1 Chapter 7: Accounts Receivable and Notes Receivable

2 Accounts Receivable Accounts receivable arise from selling goods or services to customers on account. Recorded at face amount to be collected. However, we must also reflect the fact that a portion of A/R may not be collected. Two ways to account for the uncollectibles: – Direct Write-Off method – Allowance method

3 Direct Write-Off Method Assume $100,000 is recorded in sales on account in 2006; one of the customers defaults on collection in Record sale in 2006: A/R100,000 Sales Revenue 100,000 Record default in 2007: Bad Debt Expense 1,000 A/R 1,000 Note: this is called the direct method, and is not the preferred method for most companies for several reasons.

4 Problems with Direct Method Problem: the direct method, on the previous slide, does not achieve matching (revenues recognized in 2006, but a related expense was recognized in 2007). Problem: the direct method does not correctly value the asset, A/R. The assets are overvalued until 2007, when the receivable is finally written off. Solution: create a contra to A/R, called Allowance for Doubtful Accounts (ADA) and estimate the A/R that will not be collected.

5 Solution: the Allowance Method In year of sale, the AJE to record an estimate for all future uncollectibles in 2006 (ex: 4% of sales): Bad Debt Expense4,000 ADA 4,000 The General JE during 2007, when a specific A/R is deemed uncollectible (this is called the write- off of a specific A/R): ADA1,000 A/R 1,000 (Other uncollectible accounts would also be written off against the allowance account.) When are the income statement and balance sheet affected?

6 Estimation of Uncollectibles Note that, in Slide 5, we do not know in 2006 which A/Rs will not be collected in Therefore, we must estimate uncollectibles. There are two methods: 1. Percentage of sales 2. Percentage of accounts receivable Both methods are used to estimate uncollectibles for the AJE. The percentage of sales method is simpler, but the percentage of A/R method is more comprehensive.

7 1. Percentage of Sales Method Usually based on credit sales, but may use total sales or net sales as basis. Calculation: Sales x % = Bad Debt Expense (focus on the debit side of the AJE) Called the Income Statement approach, because: revenues x % = expense.

8 2. Percentage of A/R Method Based on ending A/R and ending Allowance account. Calculation: Ending A/R x % = Ending Allowance (focus on the credit side of the AJE) Called Balance Sheet approach, because: ending asset x % = ending contra asset. Requires the analysis of the Allowance account before preparing the AJE. May be based on one percentage or multiple percentages - see the aging schedule. An aging schedule of A/R is the most accurate way to estimate uncollectibles (see pp ).

9 T-Account Approach for Percentage of A/R Method Based on the analysis of the Allowance account. Calculate the “desired ending balance” based on an aging of A/R. Now, given the Beginning, Ending and Write-off amounts, calculate the amount of the current estimate that must be added to the Allowance account to achieve the “desired ending balance.”

10 Allowance for Doubtful Accts. (T-account) Allowance for Doubtful Accts. 1. Beginning Balance 1. The allowance established in the prior period carries forward for current period write-offs.

11 Allowance for Doubtful Accts. (T-account) Allowance for Doubtful Accts. Beginning Balance Accounts Receivable 2. Write-off of specific accounts receivable 2. Write-off of specific accounts receivable 2. As specific accounts are determined uncollectible during the year, they are written-off to the allowance account as shown. These write-offs may cause the allowance account to have a debit balance before the AJE if the prior year’s expense was underestimated.

12 Allowance for Doubtful Accts. (T-account) Allowance for Doubtful Accts. Beginning Balance Accounts Receivable Write-off of accounts receivable 3. Ending Balance Write-off of accounts receivable 3. The “desired ending balance” in the allowance account is estimated using the percentage calculation or the aging schedule.

13 Allowance for Doubtful Accts. (T-account) Allowance for Doubtful Accts. Beginning Balance 4. Recognition of bad debt expense Bad Debts Expense 4. Recognition of bad debt expense Accounts Receivable Write-off of accounts receivable Ending Balance Write-off of accounts receivable 4. The AJE to record the estimate of uncollectibles is calculated based on the amount necessary to achieve the “desired ending balance” in the allowance account. The focus is on the Allowance account.

14 Class Problem 1 Given the following information: At December 31, 2007, Company Z prepared an aging schedule to determine that the uncollectible accounts receivable at that date were $18,000. The balance in the Allowance for Doubtful Accounts at 1/1/07 was a $3,000 credit. During 2007, the company wrote off $5,000 of specific accounts receivable that were deemed to be uncollectible. Required: prepare the AJE to record the estimated uncollectibles at 12/31/07.

15 Solution to Class Problem 1 Allowance for Doubtful Accounts (1) Post the beginning balance and write-off. (2) Post the desired ending balance. (3) Post the adjusting journal entry.

16 Notes Receivable Notes Receivable (N/R) are similar to A/R, except they usually have a longer collection period, and also may include interest. Activity to record N/R includes the following: To record N/R N/Rxx Sales Revenuexx To record interest at the end of the period: Int. Receivablexx Interest Revenuexx Calculation of the interest at the end of the period is based on the following formula: Principal x rate per year x time period P x R x T

17 Class Problem 2 On November 1, 2008, Pistol Pete’s Western Gear sold merchandise totaling $10,000 to the Orange Cow Company. Pete’s accepted a note containing a 6 % annual interest rate, where interest and principal were to be repaid in 3 months, on January 31, Prepare the journal entries for Pistol Pete’s on the following dates: 1. Sale on November 1, 2008 (ignore COGS). 2. Interest accrual at December 31, Collection of note and interest at January 31, 2009.

18 Solution to Class Problem 2 1. Sale on November 1, 2008: 2. Interest accrual at December 31, 2008: 3. Collection of loan and interest at 1/31/09: