Receivable valuation

The term receivables refers to amounts due from individuals and companies. Receivables are
claims that are expected to be collected in cash. The management of receivables is a very
important activity for any company that sells goods or services on credit.
The relative significance of a company’s receivables as a percentage of its assets depends on
various factors: its industry, the time of year, whether it extends long-term financing, and its
credit policies. To reflect important differences among receivables, they are frequently classified
as (1) accounts receivable, (2) notes receivable, and (3) other receivables.
1. Accounts receivable are amounts customers owe on account. They result from the sale of
goods and services. Companies generally expect to collect accounts receivable within 30 to 60
days. They are usually the most significant type of claim held by a company.

2. Notes receivable are a written promise (as evidenced by a formal instrument) for amounts to
be received. The note normally requires the collection of interest and extends for time periods of
60–90 days or longer. Notes and accounts receivable that result from sales transactions are often
called trade receivables.

3. Other receivables include nontrade receivables such as interest receivable, loans to company
officers, advances to employees, and income taxes refundable. These do not generally result
from the operations of the business. Therefore, they are generally classified and reported as
separate items in the balance sheet.
1. VALUING ACCOUNTS RECEIVABLE
Once companies record receivables in the accounts, the next question is: How should they report
receivables in the financial statements? Each customer must satisfy the credit requirements of the
seller before the credit sale is approved. Inevitably, though, some accounts receivable become
uncollectible. Companies record credit losses as Bad Debt Expense (or Uncollectible Accounts
Expense).
1.1 Methods of valuation
Two methods are used in accounting for uncollectible accounts: (1) the direct write-off method
and (2) the allowance method. The following sections explain these methods.
1.1.1 Direct write-off method for uncollectible accounts
Under the direct write-off method, when a company determines a particular account to be
uncollectible, it charges the loss to Bad Debt Expense. Under this method, Bad Debt Expense
will show only actual losses from uncollectible. The company will report accounts receivable at
its gross amount.
Under the direct write-off method, companies often record bad debt expense in a period different
from the period in which they record the revenue. The method does not attempt to match bad

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debt expense to sales revenue in the income statement. Nor does the direct write-off method
show accounts receivable in the balance sheet at the amount the company actually expects to
receive. Consequently, unless bad debt losses are insignificant, the direct write-off method
is not acceptable for financial reporting purposes.
1.1.2 Allowance method for uncollectible accounts
The allowance method of accounting for bad debts involves estimating uncollectible accounts at
the end of each period. This provides better matching on the income statement. It also ensures
that companies state receivables on the balance sheet at their cash (net) realizable value. Cash
(net) realizable value is the net amount the company expects to receive in cash. It excludes
amounts that the company estimates it will not collect. Thus, this method reduces receivables in
the balance sheet by the amount of estimated uncollectible receivables.
GAAP requires the allowance method for financial reporting purposes when bad debts
are material in amount. This method has three essential features:
1. Companies estimate uncollectible accounts receivable. They match this estimated
expense against revenues in the same accounting period in which they record the
revenues.
2. Companies debit estimated uncollectibles to Bad Debt Expense and credit them to
Allowance for Doubtful Accounts through an adjusting entry at the end of each period.
Allowance for Doubtful Accounts is a contra account to Accounts Receivable.
3. When companies write off a specific account, they debit actual uncollectibles to
Allowance for Doubtful Accounts and credit that amount to Accounts Receivable.
Presentation of allowance for doubtful accounts

ESTIMATING THE ALLOWANCE

Two bases are used to determine this amount: (1) percentage of sales and (2) percentage of
receivables.
Percentage-of-Sales In the percentage-of-sales basis, management estimates what percentage
of credit sales will be uncollectible. This percentage is based on past experience and anticipated
credit policy.

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Percentage-of-Receivables Under the percentage-of-receivables basis, management estimates
what percentage of receivables will result in losses from uncollectible accounts. The company
prepares an aging schedule, in which it classifies customer balances by the length of time they
have been unpaid. Because of its emphasis on time, the analysis is often called aging the
accounts receivable.
The percentage-of-sales basis results in a better matching of expenses with revenues—an income
statement viewpoint. The percentage-of-receivables basis produces the better estimate of cash
realizable value—a balance sheet viewpoint. Under both bases, the company must determine its
past experience with bad debt losses.
Format of aging schedule:

Estimation of doubtful debts using Aging Schedule

Number of days past due Amount % of doubt Doubtful amount
Not yet due
1-30 days past due
31-60 days past due
61-90 days past due
Over 90 days past due
Total estimated doubtful debts

1.2 Selling accounts receivable

A company can sell all or a portion of its receivables to a finance company or bank. The buyer,
called a factor, charges the seller a factoring fee and then the buyer takes ownership of the
receivables and receives cash when they come due. By incurring a factoring fee, the seller
receives cash earlier and can pass the risk of bad debts to the factor. The seller can also choose to
avoid costs of billing and accounting for the receivables.
To illustrate, if TechCom sells $20,000 of its accounts receivable and is charged a 4% factoring
fee, it records this sale as follows:

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2. NOTES RECEIVABLE
Companies may also grant credit in exchange for a formal credit instrument known as a
promissory note. A promissory note is a written promise to pay a specified amount of money on
demand or at a definite time. Promissory notes may be used: (1) When individuals and
companies lend or borrow money, (2) when the amount of the transaction and the credit period
exceed normal limits, or (3) in settlement of accounts receivable.
The basic issues in accounting for notes receivable are the same as those for accounts receivable.

