Accounting for Receivables
1) Explain the allowance method of accounting for bad debt expense
2) Use the percentage of revenue method to estimate bad debt expense
3) Use the direct write off method to estimate bad debt expense
4) Explain how accounting for notes receivable and accrued interest affects financial statements
5) Explain how credit card sales affects the financial statement
We have talked about accounts receivables but now we are going to add new complexities to accounting for receivables.
In order to boost sales, most businesses sell products and services on short term credit. When a customer buys on credit, they have an obligation to pay back. Most accounts receivable policy require payment within 30 days. When a customer buys on credit, the business owner records the sale as follows:
Debit Accounts Receivable
And when cash is collected the journal entry is:
The revenue is immediately recognized because according to GAAP, revenue is recognized when:
- Realized or realizable: Revenue is realized when products or services are exchanged for cash or claims to cash. At this point, revenue is earned meaning the product or service has been delivered or completed. In the case of accounts receivable, revenue has been earned but no cash has exchanged hands.
When revenue is recognized on the income statement and accounts receivable has been recognized on the balance sheet. There is a possibility that not all receivables will convert to cash or not all revenue will actually be realized. As a result, GAAP accounting requires we estimate the amount of bad debt we expect to have.
You can see this applied in your personal life. I have family members I loan money to that I know I can always trust them to pay back, and I also have family members I know when I lend them money, I better kiss it good bye. I am sure there are people in your life you borrow money to that you think of it more as a gift than a loan.
Businesses face the same problem. Just like cousin Lou never pays you back, he properly will not pay back any business that issues him credit. In my personal finances, I do not record cash I give to unreliable friends and family as a loan but I record it as a gift. A business on the other hand, cannot record the amount they estimate they cannot get back as a gift but rather record it as bad debt expense. Bad debt expense is sometimes called uncollectible account expense.
Estimating bad debt/ uncollectible account expense
Accounts receivable is classified as a current asset on the balance sheet. An asset, is a resource controlled by the business. The major characteristics of assets are as follows:
- A probable future benefit: this means that there is expectation of some future monetary value. If Uncle Joe owes you money for lemonade he bought today, the amount he owes you is an asset because you expect to collect in the future.
- The business controls the resource and the benefit: unless the business has control it cannot be considered an asset of the business. If a business leases a vehicle, the vehicle cannot be considered an asset to the business if the business does not control or have exclusive rights to the vehicle.
- The event or transaction bringing about the benefit must have occurred: For instance if I agree to purchase a piece of equipment next month, the equipment is not an asset to me just yet.
- The asset must be measured in monetary terms: you have to be able to assign a value to the asset. The value of loyal customers are hard to determine so do not appear on the balance sheet.
For an accounts receivable to meet the definition of an asset, it has to meet all 4 characteristic of an asset. However, characteristic #1, probable future benefit is not true for 100% of a businesses’ accounts receivable account. As a result, we have to estimate the percentage of accounts receivable that will have no probable future benefit and classify that percentage as a bad debt expense.
Net Realizable Value
We have established that 100% of accounts receivable does not meet the probable future benefit characteristic of an asset. As a result not 100% of accounts receivable can be classified as an asset. Accounts receivable is therefore recorded at its net realizable value. The net realizable value represents the percentage of account receivable that have a future benefit that is the amount that a business is most likely to collect.
In order to arrive at the net realizable value, we will need to create a contra account for accounts receivable.
A contra account is an account that offsets a related account. Contra accounts are specifically created to offset other accounts. A contra account is created when a change in the account should not affect the balance. For instance allowance for doubtful account offsets accounts receivable so that the accounts receivable balance remains unchanged. We still maintain the balance in our accounts receivable account but at the same time we have the privilege of reducing accounts receivable by using a contra account. Contra accounts natural balance is opposite that of its related account. So since accounts receivable has a debit natural balance, allowance for doubtful account will have a credit natural balance.
Computing Net realizable value
Net realizable value is computed as follows:
Accounts receivable minus allowance for doubtful account
On January 1, 2013, the Accounts Receivable of Uncle Joe, Inc. balance was $17,500 and the balance in the Allowance for Doubtful Accounts was $1,300. What is the net realizable value?
The net realizable value will be $17,500 minus $1,300 = $16,200
The practice of reporting the net realizable value of receivables in the financial statements is commonly called the allowance method of accounting for uncollectible accounts/ bad debt expense
The allowance method dictates that a company report its receivables net of estimated bad debt/ uncollectible accounts.
Recording transactions at net realizable value
Recoding transactions at net realizable value is a period end adjustment (step 2 of the accounting cycle). At the end of an accounting period, a business estimates the amount of accounts receivable that is uncollectible and write it off as a bad debt expense. The account used to reduce accounts receivable is the contra account, allowance for doubtful account. The amount in the accounts receivable remains the same because we have not fully determined that these amounts are uncollectible. At this point we are only making an estimation. The adjusting entry to recognize bad debt/ uncollectible account expense is as follows:
Debit Bad debt/ Uncollectible account expense
Credit Allowance for doubtful account
Now that we know what bad debt expense is, how we go about estimating the amount that shows up in the financial statement. The next section discusses how we derive bad debt expense.
