Chapter 2

CHAPTER 2
Accounting for Receivables

CHAPTER 2
Accounts Receivable: An Introduction

Accounting for Bad Debt
Approaches to Estimate Bad Debt
Managing Account Receivable Information Using Reports
Measuring the Effectiveness of Collections Using Ratios
Accounts Receivable Controls
The Promissory Note and Notes Receivable
An Ethical Approach to Managing Accounts Receivable
In Summary
Exercise
Copyright © 2016 AME Learning Inc. 2

The term receivables refers to amounts due from individuals and other companies and are expected to
be collected in cash. Accounts receivable are amounts owed by customers on account. They result from
the sale of goods and services.
Accounts
Receivable
Company
Customers
Invoice
Payments

Self Study Question
A customer signs a legal contract with your company in January, receives product from you
in February, and pays in March. When does equity increase?
a. January, when the contract is signed.
b. February, when the product is received.
c. March, when payment is received.
0% 0% 0% 0%
d. It depends on your accounting policy.
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CHAPTER 2

In Summary
Exercise

Each customer must satisfy the credit requirements of the seller before the credit sale is approved.
Inevitably, though, some accounts receivable become uncollectible. The latter is referred to as bad
debt. Bad debt is considered an operating expense, and must be recorded in a way that is consistent
with ASPE or IFRS principles. To record bad debt in a way that satisfies expense recognition, accountants
have created an account called allowance for doubtful accounts (AFDA).
Uncollectible
Sales Invoice Bad Debt
Accounts

Example
At the end of 2016, Columbo Company’s customers owe a total of $100,000. After analyzing the existing
data and the current economy, it has been determined that $5,000 of the accounts receivable may not
be collectable.

The accounts receivable account of $100,000 does not change. It remains as a debit on the balance
sheet. Instead, the AFDA contra account is credited with $5,000, resulting in a net realizable value of
$95,000.
For the debit side of this transaction, bad debt expense is increased by $5,000 and this amount is
reported as an expense for the period in the income statement. The journal entry at the end of 2016 for
this transaction is shown below.

The net realizable value of accounts receivable is $95,000 and this figure would be presented on the
balance sheet. The presentation of this part of the balance sheet for Columbo Company is shown below.

After companies anticipate bad debt by setting up the AFDA contra account, several scenarios can
exist.
1. A customer is unable or unwilling to pay the debt and the amount is considered uncollectible.
2. After an account is written off as uncollectible, the customer informs you that he or she will pay the
amount.
3. The customer is unable to pay the debt when it is due, but will be able to pay it in the future.

Scenario 1: On February 16, 2017, a customer who owes you $250, informs you that he is unable or
unwilling to pay his account.
Usually, a company will attempt to contact and collect from a customer for many months. After a period
of time, the company may realize the customer just will not pay or cannot be contacted.

Scenario 2: The customer in scenario 1 has improved his cash flow and is now willing to pay his account
(which was previously written off as uncollectible). He pays the amount on June 25, 2017.
Two journal entries must be made in this scenario.
1. Reinstate the customer's account balance.
2. Record receipt of payment on account.

Scenario 3: The customer is unable to pay the debt by the due date, but will be able to pay in the future.
Even customers with a good credit record sometimes take time to settle their bills. If the customer talks to
the company and lets them know about the delay in payment, nothing needs to be done. The original
amount in accounts receivable will remain on the books and will be credited when the account is finally
paid.
After many months of attempting to collect from a customer, the company would face the decision of
writing off the account as uncollectable. If the amount is written off , the transaction in scenario 1 would
be made. If the customer finally does pay, the two transactions in scenario 2 would be made.

Self Study Question
Sales in 2016 are $1,000,000 and it is estimated that about $50,000 will not be collected. However,
this will only be known for sure in fiscal year 2017. Which of the following is true for 2016?
Dr. Cr.
Bad Debt Expense $50,000
a. (a)
Account Receivable $50,000
- Equity decreases
b. Account
(b) Receivable $50,000
- Equity decreases
c.
Bad
(c)
Debt Expense $50,000
AFDA $50,000
- No change to equity
d. (d)
AFDA $50,000
- Equity decreases
0% 0% 0% 0%
14
)
(c)
(a
(b
(d
Self Study Question
Corning Distributors’ fiscal year end is July 2016 and their accounts receivable outstanding
are $120,000. It has been established that $5,000 may not be collected. Which of the
following is correct?
Dr. Cr.
Accounts Receivable $5,000
a. (a) Bad Debt Expense $5,000

b. (b) Accounts $5,000
Receivable
AFDA $5,000
c. (c) Accounts
$5,000
Receivable
d. Bad
(d) Debt Expense $5,000
AFDA $5,000
0% 0% 0% 0%
15
)
(c)
(a
(b
(d
Self Study Question
If an amount of $1,000 is recovered from a customer that was previously written off, which of
the following is correct?
Dr. Cr.
Cash X
a. (a) Bad Debt Expense X
Dr. Cr.
Bad Debt Expense X
b. (b)
Cash X
Dr. Cr.
Bad Debt Expense X
c. (c)
AFDA X
Dr. Cr.
d. Accounts
(d) Receivable X
AFDA X
Cash X
Accounts Receivable X
0% 0% 0% 0%
16
)
(c)
(a
(b
(d
CHAPTER 2

In Summary
Exercise

Approaches to Estimate Bad debt
Companies must estimate the amount of bad debt when they use the allowance method. Two methods
to determine this amount are (1) the income statement approach, and (2) the Balance sheet approach.
Income Statement Approach Balance Sheet Approach
Matching Cash Realizable Value
Bad Debt Accounts Allowance

Sales
Expense Receivable for
Doubtful
Accounts

The Income Statement Approach
The income statement approach, or the percentage of sales method, is so called because credit sales
from the income statement are used as a basis to estimate future bad debt. This percentage is based on
past experience and anticipated credit policy.

