Fse2200 -accounting_-_ch 8

Accounting for Receivables and Accounting for Receivables and PayablesPayables

(C) 2013 - Professor Joseph Finocchiaro

Selling Goods and ServicesSelling Goods and ServicesGoods and services can be sold for cash

or creditMost organizations would prefer cashWe have learned that when we sell on

‘credit’ that the effect is to establish an Accounts Receivable account in the name of the customer.

When the customer pays the bill, the AR is converted to cash


Selling Goods and ServicesSelling Goods and ServicesThere are plenty of credit reporting

companies who can determine credit “worthiness” of a potential customer for your business whether it is a person or a business.

There may be different credit terms for those whose credit history is poor or is a 1st time customer with your firm until you have experience with them.


Selling Goods and ServicesSelling Goods and ServicesUsually credit is extended to those

individuals or businesses who have done cash transactions with a firm prior

A credit check may be done on anyone or small firms in a highly competitive field may just use their “gut feeling” to determine credit worthiness


Recognizing bad debtsRecognizing bad debtsBad debt is an expense recognized by

the business that was caused by a customer failing to pay an obligation arising out of a prior credit sale.


Recognizing bad debtsRecognizing bad debtsThere are three common methods

◦Direct Write Off◦Net Sales◦Aging of Accounts Receivable Method


Direct Write Off MethodDirect Write Off MethodUsed when it is possible to determine

that an account will prove to be uncollectible within the same accounting period as the original sale took place.

Usually not allowed on the business’ books

Used typically when most of the sales are done for cash and credit sales are very small


Direct Write Off MethodDirect Write Off MethodThis is the ONLY method allowed on a

tax returnCredit period is usually short, the bad

debt is discovered quickly, and usually adjusted in the same accounting period.


Direct Write Off MethodDirect Write Off MethodForm is simple

◦Original Transaction Dr – Accounts Receivable Cr – Sales

◦Write Off Dr – Bad Debt Expense (full amount of Sale/AR) Cr – Accounts Receivable


Direct Write Off MethodDirect Write Off MethodBy writing it off completely during the

accounting period the accountant is able to more correctly match costs with revenue


Direct Write Off MethodDirect Write Off MethodWhen (if) the customer ponies up the

cash◦Restore the obligation (remember – we

closed it out) Dr – Accounts Receivable Cr – Bad Debt Expense

◦Pay it off like normal Dr – Cash Cr – Accounts Receivable


Direct Write Off MethodDirect Write Off MethodWe are intentionally not discussing

charges associated with the bad debt such as carrying fees, etc. at this point.

The book says that it has a “failure” to match costs and revenue within the same accounting period ONLY because we do not have a way to “anticipate” what accounts will go bad so we are “surprised” by the debt when it happens.


Net sales methodNet sales methodAn adjusting entry is made at the

beginning of an accounting period to anticipate for bad debt expense.

We determine the net sales (learned in a previous chapter) and a percentage of that net sales will be used to determine an estimated amount of bad debt.


Net sales methodNet sales methodSince it is unknown the actual amount,

it is NOT placed in bad debt expense but in a separate account called Allowance for Bad Debts.

This is a contra-asset account.


Net sales methodNet sales methodA “realizable” value of accounts

receivable is a ledger (book) value of the account minus your allowance for bad debts.

This is not unlike a “net” accounts receivable


Net sales methodNet sales methodIt is impossible to determine the exact

amount of bad debt so a balance will probably remain in this account.

At the end of an accounting period (which is when we do adjusting entries) we recognize the allowance for the NEXT year


Net sales methodNet sales methodEstablish the Allowance Account

◦Dr – Bad Debt Expense ◦Cr – Allowance for Bad Debt

Since we are removing revenue we recognize it as an expense

◦A line item is placed on the balance sheet showing why we’re taking the asset out


Net sales methodNet sales methodDuring the next accounting period we

would “write off” the accounts by utilizing this account◦Writing off a bad debt (net sales)

Dr – Allowance for Bad Debt Cr – Accounts Receivable


Aging of Accounts ReceivableAging of Accounts ReceivableCustomer accounts are recorded in an

analysis chart according to the due date of the receivables.

Accounts past due are placed in categories regarding the amount of time past due (1-30, 31-60, 61-90, etc).


Aging of Accounts ReceivableAging of Accounts ReceivableA percentage based on past experience

is placed on the accounts currently due AND the accounts overdue. This number derived from this is what is used to determine the allowance for bad debt


Aging of Accounts ReceivableAging of Accounts ReceivableWhen adjusting the balance in the

allowance account, take into consideration the existing balance. If you have money already in there (credit balance) you will need less current money to get yourself to the final allowance◦If you have a credit balance of $500 in the

allowances account and you need to have $1500, you would only credit the $1000 you actually need.


