CHAPTER 7 ACCOUNTING FOR RECEIVABLES

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Revised Fall 2012CHAPTER 7ACCOUNTING FOR RECEIVABLESKey Terms and Concepts to KnowAccounts Receivable: Result from sales on account (credit sales), not cash sales. May also result from credit card sales if there is a delay between when sale ismade and when the cash is received from the credit card company.Accounting for Uncollectible Accounts: Not all sales on account result in cash being collected from the customer. Account receivable that are not collected result in an operating expense. The matching principle requires that this expense be recorded in the period ofsale, not the period when the account is determined to be uncollectible. The Allowance Method is GAAP and fulfills the matching principle. The Direct Write-off Method is not GAAP and may not be used unless the expenseclosely approximates the expense under the Allowance Method.Determining the Amount of Uncollectible Receivables and Bad Debt Expense: The Percent of Sales Methodo Uses credit sales for the period to estimate bad debt expense for the period.o Sometimes referred to as the income statement method. The Percent of Receivables Methodo Analyses the balance in Accounts Receivable to estimate the balance in theAllowance for Uncollectible Accounts at the end of the period.o Sometimes referred to as the balance sheet method.Accounts Receivable on the Balance Sheet: Allowance account is deducted from Accounts Receivable to determine NetRealizable Value.Notes Receivable: Notes Receivable may be accepted by the seller in payment for a sale or toreplace an account receivable from a prior sale. Notes bear interest for their term which is paid at the end of the term, thematurity date. Interest rates are typically stated as a percent per annum, that is, as a yearly orannual rate.Page 1 of 23

Revised Fall 2012 Interest revenue is earned as time passes, regardless of whether payment hasbeen received. Interest revenue for outstanding notes receivable is typically accrued at the end ofthe year, although it may be accrued at the end of a quarter or month. If the note is not paid or dishonored at maturity, the amount of the principal andinterest is debited to accounts receivable because it is still payable to the seller bythe buyer. Another note may also be accepted by the buyer in place of theaccount receivable.Accounts Receivable Turnover RatioPage 2 of 23

Revised Fall 2012Key Topics to KnowAllowance MethodThe Allowance Method takes its name from the Allowance for Uncollectible Accountwhich is used to properly value accounts receivable until the uncollectible accountreceivable can be written-off.The Allowance Method debits bad debt expense in the period when the sale is recordedand credits a contra-asset account, Allowance for Uncollectible Accounts.Uncollectible Accounts ExpenseAllowance for UncollectibleAccountsxxxxxxIn the period in which a specific account is determined to be uncollectible, the Allowanceis debited and Accounts Receivable is credited.Allowance for Uncollectible AccountsAccounts ReceivablexxxxxxUncollectible Accounts Expense is reported on the Income Statement. The Allowance forUncollectible (Doubtful) Accounts is a contra asset account and is reported on theBalance Sheet as a deduction from Accounts Receivable. The result is called NetRealizable Value:Current Assets:Accounts Receivableless allowance for doubtful accountsNet Realizable Value25,0003,00022,000Sometimes a customer will pay the accounts receivable after it was written off.Recording the receipt of cash is always a two-step process: first, the account receivableis reinstated (added back into the general ledger) and second, the cash is recorded andaccounts receivable is reduced for the payment.To reinstate the accounts receivable:Accounts ReceivableAllowance for UncollectibleAccountsxxxPage 3 of 23xxx

Revised Fall 2012To apply the cash received:CashxxxAccounts ReceivablexxxExample #1: Journalize the following transactions.201112/3120121/053/18Estimated that 7,000 of accountsreceivable would become uncollectible.Wrote-off the 800 balance owed by JaneCamp and the 500 balance owed byFriends, Inc.Reinstated the account of Jane Camp thathad been written off as UncollectibleSolution #1Uncollectible Accounts ExpenseAllowance for UncollectibleAccounts7,000Allowance for Uncollectible AccountsAccounts Receivable-CampAccounts Receivable-Friends1,3007,000Accounts Receivable-CampAllowance for UncollectibleAccounts800Cash800Accounts Receivable-Camp800500800800Methods for Estimating the Uncollectible AmountIn the period of sale, the customer that eventually will not pay, the amount that will notbe paid and the period in which the customer’s account will become uncollectible cannotbe determined. Therefore, the uncollectible accounts expense must be estimated at theend of each accounting period.Page 4 of 23

