Chapter 07 - Accounts and Notes Receivable

Chapter Outline Notes

I. Accounts Receivable
A receivable is an amount due from another party. Accounts
Receivable are amounts due from customers for credit sales.
A. Recognizing Accounts Receivable
Accounts Receivable occur from credit sales to customers.
1. Sales on Credit
Credit sales are recorded by increasing (debiting) Accounts
Receivable.
a. The General Ledger continues to keep a single Accounts
Receivable account.
b. A supplementary record, called the accounts receivable
ledger, is created to maintain a separate account for each
customer that tracks the balance of each customer.
c. The sum of the individual accounts in the accounts
receivable ledger equals the debit balance of the Accounts
Receivable account in the general ledger.
d. Entry to record credit sale: debit Accounts Receivable—
Customer Name, credit Sales. The debit is posted to the
Accounts Receivable account in the general ledger and to
the customer account in the accounts receivable ledger.
e. Many larger retailers maintain their own credit cards to
grant credit to preapproved customers and to earn interest
on unpaid balances. The entries are the same as in d.
above except for the possibility of added interest revenue;
entry to record interest: debit Interest Receivable, credit
Interest Revenue.
2. Credit Card Sales (examples: Visa, MasterCard, American
Express)
Sellers allow customers to use third-party credit and debit
cards for several reasons:
a. The seller does not have to evaluate each customer’s
credit standing.
b. The seller avoids the risk of extending credit to customers
who may not pay.
c. The seller typically receives cash from the credit card
company sooner than had it granted credit directly to
customers.
d. A variety of credit options for customers offers a potential
increase in sales volume.
e. Entry for credit card sales when cash is received upon
deposit of sales receipt: debit Cash (for the amount of sale
less the credit card charge), debit Credit Card Expense (for

7-3
Chapter 07 - Accounts and Notes Receivable

Chapter Outline Notes

the fee), credit Sales (for the full invoice amount).
f. Entry if company must remit the credit card sales receipts
to the credit card company and wait for the cash payment:
debit Accounts Receivable (for full invoice less the fee),
debit Credit Card Expense (for the fee), credit Sales. Entry
when payment is received: debit Cash, credit Accounts
Receivable.
3. Installment Sales and Receivables – amounts owed by
customers from credit sales where payments are made in periodic
amounts over an extended time period. The customer is usually
charged interest. Classified as current assets.
B. Valuing Accounts Receivable – Direct Write-Off Method
Accounts of customers who do not pay what they promised are
uncollectible accounts, commonly called bad debts. The total
amount of uncollectible accounts is an expense of selling on
credit. Two methods are used to account for uncollectible
accounts: the direct write-off method and the allowance method.
1. Recording and Writing Off Bad Debts—The direct write-
off method records the loss from an uncollectible account
receivable when it is determined to be uncollectible. Entry to
write off uncollectible and recognize loss: debit Bad Debt
Expense, credit Accounts Receivable.
2. Recovering a Bad Debt – sometimes, an account which was
written off is later collected. This results in two journal
entries. First a reversal of the write off (see above) and
second, a normal collection of account entry.
3. Assessing the Direct Write-Off Method – companies must
weigh at least two accounting concepts when considering the
use of the direct write-off method including the following:
a. The matching (expense recognition) principle requires
expenses to be reported in the same accounting period as
the sales they helped produce; the direct write-off method
usually does not best match sales and expenses because
the related expense is not recorded until an account
becomes uncollectible, which may be in the next
accounting period.
b. The materiality constraint states that an amount can be
ignored if its effect on the financial statements is
unimportant to users’ business decision,; it permits the use
of the direct write-off method when bad debts expenses are
very small in relation to a company’s other financial
statement items.
C. Valuing Accounts Receivable -- Allowance Method. The
allowance method matches the estimated loss from uncollectibles
against the sales they helped produce. At the end of each

