CHAPTER-FOUR

ACCOUNTING FOR RECEIVABLE

Receivables are all claims against individuals, organization or other debtors. They are
acquired by business enterprises in various types of transactions common being the sale
of merchandise or services on a credit basis.

Receivables that are based on oral agreements are known as open accounts.
Receivables that are based on formal (written) instruments are called promissory
notes .Receivables based on open accounts are known as accounts receivables.
Receivables based on promissory notes are known as Notes receivables.

The sales of equipment on the installment plan involving a large amount of money also
come under note receivables. Promissory notes may also be used installment of an open
account and in borrowing and lending.

From the point view of the creditor, a claim evidenced by a note has same advantages
over a claim in the form of account receivables. By signing a note, the debtor
acknowledges the debts and agrees to pay in accordance with the terms specified. The
note is therefore strong legal claim in the account of court action. It is also more liquid
than an open account because the holder cans usually transfers it more readily to a
bank or other financial agency in exchange for cash.

Accounts and notes receivables originating from sales transactions are called Trade
Receivables. Receivables originating from such sources as interest on N/R, loans to the
officer or employees and loans to affiliated companies are referred to as other
receivables.

All receivables that are collectible in cash within a year are classified under current
assets on the balance sheet. If the period of collection is longer than a year such long
term loan are listed under investments.

Control over Receivables

The management of a business enterprise installs the means of internal control over
their receivables. Thus controls include the separation of the business operations and
the accounting for receivables, so that the accounting records can serve as an
independent check on options. Thus the employee who handles the accounting for
notes and account receivables should not be involved with credit approvals or collection
of receivables. Separation of these functions reduces the possibility of errors and
embezzlement. The controls would also include the separation of responsibilities for

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related functions, so that the work of one employee can serve as a check on the work of
another employee.

For most businesses, the principal receivables are notes receivable and account
receivable. Generally, notes receivable are recorded in a single general ledger account. If
there are numerous notes, the general ledger account can be supported by a notes
receivable register.

Adequate control over account receivable begins with the approval of the sale by a
responsible company official or the credit department, after the customer’s credit rating
has been reviewed. Likewise, adjustments of account receivable, such as for sales
returns and allowances and sales discounts should be authorized or reviewed by a
responsible party. Effective collection procedures should also be established to ensure
timely collection of account receivable and to minimize losses from uncollectible
accounts.

Characteristics of Notes Receivables

A note is a written promise to pay a sum of money on a demand or at a definite time. A

note is payable to the order of a particular person, firm or bearer. A note must be signed
by the person who makes it. The one to whose order the note is payable is a payee and
the one making the promise is a maker

Notes have several characteristics that have accounting implications. These

characteristics are described as follows

 Due date: the date a note is to be paid is called the due date or maturity date. The
period of time between the issuance date and the due date of a short term note
may be stated in either days or months.
When the term of a note is stated in days, the due date is the specified number of days
after its issuance.
Example: Zamra construction makes a note receivable from sunshine construction on
October 2, 2008 of 60 days $2500 payable at Dashen bank with interest at 7%. The due
date for the note is
Term of the note-----------------------------------60 days
October (days) ----------------31
Date of note------------------- 2 29
Number of days remaining----------------------31
November (days) ----------------------------------30
Due date (December) ----------------------------- 1

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When the term of a note is stated as certain number of months after the issuance date,
the due date is determined by counting the number of months from the issuance date.
Example: a 3 month note dated June 5 would be due on September 5.
NB: if there is no date in the month of maturity that corresponds to the issuance date,
the due date becomes the last day of the month. For example 2 month note dated July
31 would be due on September 30.
 Interest bearing notes and non-interest bearing notes: there are two types of
notes.
Interest bearing note: a note that provides for the payment of interest for the period
between the issuance date and the due date.
Non-interest bearing note: a note that does not provide for the payment of interest.
 Maturity Value: the amount that is due on a note on date of maturity or due date is
maturity value. The maturity value of non-interest bearing note is the same with the
face amount or principal of the note. The maturity of an interest bearing note is the
sum of the principal and the interest due on the note.
Example: the maturity value of the note receivable for sunshine construction is
Maturity value= principal + interest
= 2500 + (2500x 7% x 60/360)
= $2529.17

