1. Chapter 8 Receivables

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Learning Objectives
Define and explain common types of receivables and journalize sales on credit, credit card sales, and debit card sales
Apply the direct write-off method for uncollectibles
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Learning Objectives
Apply the allowance method for uncollectibles and estimate bad debts expense based on the percent-of-sales, percent-of-receivables, and aging-of-receivables methods
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Learning Objectives
Account for notes receivable including computing interest and recording honored and dishonored notes
Use the acid-test ratio, accounts receivable turnover ratio, and days’ sales in receivables to evaluate business performance
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Learning Objective 1
Define and explain common types of receivables and journalize sales on credit, credit card sales, and debit card sales
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What Are Common Types of Receivables, and How Are Credit Sales Recorded?
A receivable occurs when a business sells goods or services to another party on account (on credit).
A receivable is a monetary claim against a business or an individual.
A receivable is a right to receive cash in the future from a current transaction.
A creditor is the party who receives a receivable.
A debtor is the party to a credit transaction who is obligated to pay later.
A receivable occurs when a business sells goods or services to another party on account (on credit). It is a monetary claim against a business or an individual. The receivable is the seller’s claim for the amount of the transaction. Receivables also occur when a business loans money to another party. A receivable is the right to receive cash in the future from a current transaction. It is something the business owns; it is an asset. Each receivable involves two parties: the creditor and the debtor. The creditor receives a receivable (an asset). The creditor will collect cash from the customer or borrower. The debtor is the party to a credit transaction who takes on an obligation/payable (a liability). The debtor will pay cash later.
The three major types of receivables are: accounts receivable, notes receivable, and other receivables.
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Accounts Receivable
Accounts receivable, also called trade receivables, represents the right to receive cash in the future from customers for goods or services performed.
Generally collected within 30 to 60 days
Reported as a current asset on the balance sheet
Accounts receivables are sometimes referred to as trade receivables. An accounts receivable is the right to receive cash in the future from customers for goods sold or for services performed. Accounts receivable are treated as current assets and are usually collected within 30–60 days of the billing date.
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Notes Receivable
Notes receivable usually have longer terms than accounts receivable.
Notes receivable are sometimes called promissory notes.
A note receivable represents a promise to pay a fixed amount of principle plus interest by a certain due date.
The maturity date is the date on which a note receivable is due.
Notes receivable arise when a company loans money to its customers or another individual or business. Notes receivable usually have longer terms than accounts receivable. A note receivable is a written promise that a customer will pay a fixed amount of principal plus interest by a certain date in the future. The maturity date is the date when a note is due.
Notes receivable are generally evidenced by a legally binding document called a promissory note, a written promise to pay a specified amount in the future. Usually the signer agrees to pay interest at a specified rate. Notes receivable are generally long-term assets, but some notes receivable may be short-term assets, for 90 or even 180 days.
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Other Receivables
Any other type of receivable is considered other receivables.
Receivables are classified as either current or long-term, depending on whether they will be received in one year or less.
Examples include:
Dividends receivable
Interest receivable
Taxes receivable
Other receivables make up a miscellaneous category that includes any other type of receivable where there is a right to receive cash in the future. Common examples include dividends receivable, interest receivable, and taxes receivable. These other receivables may be either current or long-term assets, depending on whether they will be received within one year or less.
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10. Recording Sales on Credit
Smart Touch Learning performs $5,000 in services to Brown on account and sells $10,000 (sales price) of merchandise inventory to customer Smith on account on August 8. Ignore Cost of Goods Sold.
As stated earlier, selling on account (on credit) creates an account receivable. Businesses must maintain a separate Accounts Receivable account for each customer in order to account for payments received from the customer and amounts still owed.
For example, Smart Touch Learning performs $5,000 in services for Brown on account and sells $10,000 (sales price) of merchandise inventory to Smith on account on August 8. The revenue is recorded. (Ignore Cost of Goods Sold.)
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11. Recording Sales on Credit
The control account, Accounts Receivable, shows a balance of $15,000. The individual customer accounts in the subsidiary ledger (Accounts Receivable—Brown $5,000 + Accounts Receivable—Smith $10,000) add up to $15,000.
