SUPPLEMENTARY LEARNING MATERIALS IN ACCOUNTING 3

(Prepared by Dr. Lily P. Custodio, CPA)

B.1 - Accounts Receivable

I. Discussion of Accounting Principles

Nature of Receivables

1. Receivables are financial assets that represent a contractual right to receive cash or another
financial asset from another entity.

For retailers or manufacturers, receivables are classified as trade receivables and nontrade
receivables.

2. Trade receivables are claims arising from sale of merchandise or services in the ordinary course
of business. Included are accounts receivable and notes receivable.

Accounts receivable are open accounts arising from the sale of goods and services in the
ordinary course of business and not supported by promissory notes. Other names are
customers’ accounts, trade debtors, and trade accounts receivable.

Notes receivable are those supported by formal promises to pay in the form of notes.

3. Nontrade receivables represent claims arising from sources other than the sale of merchandise
or services in the ordinary course of business.

4. Loans receivable – for banks and other financial institutions, receivables result primarily from
loans to customers.

5. Classification of trade and nontrade receivables

 Trade receivables are current assets if expected to be realized in cash within the normal
operating cycle or one year, whichever is longer.

 Nontrade receivables which are expected to be realized in cash within one year, the length of
operating cycle notwithstanding, are classified as current assets.

 If collectible beyond one year, nontrade receivables are classified as noncurrent assets.

 The classifications are in accordance with PAS 1, Presentation of Financial Statements,

paragraph 66, which reads as follows:

“An entity shall classify an asset as current when the entity expects to realize the asset or
intends to sell or consume it in the entity’s normal operating cycle, or when the entity expects
to realize the asset within twelve months after the reporting period”.

6. Examples of Nontrade Receivables

a. Advances to or receivables from shareholders, directors, officers or employees. If collectible

in one year, such advances or receivables should be classified as current assets.

Otherwise, such advances or receivables are classified as noncurrent assets.

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 b. Advances to affiliates are usually treated as long-term investments.

c. Advances to suppliers for the acquisition of merchandise are current assets.

d. Subscriptions receivable are current assets if collectible within one year. Otherwise,
subscriptions receivable should be shown preferably as a deduction from subscribed share
capital.

e. Creditors’ accounts may have debit balances as a result of overpayment or returns and
allowances. These are classified as current assets.

If the debit balances are not material, an offset may be made against the creditors’ accounts
with credit balances and only the net accounts payable may be presented.

f. Special deposits on contract bids normally are classified as noncurrent assets because such
deposits are likely to remain outstanding for a considerable long period of time.

g. Accrued income such as dividend receivable, accrued rent receivable, accrued royalties
receivable and accrued interest receivable on bond investment are usually classified as
current assets.

h. Claims receivable such as claims against common carriers for losses or damages, claim for
rebates and tax refunds, claim from insurance entity, are normally classified as current
assets.
7. Customers’ credit balances are credit balances in accounts receivable resulting from
overpayments, returns and allowances, and advance payments from customers.

These credit balances are classified as current liabilities and are not offset against the debit
balances in customers’ accounts, except when the same is not material in which case only the
net accounts receivable may be presented.

Measurement of Accounts Receivable

1. A financial asset shall be recognized initially at fair value plus transaction costs that are directly
attributable to the acquisition (PFRS 9, paragraph 5.1.1).

2. The fair value of a financial asset is usually the transaction price which means the fair value of
the consideration given.

3. Short-term receivables – the fair value is equal to the face amount or original invoice amount.

4. Accounts receivable shall be measured initially at face amount or original invoice amount.

5. After initial recognition, accounts receivable shall be measured at amortized cost.

6. The amortized cost is actually the net realizable value of accounts receivable.

7. The term amortized cost has more relevance in long-term note receivable.

8. Thus, the term net realization value is preferably used in relation to accounts receivable.

9. The net realizable value of accounts receivable is the amount of cash expected to be collected
or the estimated recoverable amount.

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Net Realizable Value

1. The initial amount recognized for accounts receivable shall be reduced by adjustments which in
the ordinary course of business will reduce the amount recoverable from the customer.

2. This is based on the established basic principle that assets shall not be carried at above their
recoverable amount.

3. In estimating the net realizable value of trade accounts receivable, the following deductions are
made:
a. Allowance for freight charge
b. Allowance for sales return
c. Allowance for sales discount
d. Allowance for doubtful accounts

Terms Related to Freight Charge

1. In order to give proper accounting recognition to freight charge in relation top accounts
receivable, the following terms should be understood – FOB destination, FOB shipping point,
freight collect, and freight prepaid.

2. FOB destination means that ownership of the goods purchased is vested in the buyer upon
receipt thereof. Hence, the seller shall be responsible for the freight charge up to the point of
destination.

3. FOB shipping point means that ownmership of the transportation charge from the point of
shipment to the point of destination. Therefore, it is incumbent upon the buyer to pay for the
transportation charge from the point of shipment to the point of destination.

4. Freight collect means that freight charge on the goods shipped is not yet paid. The common
carrier shall collect the same from the buyer. In this case, the freight charge is actually paid by
the buyer.

5. Freight prepaid means that freight charge on the goods shipped is already paid by the seller.

Accounting for Freight Charge

1. There are times when goods are sold FOB destination but shipped freight collect with the
understanding that the buyer will pay for the freight charge and deduct the same when
remittance is made by him/her.

2. On the part of the seller, the freighht charge is recorded by debiting freight out and crediting
allowance for freight charge.

3. For example, the entity has a P50,000 account receivable at the end of accounting period.

4. The term are 2/10, n/30, FOB destination and freight collect. The customer paid freight charge
of P2,000.

1. To record the sale:

Accounts receivable 50,000
Freight out 2,000
Sales 50,000
Allowance for freight charge 2,000

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 2. To record the collection within the discount period:

Cash 47,000
Sales discount (50,000 x 2%) 1,000
Allowance for freight charge 2,000
Accounts receivable 50,000

Allowance for Sales Returns

1. The measurement of accounts receivable shall also recognize the probability that some
customers will return goods that are unsatisfactory or will make other claims requiring reduction
in the amount due as in the case of shipment shortages and defects.

2. For example, an amount of P20,000 of the total accounts receivable at year-end represents
selling price of goods that will probably be returned. The journal entry to recognize the probable
return is:

Sales return 20,000

Allowance for sales return 20,000

Sales Discount

1. Entities usually offer cash discounts to credit customers. A cash discount is a reduction from an
invoice price by reason of prompt payment.

2. A cash discount is known as sales discount on the part of the seller and purchase discount on
the part of the buyer.

3. A cash discount may be expressed as 5/10, n/30. This means that the customers is entitled to a
5% discount if payment is made in 10 days from the invoice date.

4. If the customer fails to pay within the 10-day discount period, the gross amount of the invoice
price must be paid within 30 days from the invoice date.

Methods of Recording Credit Sales

a. Gross method – Accounts receivable and sales are recorded at gross amount of the invoice.
This is the common and widely used method because it is simple to apply.

b. Net method – Accounts receivable and sales are recorded at net amount of the invoice,
meaning the invoice price minus the cash discount.

Illustration – Gross method

1. Sales of merchandise for P100,000, terms 5/10, n/30.

Accounts receivable 100,000
Sales 100,000

2. Assume collection is made within the discount period.

Cash 95,000
Sales discount 5,000
Accounts receivable 100,000

3. Assume collection is made beyond the discount period.

Cash 100,000
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 Accounts receivable 100,000
Illustration – Net method

1. Sale of merchandise for P100,000, terms 5/10, n/30.

Accounts receivable 95,000
Sales 95,000

2. Assume collection is made within the discount period.

Cash 95,000
Accounts receivable 95,000

3. Assume collection is made beyond the discount period.

Cash 100,000
Accounts receivable 95,000
Sales discount forfeited 5,000

The sales discount forfeited account is classified as other income.

Allowance for Sales Discount

1. If customers are granted cash discounts for prompt payment, it follows that estimates of cash
discounts on open accounts at the end of the period based on past experience shall be made.

2. For example, of the accounts receivable of P1,000,000 at the end of the period, it is reliably
estimated that discounts to be taken will amount to P50,000.

3. The adjustment to record the expected sale discount is:

Sales discount 50,000

Allowance for sales discount 50,000

4. The adjustment may be reversed at the beginning of the next period in order that discounts can
then be charged normally to sales discount account.

Accounting for Bad Debts

1. Business entries sell on credit rather than only for cash to increase total sales and thereby
increase income.

2. An entity that sells on credit assumes the risk that some customers will not pay their accounts.

3. When an account becomes uncollectible, the entity has sustained a bad debt loss. This loss is
simply one of the cost of doing business on credit.

4. Two methods are followed in accounting for this bad debt loss, namely:
a. Allowance method
b. Direct writeoff method

Allowance Method

1. The allowance method requires recognition of a bas debt loss if the accounts are doubtful of
collection. The journal entry to recognize the doubtful accounts is:

Doubtful accounts xx
Allowance for doubtful accounts xx

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2. The “allowance for doubtful accounts” is deduction from accounts receivable.

3. If the doubtful accounts are subsequently found to be worthless or uncollectible, the accounts
are written off as follows:

Allowance for doubtful accounts xx

Accounts recivable xx

4. Generally accepted accounting principle require the use of the allowance method because it
conforms with the matching principle.

5. In this instance, accounts receivable would be properly measured at net realizable value.

Recoveries of Accounts Written Off

1. If a collection is made on account previously written of as collectible, the customary procedure

is first to rechargethe customer’s account with the amount collected and possibly with the entire
amount previously charged off it is now expected that collection will be received in full.

2. The collection is then recorded normally by debiting cash and crediting accounts recivable.

3. The recharging of the customer’s account is usually followed because it is an evidence of the
attempt of the customer to reestablish his credit with the entity.

What account should be credited when the customer’s account is recharged?

4. The generally accepted approach is to simply reverse the original entry of writeoff regardless of
whether the recovery is during the year of writeoff or subsequent thereto.

Illustration – Allowance method

1. Accounts of P30,000 are considered doubtful accounts of collection.

Doubtful accounts 30,000

Allowance for doubtful accounts 30,000

2. The accounts are subsequently discoverd to be worthless or uncollectible.

Allowance for doubtful accounts 30,000

Accounts receivable 30,000

3. The same accounts that are previously written off are unexpectedly recovered
or collected.

Accounts receivable 30,000

Allowance for doubtful accounts 30,000

Cash 30,000
Accounts receivable 30,000

Direct Write-off Method

1. The direct writeoff method requires recognition of a bad debt loss only when the accounts
proved to be worthless or uncollectible.

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2. Worthless accounts are recorded by debiting bad debts and crediting accounts receivable. If the
accounts are only doubtful of collection, no adjustmenrt is necessary.

3. This approach is often used by small business because it is simple to apply.

4. As a matter of fact the Bureau of Internal Revenue recognizes only this method for income tax
purposes.

5. However, the direct writeoff method violates the matching principle because the bad debt loss is
often recognized in later accounting period than the period in which the sales revenue was
recognized.

6. The direct writeoff method is not permitted under IFRS.

Illustration – Direct Writeoff Method

1. Accounts of P30,000 are considered doubtful of collection.

No entry

2. The accounts proved to be worthless.

Bad debts 30,000

Accounts receivable 30,000

3. The same accounts that are previously written off as worthless are recoverd
or collected.

Accounts receivable 30,000

Bad debts 30,000

Cash 30,000
Accounts receivable 30,000

Doubtful Accounts in the Income Statement

1. Distribution cost

If the granting of credit and collection of accounts are under the charge of the sales manager,
doubtful accounts shall be considered as distribution cost.

