods use balance sheet relation to estimate bad
debts, primarily, the relation between accounts receivable and the allowance
amount. It is based on the idea that some portion of the end-of period account
receivable balance is not collectible. The objective for this bad debts adjusting
entry is to make the Allowance for Doubtful Account balance equal to the
portion of outstanding account receivable estimated as uncollectible. To obtain
this required balance for the Allowance for Doubtful Accounts, we compare its
balance before the adjustment with our estimated balance. Account is done in
one of two ways: (1) simple estimates of percent uncollectible from the total
outstanding account receivable and (2) aging account receivable.

Percent Accounts Receivable method

The percent of accounts receivable approach assumes a given percent of a

company’s outstanding receivable are uncollectible. This estimated percent is
based on experience and the experience of similar companies. Current
conditions such as recent economic trends and difficulties faced by customers
do also have impacts on it. The total dollar amount of all outstanding
receivable is multiplied by an estimated percent to get the estimated dollar
amount of uncollectible account. This amount is reported in the balance sheet
as the balance for allowance for Doubtful Accounts, We prepare an adjusting
entry debiting Bad Debts Expense and crediting Allowance for Doubtful
Accounts. The amount of adjustment is the amount necessary to give us the
required balance in Allowance for Doubtful Accounts.

Assume ABC had Birr 50,000 of outstanding accounts receivable on December

31.1999 past experience suggests 5% of outstanding receivable are

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 uncollectible. This means that after the adjusting entry is posted, we want the
Allowance for Doubtful Accounts to show a Birr 2,500 credit balance
computed as 5% of Birr 50,000=2500). Before the adjustment, the account
appears as:

Prior to the December 31, 1999 adjustment, the allowance for doubtful
account has a credit balance of Br 200. The Adjusting entry to give the
allowance the required Birr 2,500 balance is:

Dec. 31 Bad Debts Expense …………………. 2,300

Allowance for Doubtful Account…… 2,300

Aging of Accounts receivable method

Both the percent of sales (income statement) method and the percent of
accounts receivable (balance sheet) method use information from past
experience to estimate the amount of bad debts expense. Another balance
sheet method using receivables information produces a more precise estimate
and uses experience and current information. The aging of accounts receivable
method examines each account receivable to estimate the amount
uncollectible. Receivable are classified by how long they are past their due
dates. Then, estimates of uncollectible amount are made assuming the longer
an amount is past due the more likely it is to be uncollectible.

In aging accounts receivable outstanding at the end a period, we examine each

account and classify it by how much time has passed since it was due.
Classification depends on the judgment of a company’s management.
However, classes are often based on 30-days (or one-month period). After the
outstanding amounts are classified (or aged), experience is used to estimate
the percent of each class that is uncollectible. These percents are applied to
the amount in each class to get the required balance of the Allowance for
Doubtful Account.

Aging of Accounts Receivable

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 Estimated uncollectible

Age Interval Balanc Percent

e Amount
Not past due 75,000 2% = 1500
1-30 days past 4000 5% = 200
due
31-60 days 3100 10% = 310
past due
61-90 days 1900 20% = 380
past due
91-180 days 1200 30% = 360
past due
181-365 days 800 50%= 400
past due
> 365 days 300 80%= 240
past due

Total 86,300 Br 3390

The longer an accounts receivable remains outstanding, the less likely that it will
be collected. In the aging of receivables, an aging schedule is prepared by
classifying each receivable by its due date. Based on the above exhibit, the
desired balance for the allowance for doubtful accounts is estimated as Br 3390.
Assume that the unadjusted balance of the allowance account is credit balance
of Br 510. The amount to be added to this balance is therefore Br 2880 (3390-
510). Then the adjusting entry will be:

Uncollectible accounts expense………2880

Allowance for doubtful account………2880

Estimation of uncollectible accounts expense based on aging of receivables

emphasizes on the current net realizable value of receivables and hence the
amount of uncollectible receivables estimated by aging is the adjusted balance
of receivables.

Required adjustment for Accounts Receivable is Br.3390 .