7-4
Chapter 07 - Accounts and Notes Receivable

Chapter Outline Notes

accounting period, bad debts expense is estimated and recorded
in an adjusting entry. Advantages include that it records bad debt
expense when the related sales are recorded and it reports
accounts receivable on the balance sheet at the estimated amount
of cash to be collected.
1. Recording bad debts expense. The allowance method
estimates bad debts expense at the end of the accounting
period and records it with an adjusting entry. Entry to record
estimate of bad debt expense: debit Bad Debts Expense,
credit Allowance for Doubtful Accounts, a contra-asset
account. (This contra account is used instead of Accounts
Receivable because, at the time of the adjusting entry, the
company does not know which customers will not pay.).
Realizable value is the expected proceeds from converting
an asset into cash; in the balance sheet, the Allowance for
Doubtful Accounts is subtracted from Accounts Receivable
to show the amount expected to be collected.
2. Writing off a bad debt. When a specific account is
identified as uncollectible, it is written off against the
Allowance for Doubtful Accounts. Entry to write off a bad
debt: debit Allowance for Doubtful Accounts, credit
Accounts Receivable. (Note that the write-off does not affect
the realizable value of accounts receivable.)
3. Recovering a bad debt. Recovering of a bad debt requires
two journal entries. The first entry is a reversal of the write-
off (see iv above) and effectively reinstates the customer’s
account. The second entry records the collection of the
reinstated account.
D. Estimating Bad Debts —Percent of Sales Method
The allowance method requires an estimate of bad debts expense
to prepare an adjusting entry at the end of the accounting period.
The percent of sales method—also referred to as the income
statement method, uses income statement relations to estimate
bad debts.
1. Based on experience, company estimates what percentage of
credit sales will be uncollectible.
2. Bad debts expense is calculated as the estimated percentage
times sales for the period.
3. The amount calculated is the estimated bad debt expense for
the period; this amount is used in the adjusting entry. The
allowance account ending balance rarely equals the bad debt
expense because the allowance account was not likely to be
zero prior to adjustment.

7-5
Chapter 07 - Accounts and Notes Receivable

Chapter Outline Notes

E. Estimating Bad Debts—Percent of Receivables Method—the
accounts receivable method uses balance sheet relations to
estimate bad debts.
1. Goal of the bad debts adjusting entry for these methods is to
make the Allowance for Doubtful Accounts balance equal to
the portion of accounts receivable that is estimated to be
uncollectible. The estimated balance for the allowance account
is obtained in one of two ways.
2. The percent of accounts receivables method assumes that a
given percentage of a company’s receivables is uncollectible.
F. Estimating Bad Debts—Aging of Receivables Method. The aging
of accounts receivable method uses both past and current
receivables information to estimate the allowance amount. See
Exhibit 7.11 for an example. Specifically:
1. Each receivable is classified by how long it is past its due date,
2. Experience is used to estimate the percent of each
uncollectible class (the longer an amount is past due, the more
likely it is to be uncollectible),
3. The percents are applied to each class and then totaled to get
the estimated balance in the Allowance for Doubtful
Accounts.
G. Estimating Bad Debts—Summary of Methods. Exhibit 7.13
summarizes the principles for all three estimation methods.
Percent of sales is focused on the income statement and matches
bad debts expense with sales. The accounts receivables methods
are balance sheet focused and report accounts receivable at
realizable value.
II. Notes Receivable
A promissory note is a written promise to pay a specified amount of
money (the principal of the note) usually with interest (the cost for
borrowing money) either on demand or at a definite future date.
Promissory notes are notes payable to the maker (person promising to
pay) and notes receivable to the payee (person to be paid). Sellers
sometimes ask for a note to replace an accounts receivable when a
customer requests an extension to pay their account.
A. Computing Maturity and Interest
1. The maturity date is the day the note must be repaid.
a. When the time of the note is expressed in days, its maturity
date is the specified number of days after the note’s date.
b. When months are used, the note matures and is payable in
the month of its maturity on the same day of the month as
its original date.