2. Administrative expense

If the granting of credit and collection of accounts are under the cahrge of an officer other than
sales manager, doubtful accounts shall be considered as administrative expense.

In the absence of any contrary statement, doubtful accounts shall be classified as administrative
expense.

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 II. Application Exercises

You are provided with exercises that will demonstrate the application of accounting principles
discussed for accounts receivable using appropriate analysis in solving the exercises correctly and
accurately.

Four exercises are provided, as follows:

Exercise 1

D’GREAT Company reported the “Receivables” account with a debit balance of Ᵽ2,000,000 at
year-end.
The allowance for doubtful accounts had a credit balance of Ᵽ50,000 on the same date.
Subsidiary details revealed the following:
Trade accounts receivable 775,000
Trade notes receivable 100,000
Instalments receivable, normally due 1 year to two years 300,000
Customers’ accounts reporting credit balance arising from sales return ( 30,000)
Advance payments for purchase of merchandise 150,000
Customers’ accounts reporting credit balances arising from advance
payments (20,000)
Cash advance to subsidiary 400,000
Claim from insurance entity 15,000
Subscription receivable due in 60 days 300,000
Accrued interest receivable 10,000
2,000,000
Required:
a. Prepare one compound entry to reclassify the receivables account.
b. Compute the amount to be presented as “trade and other receivables” under current assets.
c. Indicate the classification and presentation of the other items excluded from “trade and
other receivable”.
Solution to Exercise 1

a. Compound Entry to reclassify the receivables account.

Accounts receivable 775,000
Notes receivable 100,000
Installment receivable 300,000
Advance to suppliers 150,000
Advance to subsidiary 400,000
Claim receivable 15,000
Subscription receivable 300,000
Accrued internet receivable 10,000
Customers credit balances 30,000
Advances from customers 20,000
Receivable 2,000,000

b. Amount to be presented as “trade and other receivables” under current assets

Accounts receivable 775,000
Less: Allowance for doubtful accounts 50,000 725,000
Notes receivable 100,000
Installments receivable 300,000
Advance to suppliers 150,000
Subscription receivable 300,000
Claim receivable 15,000

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 Accrued internet receivable 10,000
Total trade and other receivable 1,600,000

c. Classification and presentation of other items excluded from “trade and other
receivables”
Advance to subsidiary – Noncurrent asset ----- presented as long-term investment
Customers credit balances - Classified as current liabilities
Advances from customers - Part of trade and other payables

Exercise 2

ALYNA Company provided the following T-account summarizing the transactions affecting the
account receivable for the current year:

Accounts Receivable
Jan. 1 balance 600,000 Collections from customers 5,300,000
Charge sales 6,000,000 Write off 35,000
Shareholders’ subscription 200,000 Merchandise returns 40,000
Deposit on Contract 120,000 Allowance to customer for shipping
damages 25,000
Claims against common Collections on carrier claims 40,000
carrier for damages 100,000
IOUs from employees 10,000 Collection on subscription 50,000
Cash advance to affiliates 100,000
Advances to a supplier 50,000

Required:
a. Compute the correct amount of accounts receivable.
b. Prepare one compound entry to adjust the accounts receivable.
c. Compute the amount to be presented as “trade and other receivables” under current assets.
d. Indicate the classification and presentation of the other items.

Solution to Exercise 2

a. Accounts receivable – Jan. 1 600,000

Change sales 6,000,000
Total 6,600,000
Less: Collection from customers 5,300,000
Write off 35,000
Merchandise returns 40,000
Allowance to customers 25,000 5,400,000
Accounts receivable – Dec. 31 1,200,000

b. Subscription receivable (200,000-50,000) 150,000

Deposit on contract 120,000
Claim receivable (100,000-40,000) 60,000
Advances to employees 10,000
Advances to affiliates 100,000
Advances to supplier 50,000
Accounts receivable 490,000

c. Accounts receivable 1,200,000

Claim receivable 60,000
Advances to employees 10,000
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 Advances to suppliers 50,000
Total trade and other receivables 1,320,000
d. The subscription receivable should be deducted from Subscribed Share Capital
Deposit on contract – noncurrent – presented as Other Noncurrent Asset
Advances to affiliates – noncurrent – presented as Long-term Investment

Exercise 3

KRISTEL Company sold merchandise on account for Ᵽ500,000. The terms are 3/10, n/30. The
related freight charge amounted to Ᵽ10,000. The account was collected within the discount period.

Required:
Prepare journal entries to record the transactions under the following freight terms:
1. FOB destination and freight collect
2. FOB destination and freight prepaid
3. FOB shipping point and freight collect
4. FOB shipping point and freight prepaid

Solution to Exercise 3

1. FOB destination & freight collect

a. Accounts receivable 500,000
Freight out 10,000
Sales 500,000
Allowance for freight charge 10,000

b. Cash 475,000
Sales discount (500,000 x 3%) 15,000
Allowance for freight charge 10,000
Accounts receivable 500,000

2. FOB destination & freight prepaid

a. Accounts receivable 500,000
Freight out 10,000
Sales 500,000
Cash 10,000

b. Cash 485,000
Sales discount 15,000
Accounts receivable 500,000

3. FOB shipping point & Freight collect

a. Accounts receivable 500,000
Sales 500,000

b. Cash 485,000
Sales discount 15,000
Accounts receivable 500,000

4. FOB shipping point/ Freight prepaid

a. Accounts receivable 510,000
Sales 500,000
Cash 10,000

b. Cash 495,000
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 Sales discount 15,000
Accounts receivable 510,000
Exercise 4

APOL Company records sales return during the year as a credit to accounts receivable. However,
at the end of the accounting period, the entity estimates the probable sales return and records the
same by means of an allowance account.

The following transaction occurred in summary form:

1. Sales on merchandise on account, 2/10, n/30 4,000,000
2. Collection within the discount period 1,470,000
3. Collection beyond the discount period 1,000,000
4. Sales return granted 100,000
5. Sales return estimated at the end of the year 20,000

Required: Prepare journal entries to record the transaction.

Solution to Exercise 4

1. Accounts receivable 4,000,000

Sales 4,000,000

2. Cash 1,470,000
Sales discount 30,000
Accounts receivable (1,470,000/ .98) 1,500,000

3. Cash 1,000,000
Accounts receivable 1,000,000

4. Sales return 100,000

Accounts receivable 100,000

5. Sales return 20,000

Allowance for sales returns 20,000

*****

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 SUPPLEMENTARY LEARNING MATERIALS IN ACCOUNTING 3
(Prepared by Dr. Lily P. Custodio, CPA)

B.2 – Estimation of Doubtful Accounts

I. Discussion of Accounting Principles

Methods of Estimating Doubtful Accounts

1. Three methods of estimating doubtful accounts:

a. Aging the accounts receivable or “statement of financial position approach”
b. Percent of accounts receivable or also “statement of financial position approach”
c. Percent of sales or “income statement approach”

Aging of Accounts Receivable

1. Aging of accounts receivable involves an analysis where the accounts are classified into not
due or past due.
a. Not due e. 91 to 120 days past due
b. 1 to 30 days past due d. 121 to 180 days past due
c. 31 to 60 days past due g. 181 to 365 days past due
d. 61 to 90 days past due h. More than 1 year past due

2. The allowance is then determined by multiplying the total of each classification by the rate of
percent of loss experienced by the entity for each category.

3. The marjor agrument for the use of this method is the more accurate and scientific computation
of the allowance for doubtful accounts.

This method has the advantage of presenting fairly the accounts receivable in the
statement of financial position at net realizable value.

4. The objection to the aging method is that it violates the matching process.

5. The aging method could be time consuming if a large number of accounts re involved.

When is an account past due?

1. The credit terms will determine whether an account is past due. For example, if the credit terms
were 2/10, n/30, and the accounts is 45 days old, it is considered to be 15 days past due.

2. The phrase “past due” refers to the period beyond the maximum credit term, as in No. 1, 30
days.

Percent of accounts receivable

1. A certain rate is multiplied by the open accounts at the end of the period in order to get the
required allowance balance.

2. The rate is usually determine from the past experience of the entity.

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3. This procedure has the advantage of presenting the accounts receivable at estimated net
realizable value.

4. The application of this approach violates the principle of matching bad debt loss against the
sales revenue.

5. The loss experience rate may be difficult to obtain and may not be reliable.

Percent of sales

1. The amount of sales for the year is multiplied by a certain rate to get the doubtful accounts
expense. The rate may be applied on credit sales or total sales.

2. Theoretically, the rate to be used is computed by dividing the bad debt losses in prior years by
the charge sales of prior years.

3. The rate obtained is multiplied by the current year’s charge sales to arrive at the doubtful
account expense.

4. This procedure of determining the rate has the advantage of eliminating the extra work of
making a record of cash sales and credit sales.

5. However, this approach may prove unsatifactory when there is a considered fluactuation in the
proportion of cash and credit sales periodically.

Argument for percent of sales method

1. When the “percent of sales” method is used in computing doubtful accounts, proper matching of
cost against revenue is achieved.

2. This is because the bad debt loss is directly related to sales and reported in the year of sale.

3. This method is an income statement approach because it favors the income statement.

Argument againts percent of sales method

1. Accounts receivable may not be shown at estimated realizable value because the allowance for
doutful accounts may prove excessive or inadequate.

2. It becomes necessary that from time to time the accounts should be “aged” to ascertain the
probable loss.

3. As a consequences, the rate applied on sales should be revised accordingly.

Correction in allowance for doubtful accounts

1. The percent of sales method of estimating doubtful accounts has the disadvantage of the
allowance for doutful accounts being inadequate or excessive.

2. Aging the accounts is then necessary to test the reasonableness of the allowance.

3. Where the allowance is inadequate or excessive, a question arises as to the proper treatment
of the discrepancy, whether to consider it as an error or a component of profit or loss.

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 The correction is to be reported in the income statement either as an additional to
or subtraction from doutful accounts expense.

4. This correction is the natural result of a change in estimate. Changes in estimate are treated
currently and prospectively, if necessary.

5. Accordingly, an inadequate allowance is adjusted as follows:

Doubtful accounts xx
Allowance for doubtful accounts xx

6. An excessive allowance is recorded as follows:

Allowance for doutful accounts xx

Doutful accounts xx

7. When the allowance is excessive, there is a corollary problem when the discrepancy is more
than the debit balance in the doubtful accounts expense account.

8. For example, if the amount of correction due to excessive allowance is P30,000 and the
doubtful accounts expense account has a debit balance of P20,000, following the above
procedure will result to a credit balance in the doubtful accounts expense account of P10,000.
Such balance is obviously abnormal.

9. It is believed that in such a case, the P10,000 diffrence shall not be trated as a prior period error
but included in the detrmination of the income of the current period.

Journal entry

Allowance for doubtful accounts 30,000

Doubtful accounts 20,000
Miscellaneous income 10,000

Debit balance in allowance account

1. The allowance for doubtful accounts normally has a credit balance.

2. However, in certain instances, it may have a debit balance because it may be the policy of the
entity to adjust the allowance at the end of the period and record accounts written off during
the year.

3. For example, on January 1, the allowance account before adjustment has a credit balance of
P30,000 and during the year an account of P50,000 is written off and recorded as follows:

Allowance for doubtful accounts 50,000

Accounts receivable 50,000

4. Thus, on December 31, the allowance account has debit balance of P20,000 before
adjustment.

5. The debit balance does not indicate that the allowance is inadequate because the accounts
written off during the year and charged to the allowance may have arisen from current year
sales.
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6. Thus, the charge to the allowance account simply predates the recording of doubtful accounts.