2.1 Recognizing notes receivable: The Company records the note receivable at its face value,
the amount shown on the face of the note. No interest revenue is reported when the note is
accepted, because the revenue recognition principle does not recognize revenue until earned.
Interest is earned (accrued) as time passes.
To illustrate the recording for the receipt of a note, we use the $1,000, 90-day, 12% promissory
note. TechCom received this note at the time of a product sale to Julia Browne. This transaction
is recorded as follows:

When a seller accepts a note from an overdue customer as a way to grant a time extension on a
past-due account receivable, it will often collect part of the past-due balance in cash. This partial
payment forces a concession from the customer, reduces the customer’s debt (and the seller’s
risk), and produces a note for a smaller amount. To illustrate, assume that TechCom agreed to
accept $232 in cash along with a $600, 60-day, 15% note from Jo Cook to settle her $832 past
due account. TechCom made the following entry to record receipt of this cash and note:

2.2 Valuing notes receivable: Valuing short-term notes receivable is the same as valuing
accounts receivable. Like accounts receivable, companies report short-term notes receivable at
their cash (net) realizable value. The notes receivable allowance account is Allowance for
Doubtful Accounts.

2.3 Disposing of notes receivable.

Notes may be held to their maturity date, at which time the face value plus accrued interest is
due. In some situations, the maker of the note defaults, and the payee must make an appropriate

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adjustment. In other situations, similar to accounts receivable, the holder of the note speeds up
the conversion to cash by selling the receivables.
2.3.1 Honor of the notes receivable
A note is honored when its maker pays in full at its maturity date. For each interest bearing note,
the amount due at maturity is the face value of the note plus interest for the length of time
specified on the note.
To illustrate, when J. Cook pays the note above on its due date, TechCom records it as follows:

2.3.2 Accrual of interest receivable

When notes receivable are outstanding at the end of a period, any accrued interest earned is
computed and recorded. To illustrate, on December 16, TechCom accepts a $3,000, 60-day, 12%
note from a customer in granting an extension on a past-due account. When TechCom’s
accounting period ends on December 31, $15 of interest has accrued on this note ($3,000 3 12%
3 15y360). The following adjusting entry records this revenue:

2.3.3 Dishonor of note receivable

A dishonored note is a note that is not paid in full at maturity. A dishonored note receivable is no
longer negotiable. However, the payee still has a claim against the maker of the note for both the
note and the interest. Therefore the note holder usually transfers the Notes Receivable account to
an Account Receivable.
To illustrate, assume that J. Cook dishonors the note above at maturity. The journal entry to
record
the dishonoring of the note follows:

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3. CREDIT CARD SALES
Many companies allow their customers to pay for products and services using third-party credit
cards such as Visa, MasterCard, or American Express, and debit cards (also called ATM or bank
cards). Customers using these cards can make single monthly payments instead of several
payments to different creditors and can defer their payments. Many sellers allow customers to
use third-party credit cards and debit cards instead of granting credit directly for several reasons.
There are guidelines for how companies account for credit card and debit card sales. Some credit
cards, but nearly all debit cards, credit a seller’s Cash account immediately upon deposit, via
electronic funds transfer. The majority of credit cards, however, require the seller to remit a copy
electronically of each receipt to the card company. Until payment is received, the seller has an
account receivable from the card company. In both cases, the seller pays a fee for services
provided by the card company, often ranging from 1% to 5% of card sales. This charge is
deducted from the credit to the seller’s account or the cash payment to the seller.
Cash Received Immediately on Deposit: To illustrate, if TechCom has $100 of credit card
sales with a 4% fee, and its $96 cash is received immediately on deposit, the entry is:

Cash Received Sometime after Deposit: However, if instead TechCom must remit
electronically the credit card sales receipts to the credit card company and wait for the $96 cash
payment, the entry on the date of sale is:

When cash is later received from the credit card company, usually through electronic funds
transfer, the entry is