7-6
Chapter 07 - Accounts and Notes Receivable

Chapter Outline Notes

2. Interest Computation:
Principal of note times the annual interest rate times the time
expressed in years. Note that a year has 360 days for interest
computations (the banker’s rule).
B. Recognizing Notes Receivable: debit Notes Receivable for
principal or face amount of note; credit will vary (depends on
reason note is received). Note that interest is not recorded until
earned.
C. Valuing and Settling Notes
The principal and interest of a note are due on its maturity date.
1. Recording an Honored Note. The maker of the notes usually
honors the note and pays it in full; entry (by the payee) to
record: debit Cash, credit Notes Receivable, credit Interest
Revenue. When a note is dishonored, we remove it from Notes
Receivable and charge it back to an Account Receivable.
2. Recording a Dishonored Note. When the maker does not pay
at maturity, the note is dishonored; entry (by payee) to record:
debit Accounts Receivable (for the principal and interest due),
credit Note Receivable (for principal), credit Interest Revenue.
3. Recording End-of-Period Interest Adjustment. When notes
receivable are outstanding at the end of a period, any accrued
interest earned is computed and recorded. Entry (by payee) to
record: debit Interest Receivable, credit Interest Revenue.
4. Entry to record honoring of a note if interest has been accrued:
debit Cash (for full amount received), credit Interest
Receivable (amount previously accrued), credit Interest
Revenue (amount earned since accrual date), credit Notes
Receivable (face amount of note).
III. Disposing of Receivables
Companies can convert receivables to cash before they are due.
Reasons for this include the need for cash or a desire to not be
involved in collection activities.
A. Selling Receivables
A company can sell all or a portion of its receivables to a finance
company or a bank.
1. Buyer, called a factor, charges the seller a factoring fee and
then takes ownership of the receivables and receives cash
when come due.
2. Entry (by seller of receivables): debit Cash, debit Factoring
Fee Expense, credit Account Receivable.

7-7
Chapter 07 - Accounts and Notes Receivable

Chapter Outline Notes

B. Pledging Receivables
A company can pledge its receivables as security for a loan.
1. Borrower retains ownership of the receivables.
2. If borrower defaults on the loan, the lender has the right to be
paid from the cash receipts of collections on accounts
receivable.
3. The borrower’s financial statements must disclose the
pledging of the receivables.
C. Global View
1. Recognition of Receivables – Both GAAP and IFRS have
similar asset criteria that apply to recognition of receivables.
Both refer to the realization principle and an earnings process.
Under GAAP, realization implies an arm’s-length transaction.
Under IFRS realization is applied in terms of reliable
measurement and likelihood of economic benefits. IFRS refers
to risk transfer and ownership reward.
2. Valuation of Receivables – Both GAAP and IFRS require that
receivables be reported net of estimated uncollectibles and both
systems require that the expense for estimated uncollectibles be
recorded in the same period when any revenues from those
receivables are recorded. Both systems require the allowance
method.
3. Disposition of Receivables – both GAAP and IFRS apply
similar rules in recording dispositions of receivables. Under
GAAP, companies disclose Bad Debts Expense as Provision
for Bad Debts, where provision refers to expense. Under
IFRS, provision refers to a liability whose amount or timing is
uncertain.
V. Decision Analysis—Accounts Receivable Turnover
A. The accounts receivable turnover ratio measures both the
quality (refers to the likelihood of collection without loss) and
liquidity of accounts receivable; it indicates how often the average
accounts receivable balance was converted to cash during the year.
B. It is calculated by dividing net sales by average accounts
receivable.
C. A high turnover in comparison with competitors suggests that
management should consider using more liberal credit terms to
increase sales. A low turnover suggests management should
consider stricter credit terms and more aggressive collection
efforts.

7-8