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 Unadjusted balance ………… Birr 510 credit

Required balance ………..…….Birr 2,880 credit

Required adjustment …………Birr 3390 credit

4.2.: Notes Receivable

Promissory notes are used in many transactions, including paying for

products and services, in the lending and borrowing of money, and to pay for
accounts receivable. In this section, we will discuss computations of maturity
date and maturity value of a note, how to record receipt of a note, how to
account for discounting of a note before it matures. We also discuss cases of
dishonored note.

4.2.1 Interest bearing

The typical notes receivable requires the payment of a specified face amount,
also called principal, at a specified maturity date or dates. In addition, interest
is paid at a stated percentage of the face amount. Interest is the cost of
borrowing money for the borrower or the profit from lending money for the
lender. Unless otherwise stated, the rate of interest on a note is the rate
charged for the use of the principal for one year.

Interest on notes is calculated as:

I= (P) (R) (T)

Where

I=Interest

P=Principal

R=Annual Interest Rate, and

T=Time (Period)

For example-On January 1, 2.007, Ambasel Trading sold fertilizers to

cooperatives agreeing to accept, Br 700,000, 6-month, 12% notes. The note is
payable on December 31, 2007

The entry is:

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 Jan-1, 2007 Notes receivable---------700,000

Sales revenue-----------700,000

(To record the ale of fertilizers)

Dec, 31, 2007, Cash------------------------------784,000

Notes receivable----------------------------700,000

Interest income (700,000x12%x1yr) -----84,000

(To record the collection of cash at maturity)

4.2.2 Maturity Date and Period

The maturity date of a note is the day on which the note (principal and
interest) must be repaid. The period of a note is the time from the date of the
note to its maturity date. Many notes mature in less than a full year, and the
period covered by then is often expressed in days. When the time of a note is
expressed in days, the maturity date is the specified number of days after the
date of the note. As an example, a five-day not dated June 15 matures and is
due on June 20. A 90-day note dated July 10 matures on October 8. Thus
October 8, due date, is computed as shown below

Maturity Date Computation

Day in July 31
………………………….
Minus the date of the 10
note …
Days remaining in 21
July……………
Add days in August 31
……………….
Add days in September 30
…………..
Days to equal 90 days, or Maturity 8 Maturi
Date, October ty

Date
Period of the note in 90
days

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 The period of a note is sometimes expressed in months or years. When
months are used, the note matures and is payable in the month of its maturity
on the same day of the month as its original date. A three-month note, dated
July 10, for instance, is payable on October 10. The same analysis applies
when years are used.

4.2.3. Receipt of a Note

Notes receivable is usually recorded in a single notes receivable account to

simplify record keeping. We need only one account because the original notes
are kept on file. This means, that we can understand the maker, rate of
interest, due date, and other information by examining the actual note

To illustrate the recording for the receipt of a note, assume ABC receives a
note of the Birr 1,000. 90-day, 12%. This transaction is recorded as:

July 10 Notes receivable ……………… 1,000

Sales………………………….. 1,000
( Sold merchandise in exchange for a 90-day,
12% note)

Companies also sometimes accept a note from an overdue customer as a way

of granting a time extension on a past-due account receivable. When this
occurs, a company may collect part of the past-due balance in cash. This
partial payment forces a concession from the customer, reduces the
customer’s debt and produces a note for a smaller amount. ABC, for instance,
agreed to accept Birr 400 in cash and a Birr 600, 60-day, 15% note to settle
its Birr 1000 past-due account. ABC made the following entry to record
receipt of this cash and note:

Oct. 5 Cash……………………..….. 400

Note Receivable…………… 600
Accounts Receivable……… 1000
Received cash and note to settle account

Honoring and dishonoring a Note

The principal and interest of a note are due on its maturity date. The maker
of the note usually honors the note and pays it in full. But sometimes a
maker dishonors the note and does not pay it at maturity.