These separate customer accounts receivable (for example, Accounts Receivable—Brown) are called subsidiary accounts. The sum of all balances in subsidiary accounts receivable equals a control account balance.
It is obviously impractical to include each individual account receivable on the balance sheet. A control account, Accounts Receivable, is maintained to represent the total of all the individual subsidiary accounts.
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12. Recording Sales on Credit
When the business collects cash from both customers on August 29—$4,000 from Brown and $8,000 from Smith—Smart Touch Learning makes the following entry:
When the business collects cash from both customers on August 29—$4,000 from Brown and $8,000 from Smith—Smart Touch Learning records the payments in a journal entry and posts the entry to the T-accounts.
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13. Recording Credit Card and Debit Card Sales
Credit and debit card sales are recorded the same as cash sales.
A fee is usually charged by the card company.
There are two methods for recording credit card sales:
Net method
Gross method
In addition to selling on account, most companies also accept credit cards and debit cards. By accepting credit and debit cards, such as Visa, MasterCard, and American Express, businesses are able to attract more customers. Businesses benefit from accepting payment by credit and debit cards because they do not have to check each customer’s credit rating or keep accounts receivable records.
There are two methods allowable for recording credit card and debit card sales: the net method and the gross method. Under the net method, the total sales less the processing fee assessed equals the net amount of cash deposited by the processor, usually within a few days of the sale date. Under the gross method, the total sale is deposited within a few days of the actual sale date. The processing fees for all transactions processed for the month are deducted from the company’s bank account by the processor, often on the last day of the month.
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14. Recording Credit Card and Debit Card Sales
Smart Touch Learning sells merchandise inventory (ignore Cost of Goods Sold) to a customer for $3,000. The customer pays with a third-party credit card. The card processor assesses a 4% fee. Use the net method.
Under the net method, the seller records the total amount of the sale at the time of the sale. The anticipated amount of the fee is deducted, and only the net amount of cash is recorded.
On August 15, Smart Touch Learning sells merchandise to a customer for $3,000. The customer pays with a credit card. The credit card company assesses a 4% fee. The full $3,000 is credited to Sales Revenue; 4% of the sale, or $120, is charged to Credit Card Expense; and the net amount of cash ($3,000 – $120) is debited to the Cash account.
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15. Recording Credit Card and Debit Card Sales
Smart Touch Learning sells merchandise inventory (ignore Cost of Goods Sold) to a customer for $3,000. The customer pays with a third-party credit card. The card processor assesses a 4% fee. Use the gross method.
Under the gross method, the full amount of the sale is credited to Sales on the sale date, along with a debit of the full amount to Cash. The credit card fee is recorded later, when the credit card company actually deducts the amount from the cash it pays to the seller.
On August 15, Smart Touch Learning sells merchandise to a customer for $3,000. The customer pays with a credit card. The credit card company assesses a 4% fee.
This will require two journal entries on different dates. On August 15, Smart Touch Learning records a debit to Cash for $3,000 and a credit to Sales Revenue for $3,000.
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16. Recording Credit Card and Debit Card Sales
At the end of August, the process collects the fee assessed for the month.
On August 31, when the processor collects the 4% fee, the Credit Card Expense is debited for $120 and Cash is credited for $120.
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Learning Objective 2
Apply the direct write-off method for uncollectibles
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How Are Uncollectibles Accounted for When Using the Direct Write-Off Method?
Bad debts expense arises from failure to collect from some customers who purchase on account.
There are two methods of accounting for uncollectible receivables:
Direct write-off method
Allowance method (required by GAAP)
Selling on account brings both a benefit and a cost. The benefit to a business is the potential increased revenues and profits by making sales to a wider range of customers. The cost, however, is that some customers do not pay, creating uncollectible receivables.
Customers’ accounts receivable that are uncollectible must be written off or removed from the books because the company does not expect to receive cash in the future. Instead, the company must record an expense associated with the cost of the uncollectible account. Bad debts expense is the cost to the seller of extending credit. It arises from the failure to collect from some credit customers.