7. At the end of the period when adjustments are made, the debit balance should be considered.

8. To continue the example – if on December 31, the required allowance is P40,000, the
adjustment should be:

Doubtful accounts 60,000

Allowance for doubtful accounts 60,000

Required allowance 40,000

Add: Debit balance in allowance 20,000
Doubtful accounts expense 60,000

9. Note that after the adjustment for the doubtful accounts, the allowance accounts has credit of
P40,000, which is the required allowance.

II. Application Exercises

You are provided with exercises that will demonstrate the application of accounting principles
discussed for estimation of doubtful accounts. Appropriate analysis was used to solve the exercises
correctly and accurately.

Three exercises are provided.

Exercise 1

AFA Company reported the following information before adjustment at year-end:

Accounts receivable 500,000

Notes receivable 200,000
Allowance for doubtful account 20,000
Sales 5,000,000
Sales return and allowance 30,000
Sales discount 20,000

Required:
Prepare adjusting entry to provide for doubtful accounts under each of the following
independent assumptions:

a. Past experience indicates that 75% of all sales are credit sales and that an average 2% of
credit sales may prove uncollectible.
b. One percent of gross sales may prove uncollectible.
c. An analysis of the aging of trade receivable indicates that accounts receivable in the amount
of Ᵽ80,000 may prove uncollectible.
d. The policy is to maintain an allowance for doubtful accounts equal to 10% of the outstanding
accounts receivable.

Solution to Exercise 1
a. Credit sales (5,000,000 x 75%) 3,750,000
Doubtful accounts (3,750,000 x 2%) 75,000

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 Doubtful accounts 75,000
Allowance for doubtful accounts 75,000
b. Doubtful accounts 50,000
Allowance for doubtful accounts 50,000
(5,000,000 x 1%)

c. Required allowance 80,000

Less: Credit balance of allowance 20,000
Doubtful accounts expense 60,000

Doubtful accounts 60,000

Allowance for doubtful accounts 60,000

d. Required allowance (10% x 500,000) 50,000

Less: Credit balance of allowance 20,000
Doubtful accounts expense 30,000

Doubtful accounts 30,000

Allowance for doubtful accounts 30,000

Exercise 2
At the beginning of current year, AA Company showed the following balances:
Accounts receivable 1,000,000
Allowance for doubtful accounts 40,000

The following summary transactions occurred during the current year:

1. Sales on account, 2/30, n/30 7,000,000
2. Collections from customers within the discount period 2,450,000
3. Collections from customers beyond the discount period 3,900,000
4. Accounts receivable written off a worthless 30,000
5. Recovery of a accounts previously written off not included in 10,000
the above collections
6. Credit memo for sales return 70,000

Required:
a. Prepare journal entries pertaining to accounts receivable.
b. Prepare the adjustment for doubtful accounts at year-end if the entity uses the percentage
of accounts receivable method consistently.
c. What is the net realization value of accounts receivable at year-end?

Solution to Exercise 2

Requirement a: Journal Entries

1. Accounts receivable 7,000,000
Sales 7,000,000

2. Cash 2,450, 000

Sales discount 50,000
Accounts receivable (2,450,000 x 8%) 2,500,000

3. Cash 3,900,000
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 Accounts receivable 3,900,000

4. Allowance for doubtful accounts 30,000

Accounts receivable 30,000

5. Accounts receivable 10,000

Allowance for doubtful accounts 10,000

Cash 10,000
Accounts receivable 10,000

6. Sales return 70,000

Accounts receivable 70,000

Requirement b: Adjusting Journal Entries

Doubtful accounts 40,000

Allowance for doubtful accounts 40,000

Rate = 40,000 = 4%
1,000,000
Allowance for doubtful accounts – Dec. 31 (4% x 1,500,000) 60,000
Less: allowance before adjustment 20,000
Doubtful account expense 40,000

Requirement c: Adjusting Journal Entries

Accounts receivable - December 31 1,500,000

Less: Allowance for doubtful accounts (60,000)
Net realizable value 1,440,000

Exercise 3

At the beginning of the current year, REPA Company reported that the allowance for doubtful
accounts has a credit balance of Ᵽ170,000. Bad debt recoveries and bad debt written off in the
current year were Ᵽ30,000 and Ᵽ235,000, respectively. The allowance account had been
previously calculated as percentage of net sales.

It was decided however to provide for doubtful accounts commencing with the year-end adjusting
entry on the basis of an analysis of the age of the receivable.

The following schedule was prepared.

Percent uncollectible
Not yet due 1,700,000 NIL
1-30 days past due 1,200,000 5
31-60 days past due 100,000 25
61-90 days past due 150,000 50
Over 90 days past due 120,000 100
Additional accounts to be written off 30,000

Required:
1. What is the required allowance for doubtful accounts at year-end?
2. How much would be the doubtful accounts expense for the current year?
3. What is the adjusting entry for the doubtful accounts expense for the current year?
4. What is the net realizable value of accounts receivable at year-end?

49
 Solution to Exercise 3

Requirement 1 : Required allowance

Percent of Required
Amount uncollectible allowance
Not yet due 1,700,000 - -
1-30 days past due 1,200,000 5% 60,000
31-60 days past due 100,000 25% 25,000
61-90 days past due 150,000 50% 75,000
Over 90 days past due 120,000 100% 120,000
Total 3,270,000 280,000

Requirement 2 : Doubtful Expense for the current year

Allowance , January 1 170,000

Recovery 30,000
Doubtful accounts expense (squeeze) 345,000
Total 545,000
Less: Write off (235 + 30,000) 265,000
Required allowance - December 31 280,000

Requirement 3 : Adjusting Entry for the current year

Doubtful accounts expense 345,000

Allowance for doubtful accounts 345,000

Requirement 4: Net Realizable Value of Accounts Receivable

Accounts receivable 3,270,000

Less: Allowance for doubtful accounts 280,000
Net realizable value 2,990,000

*****

50
 SUPPLEMENTARY LEARNING MATERIALS IN ACCOUNTING 3
(Prepared by Dr. Lily P. Custodio, CPA)

B.3 – Notes Receivable

I. Discussion of Accounting Principles

1. Notes receivable are claims supported by formal promises to pay usually in the form of notes.

 A negotiable promissory note is an unconditional promise in writing made by one person to

another, signed by the maker, engaging to pay on demand or at a fixed determinable future
time a scum certain in money to order or to bearer.

 It is a written contract in which one person, known as the maker, promises to pay another
person, known as the payee, a definite sum of money.

 It may be payable on demand or at a definite future date.

 Standing alone, the term note receivable represents only claims arising from the sale of
merchandise or service in the ordinary course of business.

 Therefore, note received from officers, employees, shareholders and affiliates shall be
designated separately.

2. When a promissory note matures and is not paid, it is a dishonored note.

 Dishonored notes receivable should be removed from the notes receivable accounts and
transferred to account receivable.

 The amount debited to accounts receivable should include the face amount, interest and
other charges.

 This approach is defended on the ground that the overdue note has lost part of its status as
a negotiable instrument and really represents only an ordinary claim against the maker.

3. Notes receivable are initially measured at present value.

 The present value is the sum of all future cash flows discounted using the prevailing market
rate of interest for similar notes.

 The prevailing market rate of interest is actually the effective interest rate.

 On the other hand, short-term note receivable shall be measured at face value.

 Cash flows relating to short-term notes receivable are not discounted because the effects of
discounting is usually not material.

4. The initial measurement of long-term notes will depend on whether the notes are interest-
bearing or noninterest-bearing.
51
  Interest-bearing long-term notes are measured at face value which is actually the present
value upon issuance.
 Noninterest-bearing long-term notes are measured at present value which is the discounted
value of the future cash flows using the effective interest rate.

 Actually, the term “noninterest-bearing” is a misnomer because all notes implicitly contain
interest.

 It is simply a case of “interest being included in the face amount” rather than being stated as
a separate rate.

5. Subsequent to initial recognition, long-term notes receivable shall be measured at

amortized cost using the effective interest method (see PFRS 9, paragraph 5.2.1).

6. Amortized cost is the amount at which the note receivable is measured initially:

a. Minus principal payment

b. Plus or minus cumulative amortization of any difference between the initial carrying amount
of the principal maturity amount

c. Minus reduction for impairment or uncollectibility

 For long-term noninterest-bearing notes receivable, the amortized cost is the present
value plus amortization of the discount, or the face value minus the unamortized earned
interest income

II. Application Exercises

You are provided with exercises that will demonstrate the application of accounting principles
discussed for notes receivable. Appropriate analysis was used to solve the exercises correctly and
accurately.

Four exercises are provided.

Exercise 1

CBA Company sold to another entity a tract of land costing Ᵽ5,000,000 for Ᵽ7,000,000.

The buyer paid Ᵽ1,000,000 down and signed a two-year promissory note for the remainder of the
purchase price plus 12% interest compounded annually. The note matures on January 1, 2025.

Required: Prepare journal entries for 2023, 2024 and 2025.

Solution to Exercise 1

Journal entries for 2023, 2024 and 2025

2023
Jan. 1 Cash 1,000,000
Notes receivable 6,000,000
Land 5,000,000
52
 Gain on sale of land 2,000,000

Dec. 31 Accrued interest receivable 720,000

Interest income (12% x 6,000,000) 720,000

2024
Dec. 31 Accrued interest receivable 806,400
Interest income (12% x 6,720,000) 806,400

2025
Jan. 1 Cash 7,526,400
Notes receivable 6,000,000
Accrued interest receivable 1,526,400

Exercise 2

CICT Company manufactures and sells computers. On January 1, 2023, the entity sold a computer
costing Ᵽ400,000 for Ᵽ600,000.

The buyer signed a noninterest bearing notes for Ᵽ600,000 payable in three equal instalments
every December 31. The cash selling price of the computer is Ᵽ540,000.

Required: Prepare journal entries for 2023.

Solution to Exercise 2

Journal entries for 2023:

Jan. 1 Notes receivable 600,000

Sales 540,000
Unearned interest income 60,000

Dec. 31 Cash 200,000

Notes receivable 200,000

Unearned interest income 30,000

Interest income 30,000

Computations

Year Notes receivable Fraction Interest income

2023 600,000 6/12 30,000
2024 400,000 4/12 20,000
2025 200,000 2/12 10,000
1,200,000 60,000

Exercise 3

CIT Company manufactures and sells electrical generators. On January 1, 2023, the entity sold an
electrical generator costing Ᵽ700,000 for Ᵽ1,000,000. The buyer paid Ᵽ100,000 down and signed a
Ᵽ900,000 noninterest bearing note payable in three equal instalments every December 31.

53
The prevailing interest rate for the note of this type is 12%. The present value of an ordinary annuity
of 1 for three periods in 2.4018.

Required: Prepare journal entries for 2023.

Solution to Exercise 3

Computations:

Face value 900,000

Present value 720,540
Unearned interest income 179,460

Present value 720,540

Cash receivable 100,000
Sales price 820,540
Cost of generator 700,000
Gross income 120,540

Journal Entries for 2023:

Jan. 1 Cash 100,000

Note receivable 900,000
Sales 820,540
Unearned interest income 179,460

Dec. 31 Cash 300,000

Note receivable 300,000

31 Unearned interest income 86,465

Interest income 86,465

Computations:

Date Collection Interest Principal Present value

Jan. 1, 2023 720,540
Dec. 31, 2023 300,000 86,465 213,535 507,005
Dec. 31, 2024 300,000 60,841 239,159 267,846
Dec. 31. 2025 300,000 32,154 267,846 -

Exercise 4

CEA Company is a dealer in equipment. On January 1, 2023, the entity sold an equipment in
exchange for noninterest bearing note requiring five annual payments of Ᵽ500,000.