4.2.4. Recording an Honored Note

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 We use the ABC note transaction above to illustrate the honoring of a note.
When ABC collects a note on its due date, It records its receipt as:

4 Cash……………………….. 615
Notes receivable…….600
Interest earned………5
Collected note with interest of
Birr 600 x 15% x 60/360.

Interest Earned, also called Interest Revenue, is reported on the current

period’s income statement.

Recording a Dishonored Note

When a maker of a note is unable or refuses to pay at maturity, the note is

said to be dishonored. The act of dishonoring a note does not relieve the
maker of the obligation to pay. The payee should use every legitimate means
to collect.

The balance of the Notes Receivable account normally includes only those
notes that have not been matured. When a note is dishonored, we, therefore,
remove the amount of this note from the notes receivables account and charge
it back to an account receivable from its maker. For instance, Geni holds a
Birr 800, 12%, 60-day note of Tigist. At maturity, Tigist dishonored the note.
Geni records this dishonoring of its notes receivable as follows:

Accounts receivable-Geni……. 816

Interest earned …………… ….16
Notes receivable………………800
To charge account of Geni for a dishonored note and
interest of Birr 800 x 12% x 60/360

Charging dishonored note back to the account of its maker serves two
purposes. First, it removes the amount of the note from the notes receivable
account, leaving in the accounts that have not been matured. It also records
the dishonored note in the maker’s account.

Second, and more important, if the maker of the dishonored note applies for
credit in the future; his or her account will show all past dealings, including
the dishonored note. Restoring the account also reminds the company to
continue collection efforts. Note that Geni owes both principal and interest.
The above entry records the full amount owed in Geni’s account and credits

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 the interest earned. This ensures that interest is included in efforts to collect
from Geni.

4.2.5. End-of-Period Interest Adjustment

When notes receivable are outstanding at the end of an accounting period,

accrued interest is computed and recorded. This recognizes both the interest
revenue when it is earned and the added asset (interest receivable) owned by
the holder of the note. For instance, on December 16, ABC accepted a Birr
3,000, 60-days, 12% note from a customer in granting an extension on a past-
due account. When ABC’ accounting period ends on December 31, Birr 15 of
interest has accrued on this note (Birr 3,000 x 12% x 15/360). The following
adjusting entry records this revenue:

Dec. 31 Interest receivable………………….15

Interest earned ……………………………15
To record accrued interest adjustment.

This adjusting entry means interest earned appears on the balance sheet as a
current asset.

4.3. Presentation of receivables in the balance sheet

Accounts receivables are current assets because they will be converted in to

cash with in the current accounting period. Hence, it is reported as current
asset in the balance sheet section. However notes receivables may be classified
as current or non-current asset depending on the expected payment dates.

Receivables are reported in the balance sheet at net realizable value.

Allowance for doubtful account is a contra account to accounts receivable. In
the current asset section of the balance sheet, accounts receivable would be
reported net of the allowance as follows

Accounts receivable…...........................450,000

Less: allowance for doubtful account…...50,000

Balance…………………………………….. 400,000
4.4 Uses of Receivables as a Source of Cash

Business enterprises raise cash needed for current operation through the collection
of receivables. This can be accelerated by :

i. Pledging receivables as a collateral for loans

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 ii. Selling receivables
iii. Assigning receivables

Enterprises engaged in buying of receivables are called factors, and the process of
selling receivables is called factoring. Factors buy receivables outright, i.e. without
recourse. Alternatively, factors or other lenders may buy receivable with recourse, or
may lend money to the owner of the receivable under a legal agreements known as an
assignment. In such cases customers are instructed to make payments to the factors.

Sales of Receivables without recourse

The purpose of selling receivables without recourse is to shift the purchaser of the
receivables the risk of credit losses, the effort of collection, and the waiting period that
result from granting credit.

Sales of Receivables with recourse

When receivables are sold with recourse, the seller (transferor) guarantees the
receivables, and the purchaser (transferee) is reimbursed for failure of debtors to pay
the full amounts anticipated at the time of sale. The proceeds received under this sale
method is less than the face amount of the receivables sold.