There are two methods of accounting for uncollectible receivables and recording the related bad debts expense: direct write-off method and allowance method.
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Recording and Writing Off Uncollectible Accounts—Direct Write-off Method
The direct write-off method of accounting for uncollectible receivables is primarily used by small, nonpublic companies.
Accounts receivable are written off when the business determines that it will never collect from a specific customer.
Bad debts expense is recorded.
The direct write-off method of accounting for uncollectible receivables is primarily used by small, nonpublic companies. Under the direct write-off method, accounts receivable are written off and bad debts expense is recorded when the business determines that it will never collect from a specific customer.
Once an account receivable is written off, the company stops pursuing the collection. Some companies might turn over delinquent receivables to an attorney or a collection agency to recover some of the cash for the company, but generally companies do not expect to receive any future payment.
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Recording and Writing Off Uncollectible Accounts—Direct Write-off Method
On August 9, Smart Touch Learning determines that it will not be able to collect $200 from customer Dan King for a sale of merchandise inventory made on May 5.
Dan King’s subsidiary Accounts Receivable account will be credited for $200 to remove the uncollectible account from the books. In addition, a corresponding $200 debit will be posted to the Bad Debts Expense account.
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Recording and Writing Off Uncollectible Accounts—Direct Write-off Method
Sometimes customers make payments after the company writes off the account.
To account for this recovery, the company must reverse the earlier write-off.
Then it records the receipt of the payment.
Even though customer accounts are sometimes written off, the customer may still feel an obligation to pay the amount owed. If, at some future date, the customer is able to send in the original payment, the company reverses the earlier write-off. Then the company records the payment by debiting cash and crediting the customer’s accounts receivable account.
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Learning Objective 3
Apply the allowance method for uncollectibles and estimate bad debts expense based on the percent-of-sales, percent-of-receivables, and aging-of-receivables methods
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23. How Are Uncollectibles Accounted for When Using the Allowance Method?
Most companies use the allowance method to measure bad debts.
The allowance method is based on the matching principle.
It records bad debts in the same period as the sales revenue.
A contra asset account called Allowance for Bad Debts reduces the Accounts Receivable to the net realizable value.
In order to be in accordance with Generally Accepted Accounting Principles (GAAP), companies must account for their uncollectible accounts using the allowance method. The allowance method is based on the matching principle; thus, the key concept is to record bad debts expense in the same period as the sales revenue. The allowance method is a method of accounting for uncollectible receivables in which the company estimates bad debts expense instead of waiting to see which customers the company will not collect from. To do this, we will rely on past experience and our understanding of the axiom that the older accounts receivable are, the less likely it is that we will actually collect them.
The offset to the expense is a contra asset account called Allowance for Bad Debts or Allowance for Doubtful Accounts. The Allowance for Bad Debts is a contra account, related to accounts receivable, that holds the estimated amount of uncollectible accounts. The allowance reduces the asset Accounts Receivable. The net realizable value is the net value a company expects to collect from its accounts receivable. Net realizable value is Accounts Receivable less Allowance for Bad Debts.
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24. Recording Bad Debts Expense—Allowance Method
As of December 31, 2017, Smart Touch Learning estimates that $80 of its $4,400 accounts receivable are uncollectible.
The entry to establish the allowance for bad debt associated with the accounts receivable balance will include a debit to Bad Debts Expense for $80 and a credit to Allowance for Bad Debts for $80.
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25. Recording Bad Debts Expense—Allowance Method
Accounts Receivable will be reported on the balance sheet, but it will now be shown at the net realizable value. The balance sheet now reports the amount of Accounts Receivable that Smart Touch Learning expects to collect: $4,320. The contra account, Allowance for Bad Debts, is subtracted from Accounts Receivable, showing that although $4,400 is owed to Smart Touch Learning, the company estimates that $80 of Accounts Receivable will be uncollectible.
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26. Writing Off Uncollectible Accounts—Allowance Method
An allowance is established for the estimated uncollectible accounts.
