CHAPTER ONE

ACCOUNTING FOR RECEIVABLES

1.1 INTRODUCTION
In this unit, we emphasize on how companies account for and report receivables. We have
discussed the importance of estimating uncollectibles in order to determine the reasonable
balance of receivables on the balance sheet.

Most of the companies sell goods and services on credit in order to earn more profits.
Receivables represent claims for money, goods, services, and non-cash assets from other
firms. Receivables may be current or non-current depending on the expected collection date.

1.2 CLASSIFICATION OF RECEIVABLES

Receivables can be broadly classified into Trade Receivables and Non-trade Receivables.
Trade Receivables describe amounts owed to the company for goods and services sold in the
normal course of business. Non-trade Receivable arise from many other sources, such as
advance to employees, interest receivables, rent receivables and loan to affiliated companies.
Unless we indicate otherwise, we will assume that all receivables in this unit are trade
receivables.

Based on the above broad classification, receivables can be further classified into Account
Receivable and Notes Receivables. Account Receivable refers to amounts due from customers
for credit sales. These receivables are supported by sales invoices or other documents rather
than any formal written promises. Such Account Receivables are normally expected to be
collected within relatively short period, such as 30 or 60 days. They are classified on the
balance sheet as a current asset. On the other hand, Notes Receivable refers to amounts that
customers owe, for which a formal, written instrument of credit has been issued. Notes are
usually used for credit periods of more than sixty days and for transactions of relatively large
value. Notes may also be used in settlement of an open account and in borrowing or lending
money.
1.3 INTERNAL CONTROL OVER RECEIVABLES
The principles of internal control that we saw in chapter 5 are required by organizations to
safeguard their assets from any kind of error and misconduct. These control procedures
should apply on receivables because they are one of the asset elements for the organization.
For example, the individual responsible for sales should be separate from the individual
accounting for the receivables and approving credit. By doing so, the accounting and credit
approval functions serve as independent checks on sales. Separation of responsibility for
related functions reduces the possibility of errors and misuse of funds.

Adequate control over Accounts Receivable begins with the approval of the sales by a
responsible company official or the credit department, after the customer’s credit rating has
been reviewed. Likewise, adjustments of Account Receivable, such as for sales return and
allowance, and sales discount, should be authorized or reviewed by a responsible party.
Effective collection procedure should also be established to ensure timely collection of
receivables and to minimize losses from uncollectible accounts.

1.4 CHARACTERISTICS OF NOTES RECEIVABLE

A claim supported by a note has some advantages over a claim in the form of an Account
Receivable. By signing a note, the debtor recognizes the debt and agrees to pay according to
the terms listed. A note is therefore a strong legal claim if there is a court action.

A promissory note is a written promise to pay a sum of money on demand or at a definite

time. It is payable to the order of a person or firm or to the bearer or holder of the note. The
person or firm that makes the promise signs it. The one to whose order the note is payable is
called the payee,
payee, and the one making the promise is called the maker.
maker.

Notes have several characteristics that affect how they are recorded and reported in the
financial statements. The characteristics are described in the following paragraphs: -

 Due Date
The date a note is to be paid is called the Due Date or Maturity date.
date. The period of time
between the issuance date and the due date of a short-term note may be stated in either days or
months. When the term on a note is expressed in days, the maturity date is the specified
number of days after the note’s date. As an example, a five-day note dated January-1 matures
and is due on Jannuary-6. A 90-day notes dated March-10, matures on Jun-8. This due date,
June-8, is computed as below: -

Term of the Note--------------------------------------------90

Days in March---------------------------31
Minus the date of the note-------------10
Days remaining in March------------------------21
Add days in April---------------------------------30
Add days in May----------------------------------31
May----------------------------------31
82
Number of days remaining to equal 90-days
(90 – 82 = 8)------------------------------------------------8
Therefore, Due date is June-8.

The period of a note is sometimes expressed in months. When months are used, the note
matures and is payable in the month of its maturity on the same date of the month as its
original date

A three-month note dated March-10, for instance, is payable on June-10.

 Interest Computation

Interest is the cost of borrowing money for the borrower. It is the profit from lending money
for the lender. The interest rate on notes is normally stated in terms of per year, regardless of
the actual period of time involved.