The first payment was made on December 31, 2023. The market interest rate for similar notes was
8%. The relevant present value factors are:

PV of 1 at 8% for 5 periods 0.68

PV of an ordinary annuity of 1 at 8% for 5 periods 3.99

Required:

1. Prepare journal entries for 2023 and 2024.

2. Determine the carrying amount of the note receivable on December 31, 2023.

54
 Solution to Exercise 4

Requirement 1. Journal entries for 2023 and 2024:

2,500,000
Dec. 31, 2023 Note receivable (5 x 500,000)
Sales (500,000 x 3.99) 1,995,000
Unearned interest income 505,000

Dec. 31, 2024 Cash 500,000

Note receivable 500,000

Unearned interest income 159,600

Interest income (8% x 1,995,000) 159,600

Requirement 2. Carrying amount of the note receivable on December 31, 2023

Note receivable 2,500,000

Unearned interest income (505,000)
Carrying amount – December 31, 2023 1,995,000

Exercise 5

On January 1, 2023, CAF Company sold an equipment costing Ᵽ500,000 which had a carrying
amount of Ᵽ350,000, receiving a Ᵽ125,000 down payment and, as additional consideration, a
Ᵽ400,000 noninterest bearing note due on January 1, 2026. There was no established exchange
price for the equipment.

The prevailing rate of interest for a note of this type at January 1, 2021 was 12%. The present value
of 1 at 12% for three periods is 0.7118.

Required: Prepare journal entries for 2023, 2024, 2025 and 2026.

Solution to Exercise 5

Journal entries for 2023, 2024, 2025 and 2026

2023
Jan. 1 Cash 125,000
Note receivable 400,000
Accumulated depreciation 150,000
Equipment 500,000
Gain on sale of equipment 59,720
Unearned interest income 115,280

Dec. 31 Unearned interest income 34,166

Interest income (284,720 x 12%) 34,166

Computations
Face value of note 400,000
PV (400,000 x .7118) 284,720
Unearned interest income 115,280

55
 Present value 284,720
Cash received 125,000
Sales price 409,720
Carrying amount 350,000
Gain on sale 59,720

Date Interest income Unearned interest Present value

Jan. 1, 2023 115,280 284,720
Dec. 31, 2023 34,166 81,114 318,886
Dec. 31, 2024 38,266 42,848 357,152
Dec. 31, 2025 42,848 - 400,00

2024
Dec. 31 Unearned interest income 38,266
Interest income 38,266

2025
Dec. 31 Unearned interest income 42,848
Interest income 42,848

2026
Jan. 1 Cash 400,000
Note receivable 400,000

*****

56
 SUPPLEMENTARY LEARNING MATERIALS IN ACCOUNTING 3
(Prepared by Dr. Lily P. Custodio, CPA)

B.4 - Loan Receivable

I. Discussion of Accounting Principles

1. A loan receivable is a financial asset arising from a loan granted by a bank or other financial
institution to a borrower or client.

 The term of the loan may be short-term, but in most cases the repayment periods cover
several years.

2. Initial measurement of loan receivable is at fair value plus transaction costs that are directly
attributable to the acquisition of the financial asset.

 The fair value of the loan receivable at initial recognition is normally the transaction price,
meaning, the amount of the loan granted.

 Transaction cost that are directly attributable to the loan receivable include direct origination
cost.

Direct origination cost should be included in the initial measurement of the loan
receivable. However, indirect origination costs should be treated as outright
expense.

3. The subsequent measurement of loan receivable is at amortized cost using the effective
interest method (PFRS 9, paragraph 4.1.2).

4. Amortized cost is the amount at which the loan receivable is measured initially:

a. minus principal payment

b. plus or minus cumulative amortization of any difference between the initial carrying amount
and the principal maturity amount
c. minus reduction for impairment or uncollectibility

 If the initial amount recognized is lower than the principal amount, the amortization of the
difference is added to the carrying amount.

 If the initial amount recognized is higher than the principal amount, the amortization of the
difference is deducted of the difference is deducted from the carrying amount.

5. Origination fees are fees charged by the bank against the borrower for the creation of the
loan.

 Origination fees include compensation for the following activities:

a. Evaluating the borrower’s financial condition

57
 b. Evaluating guarantees, collateral and other security
c. Negotiating the terms of the loan
d. Preparing and processing the documents related to the loan
e. Closing and approving the loan transaction

 The origination fees received from borrower are recognized as unearned interest income
and amortized over the term of the loan.

 If the origination fees are not chargeable against the borrower, the fees are known as
“direct origination cost”.

 The direct origination costs are deferred and also amortized over the term of the loan.

 Direct origination costs are offset directly against any unearned origination fees received.

 If the origination fees received exceed the direct origination costs, the difference is
unearned interest income and the amortization will increase interest income.

 If the direct origination costs exceed the origination fees received, the difference is charged
to “direct origination costs” and the amortization will decrease interest income.

Direct origination cost should be included in the initial measurement of the loan
receivable. However, indirect origination costs should be treated as outright expense.

ILLUSTRATIONS

Initial carrying amount of the loan

Principal amount 5,000,000

Origination fees received ( 331,800)
Direct origination cost incurred 100,000
Initial carrying amount of loan 4,768,200

Journal entries on January 1, 2023

1. To record the loan:

Loan receivable 5,000,000
Cash 5,000,000

2. To record the origination fees received from the borrower:

Cash 331,800
Unearned interest income 331,800

3. To record the direct origination cost incurred by the bank:

Unearned interest income 100,000
Cash 100,000

Notes:

 The unearned interest income has credit balance of P231,800 to be amortized over the term
of the loan using the effective interest method.

 Because of the origination fees received and the direct origination costs, a new effective
rate must be computed.
58
  Since the initial carrying amount of the loan receivable of P4,768,200 is lower than the
principal amount, it means there is a discount and therefore the effective rate must be
higher than the nominal rate of 12%.

 After considering the origination fee received from the borrower and the direct origination
cost, the effective interest rate is determined to be 14%.

Amortization table – effective interest method

Interest Carrying
Date received Interest income Amortization amount
Jan. 1, 2023 4,768,200
Dec. 31, 2023 600,000 667,548 67,548 4,835,748
Dec. 31, 2024 600,000 677,005 77,005 4,912,753
Dec. 31, 2025 600,000 687,247 87,247 5,000,000

Effective interest method

Interest received = Principal time nominal rate
Interest income = Carrying amount times effective rate

December 31, 2023

Interest received (5,000,000 x 12%) 600,000
Interest income (4,768,200 x 14%) 667,548
Amortization 67,548
Carrying amount – January 1, 2023 4,768,200
Carrying amount - December 31, 2023 4,835,748

December 31, 2024

Interest received 600,000
Interest income (4,835,748 x 14%) 677,008
Amortization 77,005
Carrying amount – January 1, 2024 4,835,748
Carrying amount - December 31, 2024 4,912,753

December 31, 2025

Interest received 600,000
Interest income 687,247*
Amortization 87,247
Carrying amount – January 1, 2025 4,912,753
Carrying amount - December 31, 2025 5,000,000

 P4,912,753 x 14% equals P687,785. Therefore is a difference of P538 due to the rounding
of present value factors.

Journal entries on December 31, 2023

Cash 600,000
Interest income 600,000

Unearned interest income 67,548

Interest income 67,548

59
Statement Presentation

If a statement of financial position is prepared on December 31, 2023, the loan receivable is
presented as follows:

Loan receivable 500,000

Unearned interest income (231,800 – 67,548) ( 164,252)
Carrying amount - December 31, 2023 4,835,748

The carrying amount is actually the amortized cost.

Journal entries on December 31, 2024

Cash 600,000
Interest income 600,000

Unearned interest income 77,005

Interest income 77,005

Journal entries on December 31, 2025

Cash 600,000
Interest income 600,000

Unearned interest income 87,247

Interest income 87,247

Cash 5,000,000
Load receivable 5,000,000

Impairment of loan

1. PFRS 9, paragraph 5.5.1, provides that an entity shall recognize a loss allowance for expected
credit losses on financial asset measured at amortized cost.

2. Paragraph 5.5.3 provides that an entity shall measure the loss allowance for a financial
instrument at an amount equal to the lifetime expected credit losses if the credit risk on that
financial instrument has increased significantly since initial recognition.

3. Credit losses are the present value of all cash shortfalls.

Expected credit losses are an estimate of credit losses over the life of
the financial instrument.

Measurement of impairment

When measuring expected credit losses, an entity should consider:

a. The probability weighted outcome
The estimate should reflect the possibility that a credit loss occurs and the possibility that no
credit loss occurs.
b. The time value money
60
 c. Reasonable and supportable information that is available without undue cost or effort.

PFRS 9 does not prescribe particular method of measuring expected credit

losses.

 An entity may use various sources of data both internal or entity-specific and external in
measuring expected credit losses.

The amount of impairment loss can be measured as the difference between the
carrying amount and the present value of estimated future cash flows
discounted at the original effective rate.

 The carrying amount of the loan receivable shall be reduced either directly or through the
use of an allowance account.

Meaning of credit risk

Credit risk is the risk than one party to a financial instrument will cause a
financial loss for the other party by failing to discharge and obligation.

 The risk contemplated is the risk that the issuer will fail to perform a particular obligation.

 The risk does not necessarily relate to the credit worthiness of the issuer.

 For example, if an entity issued a collateralized liability and the noncollateralized liability that
are otherwise identical, the credit risk of the two liabilities will be different.

 The credit risk of the collateralized liability is surely less than the credit risk of the
noncollateralized liability.

 The credit risk for a collateralized liability may be zero.

Three-stage impairment approach

Stage 1 – This stage covers debt instrument that have not declined significantly in credit quality
since initial recognition or that have low credit risk.

Under this scenario, a 12-month expected credit loss is recognized.

Stage 2 – This stage covers debt instruments that have declined significantly in credit quality since
initial recognition but do not have objective evidence of impairment.

Under this scenario, a lifetime expected credit loss is recognized.

There is rebutable presumption that there is a significant increase in credit risk if the
contractual payments are more than 30 days past due.

Stage 3 – This stage covers debt instruments that have objective evidence of impairment at the
reporting date.

Under this scenario, a lifetime expected credit loss is recognized.

12-month expected credit loss

61
  A 12-month expected credit loss is defined as the portion of the lifetime expected credit loss
from default events that are possible within 12 months after the reporting period.

Lifetime expected credit loss

 Lifetime expected credit loss is defined as the expected credit loss that results from all
default events over the expected life of the instrument.

 Lifetime expected credit loss shall always be recognized for trade receivable through aging,
percentage of accounts receivable and percentage of sales.

Interest income

a. Under the stage 1 and 2, interest income is computed based on the gross carrying amount
or face amount.

b. Under stage 3, interest income is computed based on the net carrying amount which is
equal to the gross carrying amount or face amount minus allowance for credit loss.

Stage 1 – low credit risk

 On January 1, 2023, a bank loaned P2,000,000 to a borrower.

 The contract specified an effective interest of 10%, a term of 8 years and interest is payable
annually every December 31.

 On December 31, 2023, based on the most relevant information available, the bank
determined that the loan had a 12-month probability of default of 5% and expected to collect
only 80% of the principal.

 The present value of 1 at 10% for 7 periods is 0.51.

Journal Entries for 2023

Jan. 1 Loan receivable 2,000,000
Cash 2,000,000

Dec. 31 Cash (2,000,000 x 10%) 200,000

Interest income 200,000

Impairment loss 59,200

Allowance for loan impairment 59,200

Computations
Carrying amount – Dec. 31, 2021 2,000,000
Probability of collection 80%
Expected cash flow 1,600,000
Multiply by PV of 1 at !0% for 7 periods 0.51
PV of cash flow – Dec. 31, 2021 816,000

Carrying amount – Dec. 31, 2021 2,000,000

PV of expected cash flow – Dec. 31, 2021 816,000
Expected credit loss 1,184,000
Multiply by probability of default within 12 months 5%
12-month expected credit loss 59,200

62
 Loan receivable 2,000,000
Allowance for loan impairment ( 59,200)
Carrying amount – Dec. 31, 2021 1,940,800
Stage 2 – Significant increase in credit risk but no objective evidence of impairment

 On December 31, 2024, the bank determined that there was a significant increase in the
credit risk of the loan receivable but no objective evidence of impairment.