Revised Fall 2012Percentage of Sales MethodThe Percent of Sales Method uses one income statement account, Sales, to estimate thechange in another income statement account, Bad Debt Expense, for the period. This isthe amount of the required adjusting entry. This method is typically used by businesseswith a large number of customers with relatively uniform accounts receivable balances.The balance in the Allowance account is the balance in the ledger before adjustmentplus the adjusting entry for bad debt expense.The bad debt expense for the period is calculated by multiplying the uncollectiblepercentage times the credit sales in the period to determine the uncollectible accountsexpense for the period. This will be the amount of the adjusting entry.Example #2: Uncollectible accounts expense is estimated at ¼ of 1% of net sales of 4,000,000 for the year. The current balance in Allowance for Doubtful Accounts is 300 credit. Determine the following:a) The uncollectible accounts expense for the year.b) The adjusting entry to be made on December 31.c) The balance in Allowance for Doubtful Accounts after adjustment.Solution #21. 4,000,000 * .0025 10,0002. Uncollectible Accounts Expense10,000Allowance for Uncollectible10,000Accounts3. 300 credit balance 10,000 additional credit 10,300 creditbalancePercent of Accounts Receivable MethodThe Percent of Receivables Method uses the balance in one balance sheet account,Accounts Receivable, to estimate the balance in another balance sheet account,Allowance for Uncollectible Accounts, at the end of the period.The adjusting entry for bad debt expense is the difference between the balance in theledger for the allowance account before adjustment and the estimated balance in theallowance account.Page 5 of 23

Revised Fall 2012The current balance of accounts receivable is analyzed by use of an aging schedule todetermine the desired ending balance for the Allowance for Doubtful Accounts. Theuncollectible accounts expense for the period is determined based on the current(unadjusted) balance in the Allowance, the desired ending balance in the Allowanceaccount and any write-offs of uncollectible accounts during the period.Allowance for Doubtful AccountsBeginning balanceWrite-offsSolve for bad debt expenseEnding balanceBad debt expense ending balance write-offs – beginning balanceHowever, if there have been more write-offs than expected, the balance beforeadjustment in the allowance account may be a debit:Allowance for Doubtful AccountsBeginning balanceWrite-offsSolve for bad debt expenseEnding balanceBad debt expense ending balance write-offs beginning balanceExample #3: The balance of Allowance for Doubtful Accounts before adjustment atthe end of the period is 400 debit. Based on an analysis of Accounts Receivable, it wasestimated that 9,000 would become uncollectible.Determine the following:a) The uncollectible accounts expense for the year.b) The adjusting entry to be made of December 31.c) The balance in Allowance for Doubtful Accounts after adjustment.Page 6 of 23

Revised Fall 2012Solution #3a)Allowance for Doubtful AccountsBalance400Uncollectible accountsexpense ?Accounts receivablewritten-off 09,000 ending balanceUncollectible accounts expense 400 9,000 -0 9,400b)Uncollectible accounts expenseAllowance for doubtful accounts9,4009,400c) 9,000Practice Problem #1: Journalize the following transactions assuming the allowancemethod is used to account for uncollectible receivables.05/1406/2007/2712/31Received 75% of the 20,000 balance owed by Webb Co., abankrupt business. Wrote off remainder as uncollectible.Reinstated the account of Zorn Co., which had been writtenoff in the preceding year as uncollectible. Received 5,225cash as full payment of Zorn’s account.Wrote off the 2,500 balance owed by Schmich, Inc. whichhad no assets.Based on an analysis of Accounts Receivable, it isdetermined that 11,500 will become uncollectible. Thebalance in Allowance for Doubtful Accounts on December 31prior to adjustment is 200 credit.Determine the following:a) The balance in Allowance for Doubtful Accounts after adjustment.b) The Net Realizable Value of Accounts Receivable if the balance ofAccounts Receivable is 62,000.c) Redo the entry for 12/31and questions a) and b) if the percent ofsales method had been used to estimate uncollectible accountsexpense at the rate of ½ of 1% of net sales of 2,000,000.Page 7 of 23

Revised Fall 2012DIRECT WRITE-OFF METHODThe Direct Write-off Method records uncollectible accounts expense in the period whenthe customer’s account is determined to be uncollectible. The entry to write-off theaccount receivable isUncollectible accounts expenseAccounts receivablexxxxxxin the period when a specific account is determined to be uncollectible. The DirectWrite-off Method violates the matching principle because it does not match revenuesand expenses in the same period.NOTES RECEIVABLEA Promissory Note is a written promise to pay a specific dollar amount on demand or ata specific time, usually with interest. If the note is paid according to the terms, the noteis honored. If the note is not paid as agreed according to the terms, the note isdishonored. If the note is dishonored, the amount due including the interest earned andunpaid is recorded in accounts receivable.At the end of the accounting period, in order to comply with the matching principle,interest must be accrued for the number of days between the most recent interestpayment date and the end of the accounting period using the calculation method shownabove.Example #4: On July 17, 2001, received a 12,000, 90-day, 10% note on accountfrom Adams Co.Determine:a) Due date for the noteb) Interest earned during the term of the notec) Maturity value of the notePrepare journal entries whether:d) The note is honored on the maturity datee) The note is dishonored on the maturity datePage 8 of 23