Accounting for Notes Receivable

The typical retail enterprise makes most of its sales for cash or on account. If the
account of a customer becomes delinquent, the creditor may insist that the account be
converted into a note. In this way, the debtor is given more time, if the creditor needs
more fund, the note may be endorsed and transferred to a bank or other financial
agency. Notes may also be received by retail firms that sell merchandise on long term
credit.
When a note is received from a customer to apply on account, the facts are recorded by
debiting the n/r account of the customer from whom the note is received.
Example : assume that the account of BM co. , which has a debit balance of $900 is past
due a 20 day, 8% note for that amount , dated Aptil23, is accepted in settlement of the
account.
The entry for the acquisition of the note is as follows
April 23 Notes Receivable----------------900
Accounts Receivable-----------900

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 After 20 days may 13 the note matures. The necessary entries on this date is
May 13 Cash--------------------904
Notes Receivable---------------900
Interest Income----------------- 4
If the above information is non interest bearing note the entry on maturity date is
May 13 Cash--------------------900
Notes receivable---------------900
Example: A 30 day, 12% note dated dec.21, 2008, is accepted in settlement of the
account of AMBASSEL Company which has a balance of $4000. The entry to record the
transaction on
1. December 21 settlement of the account
2. Adjusting entry for accrued ones, Dec.31,2008
3. Reversing entry Jan. 1,2009
4. The necessary entry on the maturity date
Dec 21 Note receivable----------4000
Account receivable----------4000

Dec 31 Interest receivable-------13.3

Interest Income----------------13.3
(4000 x 10/360 x 12%)

Jan. 1 Interest Income------------13.3

Interest revenue---------------13.3
Jan 21 Cash---------------------------4040
Note Receivable---------------4000
Interest income-------------------40

Discounting Notes Receivable

A business may keep the note it has received until the due date or transfer it to a bank
by endorsement. If a note is transferred to a bank, it is said to be discounted and bank
charges interest for discounting the note. The discount (interest) charged is computed

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on the maturity value of the note for the period of time the bank must hold the note.
The amount paid to the endorser is the excess of the maturity value over the discount or
interest charged by the bank. This amount is known as proceeds.
Example: assume that a 90 day non-interest bearing note for $1350, dated august 21 is
discounted at Lion Bank on September 20 at the rate of 7%.
What is the maturity value of the note?
What is the number of days in the discount period?
What is the amount of the discount?
What is the amount of the proceeds?
Face value of the note dated aug.21------------------------------$1350
Maturity value of the note due Nov.19--------------------------- 1350
Discount period (sep.20-Nov.19) ----------------60 days
Discount on maturity value (1350 x 7% x6/36) ----------------- 15.75
Proceeds--------------------------------------------------------------$1334.25

The entry for the transaction is

Sep. 20 Cash-----------------------1334.25
Interest expense----------------------15.75
Notes Receivable----------------------1350
Example: Misrak enterprise which has a 90 day, 9% notes receivable for $2000, dated
nov.8 is discounted at a bank on Dec.3 at the rate of 10%.
What is the maturity value of the note?
What is the number of days in the discount period?
What is the amount of the discount?
What is the amount of the proceeds?

Face value of the note dated Nov.8------------------------------$2000

Interest on note (2000x90/360x9%) 45
Maturity value of the note due Feb 6 --------------------------- 2045
Discount period (Dec 3-Feb 6) --------------------------65days
Discount on maturity value (2045x65/360x10%) ------------- 36.92
Proceeds------------------------------------------------------------$2008.08
The entry for the transaction is:

Dec 3 Cash ---------------------2008.08

Notes receivable----------------2000
Interest income------------------8.08

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When the proceeds from discounted note is less than the face value is recorded as
interest expense and to the reverse the face value is less than the proceed the
difference is recorded as interest income.

Contingent liability
In the absence of a statement limiting responsibility, the endorser of a note is
committed in paying the note if the maker should default. Such potential obligations
that will become actual liabilities only if certain events occur in the future are called
Contingent liability that is in effect until the due date. Significant Contingent liabilities
are disclosed on the balance sheet or in an accompanying note.