 The bank concluded that there is 40% probability of default over the remaining life of the
loan and the bank expected to collect only 70% of the principal balance.

 The present value of 1 at 10% for 6 periods is 0.56.

Journal Entries for 2024

Dec. 31 Cash 200,000

Interest income 200,000

Dec. 31 Impairment loss 427,200

Allowance for loan impairment 427,200

Computations
Carrying amount – Dec. 31, 2024 2,000,000
Probability of collection 70%
Expected cash flow 1,400,000
Multiply by PV of 1 at !0% for 6 periods 0.56
PV of expected cash flow 784,000

Carrying amount – Dec. 31, 2024 2,000,000

PV of expected cash flow – Dec. 31, 2024 784,000
Expected credit loss 1,216,000
Multiply by probability of default within 6 years 40%
Lifetime expected credit loss allowance 486,400
Unadjusted allowance – Dec. 31, 2023 59,200
Impairment loss 427,200

Loan receivable – Dec. 31, 2024 2,000,000

Allowance for loan impairment – Dec. 31, 2024 ( 486,400)
Carrying amount – Dec. 31, 2024 1,513,600

Stage 3 – Objective evidence of impairment

 On December 31, 2025, the borrower was in financial difficulty ad the loan was considered
impaired. The bank concluded that only 50% of the principal balance will be collected on
December 31, 2030. Interest for 2025 was collected. The present value of 1 at 10% for 5
periods is 0.62.

Journal Entries for 2025

Dec. 31 Cash 200,000

Interest income 200,000

31 Impairment loss 893,600

Allowance for loan impairment 893,600

31 Allowance for loan impairment 1,000,000

63
 Loan receivable 1,000,000
Writeoff of uncollectible loan.

Computations
Carrying amount – Dec. 31, 2025 2,000,000
Probability of collection 50%
Expected cash flow 1,000,000
Multiply by PV of 1 at !0% for 5 periods 0.62
PV of expected cash flow 620,000

Carrying amount – Dec. 31, 2025 2,000,000

Present value of expected cash flow – Dec. 31, 2025 620,000
Lifetime expected credit loss 1,380,000
Unadjusted allowance (486,400)
Impairment loss 893,600

 The interest income for 2025 is still based on the face amount because the loan is under
Stage 2 for the entire year 2025.

Journal Entries for 2026

Dec. 31 Allowance for loan impairment 62,000

Interest income 62,000

 The interest income for 2026 is based on the net carrying amount using the effective
method.

Computations
Loan receivable – Dec. 31, 2025 1,000,000
Allowance for loan impairment (380,000)
Carrying amount – Dec. 31, 2025 620,000

Allowance for loan impairment – Jan. 1, 2025 486,400

Increase in allowance for 2025 893,600
Allowance – Dec. 31, 2025 before writeoff 1,380,000
Writeoff of uncollectible loan (1,000,000)
Allowance for loan impairment – Dec. 31, 2025 380,000

Carrying amount - Januari 1, 2026 620,000

Interest income for 2026 (620,000 x 10%) 62,000
Carrying amount – December 31, 2026 682,000
Interest income for 2027 (682,000 x 10%) 68,200
Carrying amount – December 31, 2027 750,200
Interest income for 2028 (750,200 x 10%) 75,020
Carrying amount – December 31, 2028 825,220
Interest income for 2029 (825,220 x 10%) 82,522
Carrying amount – December 31, 2029 907,742
Interest income for 2030 (this is simply the difference) 92,258
Carrying amount – December 31, 2030 1,000,000

Journal Entries for 2030

2030
Dec. 31 Allowance for loan impairment 92,258
Interest income 92,258

Cash 1,000,000
Loan receivable 1,000,000
64
Objective evidence of impairment
1. Significant financial difficulty of the borrower
2. Breach of contract, such as a default or delinquency in interest or principal payments
3. Debt restructuring
4. The borrower will enter bankruptcy or other financial reorganization
5. Measurable decrease in the estimated future cash flows from the financial asset

Improvement in credit risk

If there is an improvement in credit risk, the lender may revert back from recognizing “lifetime credit
loss” to recognizing “12-month credit loss”.

Any adjustment from the change in expected credit loss is recognized immediately in profit or loss.

To illustrate:

On January 1, 2023, Provident Bank loaned P4,000,000 to a borrower due on December 31, 2025.
The interest on the loan is 10% payable annually on December 31.

The bank estimated the following credit risk and expected credit loss from default on January 1,
2023, December 31, 2023 and December 31, 2024:

January 1, 2023
Expected credit loss from default 1,500,000
Credit risk for 12 months 2%
Lifetime credit risk for 36 months 8%

December 31, 2023

Expected credit loss from default 1,200,000
Credit risk for 12 months 3%
Lifetime credit risk for 36 months 15%

December 31, 2024

Expected credit loss from default 800,000
Credit risk for 12 months 1%
Lifetime credit risk for 36 months 5%

On January 1, 2023, the bank should recognize a credit loss provision equal to 12-month expected
credit loss of P30,000 computed by multiplying 2% by P1,500,000.

2023 Entries:
Jan. 1 Loan receivable 3,000,000
Cash 3,000,000

1 Impairment loss 30,000

Allowance for loan impairment 30,000

Dec. 31 Cash (10% x 4,000,000) 400,000

Interest income 400,000

65
On December 31, 2023, the lifetime credit risk increased from 8% to 15%. The bank concluded that
the increase in credit risk of 7% is significant.

Accordingly, the bank should recognize a lifetime expected credit loss instead of a 12-month
expected credit loss.
Expected lifetime credit loss (15% x P1,200,000) 180,000
Allowance for loan impairment – January 1, 2023 (30,000)
Additional impairment loss for 2023 150,000

Impairment loss 150,000

Allowance for loan impairment 150,000

On December 31, 2024, the lifetime credit risk decreased from 15% to 5%. The bank concluded
that there is an improvement in credit risk.

Accordingly, the bank should revert back to recognizing 12-month expected credit loss.

12-month expected credit loss (1% x P800,000) 8,000

Allowance for loan impairment – Dec. 31, 2023 180,000
Gain on reversal of impairment 172,000

2024 Entries:
Dec. 31 Cash 400,000
Interest income 400,000

31 Allowance for loan impairment 172,000

Gain on reversal of impairment 172,000

2025
On December 31, 2025, the bank collected from the borrower P3,500,000 in full settlement of the
loan. The balance of the loan of P500,000 was deemed uncollectible and the accrued interest of
P400,000 for 2025 was unlikely to be collected.

Cash 3,500,000
Allowance for loan impairment 8,000
Loss from default 892,000
Loan receivable 4,000,000
Accrued interest receivable 400,000

II. Application Exercises

You are provided with exercises that will demonstrate the application of accounting principles
discussed for loan receivable. Appropriate analysis was used to solve the exercises correctly and
accurately.

Four exercises are provided.

Exercise 1

MAJESTIC Bank granted a loan to a borrower on January 1, 2023. The interest on the loan is 10%
payable annually starting December 31, 2023. The loan matures in three years on December 31,
2025.
Principal amount 4,000,000
Direct origination cost incurred 150,000
Origination fee received from the borrower 342,100
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After considering the origination fee received from the borrower and direct origination cost incurred,
the effective rate on the loan is 12%.

Required: Prepare journal entries for 2023, 2024, 2025.

Solution to Exercise 1

Journal Entries for 2023, 2024, 2025

2023
Jan. 1 Loan receivable 4,000,000
Cash 4,000,000

Cash 342,100
Unearned interest income 342,100

Unearned interest income 150,000

Cash 150,000

Dec. 31 Cash 400,000

Interest income 400,000

Unearned interest income 56,948

Interest income 56,948

Computations

(10%) (12%) Carrying

Date Interest received Interest income Amortization amount
Jan. 1, 2023 3,807,900
Dec.31, 2023 400,000 456,948 56,948 3,864,848
Dec.31, 2024 400,000 463,782 63,782 3,928,630
Dec.31, 2025 400,000 471,370 71,370 4,000,000
12% x 3,928,630 = 471,435 or a difference of P65 due to rounding.

Computation of carrying amount

Principal amount 4,000,000

Direct origination cost incurred 150,000
Origination fee received from borrower ( 342,100)
Carrying amount 3,807,900

2024
Dec. 31 Cash 400,000
Interest income 400,000

Unearned interest income 63,782

Interest income 63,782

2025
Dec. 31 : Cash 400,000
Interest income 400,000

Unearned interest income 71,370

Interest income 71,370

Cash 4,000,000
Loan receivable 4,000,000

67
Exercise 2

IMPRESSIVE Bank granted a loan to a borrower on January 1, 2023. The interest rate on the loan
is 10% payable annually starting December 31, 2023. The loan matures in five years on December
31, 2027.
Principal amount 4,000,000
Direct origination cost 61,500
Origination fee received from the borrower 350,000

The effective rate on the loan after considering the direct origination cost and origination fee
received is 12%.

Required:
1. Compute the carrying amount of the loan receivable on January 1, 2023.
2. Prepare a table of amortization for the loan receivable.
3. Prepare journal entries for 2023 and 2024.

Solution to Exercise 2

Requirement 1: Computation of carrying amount

Principal amount 4,000,000

Direct origination cost incurred 61,500
Origination fee received from borrower ( 350,000)
Carrying amount 3,711,500

Requirement 2: Table of amortization

(10%) (12%) Carrying
Date Interest receivable Interest income Amortization amount
Jan. 1, 2023 3,711,500
Dec. 31, 2023 400,000 445,380 45,380 3,756,880
Dec. 31, 2024 400,000 450,825 50,825 3,807,705
Dec. 31, 2025 400,000 456,925 56,925 3,864,630
Dec. 31, 2026 400,000 463,756 63,756 3,928,386
Dec. 31, 2027 400,000 471,614 71,614 4,000,000

Requirement 3: Journal entries for 2023 & 2024

2023
Jan. 1 Loan receivable 4,000,000
Cash 4,000,000

Cash 350,000
Unearned interest income 350,000

Unearned interest income 61,500

Cash 61,500

Dec. 31 Cash 400,000

Interest income 400,000

Unearned interest income 45,380

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 Interest income 45,380

2024
Dec. 31 Cash 400,000
Interest income 400,000

Unearned interest 50,825

Interest income 50,825

Exercise 3

SPLENDID Bank granted a loan to a borrower on January 1, 2023. The interest on the loan is 8%
payable annually starting December 31, 2023. The loan matures in three years on December 31,
2025.

Principal amount 3,000,000

Direct origination cost incurred 260,300
Origination fee charged against the borrower 100,000

After considering the origination fee charged to the borrower and the direct origination cost
incurred, the effective rate on the loan is 6%.

Required:
1. Prepare journal entries for 2023, 2024 and 2025.
2. Present the loan receivable on December 31, 2023.