Instead of recording a debit to Bad Debts Expense, the company records a debit to Allowance for Bad Debts.
The entry to write off an account under the allowance method has no effect on net income at the time of entry.
When using the allowance method, companies still write off accounts receivable that are uncollectible. However, instead of recording a debit to Bad Debts Expense (as is done when using the direct write-off method), the company will record a debit to Allowance for Bad Debts. Bad Debts Expense is not debited when a company writes off an account receivable when using the allowance method because the company has already recorded the Bad Debts Expense as an adjusting entry.
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27. Writing Off Uncollectible Accounts—Allowance Method
On January 10, 2018, Smart Touch Learning determines that it cannot collect a total of $25 from its customer Shawn Clark.
On January 10, 2018, Smart Touch Learning determines that it will not collect $25 from customer Shawn Clark. The Allowance for Bad Debt account is debited for $25 and the Account Receivable—Clark account is credited for $25.
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28. Recovery of Accounts Previously Written Off—Allowance Method
Recall that Smart Touch Learning wrote off the $25 receivable from Shawn Clark on January 10, It is now March 4, 2018, and Smart Touch Learning unexpectedly receives $25 cash from Clark.
Occasionally, a customer will decide to pay us, even after the account has been written off. This requires two entries. The first entry will reverse the earlier write-off. The second entry will receive the cash against the reinstated Account Receivable.
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29. Estimating and Recording Bad Debts Expense—Allowance Method
Companies estimate bad debts expense based upon:
Past experience
The industry in which they operate
Other variables
There are three methods to estimate uncollectibles using the allowance method:
Percent-of-sales
Percent-of-receivables
Aging-of-receivables
How do companies determine the amount of bad debts expense when using the allowance method? Companies use their past experience as well as consider the economy, the industry they operate in, and other variables. In short, they make an educated guess, called an estimate. There are three basic ways to estimate uncollectibles: percent-of-sales, percent-of-receivables, and aging-of-receivables.
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30. Percent-of-Sales Method
The percent-of-sales method computes bad debts expense as a percentage of net credit sales.
Some companies use all sales, not just credit sales.
This method is also called the income-statement approach.
The percent-of-sales method is a method of estimating uncollectible receivables that calculates bad debts expense based upon a percentage of net credit sales. The percentage will be based on experience and an actuarial assessment of historical patterns. This method is also called the income-statement approach because it focuses on the amount of expense that is reported on the income statement.
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31. Percent-of-Sales Method
Smart Touch Learning uses the percent-of-sales method to account for uncollectibles. Past experience suggests that 0.5% of credit sales will be uncollectible, which amounted to $60,000.
The percent-of-sales method is a method of estimating uncollectible receivables that calculates bad debts expense based upon a percentage of net credit sales. The percentage will be based on experience and an actuarial assessment of historical patterns. This method is also called the income-statement approach because it focuses on the amount of expense that is reported on the income statement.
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32. Percent-of-Receivables Method
The percent-of-receivables method computes bad debts expense as a percentage of accounts receivable.
The percent-of-receivables method of estimating uncollectible receivables involves determining the balance of the Allowance for Bad Debts account based on a percentage of accounts receivable. This approach is called the balance-sheet approach because it focuses on Accounts Receivable (a balance sheet account) and determines a target allowance balanced based on a percentage of the receivable balance.
The calculation for bad debts expense under the percent-of-receivables method is a two-step process. First, the company determines the target balance of Allowance for Bad Debts. Then it uses the target balance to determine the amount of the bad debts expense.
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33. Percent-of-Receivables Method
Assume on December 31, 2018, Smart Touch Learning’s unadjusted Accounts Receivable balance is $6,375, and 4% of the accounts receivable is estimated to be uncollectible. The Allowance for Bad Debts account currently has a credit balance of $55, so the adjustment in only $200.
In step 1, the company determines the target balance for the Allowance for Bad Debts account: $255 ($6,375 × 0.04). Next, its accountant determines the amount of bad debts expense adjustment: $255 ‒ $55 = $200.
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34. Aging-of-Receivables Method
The aging-of-receivables method is similar to the percent-of-receivables method.