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 PROBLEMS

Problem 01: During its first year of operations, Parot Company had credit sales of $3,000,000;
$600,000 remained uncollected at year-end. The credit manager estimates that $35,000 of these
receivables will become uncollectible.
a. Prepare the journal entry to record the estimated uncollectibles.
b. Prepare the current assets section of the balance sheet for Parot Company. Assume that in
addition to the receivables it has cash of $90,000, inventory of $130,000, and prepaid
insurance of $7,500.
Problem 02: At the end of 2012, Henderson Co. has accounts receivable of $700,000 and an
allowance for doubtful accounts of $54,000. On January 24, 2013, the company learns that its
receivable from Jaime Lynn is not collectible, and management authorizes a write-off of $5,400.
a. Prepare the journal entry to record the write-off.
b. What is the cash realizable value of the accounts receivable (1) before the write-off and
(2) after the write-off?
c. Assume the same information. On March 4, 2013, Henderson Co. receives payment of
$5,400 in full from Jaime Lynn. Prepare the journal entries to record this transaction.
Problem 03: The ledger of G.K. Reid Company at the end of the current year shows Accounts
Receivable $120,000, Sales Revenue $840,000, and Sales Returns and Allowances $30,000.
Instructions
a. If G.K. Reid uses the direct write-off method to account for uncollectible accounts,
journalize the adjusting entry at December 31, assuming G.K. Reid determines that L.
Gaga’s $1,400 balance is uncollectible.
b. If Allowance for Doubtful Accounts has a credit balance of $2,100 in the trial balance,
journalize the adjusting entry at December 31, assuming bad debts are expected to be (1)
1% of net sales, and (2) 10% of accounts receivable.
c. If Allowance for Doubtful Accounts has a debit balance of $200 in the trial balance,
journalize the adjusting entry at December 31, assuming bad debts are expected to be (1)
0.75% of net sales and (2) 6% of accounts receivable.

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Problem 04: Lohan Company has accounts receivable of $93,100 at March 31. An analysis of
the accounts shows the following information

Credit terms are 2/10, n/30. At March 31, Allowance for Doubtful Accounts has a credit balance
of $1,200 prior to adjustment. The company uses the percentage-of-receivables basis for
estimating uncollectible accounts. The company’s estimate of bad debts is shown on the next
page.

Instructions
a. Determine the total estimated uncollectibles.
b. Prepare the adjusting entry at March 31 to record bad debts expense.
Problem 05: At December 31, 2011, Kardashian Company had a balance of $15,000 in
Allowance for Doubtful Accounts. During 2012, Kardashian wrote off accounts totaling
$13,000. One of those accounts ($1,800) was later collected. At December 31, 2012, an aging
schedule indicated that the balance in Allowance for Doubtful Accounts should be $19,000.
Instructions
Prepare journal entries to record the 2012 transactions of Kardashian Company.
Problem 06: On December 31, 2012, Dita Co. estimated that 2% of its net sales of $400,000 will
become uncollectible. The company recorded this amount as an addition to Allowance for
Doubtful Accounts. On May 11, 2013, Dita Co. determined that the Alex Lundquist account was
uncollectible and wrote off $1,100. On June 12, 2013, Lundquist paid the amount previously
written off.
Instructions
Prepare the journal entries on December 31, 2012, May 11, 2013, and June 12, 2013.

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Problem 07: On January 10, 2012, Honig Co. sold merchandise on account to Peregrine Co. for
$13,600, n/30. On February 9, Peregrine Co. gave Honig Co. a 10% promissory note in
settlement of this account. Prepare the journal entry to record the sale and the settlement of the
account receivable.
Problem 08: Stroup Supply Co. has the following transactions related to notes receivable during
the last 2 months of 2012.
Nov. 1 Loaned $15,000 cash to Jorge Perez on a 1-year, 10% note.
Dec. 11 Sold goods to Armle Hammer, Inc., receiving a $6,750, 90-day, 8% note.
Dec. 16 Received a $4,000, 6-month, 9% note in exchange for Max Weinberg’s outstanding
accounts receivable.
Dec. 31 Accrued interest revenue on all notes receivable.
Instructions
(a) Journalize the transactions for Stroup Supply Co.
(b) Record the collection of the Perez note at its maturity in 2013.
Problem 09: Levine Company uses the perpetual inventory system and allows customers to use
two credit cards in charging purchases. With the Suntrust Bank Card, Levine receives an
immediate credit to its account when it deposits sales receipts. Suntrust assesses a 4% service
charge for credit card sales. The second credit card that Levine accepts is the Continental Card.
Levine sends its accumulated receipts to Continental on a weekly basis and is paid by
Continental about a week later. Continental assesses a 2.5% charge on sales for using its card.
Prepare journal entries to record the following selected credit card transactions of Levine
Company.
Apr. 8: Sold merchandise for $8,400 (that had cost $6,000) and accepted the customer’s Suntrust
Bank Card. The Suntrust receipts are immediately deposited in Levine’s bank account.
Apr. 12: Sold merchandise for $5,600 (that had cost $3,500) and accepted the customer’s
Continental Card. Transferred $5,600 of credit card receipts to Continental, requesting payment.
April. 20: Received Continental’s check for the April 12 billing, less the service charge.
Problem 10: On June 30, Petrov Co. has $128,700 of accounts receivable. Prepare journal
entries to record the following selected July transactions. Also prepare any footnotes to the July
31 financial statements that result from these transactions. (The company uses the perpetual
inventory system).
July 4: Sold $7,245 of merchandise (that had cost $5,000) to customers on credit.
July 9: Sold $20,000 of accounts receivable to Main Bank. Main charges a 4% factoring fee.
July 17: Received $5,859 cash from customers in payment on their accounts.
July 27: Borrowed $10,000 cash from Main Bank, pledging $12,500 of accounts receivable as
security for the loan.

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