Solution to Exercise 3

Required Computations

Carrying Amount = 3,000,000 + 260,200 – 100,000 = 3,160,300

Table of amortization
Carrying
Date Interest receive (8%) Interest income (6%) Amortization amount
Jan. 1, 2023 3,160,300
Dec. 31, 2023 240,000 189,618 50,382 3,109,918
Dec. 31, 2024 240,000 186,595 53,405 3,056,513
Dec. 31, 2025 240,000 183,487 56,513 3,000,000

Requirement 1: Journal entries for 2023, 2024 and 2025

2023
Jan. 1 Loan receivable 3,000,000
Cash 3,000,000

Direct origination cost 260,300

Cash 260,300

Cash 100,000
Direct origination cost 100,000

Dec. 31 Cash 240,000

Interest income 240,000

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 Interest income 50,382
Direct origination cost 50,382

2024
Dec. 31 Cash 240,000
Interest income 240,000

Interest income 53,405

Direct origination cost 53,405

2025
Dec. 31 Cash 240,000
Interest income 240,000

Interest income 56,513

Direct origination cost 56,513

Cash 3,000,000
Loan receivable 3,000,000

Requirement 2: Presentation of the loan receivable on December 31, 2023

Loan receivable, beginning 3,000,000

Direct origination cost, net (260,000- 100,000) 160,300
Amortization of direct origination cost ( 50,382)
Loan receivable – December 31, 2023 3,109,918

Exercise 4

On January 1, 2023, MAGNIFICENT Bank granted a loan to a borrower. The interest on the loan is
10% payable annually on December 31, 2023. The loan matures in three years on December 31,
2025.

Principal amount 5,000,000

Direct origination cost incurred 457,500
Origination fee charged against the borrower 200,000

After considering the origination fee charged against the borrower and the direct origination cost
incurred, the effective rate on the loan is 8%.

Required:
1. Determine the carrying amount of the loan on January 1, 2023.
2. Prepare a table of amortization of the direct origination cost.
3. Prepare journal entries for 2023, 2024 and 2025.

Solution to Exercise 4

Requirement 1: Carrying Amount = 5,000,000 + 457,500 – 200,000 = 5,257,500

Requirement 2: Table of Amortization

Carrying
Date Interest received (10%) Interest income (8%) Amortization amount
Jan. 1, 2022 5,257,500
Dec. 31, 2022 500,000 420,600 79,400 5,178,100
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Dec. 31, 2023 500,000 414,248 85,752 5,092,348
Dec. 31, 2024 500,000 407,652 92,348 5,000,000

Requirement 3: Journal Entries

2023
Jan. 1 Loan receivable 5,000,000
Cash 5,000,000

Direct origination cost 457,500

Cash 457,500

Cash 200,000
Direct origination cost 200,000

Dec. 31 Cash 500,000

Interest income 500,000

Interest income 79,400

Direct origination cost 79,400

2024
Dec. 31 Cash 500,000
Interest income 500,000

Interest income 85,752

Direct origination cost 85,752

2025
Dec. 31 Cash 500,000
Interest income 500,000

Interest income 92,348

Direct origination cost 92,348

Cash 5,000,000
Loan receivable 5,000,000

*****

71
 SUPPLEMENTARY LEARNING MATERIALS IN ACCOUNTING 3
(Prepared by Dr. Lily P. Custodio, CPA)

B.5 - Receivable Financing: Pledge, Assignment and

Factoring
I. Discussion of Accounting Principles

1. Receivable financing is the financial flexibility or capability of an entity to raise money out of its
receivable.

 During genral business decline, an entity may find itself in tight cash position because sales
decrease and customers are not paying their accounts on time.

 But the entity’s current accounts and notes payable must continue to be paid if its credit
standing is not to suffer.

 The entity when be in financial distress as collectins of receivable are delayed bur cash
payments for obligations must be maintained.

 Under these circumstances, if rthe situation becomes very critical, the entity may be forced
to look for cash by financing it receivables.

2. The common forms of receivable financing are:

a. Pledge of accounts recivable

b. Assignment of accounts receivable
c. Factoring of accounts receivable
d. Discounting of notes recivable

3. When loans are obtained from the bank or any lending institution, the accounts receivable may
be pledge as collateral security for the payment of the loan.

 Normally, the borrowing entity makes the collections of the pledged accounts but may be
required to turn over the collections to the bank in satisfaction for the loan.

 No complex problems are involved in this form of financing except the accounting for the
loan.

 The loan is recorded by debiting cash and discount of note payable if loan is discounted,
and crediting note payable.

 The subsequent payment of the loan is recorded by debiting note payable and crediting
cash.

 With respect to the pledged accounts, no entry would be necessary. It is sufficient that
disclosure thereof is made in a note to financial statement.

4. Assignment of accounts receivable means that a borrower called the assignor transfers
rights in some accounts receivable to a lender called the assignee in consideration for a loan.

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  Assignment is a more formal type of pledging of accounts receivable. Assignment is
secured borrowing evidenced by a financing agreement and a promissory note both of
which the assignor signs.

 Pledging is general because all accounts receivable serve as collateral security for the loan.
 Assignment is specific because specific accounts receivable serve as collateral security for
the loan.

 Assignment may be done either on a nonnotification or notification basis.

 When accounts are assigned on a nonnotification basis, customers are not informed that
their accounts have been assigned.

 As a result, the customers continue to make payments to the assignor, who in turn remits
the collections to the assignee.

 When accounts are assigned on a notification basis, customers are notified to make their
payments directly to the assignee.

 The assignee usually lends only a certain percentage of the face value of the accounts
assigned because the assigned accounts may not be fully realized by reason of such
factors as sales discount, sales return and allowanc3es and uncollectible accounts.

 The percentage may be 70%, 80%, or 90% depending on the quality of the accounts.

 The assignee usually charges interest for the loan that it makes and requires a service of
financing charge or commission for the assignment agreement.

5. Factoring is a sale of accounts receivable on a without recourse, notification basis.

 In factoring arrangement, an entity sells accounts receivable to a bank or finance entity

called a factor.

 Accordingly, a gain or loss is recognized for the difference between the proceeds received
and the net carrying amount of the receivable factored.

 Factoring differs from an assignment in that an entity actually transfer ownership of the
accounts receivable to the factor.

 The factor assumes responsibility for uncollectible factored accounts.

 In assignment, the assignor retains ownership of the accounts assigned.

 Because of the nature of transaction, the customers whose accounts are factored are
notified and required to pay directly to the factor.

 The factor has then the responsibility of keeping the receivable records and collecting the
accounts.

 Factoring may take the form of the following:

a. Casual factoring
b. Factoring as a continuing agreement

6. Casual factoring is illustrated below:

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  If an entity finds itself in a critical cash position, it may be forced to factor some or all of its
accounts receivable at a substantial discount to a bank or a finance entity to obtain the
much needed cash.

 For example, an entity factored P200,000 of accounts receivable with an allowance for
doubtful accounts of P10,000 for P160,000.

 Journal entry to record the sale

Cash 160,000
Allowance for doubtful accounts 10,000
Loss on factoring 30,000
Accounts receivable 200,000

7. Factoring may involve a continuing arragement whre a finance entity purchases all of the
accounts receivable of a certain entity.

 In this setup, before a merchandise is shipped to a customer, the selling entity request the
factors credit approval.

 It is approved, the account is sold immediately to the factor after shipment of the goods.

 The factor then assumes the credit function as well as the collection function.

 For compensation, typically the factor charges a commission or factoring fee of 5% to 20%
for its service of credit approval, billing collecting, and assuming uncollectible factored
accounts.
 Moreover, the factor may withhold a predetermined amount as a protection against
customer returns and allowances and other special adjustments.

 The amount withheld is known as the “factor’s holdback”.

 The factor’s holdback is actually a receivable from factor and classified as current asset.

 Final settlement of the factor’s holdback is made after the factored receivfable have been
fully collected.

8. A credit card is a platic card which enables the holder to obtain credit up to a predetermined
limit from the issuer of the card for the purchase of goods and services.

 The credit card has enabled retailers and other businesses to continue to sell goods and
services where the customers obtain possession of the goods immediately but do not have
to pay for the goods for about one month.

 The major credit cards in the Philippines are Diners Club, American Express, VISA and
MasterCard.

 These entities are generally responsible for approving the credit of customers and collecting
the receivable for a service fee from 1% to 5% of the credit card sales.

 If a customer buys goods and uses a credit card, the credit card receipt must be forwarded
by the retailer to the card issuer who will then pay the retailer the appropriate amount minus
the credit service charge.

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  Two entries are necessary, one entry at the time of sale and another entry when payment is
received from the card issuer.

II. Application Exercises

You are provided with exercises that will demonstrate the application of accounting principles
discussed for receivable financing: pledge, assignment and factoring. Appropriate analysis was
used to solve the exercises correctly and accurately.

Five exercises are provided.

Exercise 1

CHUMSS Company provided the following information in connection with a bank loan.

March 1 CHUMSS Company borrowed Ᵽ2,000,000 from bank on a six-month note carrying an
interest of 12% per annum. Accounts of Ᵽ3,000,000 are pledge to secure the loan.
April 1 Pledge accounts of Ᵽ1,000,000 are collected minus 2% discount
June 1 The remaining pledge accounts are collected.
Sept.1 The bank loan is repaid plus interest.

Required: Prepare journal entries to record the transactions.

Solution to Exercise 1

Journal Entries:

March 1 – Cash 2,000,000

Notes payable – bank 2,000,000

April 1 – Cash 980,000

Sales discount 20,000
Accounts receivable 1,000,000

June 1 – Cash 2,000,000

Accounts receivable 2,000,000

Sept. 1 – Notes payable – bank 2,000,000

Interest expense (12% x 2,000,000 x 6/12) 120,000
Cash 2,120,000

Exercise 2

CHS Company secured a one-year bank loan of Ᵽ4,000,000 on October 1, 2023. The loan was
discounted at 10%.

The entity signed a note for the loan and pledged Ᵽ5,000,000 of its accounts receivable as
collateral for the same. The accounting period of the entity ends on December 31.

Required:
1. Prepare journal entries, including adjustment from the date of loan up to date of maturity.
2. Statement presentation of the bank loan with adequate disclosure on December 31, 2023.

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 Solution to Exercise 2

Requirement 1: Journal Entries

2023
Oct. 1 Cash 3,600,000
Discount on note payable (10% x 4,000,000) 400,000
Note payable – bank 4,000,000

Dec. 31 Interest expense (400,000 x 3/12) 100,000

Discount on note payable 100,000

2024
Oct 1 Note payable – cash 4,000,000
Cash 4,000,000

Oct 1 Interest expense 300,000

Discount on note payable (400,000 x 9/12) 300,000

Requirement 2: Statement Presentation on December 31, 2023

Current liabilities:
Note payable – bank (Note #) 4,000,000
Discount on note payable ( 300,000)
Carrying amount 3,700,000
Note #: The notes payable-bank with a carrying amount of P3,700,000 is secured with a pledge of
P5,000,000 accounts receivable.

Exercise 3
GHI Company provided the following transactions:

May 1 CoED Company assigned Ᵽ800,000 of accounts receivable to a bank in

consideration for a loan.

A cash advance of 80% less service charge of 20,000 was made by the
latter.

It was agreed that interest of 2% per month is to be made and that the
assignor continues to make the collections. The entity signed a promissory
note for the loan.
5 The entity issued a credit memo to a customer for returned merchandise,
Ᵽ30,000. The account is one of the assigned accounts.

10 Collections of Ᵽ500,000 of the assigned accounts were made, less 2%

discount.

June 1 Remitted the collections to the bank plus 2% interest for one month.

7 Assigned accounts of Ᵽ10,000 proved to be worthless.

20 Collections of Ᵽ200,000 for the accounts assigned were made.

July 1 Final settlement was made with the bank. CoED Company accordingly
remitted the total amount due the bank to pay off the loan plus interest
76
 change.

Required: Prepare journal entries to record the transactions.

