Notes Receivable A note is a written promise to pay a specific amount at a specific future date. Includes an interest cost for the term of the note

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1 RECEIVABLES Accounts Receivable Amounts due from customers for credit sales. Credit sales require: o Maintaining a separate account receivable for each customer. o Accounting for bad debts that result from credit sales. Notes Receivable A note is a written promise to pay a specific amount at a specific future date. Includes an interest cost for the term of the note VALUING ACCOUNTS RECEIVABLE To properly value accounts receivable you need to make an end of period adjustment to account for any accounts that you will not collect. There are two methods used to account for receivables that customers do not pay. o Allowance Method Income Statement Method (Percentage of Sales) Balance Sheet Method (Accounts Receivable) Percentage of Total Receivables Aging Accounts Receivable o Direct Write-Off Method ALLOWANCE METHOD At the end of each accounting period, bad debts expense is estimated and recorded Method satisfies matching principle expense is charged in period of related sale. Accounts Receivables are reported at their estimated realizable value (A/Rec less the allowance account). The allowance method uses a contra-asset account called the Allowance for Doubtful Accounts. At the time of estimate, the company does not yet know which accounts will not be collected. They use an estimate and retain the balance of this estimate in the AFDA. The balance in the allowance may be a debit during the period if you have under-estimated bad debt expenses. After adjusting, the balance will be a credit. Estimating and Recording Bad Debt At the end of each period, estimate the total bad debts expected to be realized from that period s sales. Entry: debit Bad Debt Expense, credit a contra-asset account called the Allowance for Doubtful Accounts. Example: Acme Industries determines that $3000 worth of accounts receivable is uncollectible. Page 1 of 7

2 Balance Sheet Presentation Assuming the balance in the accounts receivable is $50,000 and the starting balance in AFDA was zero, what would the accounts receivable total be on the balance sheet? Writing Off a Bad Debt With the allowance method, when an account is determined to be uncollectible, the debit goes to Allowance for Doubtful Accounts. This reduces the balance in the allowance as the company has identified a portion of accounts receivable that will not be collected. Example: Acme Industries determines that W. Coyote will not pay his $500 bill. They decide to write off the bad debt. Recovery of Bad Debt If the company recovers the account that has previously been determined to be uncollectible, the original write-off entry will need to be reversed before the cash collection is recorded. Example continued: W. Coyote pays his $500 bill that was previously written-off. Page 2 of 7

3 ESTIMATING BAD DEBT PERCENTAGE OF SALES METHOD Also known as the Income Statement Method Bad debts expense is calculated as a percentage of credit sales. Calculation: Current Period Sales x Estimated Bad Debt % = Estimated Bad Debt Expense Example: Based on previous experience, Acme Industries estimates at 1% of current credit sales will not be collected. What is their bad debt expense if their credit sales were $400,000? Calculation: ESTIMATING BAD DEBT EXPENSE - % OF ACCOUNTS RECEIVABLE METHOD Also known as the Balance Sheet method Desired credit balance in Allowance for Doubtful Accounts is calculated Calculation: Accounts Receivable x Estimated Bad Debt % = Final Balance of the Allowance for Doubtful Accounts To find the Bad Debt Expense for the period you need to determine the necessary credit to the AFDA. Example, in 2010, Acme Industries estimates that 5% of its Allowance for Doubtful Accounts Starting Balance + Bad Debt Expense Final Balance (Calculated as a percentage of A/R) outstanding accounts receivables of $60,000 will not be collected. What is the bad debt expense for 2010? Calculations: Allowance for Doubtful Accounts 500 Page 3 of 7

4 ESTIMATING BAD DEBT EXPENSE AGING OF ACCOUNTS RECEIVABLE METHOD Year-end Accounts Receivable is broken down into age classifications. Each age grouping has a different likelihood of being uncollectible. Compute a separate allowance for each age grouping. Final total gives you the required balance in the allowance for doubtful accounts Allowance for Doubtful Accounts 500 DIRECT WRITE-OFF METHOD Accounts for bad debts from an uncollectible account receivable at the time it is determined to be uncollectible. Entry to write-off an uncollectible: debit Bad Debt Expense, credit Accounts Receivable. This method violates matching principle frequently results in expense being charged in period different from revenue. Materiality principle permits use of this method when bad debts expenses are very small in relation to other financial statement items such as sales and net income. Example: Acme Industries uses the direct write-off method to account for bad debts. On April 1st, 2010 the company determines that the $500 account for W. Coyote will not be collected. What is the journal entry? Page 4 of 7

5 COMPARISON OF METHODS Allowance Method To record estimated bad debt DR Bad Debt Expense CR Allowance for Doubtful Accounts To write-off a bad debt DR Allowance for Doubtful Accounts CR Account Receivable Upon payment of bad debt DR Account Receivable CR Allowance for Doubtful Accounts DR CR Direct Write-off Method Bad Debt Expense Account Receivable DR CR Cash Account Receivable Page 5 of 7

6 NOTES RECEIVABLE A note is a written promise to pay a specific amount at a specific future date. Promissory notes are notes payable to the maker of the note and notes receivable to the payee of the note. Notes receivable are generally preferred by creditors over accounts receivable. Record the receipt of a $1,000, 12%, 90-day note granted as an extension of a past-due accounts receivable of W. Coyote. Note: No interest is recorded on the day the note is received. Interest Computation Receipt of Note At the maturity date a journal entry is required. End-of-Period Adjustments When a note receivable is outstanding at the end of an accounting period, the company must prepare an adjusting entry to accrue interest income. The accrued interest is equal to the number of days from the start of the note to the end of the year. Example - $3,000, 12% note dated December 16th. Due: June 16th What is the entry required on December 31st? Page 6 of 7

7 Interest Calculation: Subsequent Collection At maturity, remove the original note receivable balance, the interest accrued at year-end and record the interest earned in the current year. Example - $3,000, 12% note dated December 16th. Due: June 16th Dishonouring a Note If a note is not paid on the date of maturity, a journal entry must be made Debit Accounts Receivable for maturity value, credit Note Receivable for face amount and credit Interest Earned for the interest amount. If account receivable remains uncollected, will be written-off. Assume the note from the previous example was not paid on the date of maturity, what is the journal entry? Page 7 of 7