Dishonored notes receivable

If the maker of the note fails to pay the obligation on the due date, the note is said to be
dishonored. A dishonored note is not negotiable, and for this reason the holder usually
transfers the claim including any interest due to the accounts receivable account. This
action is necessary in order to make the subsidiary ledger disclose the dishonor of the
note.
Example: If the $900, 20 day, 8% note received and recorded on April 23 had been
dishonored at maturity, the entry to charge the note, including the interest, back to the
customer’s account would have been as follows:
May 13 Account receivable B.M co-----------904
Notes receivable---------------------------900
Interest income -----------------------------4
When the discounted N/R is dishonored, the holder usually notifies the endorser of such
fact and asks for payment. If request payment and notification of dishonor are timely,
the endorser is legally obliged to pay the amount due on the note. The entire amount
paid to the holder by the endorser including the interest, should be debited to account
receivable of the maker.
Example: assume that the $2000, 90 day, 9% note discounted on Dec 3 is dishonored at
maturity by the maker, the entry to record the payment by the endorser, in general
journal form, would be as follows:
Feb 6 A/R ------------------2008.08
Cash----------------------2008.08
In some cases, the holder of the dishonored note gives the endorser a notarized
statement of the facts of the dishonor. The fee for this statement known as a protest fee
is charged to the endorser, who intern charges it to the maker of the note. If there had
been a protest fee of $5 in connection with the dishonor and the payment recorded
above, the debit to the maker’s account and the credit to cash would be $2013.08.

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 Uncollectible receivables
When merchandise or services are sold without the immediate receipt of cash, a portion
of claims against customers ordinarily proves to be uncollectible. This is usually the case
regardless of the care used in granting credit and the effectiveness of the collection
procedures employed.
The operating expense incurred because of the failure to collect receivables is variously
termed as expense or loss from uncollectible accounts or bad debts.
There are generally accepted methods of accounting for receivables that are deemed to
be uncollectible.
1) The allowance method or the reserve method, which makes advance provision for
uncollectible receivables.
2) The direct write off method or direct charge off method, which recognizes the expense
only when specific accounts are believed to be worthless.

Allowance method of Accounting for Uncollectible

Most large business enterprise provide currently for the amount of their trade
receivables estimated to become uncollectible in the future. The advance provision for
future uncollectiblity is made by an adjusting entry at the end of the fiscal period. As
with all periodic adjustments, the entry serves two purposes. In this instance, it provides
for:

 The allocation to the current period of the expected expense resulting from such
reduction
 The reduction of the value of receivable to cash expected to be realized from
them in the future
Example: a business enterprise has a balance of receivables $45000 at the end of the
year. $2500 is estimated to be uncollectible. The adjusting entry at the end of the year
is:
Uncollectible accounts expense----------------2500
Allowance for doubtful accounts-----------2500

The balance in account receivable is the amount of the total claims against customers
on open account, and the credit balance of $2500 in allowance for doubtful accounts is
the amount to be deducted from account receivable to determine the expected
realizable value, frequently called the net realizable value. $2500 reduction in the asset
was transferred to uncollectible accounts expense, which will in turn be closed to
income summary.

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Uncollectible account expense is generally reported on the income statement as an
administrative expense because the credit granting and collection duties are
responsibilities of department within the general administrative frame work.

Write – offs to the Allowance Account

When an account is believed to be uncollectible, it is written off against the allowance
account as in the following entry:
Allowance for doubtful accounts------------xxx
Accounts receivable-----------------------------xxx
During the year, as more accounts or portions of accounts are determined to be
uncollectible, they are written off against allowance for doubtful accounts in the same
manner. Instructions for write-offs should originate with the credit manager or other
designated official. The authorizations, which should always be written, serve as
objective evidence in support of the accounting entry.
Naturally enough, the total amount written off against the allowance account during the
period will rarely be equal to the amount in the account at the beginning of the period.
The allowance account will have a credit balance at the end of the period if the write off
during the period amount to less than the beginning balance. After the year –end
adjusting entry is recorded the allowance account will have a credit balance.
An account receivable that has been written off a giant the allowance account may later
collected. In such cases, the account should be reinstated that is the exact reverse of the
write-off entry.
June 10 Account Receivable --------------------------xx
Allowance for doubtful Account------------xx
The cash received in payment would be recorded in the cash receipts journal as a
receipt on account. Although it is possible to combine the reinstatement and the receipt
of cash in to a single debit and credit, the entries in the customer’s account is
appropriate.
Estimating Uncollectable
Before the accounts are closed and the financial statements are prepared at the end the
accounting period, an estimate of the expected amount of uncollectable should be
made.
This estimate will usually be based up on past experience and modified in accordance
with current business conditions. Losses from uncollectible receivable tend to be greater
during periods of recession than in period of growth and prosperity.
The estimate is customarily based on either:
1) The amount of sales for the entire fiscal period or
2) The amount and the age of the receivable account at the end of the fiscal period.