The formula for computing interest is as follows: -

Interest = Principal X Annual X Time

(Face Amount interest Rate
of the Note)

To illustrate the formula, the interest on a Br. 10,000, 12%, 60 day note is computed as:-
 Br. 10,000 X 12% X 60/360 = 200

N.B. To simplify interest computations for notes with periods expressed in days, it is common
to treat a year as having 360 days.

 Maturity Value
The amount that is due at the maturity or due date is called the maturity value. The maturity
value of a note is the sum of the face amount and the interest. In the above example, the
maturity value is Br. 10,200 (which is Br. 10,000 face amount plus Br. 200 interest)
I.e.
MV = FV + I where MV= Maturity value
FV = Face value
I = Interest

1.5 ACCOUNTING FOR NOTES RECEIVABLE

Notes Receivable are usually recorded in a single note Receivable account to simplify record
keeping. We need only one account because the original notes are kept on file. This means the
maker; rate of interest, due date, and other information can be learned by examining the actual
note.

To illustrate the recording of the receipt of a note, assume that on Jannuary-10, Nile Co. sales
merchandise on account to Tana Co. and receive a Br. 5,000, 90-day, 12% promissory note.

This transaction is recorded as: -

Jan. 10. Notes Receivable ------------------------5000
Sales--------------------------------------5000
The maker of the note usually honors the note and pays it in full. The entry required to record
the receipt of cash by Nile Co. from Tana Co. is as follows:

April-10 Cash------------------------------5150
Notes Receivable-----------------------5000
Interest Revenue (500 X 12/100 X 90/360)----150

Companies can sometimes accept a note for an overdue customer as a way of granting a time
extension on a past-due account Receivable. To illustrate, assume that a 60-day, 10% note
dated September 5, 20x1 is accepted by Awash Co. in settlement of the account of Happy co,
which is past due and has a balance of 10,000. The entry to record the transaction is as
follows:
September 5 N/R---------------------------------------------10, 000
A/R ----------------------------------------------10,000
Received a note to settle account

Recording a dishonored note

When a note’s maker is unable or refuses to pay at maturity, the note is dishonored. The act of
dishonoring a note doesn’t relieve the maker of the obligation to pay. The payee should use
every legitimate means to collect. But how do companies report this event? The balance of the
Notes Receivable account normally includes only those notes that have not matured. When a
note is dishonored, we therefore remove the amount of this note from the Notes Receivable
account and charge it back to an Accounts Receivable from its maker. Assume for instance
Nile Co., holds a Br. 1000, 12%, 30-day note of Ato Alemu. At maturity, Alemu dishonored
the note. Nile Co. records this dishonoring of its N/R, on Oct. 25, as follows:

Oct.25, A/R---------------Ato Alemu 1010

N/R---------------------------1000
Int. Rev.-------------------------10
To record dishonored note & interest of 1000 X 12% X
30/360 =10
The above entry records interest of Br. 10, which has been earned, even though the note has
been dishonored.

End-Of-Period interest Adjustment

When notes receivable are outstanding at the end of an accounting period, accrued interest is
computed and recorded. For example, on December 20, 20x1, Nile Co. accepted a Br. 2000,
60-day, 12% note from a customer in granting an extension of a past-due account. Assuming
that the accounting period ends on Dec. 31, the entries to record the receipt of the note,
accrued interest, and payment of the note at maturity are shown below: -

Dec. 19. N/R -------------------------------------2000

 A/R- customer-X --------------------------------2000
Received note in settlement of A\R
Dec. 31. Interest Receivable-------------------------8
Int. Revenue------------------------------------8
Adjusting entry for ace need
Interest, Br. 2000 X 12% X 12/360 = 8
Feb. 17. Cash----------------------------------2040
N/R---------------------------------------------2000
Int. Rec.--------------------------------------------8
Int. Revenue-------------------------------------32
Received pyt of note & interest at maturity

The adjusting entry above on Dec. 31, 20X1,was required to show the interest earned for the
period on the Income Statement.
1.6 CONVERTING RECEIVABLES TO CASH BEFORE MATURITY
Sometimes, companies convert receivables to cash before they are due. Reasons for this
include the need for cash or a desire not to be involved in collection activities. Converting
receivable is usually done either (1) by selling them, or (2) by using them as security for a
loan. The topic of using notes as security for a loan will be discussed in future courses. Notes
Receivable can be converted to cash by discounting them at a financial institution such as a
Bank. The process has three steps as indicated in the following diagram. In the first step, the
maker receives goods, service or cash from the payee in exchange for the note. In the second
step, the payee discounts the note with a bank and receives the maturity value of the note less
a discount (a fee) charged by the bank. In the third step, the maker pays the bank at the
maturity of the note.