In the aging method, businesses group individual accounts based on how long the receivable has been outstanding.
Different percentages are applied to each category.
The aging-of-receivables method is a method of estimating uncollectible receivables by determining the balance of the Allowance for Bad Debts account based on the age of individual accounts receivable. We first break the Accounts Receivable into age groups. Each age grouping will have a difference expectation of uncollectibility. Once we know the target balance for Allowance for Bad Debts and we know the existing balance of Allowance for Bad Debts, we can determine the Bad Debts Expense as the difference between the two previous totals.
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35. Aging-of-Receivables Method
Exhibit 8-1 shows the aging of the accounts receivable for Smart Touch Learning. Total Accounts Receivable is $6,375. However, that balance can be broken down into four balances. Those balances represent various transactions of differing ages. We can tell from the exhibit that our target balance for Allowance for Bad Debts is $185.
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36. Aging-of-Receivables Method
The target balance of the Allowance for Bad Debts account is $185.
Based on Exhibit 8-1, Smart Touch Learning knows the target balance of the Allowance for Bad Debts account is $185. Smart Touch Learning will determine its bad debts expense by subtracting the $55 unadjusted credit balance in the allowance account from the target balance, $185.
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37. Aging-of-Receivables Method
At year-end, Smart Touch Learning will need to record the adjusting entry to recognize Bad Debts Expense. After posting the adjusting entry, Smart Touch Learning has a debit balance in Accounts Receivable of $6,375, a debit in Bad Debts Expense of $130, and a credit balance in Allowance for Bad Debts of $185.
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38. Comparison of Accounting for Uncollectibles
Exhibit 8-2 shows the journal entries that are recorded when using both the direct write-off method and the allowance method of accounting for uncollectibles. Review the differences between these two methods. Remember that when using the direct write-off method, the business does not use an allowance account and that this method does not conform with GAAP.
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39. Comparison of Accounting for Uncollectibles
Under the allowance method of accounting for uncollectibles, businesses must estimate the amount of the bad debts expense at the end of the accounting period. This is done using one of three methods: percent-of-sales, percent-of-receivables, or aging-of-receivables. Exhibit 8-3 summarizes the differences among those three methods.
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Learning Objective 4
Account for notes receivable including computing interest and recording honored and dishonored notes
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41. How Are Notes Receivable Accounted For?
Debtor
Creditor
Interest
Interest rate
Interest period
Maturity
Maturity date
Maturity value
Notes receivable are more formal than accounts receivable. The debtor signs a promissory note as evidence of the transaction. The note receivable is recorded on the date that the promissory note is signed, and interest will have to be accrued periodically as necessary.
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42. How Are Notes Receivable Accounted For?
In order for a note receivable to be enforceable, it must be evidenced by a signed promissory note. The note must have four primary components:
The principal amount must be stated on the face of the promissory note.
The interest period must be identified.
The interest rate must be identified.
The promissory note must be signed by the maker.
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43. How Are Notes Receivable Accounted For?
Smart Touch Learning lends Lauren Holland $1,000 on September 30, 2017, for one year, at an annual rate of 6%.
On September 30, Smart Touch Learning loaned $1,000 to Lauren Holland for one year at 6% annual interest. Smart Touch Learning records a debit to Notes Receivable and a credit to Cash for $1,000.
Note: Interest is recorded only after time has passed. At the time of the issuance of the note, no time has passed. Hence there is no interest yet to be recorded. Remember that all interest rates are always stated as annual rates.
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44. Computing Interest on a Note
Interest is recorded based on the amount of time that has passed:
Interest rates are always annual.
Time is always a fraction of a year.
At the end of the accounting period, if the note is not yet due, interest will need to be accrued. The approach is fairly straightforward.
Amount of interest = Principal × Interest rate × Fraction of a year that the note has been outstanding
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45. Accruing Interest Revenue and Recording Honored Notes Receivable
December 31: The $1,000 loan to Lauren Holland is not yet due, but interest must be accrued at a rate of 6%.
The entry will require a debit to Interest Receivable for $15 and a credit to Interest Revenue for $15.