Estimating bad debt expense
Judgment is often required to derive a number for bad debt incurred during the period. The decision of how much bad debt to recognize will affect the profits for the period. However, in the long run the net effect of estimating bad debt should zero out as an estimation in one period is either written off or collected in another period.
Estimating bad debt expense is consistent with the matching principle. If bad debt were not matched to the right period, then the profitability of the later affected period will be less while the current period shows more profit.
There are two ways to estimate bad debt/ uncollectible account expense namely:
- Percent of revenue method
- Percent of receivable method
Percent of revenue method/ Income Statement approach:
When a business does not have any experience with bad debt, they start by looking at industry statistics for estimates. As the business gains more experience, they base their estimates on past experience.
The percent of revenue method uses a percentage of revenue/sales to compute bad debt expense. The formula to estimate bad debt expense is as follows:
Revenue on account* Percentage of bad debt estimate (the percentage of revenue on account you do not expect to collect).
Uncle Joe Inc., which had no beginning balance in its Accounts Receivable and Allowance for Doubtful Accounts, earned $70,500 of revenue on account during 2014. During 2014, Uncle Joe collected $54,000 of cash from its receivables accounts. Uncle Joe estimates that he will be unable to collect 2% of revenue on account. The amount of net realizable value of receivables on the December 31, 2013 balance sheet would be ______________?
Step 1: Write down the formula for net reliable value:
Accounts receivable minus allowance for doubtful account
Step 2: Determine the value of each variable
Accounts Receivable =
|Beginning Balance||$ –|
|Plus: Revenue on Account||$ 70,500.00|
|Less: Write-off||$ –|
|Less: Collectons on Account||$ (54,000.00)|
|Ending A/R||$ 16,500.00|
Allowance for doubtful account =
|Allowance for Doubtful Accounts|
|Beginning Balance||$ –|
|Less: Write-off||$ –|
|Less: Uncollectible Account Expense*||$ (1,410.00)|
|Ending balance||$ (1,410.00)|
Bad debt/ uncollectible account expense* = Revenue on account * percentage of bad debt estimate
= 70,500 * 2% = $1,410
Step 3 compute net realizable value:
|Net Realizable Value|
|Accounts Receivable||$ 16,500.00|
|Less: Allowance for doubtful account||$ (1,410.00)|
|Net Realizable Value||$ 15,090.00|
Percent of receivables method/ Balance Sheet approach:
The percent of receivables method is a more accurate way of estimating accounts receivable. The longer an accounts receivable is outstanding the less likely it will be collected.
Businesses maintain a document most likely stored in the financial software called an accounts receivable aging schedule. An accounts receivable aging schedule classifies accounts as follows:
Current: Most accounts receivable policy require 30 days for customers to pay. Any account that is under 30 days is classified as current.
1-30days past due: Any account that is not paid within the 30 days grace period is listed under this category
31 – 60 days past due: If an account is not paid within the 1-30 day past due date, it moves into the 31-60 past due date.
61-90 days past due: If an account is not paid within the 31-60 day past due date, it moves into the 61-90 past due date.
90+: Any account not paid within the 61-90 days past due date is listed under over 90 days past due.
These categories are dependent on the accounts receivable policy of the business. If a business has a 15 day payment policy then the time span within each category will be 15 days increment. Also, if the business has a 90 day payment policy the time span within each category will be 90days.
An example of an aging schedule
|Accounts Receivable Aging Report|
|Uncle Joe Inc.|
|December 31, 2014|
|Customer Name||Total Accounts Receivable||Current||1-30 days past due||31- 60 days past due||61-90 days past due||Over 90 days past due|
|Mr. Best Customer||3,000||3,000|
|Mr. Worst Customer||8,000||3,000||5,000|
|Mr. Average Customer||4,000||3,000||1,000|
|Mr. Take Advantage||5,000||2,000||3,000|
The longer the debt goes unpaid, the greater chance businesses will not collect on the debt money. The percentages of bad debt expense increases as the accounts receivables age increases.
Common events involving accounts receivable when using the allowance method
The following are common transactions involving accounts receivable when using the allowance method:
- A business makes a sale on account
- A business collects on the sale
- At the end of the year an adjusting entry is made to estimate uncollectible accounts/ bad debt expense
- An account is determined to be uncollectible, so the accounts receivable will have to be reduced by the determined amount. Please note at the end of the year, the amount was estimated and written off as an expense, so therefore the profit and loss statement is not affected a second time
- An account that is written off is paid off and so accounts receivable has to be reinstated.