Maker Goods (1) Payee

Note (2)
Cash (3) cash less discount
Bank
Note (2)
Notes Receivable are discounted with or without recourse.
recourse. When a note is discounted without
recourse, the bank assumes the risk of a bad debt loss and the original payee doesn’t have a
contingent liability. A contingent liability is an obligation to make a future payment if and
only if an uncertain future event occurs. A note discounted without recourse is like an outright
sale of an asset. If a note is discounted with recourse and the original maker of the note fails
to pay the bank when it matures, the payee of the note must pay for it. This means a company
discounting a note (an endorser) with recourse has a contingent liability until the bank is paid.
A Co. should disclose contingent liabilities in the accompanying notes to its financial
statements.

To illustrate, assume that a 90-day, 12%, Br. 20,000 N/R from Hiwot Co. dated Jan.1, 20x2 is
discounted at the payee’s bank on February 12, 20x2 at thediscount rate of 15%. The steps to
determine the proceeds (-the amount to be received by the payee from the bank upon
discounting) are as follows:

Step 1 – Determine the maturity date & maturity value.

MD = April –1 & MV = FV + I = 20,000 + [20,000 X 12% X 90/360]
= 20,600

Step 2 – Determine the Bank Discount (Bank

(Bank discount is an interest that is charged by
the bank and is computed based on the maturity value of the note for the discount
period. Discount Period is the time the bank must hold the note) before it becomes
due.

 Bank Discount = MV X DR X DP where MV = Maturity value ( 20,600)

DR = Discount Rate (15%)
Discount = 20,600 X 15% X 48/360 DP Discount period (from February12 to April 1)
= 412

Step 3-
3- Determine proceed (proceed is the amount of cash paid to the endorser after
deducting discount)
i.e. proceed = MV – D
= 20,600 – 412 = 20188
Step 4 – Record the necessary journal entry at the date of discount. (Here, record interest
revenue which is the excess of proceeds from the face value or record interest
expense when the proceed is less than the face value of the note)
Feb 12. Cash---------------------------------20,188
N/R -----------------------------------------20,000
I. Rev. --------------------------------------188.00
Discounted Br. 20,000, 90-day, 12% note at 15%

The length of the discount period and the difference between the interest rate and the discount
rate determine whether interest expense or interest revenue will result from discounting.

When a discounted Notes Receivable is dishonored, the bank notifies the endorser and asks
for payment if there is no statement that limits the responsibility of the endorser. In some
cases, the bank may charge a protest fee of notifying the endorser that a note has been
dishonored. The entire amount paid to the bank by the endorser, including the interest and
protest fee, should be debited to the A/R of the maker. For example, assume that the maker,
Hiwot Co, dishonored the above discounted note at maturity. The bank charges a protest fee
of Br. 25. The endorser’s entry to record the payment to the bank is as follows:

April 2. A/R Hiwot Co----------------- 20,625

Cash-----------------------------------20, 625
Paid dishonored, discounted note

1.7 ACCOUNTING FOR UNCOLLECTIBLE ACCOUNTS RECEIVABLE

When credit is extended, some amount of uncollectible receivables is generally inevitable
regardless of the care taken in granting credit and the control procedures used. The operating
expense incurred because of the failure to collect receivables is called Uncollectible Accounts
Expense or Bad Debts Expense or Doubtful Accounts Expense.

When does an account as a note become uncollectibles? There is no general rule for
determining when an account receivable becomes uncollectible. The fact that a debtor fails to
pay an account receivable according to a sales contract or fails to pay a note on the due date
does not necessarily mean that the account receivable will be uncollectible. The debtor’s
bankruptcy is one of the most significant indications of partial or complete uncollectibility.
Other indications include the closing of the customer’s business and the failure of repeated
attempts to collect.