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Estimate Based on Sales:

Accounts receivable are acquired as a result of sales on account. The volume of such
sales during the year there fore be used as an indication of the probable amount of the
account that will be uncollectable. For example if it is known from past experience that
about 1% of charge sales be uncollectable and the charge sales for particular year
amount to birr 300,000 the adjust entry for uncollectible accounts at the end of the year
would be as follow :

Dec. Uncollectable Account Expense---------------------------3,000

Allowance for Doubtful Accounts------------------------3,000

Instead of charge sales, total sales (including those made for cash) may be used in
developing the percentage. Total sales are obtainable from the ledger without the
necessity the analysis that may be required to determine charge sales. If the ratio of
the sales on account to cash sales does not change materially from year to year, the
result obtained will be equally satisfactory. If the above example that balance of the
sales account at the end of the year is assumed to be birr 400,000 the application of ¾
of that amount would be also yield an estimate of birr 3,000.

The estimate based on sales method of determining uncollectible account expense

widely used. In addition to its simplicity, it provides the best basis uncollectible account
expense to the period in which the related sales were made.

Estimate based on Analysis of Receivable

The process of analysis the receivable accounts some time called aging receivables. The
number and breadth of the time interval used will vary according to the credit term
granted to the customers. A portion of atypical analysis is presented below.

Estimate of Uncollectible Account

The estimate of uncollectible account, birr 3,390 in the example above, is the amount to
be deducted from accounts receivable to yield their expected realizable values. It is the
amount of the desire balance of their allowance account after adjustment. The excess of
the figure over the balance of allowance account before adjustment is the amount of
the current provision to be made uncollectible account which is as follows:

Dec: - Uncollectible Account expenses -------------------------------2,880

Allowance for Doubtful Account----------------------------------2,880

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After adjusting entry is posted, the balance in the allowance account will be birr 3,390
which is desired amount. If there had been a debit

Direct Write-off Method of accounting for Uncollectible

Some businesses do not use a valuation allowance for accounts receivable. Instead of
making year end adjusting entries to record uncollectable accounts expense on the basis
of estimates, these companies recognize no uncollectible accounts expense on the basis
of estimates, these companies no uncollectible accounts expense until specific
receivables are determined to be worthless.

If an enterprise sells most of its merchandise or services on a cash basis, the amount of
its expense from uncollectible accounts is ordinarily minor relation to its revenue. T he
amounts of its receivables at any time is all likely to represent a relatively small portion
of its total current assets. These observations are based on the assumption that the
credit period short, which would be usual if sales are mainly on a cash basis, and the
credit policies and collection procedures are adequate. T he nature of the service or the
product sold the type of clientele may also have an important bearing on collection
experience. For example, an enterprise that sells most of its output on account to a
small number of companies, all of which are financially strong , will incur little, if any,
expense from inability to collect its accounts.

Therefore, the direct write-off method or the direct charge-off method is reasonable
under some situations:
1) If a company makes most of its sales for cash, and
2) If a company sells all or most of its output to few companies which financially strong.

In such situations and in many small business and professional enterprise, it is

satisfactory to defer recognition of uncollectible until the period in which specific
accounts are deemed to be worthless and are actually written off as an expense.
Accordingly, when the direct- write- off method is in use, the accounts receivable will be
listed on the balance sheet at their gross amount, and no evaluation allowance will be
used, and there is no necessity for an adjusting entry at the end of the period.

Thus, what do you think would be entry to entry to write off an account when it is
believed to be uncollectible?

 And, what do you think would be the entry to record the collection of an
account that has been written-off?
 Is advance provision for uncollectible accounts necessary?

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Under this method, it is only when an account is believed to be uncollectible that it is
written-off as an expense.

The entry to write-off an account when it is believed to be uncollectible is as follows:

May 10 Uncollectible Accounts Expense………………….42

A/Receivable-Horn Co………………………………….42

If an account that has been written off is collectible later, the account should be
reinstated. If the recovery is in the same fiscal year as the write-off, the earlier entry
should be reversed to reinstate the account. To illustrate, let us assume that the
account written off in the May 10 entry above is collected in November of the same
fiscal year.

This entry to reinstate the account would be as follows:

Nov.21 Accounts Receivable-Horn Co………………………42

Uncollectible Account Expense…………………………42

to reinstate account written off earlier in the year.

If an account that has been written-off is collected in a later fiscal year, it may be
reinstated by either:

a) An entry that is a reverse of the related write off entry like the one illustrated
above, or
b) By debiting receivables and crediting some of the appropriately titled account,
such as: Recovery of Uncollectible Accounts Written Off. The credit balance in
such an account at the end of year may then be reported on the income
statement as a deduction from Uncollectible Accounts Expense, or the net
expense only may be reported.

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