Solution to Exercise 3

Journal Entries

May 1 - Accounts receivable assigned 800,000

Accounts receivable 800,000

1 - Cash (640,000 – 20,000) 620,000

Service charge 20,000
Note payable – bank 640,000

5 - Sales return 30,000

Accounts receivable - assigned 30,000

10 - Cash 490,000
Sales discount (2% x 500,000) 10,000
Accounts receivable – assigned 500,000

June 1 - Note payable – bank 490,000

Interest expense (2% x 640,000) 12,800
Cash 502,800

7 - Allowance for doubtful accounts 10,000

Accounts receivable – assigned 10,000

20 - Cash 200,000
Accounts receivable – assigned 200,000

July 1 - Note payable – bank (640,000 – 490,000) 150,000

Interest expense (2% x 150,000) 3,000
Cash 153,000

1 - Accounts receivable 60,000

Accounts receivable – assigned 60,000

Computations

Accounts receivable assigned 800,000

Less: Collections 690,000
Sales discount 10,000
Sales return 30,000
Worthless accounts 10,000 740,000
Balance 60,000

Exercise 4

GS Company assigned certain accounts receivable to a bank for a loan on the following basis: 75%
cash advance 4% service charge on gross accounts assigned, 2% interest per month is to be
charged, and the bank makes collections. The entity signed a promissory note for a loan.

July 1 Received remittance upon the specific assignment of Ᵽ1,500,000 in accounts

to the bank.

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 Aug. 1 Received notice from bank that Ᵽ800,000 of the assigned accounts were
collected. A check was sent to the bank for one month interest charge.

Sept. 1 Received notice from bank that assigned accounts of Ᵽ500,000 were collected
in full and the remaining accounts of Ᵽ200,000 were being returned.
Accordingly, a check was received from the bank in settlement of the
assignment contract. In making the settlement, the bank deducted the interest
charge for the corresponding period.

Required: Prepare journal entries on the books of the assignor.

Solution to Exercise 4
Journal Entries:

July 1 – Accountrs receivable assigned 1,500,000

Accounts receivable 1,500,000

1 – Cash (1,125,000 – 60,000) 1,065,000

Service charge (4% x 1,500,000) 60,000
Note payable – bank 1,125,000

Aug 1 – Note payable – bank 800,000

Accounts receivable assigned 800,000

1 – Interest expense (2% x 1,125,000) 22,500

Cash 22,500

Sept 1 – Cash 168,500

Interest expense 6,500
Note payable – bank 325,000
Accounts receivable assigned 500,000
- Accounts receivable 200,000
Accounts receivable assigned 200,000

Computations:

Collections by bank 500,000

Less: Payment of loan (1,125,000 – 800,000) 325,000
Excess collections 175,000
Less: Interest (2% x 235,000) 6,500
Cash remittance from bank 168,500

Exercise 5

JD Company provided the following information:

Dec. 1 Assigned P1,500,000 of accounts receivable to a bank on a nonnotification

basis in consideration for a loan. The bank advanced P1,300,000 less a
service charge of P50,000. The entity signed a promissory note bearing
interest of 1% per month on the unpaid loan balance.

31 Collected assigned accounts of P1,000,000 less sales discount of P30,000.

31 Remitted the collection to the bank in payment first for the interest and the
balance to the principal.
Required:
78
a. Prepare journal entries to record the transactions
b. Indicate the classification and disclosure of the accounts related to the assignment on
December 31.
Solution to Exercise 5

Requirement a: Journal Entries

Dec. 1 – Accounts receivable assigned 1,500,000

Accounts receivable 1,500,000

1 – Cash 1,250,000
Service charge 50,000
Notes payable – Bank 1,300,000

31 – Cash 970,000
Sales discount 30,000
Accounts receivable assigned 1,000,000

31 – Interest expense (1% x 1,300,000) 13,000

Notes payable – Bank 957,000
Cash 970,000

Requirement b: Classification and disclosure of accounts

 Accounts receivable assigned with a balance of P500,000 should be classified as a current

asset and included in trade and other receivables.

 The Notes payable – bank of 343,000 should be classified and presented as a current liability.

 The company should disclose the equity in assigned accounts, as follows:

Accounts receivable assigned 500,000

Notes payable – bank (343,000)
Equity in assigned accounts 157,000

Exercise 6

CBO Company sold accounts receivable without recourse with face amount of Ᵽ6,000,000. The
factor charged 15% commission on all accounts receivable factored and withheld 10% of the
accounts factored as protection against customer returns and other adjustments.

The entity had previously established an allowance for doubtful accounts of Ᵽ200,000 for these
accounts.

By year-end, the entity had collected the factor’s holdback there being no customer returns and
other adjustments.

Required: Prepare journal entries to record the factoring and the subsequent collection of the
factors holdback.

Solution to Exercise 6

Journal Entries:

1. Cash 4,500,000

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 Allowance for doubtful accounts 200,000
Receivable from factor 600,000
Loss on factoring 700,000
Accounts receivable 6,000,000

2. Cash 600,000
Receivable from factor 600,000

Computations:

Accounts receivable factored 6,000,000

Factor’s holdback (10% x 6,000,000) ( 600,000)
Commission (15% x 6,000,000) ( 900,000)
Cash received 4,500,000

Accounts receivable factored 6,000,000

Commission ( 900,000)
Net sales price 5,100,000
Realizable value of Accounts receivabler (6,000,000 – 200,000) 5,800,000
700,00
Loss on factoring 0

Exercise 7

RDS Company provided the following information with respect to factoring accounts receivable.

July 1 Factored Ᵽ800,000 of accounts receivable without recourse with a bank on

notification basis.

The bank charged a factoring fee of 5% of the amount of accounts

receivable factored and withheld 10% of the accounts receivable factored
to cover sales return and allowances.

July 15 Received notice from the bank that factored accounts are fully collected
less sales return and allowances of Ᵽ20,000.

31 Received the check from the bank as final settlement of the factoring
contract.

Required: Prepare journal entries to record the transactions.

Solution to Exercise 7

Journal Entries:

July 1 – Cash 680,000

Service charge (5% x 800,000) 40,000
Receivable from factor (10% x 800,000) 80,000
Accounts receivable 800,000

15 – Sales returns and allowances 20,000

Receivable from factor 20,000

31 – Cash (80,000 – 20,000) 60,000

Receivable from factor 60,000

80
 *****

SUPPLEMENTARY LEARNING MATERIALS IN ACCOUNTING 3

(Prepared by Dr. Lily P. Custodio, CPA)

B.6 – Receivable Financing: Discounting of note

receivable
I. Discussion of Accounting Principles

1. As a form of receivable financing, discounting specifically pertains to note receivable.

 In a promissory note, the original parties are the maker and payee.

 The maker is the one liable and the payee is the one entitled to payment on the date of
maturity.

 When a note is negotiable, the payee may obtain “cash” before maturity date by discounting
the note at a bank or other financing company.

 To discount the note, the payee must endorse it.

 Legally, the payee becomes an endorser and the bank become an endorsee.

2. Endorsement is the transfer of right to a negotiable instrument by simply signing at the back of
the instrument.

 Endorsement may be with recourse which means that the endorser shall pay the endorsee
if the maker dishonors the note.

 In the legal parlance, this is secondary liability of the endorser.

 In accounting parlance, this is the contingent liability of the endorser.

 Endorsement may be without recourse which means that the endorser avoids future liability
even if the maker refuses to pay the endorsee on the date of maturity.

 In the absence of any evidence to the contrary, endorsement is assumed to be with

recourse.

3. There are several terms related to discounting of notes, viz:

a. Net proceed refers to the discount value of the note received by the endorser from the
endorsee.

b. Net proceeds = Maturity value minus discount

c. Maturity value is the amount due on the note at the date of maturity. Principal plus interest
equals the maturity value.

d. The maturity date is the date on which the note should be paid.
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 e. Principal is the amount appearing on the face of the note. It is also referred to as face
value.

f. Interest is the amount of interest for the full term of the note. Interest is computed as
principal x rate x time.

g. Interest rate is the rate appearing on the face of the note.

h. Time is the period within which interest shall accrue. For discounting purposes, it is the
period from date of note to maturity date. “Time” is the entire period of “full term” of the
note.

i. Discount is the amount of interest deducted by the bank in advance. Discount is equal to
maturity value times discount rate times discount period.

j. Discount rate is the rate used by the bank in computing the discount. This discount rate
should not be confused with the interest rate. This discount rate and interest rate are
different from each other.

k. If no discount rate is given, the interest rate is safely assumed as the discount rate.

l. Discount period is the period of time from date of discounting to maturity date.

Simply computed, discount period equals term of the note minus the expired portion up to
the date of discounting. The discount period is the unexpired term of the note.

4. Illustration – discounting without recourse

A Ᵽ1,000,000, 180-day, 12% note dated July 1 was received from a customer and discounted
without recourse on August 30 at 15% discount rate.

Computation:

Maturity value which is equal to the principal plus interest.

Principal 1,000,000
Interest (1,000,000 x 12% x 180 / 360) 60,000
Maturity value 1,060,000

Observe that the interest should be for the “full term” of the note in determining the maturity
value.

Discount which is equal to the “maturity value times discount rate times discount period”.
Discount (1,060,000 x 15% x 120 / 360) 53,000

The discount period is the remaining term of the note on the date of discounting.
Term of note 180 days
Less: Days expired from July 1 to August 30 60 days
Discount period – remaining term 120 days

In counting, “exclude the first day but include the last day”.

Net proceed from discounting

Maturity value 1,060,000

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 Discount ( 53,000)
Net proceeds 1,007,000

Carrying amount of the note receivable

Principal 1,000,000
Accrued interest receivable (1,000,000 x 12% x 60 / 360) 20,000
Carrying amount of the note receivable 1,020,000

The accrued interest receivable is interest earned from July 1 to the date of discounting on
August 30, or 60 days.

Gain or Loss on note discounting

Net proceeds 1,007,000
Carrying amount of note receivable 1,020,000
Loss on note discounting ( 13,000)

The difference between the note proceeds from discounting and the carrying amount of the note
receivable is recognized as gain or loss.

Accounting for note receivable discounting

The accounting for note receivable discounting depends on whether the discounting is with or
without recourse.

In the illustration, the discounting is without recourse, meaning, the sale of the note receivable
is absolute and therefore there is no contingent liability.

Journal entry
Cash 1,007,000
Loan on note receivable discounting 13,000
Note receivable 1,000,000
Interest income 20,000

The note receivable accounts is credited directly because the sale of the note receivable is
without recourse or absolute.

The interest income is credited for the actual interest earned on the date of discounting.

5. Illustration – discounting with recourse

A Ᵽ2,400,000, 6-month, 12% note dated February 1, is received from a customer by an entity
and discounted by MAKUPAD Bank on March 1 at 15%.

Principal 2,400,000
Interest (2,400,000 x 12% x 6/12) 144,000
Maturity 2,544,000
Discount (2,544,000 x 15% x 5/12) ( 159,000)
Net proceeds 2,385,000
Term of note 6 months
Less: Age of note (February 1 to March 1) 1 month
Discount period 5 months

Since the term of the note is expressed in “months”, the counting is by months regardless of the
number of days in a month.
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 Principal 2,400,000
Accrued interest receivable (2,400,000 x 12% x 1/12) 24,000
Carrying amount of note receivable 2,424,000

The accrued interest receivable is for one month from February 1 to the date of discounting on
March 1.

Net proceeds 2,385,000

Carrying amount of note receivable 2,424,000
Loss on note receivable discounting ( 39,000)

If the discounting is with recourse, the transaction is accounted for as either of the following:
a. Conditional sale of note receivable recognizing a contingent liability
b. Secured borrowing

6. Conditional sale

If the discount is treated as a conditional sale of note receivable, the journal entry to record the
transaction on March 1 is as follows:

Cash 2,385,000
Loss on note receivable discounting 39,000
Note receivable discounted 2,400,000
Interest income 24,000

The note receivable discounted account is deducted from the total notes receivable when
preparing the statement of financial position with disclosure of the contingent liabilities.