There are two methods of accounting for uncollectible receivables. The allowance method,
which provides an expense for uncollectible receivables in advance of their write-off (removal
from the ledger) and the direct write-off method, which recognizes the expense only when
accounts receivable are judged to be worthless. We will discuss each of these methods next.

1.7.1 Allowance Method

The allowance method of accounting for bad debts matches the expected loss from
uncollectibles A/R against the sales they helped produce. We must use expected losses since
management can’t exactly identify the customers who won’t pay their bills at the time of sale.
This means at the end of each period the allowance method requires us to estimate the total
bad debts expected to result from that period’s sales. An allowance is then recorded for this
expected loss. This method has two advantages over the direct write-off method:

(1) Bad debt expense is charged to the period in which the related sales are recognized, and
(2) A/R is reported on the Balance Sheet at the estimated amount of cash to be collected.

The allowance method estimates bad debt expense at the end of each accountig period and
records it through an adjusting entry. To illustrate this method, assume the A/R account has a
balance of Br. 50,000 and based on careful study of the experience of other companies, Nile
Co. estimates that a total of Br. 2000 will be uncollectibles.

This estimated expense is recorded through the following adjusting entry.

Dec. 31 Uncollectibles Accounts Expense 2000
Allowance for Doubtful Accounts 2000
To record estimated bad debts

The amount Br. 2000 is an estimated reduction in A/R;but it cannot be credited to specific
customer accounts or to the A/R controlling account. Instead, a contra asset account entitled
Allowance for Doubtful Accounts is credited.

As with all periodic adjustments the above entry serves two purposes. First, it reduces the
value of the receivable to the amount of cash expected to be realized in the future. This
amount, which is Br. 48,000 (Br. 50,000 – Br. 2,000), is called the Net Realizable value of the
receivables. Second, the adjusting entry matches the Br. 2000 expense of uncollectibles
account with the related revenues of the period.

Write-off to the Allowance Account

When specific accounts are identified as uncollectibles, they are written-off against the
Allowance for Doubtful Accounts. Assume after spending some time trying to collect from
Shalla Co., Nile Co. decides that Shalla’s Br. 200 accounts receivable is uncollectible and
makes the following entry to writ-it off.

Jan. 25 Allowance for Doubtful Accounts 200

A/R-Shalla Co. 200
To write-off uncollectible accounts.

Note two aspects of this entry and its related accounts

Before Write-off After Write-off
A/R 50,000 49,800
Less Allowance for D. a/cs 2,000 1,800
NRV 48,000 48,000
Neither total assets nor net income are affected by the Write-off of a specific account. But
both total assets and net income are affected by the recognized bad debts expense for the year
in the adjusting entry.

Recovery of Uncollectibles Accounts

When a customer fails to pay and the account is written-off as uncollectibles, his or her credit
standing is jeopardized. To help restore credit standing, a customer may later choose to
voluntarily pay all or part of the amount owed. A company makes two entries when collecting
an account previously written-off. The first is to reverse the original write-off and reinstate the
customer’s account. For example, assume the amount written-of in the preceding entry is later
collected on February 15.
On Feb. 15- The entries to record this recovery are:
Feb. 15- A/R Shalla Co. 200
Allowance for Doubtful Accounts 200
To reinstate accounts previously written-off
Feb. 15- Cash 200
A/R-Shalla Co. 200
To record full payment of account

1.7.2 Estimating Uncollectible

The allowance method of accounting for bad debts requires an estimate of bad debts expense
to prepare the adjusting entry at the end of each accounting period. How does a company
estimate bad debts expense? There are two common methods. One is based on the Income
Statement relationship between bad debts expense and sales. The second is based on the
Balance Sheet relationship between A/R and the Allowance for Doubtful Accounts. Both
methods require an analysis of past experience.

8.7.2.1 Estimating Based on Sales

Accounts receivable are created by credit sales. The amount of credits sales during the period
may therefore be used to estimate the amount of uncollectible accounts expense. The amount
of this estimate is added to whatever balance exists in Allowance for Doubtful Accounts. To
illustrate, assume Wonji Co. has credit sales of Br. 500,000 in 20X2. Based on past
experience and the experience of other Cos, Wonji Co. estimated 0.007% of credit sales are
uncollectible. Using this prediction, the adjusting entry for uncollectible accounts at the end of
the period, 20X2 is as follows.