Revised Fall 2012Solution #4:a)Due Date:Term of the note 90Days remaining in July 31 – 17 14Remaining term of the note76Days in August31Remaining term of the note45Days in September30Remaining term of the note15Since the remaining 15 days are less than the 31 days in October,the note is due on October 15.b)Interest:Calculated as Principal X Rate X Time 12,000 x .10 x 90 days/360 days 300Time is calculated as the term of the note divided by360 days for the year.Time is always based on a 360-day year.c)Maturity Value:Calculated as Principal Interest 12,000 300 12,300d)Note is honored:7/17 Notes receivableAccounts receivable12,00010/15 Cash12,30012,000Notes receivableInterest receivablee)Note is dishonored:7/17 Notes receivableAccounts receivable10/15 Accounts receivableNotes receivableInterest receivable12,00030012,00012,00012,30012,000300The difference between the two entries for 10/15 is the account to be debited.Page 9 of 23

Revised Fall 2012Example #5:Journalize the adjusting entry for accrued interest on December 31for the following outstanding notes receivable. Journalize the receipt of the amount dueon the due date for each note.a)b) 24,000, 60-day, 10% note dated December 1. 12,000, 90-day, 15% note dated October 22.Solution #5:a)Interest has been earned for 30 daysDays remaining in December 31 – December 1 30 daysInterest earned: 24,000 x .10 x 30 days /360 days 200Interest receivableInterest revenueCashb)200200Notes receivableInterest revenue for JanuaryInterest receivable24,40024,000200200Interest has been earned for 30 daysDays remaining in October 31 – October 22 9 daysDays in November 30 daysDays in December 31 daysTotal days to accrue70 daysInterest earned: 12,000 x .15 x 70 days /360 days 350Interest receivableInterest revenue350350Cash12,450Notes receivableInterest revenue for Januar1Interest receivablePage 10 of 2312,000100350

Revised Fall 2012Practice Problem #2: Journalize the following 1Received a 30,000, 12%, 120-day note on account.Received a 15,000, 10%, 60-day note on account.Received an 18,000, 15%, 30-day note on account.Received the amount due on the note of October 9.The note of November 15 was dishonored.Accrued interest on the note of September 12.Practice Problem #3:At the end of the year, two similar companies were in the process of calculating baddebt expense for the year. Each company had credit sales of 1,000,000 and a debitbalance in Allowance for Uncollectible Accounts of 2,000 before any year-endadjustment. The balance of Accounts Receivable is 180,000.Company A estimates that 5% of accounts receivable will not be collected over the nextyear Determine the following:a) The uncollectible accounts expense for the year.b) The adjusting entry to be made of December 31.c) The balance in Allowance for Doubtful Accounts after adjustment.Company B estimates that 5% of credit sales will not be collected over the next yearDetermine the following:d) The uncollectible accounts expense for the year.e) The adjusting entry to be made of December 31.f) The balance in Allowance for Doubtful Accounts after adjustment.Page 11 of 23

Revised Fall 2012Sample True / False Questions1.The adjustment for uncollectible accounts involves a credit to Bad DebtExpense and a debit to the Allowance for Uncollectible Accounts.True False2.The Allowance for Uncollectible Accounts is a contra asset account representingthe amount of accounts receivable that the company does not expect tocollect.True False3.Bad debt expense is the amount of the adjustment to the allowance foruncollectible accounts that represents the cost of the estimated future baddebts.True False4.One disadvantage of the allowance method (over the direct write-off method)for recording uncollectible accounts is that it generally matches bad debtexpense with the revenue it helped to generate.True False5.Under the allowance method, when a company writes off an account receivableas an actual bad debt, it reduces total assets.True False6.Under the allowance method, when a company writes off an account receivableas an actual bad debt, it records an expense.True False7.Under the allowance method, when a company collects cash from an accountpreviously written off, total assets increase.True False8.A credit balance in the Allowance for Uncollectible Accounts before adjustmentindicates that last year's estimate of uncollectible accounts was too high.True False9.A debit balance in the Allowance for Uncollectible Accounts before adjustmentindicates that last year's estimate of uncollectible accounts was too low.True FalsePage 12 of 23