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46. Accruing Interest Revenue and Recording Honored Notes Receivable
Smart Touch Learning earns nine months (January through September) of interest, which is $1,000 × 0.06 × 9/12 = $45.
How much interest revenue does Smart Touch Learning earn in 2018 (for January 1 through September 30)? Smart Touch Learning earns nine months (January through September) of interest, which is $1,000 × 0.06 × 9/12 = $45.
On the maturity date of the note, Smart Touch Learning will receive cash for the principal amount plus interest. The company considers the note honored and records the journal entry.
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47. Recording Dishonored Notes Receivable
When a maker dishonors a note, the dishonored note and the unpaid interest are transferred to Accounts Receivable.
Later, the Accounts Receivable can be written off under the direct write-off method or the allowance method.
If the maker of a note does not pay at maturity, the maker dishonors a note (also called defaulting on a note). Because the note has expired, it is no longer in force. Dishonoring a note is a failure of a note’s maker to pay a note receivable at maturity. When a note receivable is deemed uncollectible, or goes into default, it is often first transferred to an Account Receivable, along with any unpaid interest. We then apply our accounts receivable policies to determine when this new Account Receivable will be written off.
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48. Recording Dishonored Notes Receivable
Suppose Rubinstein Jewelers has a six-month, 10% note receivable for $1,200 from Mark Adair that was signed on March 3, 2017, and Adair defaults.
Even though the note has expired, the debtor still owes the payee. The payee can transfer the note receivable amount to Accounts Receivable. Suppose Rubinstein Jewelers has a six-month, 10% note receivable for $1,200 from Mark Adair that was signed on March 3, 2017, and Adair defaults. Rubinstein Jewelers will record the default on September 2, 2017.
Rubinstein will then bill Adair for the account receivable. This also allows Rubinstein to eventually write off the receivable using either the direct write-off method or the allowance method if at a later date Rubinstein still cannot collect the account receivable.
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Learning Objective 5
Use the acid-test ratio, accounts receivable turnover ratio, and days’ sales in receivables to evaluate business performance
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How Do We Use the Acid-Test Ratio, Accounts Receivable Turnover Ratio, and Days’ Sales in Receivables to Evaluate Business Performance?
Balance-sheet data are useful because they show the relationships among assets, liabilities, and revenues.
Ratios for analysis:
Acid-test ratio
Accounts receivable turnover ratio
Days’ sales in receivables
The balance sheet can be used to calculate various ratios, such as the acid-test ratio, accounts receivable turnover ratio, and days’ sales in receivables.
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Using the information included in Exhibit 8-5 for Green Mountain Coffee Roasters, we will look at three common ratios used to evaluate business performance: the acid-test ratio, the accounts receivable turnover ratio, and days’ sales in receivables.
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52. Acid-Test (or Quick) Ratio
The acid-test ratio is used to measure a company’s ability to pay its current liabilities.
It is more stringent than the current ratio.
Quick assets are cash, cash equivalents, short-term investments, and net current receivables.
The acid-test ratio is the ratio of the sum of cash, cash equivalents, short-term investments, and net current receivables to total current liabilities. The ratio tells whether the entity could pay all its current liabilities if they came due immediately. The result is a ratio that gives us an idea of whether the company currently has sufficient liquid assets to cover current liabilities.
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53. Accounts Receivable Turnover Ratio
The accounts receivable turnover ratio measures the number of times the company collects the average accounts receivable balance in a year.
The higher the ratio, the faster the cash collections.
The accounts receivable turnover ratio is computed by dividing net credit sales for the period by the average net accounts receivable for the period. Typically, average net accounts receivable is computed as (Beginning net accounts receivable balance + Ending accounts receivable balance) / 2. If this number goes up, it is an indication that sales are slowing down.
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54. Days’ Sales in Receivables
Days’ sales in receivables indicates how many days it takes to collect the average level of accounts receivable. It is also called the collection period.
The days’ sales in receivables is the ratio of average net accounts receivable to one day’s sales. The ratio tells how many days it takes to collect the average level of accounts receivable.
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