Example receivable with face value of $20,000 has a carrying amount of $19,400 is
sold for $18,500. Record the entry.

Cash ……………………………………18,500
Allowance for doubtful accounts…………..600
Loss on sale of Accounts receivables ……...900
Accounts receivable…………………………..20,000

However the sale installment receivable that bear a higher interest rate than the
discount rate used to compute proceeds on sale would result in a gain.

Example consider a fully collectible installment receivable, which has 1.5% per month
payable at a rate of $723 a month for 36 months was sold for a discount amount of
1% . Record the sale of the installment, collection of the receivable from the customer
show whether there is gain or loss.

Solution

36 X $723 = $26,026
Present value of ordinary annuity of 36 payments of $723 a month at 1.5% interest is
$723 x 27.660684 = $20,000
The difference between them is $26026-20,000 = $6,026 is deferred interest revenue.
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Present value of ordinary annuity of 36 payments of $723 a month at 1% interest is
$723 x 30.107505 = $21768.

Cash. ……………………….. 21,768

Deferred interest revenue……..6,026
Installment receivable…………………26,026
Gain on sale of installment receivable….1,768
To record sale installment receivable on a recourse basis
The buyer of the receivable will record the following entry for acquisition and the first
collection.

Installment receivable…………………26,026
Deferred interest revenue……………………4,260
Cash ………………………………………..21,768

To record acquisition of installment receivable on a recourse basis to yield 1% a

month.

Cash. ……………………….. 723

Deferred interest revenue……..218
Installment receivable………………723
Interest revenue……………………..218
To record receipt of first monthly installment

A sale of receivable with recourse has a characteristic of borrowing collateralized by

the receivables. Transfer of receivables with recourse is recognized as a sale if the
following conditions are met:

1. The transferor surrenders control of the future economic benefit in the

receivables
2. The transferor obligation under the recourse provision can be reasonably
estimated.
3. The transferee can not require the transferor to purchase the receivables.

If any of this condition is not met, the proceeds from the transfer of receivables is
reported as a liability resulting from borrowing.

Assignment of Receivables

Instead of selling receivables, a business may borrow money using the receivables as
collateral. The proceeds from collection of receivables must be used to retire the loan.
Alternatively, receivables must be assigned under a formal arrangement where a
borrower (assigner) pledges the receivables to a lender (assignee) and signs a
promissory note payable. Assignee gives the assignee the same right to bring action to
collect the receivables that the assignor posses. The risk is absorbed by the assignor
and makes collection efforts to make good any receivables that can not collected.

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The assignor has some equity in the assigned receivable because the financing
company advances less than 100% of the face amount of the receivables assigned.
Assigned receivables are recorded in as a separate ledger account.

Example:- assume that on Jan.1 Admass co. assigned receivables of $50,000 to

Fincha co. and received $45,000 less a fee of 2% on the amount advanced. Interest 1%
of the unpaid balance of the loan was to be paid monthly. Make entries to record
assignment and subsequent transactions if Admass co. collected $30,150 on Jan.31,
and $17,000 on Feb.28. Remember the proceeds from collection of receivables must be
used to retire the loan

Jan. 1 Assigned accounts receivable ………50,000

Accounts receivable …………………………...50,000

Cash ………………………...44,100
Interest expense ………………..900
Notes payable to Fincha.co……………45,000
To record assignment and cash receipt.

Jan.31. Cash ………………………….30,150

Assigned accounts receivable………….30,150
To record cash collection from the customer.

Notes payable to Fincha.co……………29,700

Interest Expense (45,000 x 1%)………………450
Cash……………………………………30,150
To record cash payment to Fincha co.

Feb.28 Cash ………………………….17,000

Assigned accounts receivable………….17,000
To record cash collection from the customer.

Notes payable to Fincha.co…………………15,300

Interest Expense ([45,000 -29,700] x 1%)……..153
Cash…………………………………………15,300
To record cash payment to Fincha co.
Feb.28. Accounts receivable………….2,850
Assigned accounts receivable………..2,850

50,000- [30,150+17,00]= 2,850

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