Now let’s look at these events one by one by working through an example:
The following information is available for Uncle Joe, Inc., which uses the allowance method of accounting for uncollectible accounts.
|Beginning accounts receivable balance, 1/1/14||$200,000|
|Allowance for doubtful accounts, 1/1/14||$2,500|
|Revenue on account, 2014||800,400|
|Collections on accounts receivable, 2014||900,000|
Uncle Joe estimated that 1% of sales on account will be uncollectible. After several attempts at collection, Uncle Joe wrote off Sally’s account of $450 as she moved and did not have a forwarding address.
In 2015, Sally ran into Uncle Joe and felt guilty for not paying him for the services she received. She immediately wrote him a check for $450 for her past debt.
Required: Prepare journal entries for the following events:
a) 2014 service revenue
b) 2014 collections on account
c) Uncollectible accounts expense for 2014
d) Write-off of the uncollectible account
e) Collection of a debt that was previously written off
a) 2014 Service Revenue
Accounts Receivable $800,400
b) 2014 collections on account
c) Uncollectible accounts expense for 2014
Bad debt/ Uncollectible account expense $8,004
d) Write off the uncollectible account
Allowance for doubtful account 450
e) Reinstate the uncollectible account
To reinstate the uncollectible account, first you have to reverse the write off then collect the cash like you would in a normal transaction
Accounts Receivable 450
The direct method
If a business has “immaterial” bad debt, under GAAP they can use direct write off method. Immaterial information is information that does not significantly affect the decisions of users of the financial statement. Under the direct write off method, a business simply writes off bad debt when it becomes uncollectible. In the direct write off method there is no allowance for doubtful account.
So far, we have talked about accounts receivable now let us turn our attention to notes receivable. Accounts receivable policies usually require payment within 30 days, sometimes, a customer might need a longer credit term, hence the need for a note. A note receivable is a promissory note (an IOU) reflecting a credit agreement between two parties. The note specifies:
- Maturity date
- Interest rate
- Credit terms
Notes receivable is an asset account.
Unlike accounts receivable, notes receivable earn interest.
Notes receivable events
The following are typical events that take place concerning notes receivable
- Loan money/ sell goods and services
- Accrue interest
- Collect principal and interest on maturity
Loan Money/ Sell goods and services
A business can choose to issue a note to another business if the payment term required is more than 30 days. A business that issues a note earns interest on the balance. When this happens there is no cash flow at the time the note is issued. Interest is classified as cash flow from operating activities.
Sometimes businesses loan money to other businesses or individuals for investment purposes. When a business loans money to another business or individual it is classified on the cash flow statement as cash flow from investing activities. The interest on the other hand is classified as cash flow from operations.
Uncle Joe, Inc. loaned Uncle Joe $20,000 to buy a new car on September 1, 2014. Uncle Joe agrees to pay Uncle Joe Inc. 8% interest on the loan.
Note: Uncle Joe treated this transaction as an arm’s length transactions (as if dealing with a stranger) to avoid violating the principle of separate entities). Uncle Joe documented the transaction, issued an actual note and was charged interest on the transaction.
To record the note receivable for Uncle Joe Inc.
Debit Notes Receivable $2,000
Accrual of interest
Lenders continuously earn interest on loans even though they do not collect it continuously. It will be impractical to consistently record interest revenue continuously. As a result, interest is recorded in the second phase of the accounting cycle – as an adjusting entry before financial statements are issued.
The formula to compute interest is as follows:
Principal * Annual interest rate * Time Outstanding = Interest Revenue
At the end of the year, interest will have to be accrued and recorded on the books even though it is not collected.
In December of 2014, Uncle Joe, Inc. will have to recognize interest as follows
=2000 (Principal) * 8% (rate) * (4/12) = 53.33
The journal entry at period end is as follows:
Debit Interest Receivable 53.33
Collection of principal and interest
On August of 2015, Uncle Joe Inc. will collect
=2000 (Principal) * 8% (rate) * (12/12)
= 160 interest + 2000 principal = 2,160
However only 8/12 of the interest will be recognized in the current year, the other 4/12 had been recognized in the prior year
8/12 of 160 = 106.67
So when the note is collected the following journal entry is made by:
1) Increasing interest receivable by the amount accrued in the current year
Debit Interest Receivable 106.67
2) Collecting the cash and reducing note and interest receivable
Debit Cash 2,160
Credit Notes Receivable 2,000
Credit Interest Receivable 160
Credit Card Sales
When a business collects credit card from a customer, they incur credit card expenses. Also, there is usually a 2 day float (could be more or less depending on your credit card merchant) between when the credit card is swiped and when the cash is actually deposited into the business checking account.
As a result, when a company uses credit card, they have to estimate credit card expenses at the time of sale
Uncle Joe accepts a credit card payment for $1,000 of services performed. The credit card company charges 3% handling fee.
The journal entry is as follows:
Debit Accounts Receivable – Credit Card Sales 970
Debit Credit card expense $30
When the cash is collected
Debit Cash 970
End of lesson 6