Dec. 31 Uncollectibles Accounts Exp. (500,000 X 0.007%) 3500

Allowance for Doubtful Accounts 3500
To record estimated Uncoll. Exp.

This entry doesn’t mean that the Dec. 31, 20X2, balance of Allowance for Doubtful Accounts
will be Br. 3500. A Br. 3500 balance results only if the account had a zero balance prior to
posting the adjusting entry. For example, assume that Allowance for Doubtful Accounts has a
credit balance of Br. 1000 before adjustment. Now, what will be the balance of Allowance for
Doubtful Accounts be at the end of 20X2 ? It will be Br. 4500. If there had been a debit
balance of Br. 500 in the Allowance for Doubtful Accounts before the year-end adjustment,
and the amount of adjustment. would still have been Br. 3500. What will have been the end
balance of Allowance for Doubtful Accounts at the end of 20X2? (Find by your own!)

8.7.2.2 Estimate Based on Analysis of Receivables

The longer an A/R remains outstanding, the less likely that it will be collected. Thus, we can
base the estimate of uncollectibles accounts on how long the accounts have been outstanding.
For this purpose, we can use a process called Ageing receivables which examines each A/R to
estimate the amount of uncollectible. Receivables are classified by how long they are past
their due date. Then, estimates of uncollectibles are made assuming the longer an amount is
past due the more likely it is to be uncollectible. After the outstanding amounts are classified
and analyzed in the Aging schedule the expected balance for the Allowance for Doubtful
Accounts will be estimated. Let’s assume the amount estimated is Br. 5000. So, do you think
this is the adjustment amount required for the current period? NO!

Because, this estimated amount is the expected balance of the Allowance for Doubtful
Accounts after adjustment rather than the current year provision for Uncollectible Accounts
Expense. Therefore, to determine the current year provision we must take in to account the
balance before adjustment in the Allowance for Doubtful Accounts. To illustrate, assume
there is as credit Balance of Br. 1300 in the allowance account before adjustment. The amount
to be added to this balance is therefore Br. 3800 (B.r 5000 – Br. 1200) and the adjustment
entry is as follows:
Dec. 31 Uncollectible Accounts Expense 3800
Allowance for Doubtful Accounts 3800
To record Uncollectible expense.

Alternatively, if the Allowance for Doubtful Accounts had an unadjusted debit balance of Br.
700, then the required adjustment is Br. 5700. (Br. 5000 + 700) and the adjustment entry is as
follows:
Dec. 31 . Uncollectible Accounts Expense 5700
Allowance for Doubtful Accounts 5700
To record Uncollectible expense .
1.7.3 The Direct- Write-Off Method
The Direct Write-off method of accounting for bad debts records the loss from an
uncollectible A/R at the time it is determined to be uncollectible. No attempt is made to
predict uncollectible accounts expense. Bad debt expense is recorded when specific accounts
are determined to be worthless. If Wonji Co. uses a direct write-off method and determines on
Feb. 20, it can’t collect from a customer- Home Co.- Br. 500. The entry to write-off the
customer’s account is as follows

Feb. 20 Uncollectible Accounts Expense 500

A/R- Home Co. 500
To write-off Uncollectible accounts

Some times an amount previously written off is later collected. This can be due to factors such
as continual collection efforts or the good fortune of a customer. If the account of Home Co.
that was written-off directly to Bad Debit Expense is later collected in full, the following two
entries record this recovery.
Mar. 5 - A/R- Home Co. 500
Uncollectible Accounts Expense 500
To reinstate account

Mar. 5 - Cash 500

A/R- Home Co. 500
To record full payment of account

If the recovery is in the year following the writ- off, there is no balance in the Uncollectible
Accounts Expense account related to the previous year’s write-off and no other write-offs are
expected. So the credit portion of the entry recording the recovery can be made to a Bad
Debts Recoveries revenue account.

To conclude this part companies must weigh at least two principles when considering use of
the direct write-off method:

(1) Matching principle, & (2) Materiality principle