Aging of Accounts ReceivableAging of Accounts ReceivableIf you have too many receivables which

would result in a debit balance, then you need MORE money◦If you have a DEBIT balance of $500 in the

allowances account and you need to have $1500, you need to credit $2000 $500 to cover what is already there $1500 to establish the “credit” balance.


Extending CreditExtending CreditWhen you extend credit, you establish a

receivable account in the name of the seller

A receivable is a claim against an individual, business, or other debtors that will be settled by the receipt of an asset (cash or something else of value)


Promissory notesPromissory notesUnconditional written promise to pay a

stated sum of money upon demand or at a future determinable date.

Usually prepared by the debtor as a result of a request or requirement made by the creditor (receiver). ◦The debtor is the person who owes the cash,

the creditor is the person to whom the cash is owed.


Promissory notesPromissory notesThese promissory notes are recorded in

an account called “Notes Payable” All notes, regardless of interest, are

recorded at face value.


Promissory notesPromissory notesThese utilize two transactions

◦First you need to establish the amount in your ACCOUNTS Payable Dr – Supplies / Merchandise Purchases / etc Cr – Accounts Payable

◦Then you need to convert it to a note Dr – Accounts Payable Cr – Notes Payable

◦In the notes payable account you would list the name of the creditor and all terms of the note including pay date.


Promissory notesPromissory notesThis can cause some problems in the

accounting for the creditor as the DATE of the accounts receivable would be the invoice date or date the transaction occurred. Once the creditor receives the note from the buyer (debtor), then the AR account should be converted to a note payable account to reflect the change. ◦Your book calls this a conversion of assets.


Interest Bearing Promissory NotesInterest Bearing Promissory Notes

Written promise to pay a certain sum at a fixed and determinable future date along with an additional sum known as interest.

Interest is calculated based on the holding period of the note (usually # of days), and a stated specific rate of interest which is calculated against the face value of the note.

This is still treated the same as any note and recorded in notes payable / note receivable accordingly.



Notes are usually due within a year (30, 60, 90, 120 days)

All transactions assume a banking year of 360 days.



There are three things required to determine interest◦Principal

Face value of the note

◦Time Amount of time the note is in the hands of the creditor

before payment is made

◦Rate Rate of interest being charged on the note

Formula◦Principal * Rate * Time = Interest


60 Day Method of Determining 60 Day Method of Determining InterestInterest60 days at 6% always equal 1% of the

face value (principal)


Recording interestRecording interestInterest is recorded at the time the note is

paid.If you are the one paying the cash to

someone then the interest is an expense (interest Expense)

If you are the one receiving the cash then the interest is an income (Interest Income)

If interest is carried over into a new accounting period, we need to apply adjusting entries to account for interest earned.


Advantage of a NoteAdvantage of a NoteStands up in court.Ability to negotiate or transfer it

(remember it’s an asset)


Transferring and Discounting Transferring and Discounting NotesNotesYou can elect to sell the note to someone

else at a reduced rate so you can collect cash immediately.

If you do this, you are still obligated to the bank that you sold it to for the total value (face + interest) so if the debtor defaults, you are stuck with paying.◦Default

Failure to pay the obligation.◦Contingent Liability

Commitment of the endorser to pay the discounter the maturity value of the note in the event the maker of the note defaults.


Transferring and Discounting Transferring and Discounting NotesNotesTranslated:

◦The holder of the note (you) agree to pay the bank the whole amount including interest in the event the maker (debtor/purchaser of goods) defaults.


Transferring and Discounting Transferring and Discounting NotesNotesTo do this requires a bunch of

transactions◦Convert Receivable to Note the day note is

received Dr – Notes Receivable Cr – Accounts Receivable

◦Discount the note on the day you get the money from the lender Dr – Cash Cr – Notes Receivable Discounted

◦On the day the obligation is paid by the person honoring the note Dr – Notes Receivable discounter Cr – Notes Receivable


Transferring and Discounting Transferring and Discounting NotesNotesYou could just credit the notes

receivable if you wanted to, but that doesn’t give you an indication of the liability you have should the note get defaulted.


Transferring and Discounting Transferring and Discounting NotesNotesIf the note defaults there is no

difference to the 1st two steps – you would convert the receivable and then show the liability on the note the day you get the money from the lender

Defaults on Note◦Dr – Accounts Receivable◦Cr – Cash

It is important that you charge the amount to including the maturity value of the note (principal + interest) AND any charges.


Transferring and Discounting Transferring and Discounting NotesNotesYour book does not show what would

happen if payment eventually happened afterwards but alludes that you are due all monies as well as any additional interest fees.


Discounting Interest Bearing Discounting Interest Bearing NotesNotesThe only difference in these is that you

need to record the interest to the appropriate account and determine the amount of the discount also on the interest.


Discounting a Company’s Own Discounting a Company’s Own NoteNoteWhen you borrow money from a

lending institution they may discount the note immediately. If you want $1000 the bank may discount the note and only give you $950 after they take their percentage and they subtract interest. The $1000 represents the full maturity value which is different than what we’ve been doing above.


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