Note is paid by maker on maturity

On August 1, date of maturity, the note is paid by the maker to the MEGA Bank. The contingent
liability is extinguished as follows:

Note receivable discount 2,400,000

Note receivable 2,400,000

Note is dishonored by maker

The note is dishonored by the maker on August 1, and the entity pays the MEGA Bank the
maturity value of the note, Ᵽ2,544,000, plus protest fee and other bank changes of Ᵽ6,000. The
total payment is charged to accounts receivable.

Journal entries
1. To record the payment to first bank:
Account receivable 2,550,000
Cash 2,550,000

2. To cancel the contingent liabilities:

Note receivable discounted 2,400,000
Note receivable 2,400,000

7. Secured borrowing

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 If the discounting is treated as a secured borrowing, the note receivable is not derecognized
but instead an accounting liability is recorded at an amount equal to the face amount of the note
receivable discounted.

Journal entry
Cash 2,385,000
Interest expense 39,000
Liability for note receivable discounted 2,400,000
Interest income 24,000

There is no objection if the interest expense is “netted” against the interest income or a net
interest expense of Ᵽ15,000 because the discounting transaction is a borrowing.

There is no gain or loss on discounting if the note receivable discounting is accounted for as a
secured borrowing.

Note is paid by maker on maturity

If the note is paid by the maker on the MEGA Bank, the liability for note receivable discounted
and the note receivable discounted and note receivable are derecognized.

Liability for note receivable discounted 2,400,000

Note receivable 2,400,000

Note is dishonored by maker

The note is dishonored by the maker on August 1, and the entity pays the MEGA Bank the
maturity value of the note, Ᵽ2,544,000 plus protest fee and other bank charges of Ᵽ6,000.

Journal entries

1. To record the payment to MEGA Bank:

Accounts receivable 2,400,000
Cash 2,400,000

2. To derecognize the liability for note receivable discounted and note receivable:
Liability foe note receivable discount 2,400,000
Note receivable 2,400,000

8. Conditional sale or secured borrowing

PFRS 9, paragraph 3.2.3, provides that an entity shall recognized a financial asset when either
one of the following criteria is met:

a. The contractual rights to the cash flows of the financial asset have expired.
b. The financial asset has been transferred and the transfer qualifies for derecognition
based on the extent of transfer of risk and rewards of ownership.

 The first criterion is usually easy to apply.

 The contractual rights to the cash flow may expire, for example, when a note receivable
from a customer is fully collected.

 The application of the second criterion is often complex. It relies on the assessment of the
extent of the transfer of risks and rewards of ownership.

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 PRRS 9, paragraph 3.2.6, provides the following guidelines for derecognition based on transfer
of risk and rewards:

1. If the entity has transferred substantially all risks and rewards, the financial asset shall be
derecognized.

2. If the entity has retained substantially all risks and rewards, the financial asset shall not be
derecognized.

3. If the entity has neither transferred nor retained substantially all risks and rewards,
derecognition depends on whether the entity has retained control of the asset.

a. If the entity has lost control of the asset, the financial asset is derecognized in its
entirety.

b. If the entity has retained control over the asset, the financial asset is not derecognized.

9. Evaluation

 The contractual rights to the cash flows of the note receivable discounted withy recourse
have not yet expired, thus, this first criterion does not apply.

 The discounting of note with recourse does not also fall squarely within a single guideline in
the second criterion of “transfer of risk and rewards of ownership”.

 The discounting transaction is a combination of the guidelines in the second criterion as

follows:

a. The entity has substantially transferred all “rewards”

b. The entity has retained substantially all “risk”
c. The entity has lost control of the note receivable.
10. Conclusion

 Much debate on this accounting issue can go on among academicians and theoreticians
until a clearest interpretation of the standard is made by the Financial Reporting Standard
Council.

 Premises considered, it is believed that the discounting of note receivable with recourse is
to be accounted for as a conditional sale with recognition of a contingent liability.

 The main justification is that upon discounting or endorsement of the note receivable,
whether with or without recourse, the transferor or endorser has lost control over the
note receivable.

 Accordingly, the transferee has complete control over the note receivable because the
transferee has the practical ability to sell the asset to a third party without attaching any
restrictions to the transfer.

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 II. Application Exercises

You are provided with exercises that will demonstrate the application of accounting principles
discussed for receivable financing: discounting of note receivable. Appropriate analysis was used to
solve the exercises correctly and accurately.

Four exercises are provided.

Exercise 1

RDS Company provided the following transaction:

Jan. 1 The entity sold merchandise for Ᵽ500,000 accepting a note of Ᵽ500,000 for six
months with interest to be paid at maturity at 12%.
March 1 The entity discounted the note without recourse at local bank at 15%.
July 1 The customer paid the bank in full.

Required: Prepare journal entries to record the transactions.

Solution to Exercise 1

Jan. 1 Note receivable 500,000

Sales 500,000

March 1 Cash 503,500

Loss on note receivable discounting 6,500
Note receivable 500,000
Interest income 10,000

July 1 No entry

Computations:
Principal 500,000
Interest (500,000 x 12% x 6/12) 30,000
Maturity value 530,000
Discount (530,000 x 15% x 4/12) 26,500
Net proceeds 503,500

Principal 500,000
Accrued interest receivable (500,000 x 12% x 2/12) 10,000
Carrying amount of NR 510,000

Net proceeds 503,500

Less: Carrying amount of NR 510,000
Loss on note discounting ( 6,500)
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Exercise 2

CBO Company provided the following transactions:

March 14 Sale of merchandise, Ᵽ2,050,000 to a customer, FOB destination 2/10, n/30.

April 7 Receipt of 60-day, 12% note dated April 5 from the customer. The face of the note
was the amount of invoice minus freight charge of Ᵽ50,000 paid by the customer
in connection with the March 14 sale.

20 The note of the customer was discounted with the bank at 15%

June 4 Receipt notification from back that the customer dishonored the note. Accordingly,
the entity paid the bank the amount due including the protest fee and other
charges of Ᵽ10,000.

July 4 Receipt of cash from the customer for the full amount of indebtedness plus
interest on the original face value.

Required: Prepare journal entries to record the transactions assuming any discounting of note
receivable is accounted for as a conditional sale with recognition of a contingent
liability.

Solution to Exercise 2
Journal Entries:

March 14 – Accounts receivable 2,050,000

Sales 2,050,000

April 7 – Note receivable 2,000,000

Freight out 50,000
Accounts receivable 2,050,000

20 – Cash 2,001,750
Loss on note receivable discounted 8,250
Note receivable 2,000,000
Interest income 10,000

Computations:

Principal 2,000,000
Add: Interest (2,000,000 x 12% x 60/360) 40,000
Maturity value 2,040,000
Less: Discount (2,040,000 x 15% x 45/360) 38,250
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 Net proceeds 2,001,750

Principal 2,000,000
Accrued interest receivable (2,000,000 x 12% x 15/360) 10,000
Carrying amount of NR 2,010,000

Net proceeds 2,001,750

Less: Carrying amount of NR 2,010,000
Loss on discounting ( 8,250)

June 4 – Accounts receivable (2,040,000 + 10,000) 2,050,000

Cash 2,050,000

Notes receivable discounted 2,000,000

Notes receivable 2,000,000

July 4 – Cash 2,070,000

Accounts receivable 2,050,000
Interest income (2,000,000 x12% x30/360) 20,000

Exercise 3

BGS Company provided the following transactions:

April 5 Received from A, a customer, Ᵽ500,000, 60-day, 12% note, dated April 4, in payment
of an account.

19 The note of A was discounted with the bank at 14%.

May 3 Received a Ᵽ1,000,000, 30-day noninterest bearing noted dated May 1 from B, in
payment of an account.

16 The note of B was discounted with the bank at 12%.

25 Received from C, a customer, a Ᵽ1,500,000, 60-day 12% note dated May 15 and
made by Company X. Gave the customer credit for the maturity value of the note less
discount at 12%.

June 7 Received notice from the bank that the note of A was not paid on maturity.

Paid bank the amount due plus protest fee and other charges of Ᵽ20,000.

15 Received a 60-day, 12% note, Ᵽ800,000, dated June 15, from D, a customer for sale
of merchandise.

18 Received full payment from A including interest of 12% on total amount due from
maturity date of original note.

Required:
a. Prepare journal entries to record the transactions assuming any discounting of note receivable
is accounted for as conditional sale with recognition of a contingent liability.
b. Prepare a necessary adjustment on June 30.

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 Solution to Exercise 3

Requirement a: Journal Entries

April 5 – Notes receivable 500,000

Accounts receivable 500,000

19 – Cash 501,075
Loss on note receivable discounting 1,425
Notes receivable discounted 500,000
Interest income 2,500

Computations:
Principal 500,000
Add: Interest (500,000 x 12% x 60/360) 10,000
Maturity value 510,000
Less: Discount (510,000 x 14% x 45/360) 8,925
Net proceeds 501,075

Principal 500,000
Add: Accrued interest receivable (500,000 x 12% x 15/360) 2,500
Carrying amount of NR 502,500

Net proceeds 501,075

Less: Carrying amount of NR 502,500
Loss on discounting ( 1,425)

May 3 – Notes receivable 1,000,000

Accounts receivable 1,000,000

16 – Cash 995,000
Loss on note receivable discounting 5,000
Note receivable discounting 1,000,000

Computations:
Principal 1,000,000
Less : Discount (1,000,000 x 12% x 15/360) 5,000
Net proceeds 995,000

25 – Note receivable 1,500,000

Interest income 4,500
Accounts receivable 1,504,500

Computations:
Principal 1,500,000
Add: Interest (1,500,000 x 12% x 60/360) 30,000
Maturity value 1,530,000
Less: discount (1,530,000 x 12% x 50/360) 25,500
Net credit 1,504,500

June 7 – Accounts receivable (510,000 + 20,000) 530,000

Cash 530,000

Notes receivable discount 500,000

Notes receivable 500,000

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 15 – Note receivable 800,000
Sales 800,000

18 – Cash 532,650
Accounts receivable 530,000
Interest income (530,000 x 12% x 15/360) 2,650

Requirement b: – Adjustments on June 30*

1. Accrued interest receivable 4,000

Interest income (800,000 x 12% x 15/360) 4,000

2. Note receivable discounted 1,000,000

Note receivable 1,000,000

*To cancel the contingent liability on B’s note. This note matured on May 31. Since there is no notice of
dishonor it is assumed that the said note is paid on the date of maturity.

Exercise 4

On August 31, 2023, ATIC Company discounted with recourse a customer’s note at the bank at
discount rate of 15%.

The note was received from the customer on August 1, 2023, term 90-days, had a face value of
Ᵽ5,000,000, and carried an interest rate of 12%. The customer paid the note to the bank on
October 31, 2022, the date of maturity.

Required: Prepare journal entries related to the discounting of note receivable, assuming the
discounting is accounted for as a secured borrowing.

Solution to Exercise 4

Journal Entries:

1. Cash 5,021,250
Interest 28,750
Liability for note receivable discounted 5,000,000
Interest income 50,000

Computations
Principal 5,000,000
Interest (5,000,000 x 12% x 90/360) 150,000
Maturity value 5,150,000
Discount (5,150,000 x 15% x 60/360) 128,750
Net process 5,021,250

Principal 5,000,000
Accrued interest receivable (5,000,000 x 12% x 30/360) 50,000
Carrying amount of NR 5,050,000

Net proceeds 5,021,250

Less: Carrying amount of NR 5,050,000
Loss on discounting ( 28,750)

2. Liability for note receivable discount 5,000,000

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Notes receivable 5,000,000

*****

92