Revised Fall 201210. The direct write-off method violates the matching principle.True False11. A company expects 5% of its newer accounts receivable to be uncollectible and20% of its older accounts to be uncollectible. If the company has 40,000 ofnewer accounts and 5,000 of older accounts, the total estimate ofuncollectible accounts is 2,000.True False12. Notes receivable are similar to accounts receivable but are more formal creditarrangements evidenced by a written debt instrument, or note.True False13. Notes receivable only arise from sales to customers.True False14. Notes receivable typically earn interest revenue for the lender and interestexpense for the borrower.True False15. A 10,000 note that has a stated interest rate of 10% and is due in six monthswould have interest of 1,000.True False16. Accrued interest on a note receivable is interest earned by the end of the yearbut not yet received.True False17. The percentage-of-credit-sales method for estimating uncollectible accounts iscommonly referred to as the income statement method, because it alwaysresults in a higher amount of net income being reported in the incomestatement.True False18. Even though the percentage-of-receivables method and the percentage-ofcredit-sales method use different accounts to estimate future uncollectibleaccounts, the amount of bad debt expense reported in the income statementwill always be the same under the two methods.True False19. From an income statement perspective, the percentage-of-credit-sales methodis typically preferable because it better matches the revenues (credit sales)with their related expenses (bad debts).True FalsePage 13 of 23

Revised Fall 201220. From a balance sheet perspective, the percentage-of-receivables method istypically preferable because assets (net accounts receivable) are reportedcloser to their net realizable value.True FalsePage 14 of 23

Revised Fall 2012Sample Multiple Choice Questions1.The internal control procedure most relevant to receivables is:a) Cost-benefit balanceb) Safeguard assetsc) Efficient operationsd) Separate entity2.A note receivable due in 5 years is listed on the balance sheet under thecaption:a) Investmentsb) Current Assetsc) Plant Assetsd) Stockholders’ Equity3.The two methods of accounting for uncollectible receivables are the directwrite-off method and the:a) Percentage of receivables methodb) Aging of credit sales methodc) Interest methodd) Allowance method4.The Allowance for Doubtful Accounts has a debit balance of 1,000 at the endof the year (before adjustment), and uncollectible accounts expense isestimated at 2% of net sales. If net sales are 600,000, the amount of theadjusting entry to record the provision for doubtful accounts is:a) 1,000b) 13,000c) 11,000d) 12,0005.The Allowance for Doubtful Accounts has a debit balance of 1,000 at the endof the year (before adjustment), and uncollectible accounts estimate based onan aging schedule is 10,000. If accounts receivable are 600,000 the amountof the adjusting entry to record the provision for doubtful accounts is:a) 10,000b) 11,000c) 9,000d) 16,000Page 15 of 23

Revised Fall 20126.Allowance for Doubtful Accounts has a credit balance of 500 at the end of theyear (before adjustment), and an analysis of customers’ accounts indicatesdoubtful accounts of 11,500. Which of the following entries records theproper provision for doubtful accounts?a) Debit Uncollectible Accounts Expense, 11,000; credit Allowance forDoubtful Accounts, 11,000.b) Debit Uncollectible Accounts Expense, 12,000; credit Allowance forDoubtful Accounts, 12,000.c) Debit Allowance for Doubtful Accounts, 12,000; credit UncollectibleAccounts Expense, 12,000.d) Debit Allowance for Doubtful Accounts, 11,000; credit UncollectibleAccounts Expense, 11,000.7.If the direct write-off method of accounting for uncollectible receivables isused, what general ledger account is debited to write off a customer’s accountas uncollectible?a) Uncollectible Accounts Payableb) Accounts Receivablec) Uncollectible Accounts Expensed) Allowance for Doubtful Accounts8.The amount of the promissory note plus the interest earned on the due date iscalled the:a) Realizable valueb) Face valuec) Net realizable valued) Maturity value9.A 7,000, 30-day, 12% note recorded on November 21 is not paid by themaker at maturity. The journal entry to recognize this event is:a) Debit Cash 7,070; Credit Notes Receivable 7,070b) Debit Accounts Receivable 7,070; Credit Notes Receivable 7,000; CreditInterest

A Promissory Note is a written promise to pay a specific dollar amount on demand or at a specific time, usually with interest. If the note is paid according to the terms, the note is honored. If the note is not paid as agreed according to the terms, the note is dishonored. If the note is dis

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