Example
If the collection history of a company suggests that 1% of credit sales will result in bad debt, that rate is
used to estimate the portion of each period’s sales that will not be collectible.
Total credit sales for Columbo Company in 2016 amounted to $1,000,000, of which $200,000 is currently
owing by customers. On the basis of historical sales, 1% of $1,000,000 is expected to be uncollectible.
Therefore, the bad debt expense for the period is

The Balance Sheet Approach
Under the balance sheet approach, a company can calculate allowance for bad debt using either the
percentage of total accounts receivable method or the aging method. The percentage of total
accounts receivable method, as the name implies, uses a percentage of receivables to estimate bad
debt.

Under the aging method, percentages are applied to groupings based on the age of outstanding
accounts receivable amounts. Let us look at an example to illustrate this procedure.
The chart contains three groups of customers and their outstanding balances on December 31, 2016.
1. Those who have not paid within 30 days.

2. Those who have not paid for 31 to 60 days.
3. Those who have not paid for more than 60 days.

In this example, $5,800 of the accounts receivable balance of $200,000 is estimated to be uncollectible.
The $5,800 of estimated bad debt will become the ending balance of AFDA for the period regardless of
AFDA’s existing balance.
Scenario 1: AFDA has a credit balance of $3,000.

Scenario 2: AFDA has a balance of zero.

Scenario 3: AFDA has a debit balance of $1,000.

Self Study Question
Credit sales are $60,000 and bad debt is expected to be $7,000 relating to this year’s credit
sales. Identify the correct transaction using the allowance method:
Dr. Cr.
a. (a) AFDA $7,000

b. (b) Accounts
$7,000
Receivable
c. Bad
(c) Debt Expense $4,000
AFDA $4,000
d. AFDA
(d) $4,000
0% 0% 0% 0%
26
)
(c)
(a
(b
(d
Self Study Question
The amount of bad debt is expected to be $42,500 in relation to the amount of credit sales
last month. AFDA currently has a balance of $37,500. What is the journal entry for bad debt
expense?
Dr. Cr.
a. (a) Account Receivable $37,500

-Equity decreases by $37,500

b. (b) AFDA $5,000

c. (c)
AFDA $42,500
d. AFDA
(d) $5,000
-Equity Increases by $5,000
0% 0% 0% 0%
27
)
(c)
(a
(b
(d
Self Study Question
What is the correct journal entry to record an increase of $3,000 to the Allowance for Doubtful
Account?
Dr. Cr.
Account
a. (a) Receivable $3,000
Dr. Cr.
b. (b)
AFDA $3,000
Dr. Cr.
AFDA $3,000
c. (c)
Dr. Cr.
d. AFDA
(d) $42,500
Bad Debt
$42,500
Expense
0% 0% 0% 0%
28
)
(c)
(a
(b
(d
Self Study Question
If the Allowance for Doubtful Accounts increases from $5,000 to $8,000, will equity increase or
decrease?
a. Decrease
b. Increase
0% 0%
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cr
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Self Study Question
The current AFDA has a credit balance of $37,500. Based on the aging of accounts
receivable, expected losses from all unpaid accounts are expected to be $42,500. Which of
the following is the correct adjustment to AFDA?
Dr. Cr.
Account
$37,500
a. (a) Receivable
AFDA $42,500
b. (b) Bad Debt Expense $42,500

c. (c)
AFDA $5,000
d. AFDA
(d) $42,500
0% 0% 0% 0%
30
)
(c)
(a
(b
(d
Self Study Question
The current AFDA has a credit balance of $17,250. Based on the aging of accounts
receivable, expected losses from all unpaid accounts are expected to be $15,500. Which of
the following correctly adjusts AFDA?
Dr. Cr.
Account
$15,500
a. (a) Receivable
AFDA $15,500
b. (b) Bad Debt Expense $15,500

c. (c)
Account Receivable $1,750
d. AFDA
(d) $1,750
-Equity increases by $1,750
0% 0% 0% 0%
31
)
(c)
(a
(b
(d
CHAPTER 2

In Summary
Exercise

Managing Accounts Receivable Information Using Reports
Accounts receivable plays such a prominent role in the financial well-being of a company, it is important
that information about this asset is efficiently organized.
The Accounts Receivable Subledger

The yellow area shows an amount of $150 from Beta Company that has not been paid for more than
90 days.
The amount marked in red, $1,200, represents a significant portion of the outstanding balance.
The green area of this chart is notable because, unlike all the other customers on the list, Cooper
Limited does not have an outstanding balance for the 61–90 day period.

Alternative Presentations Formats
The reports that can be generated involving accounts receivable include:
 Current active customers
 Past customers not active for the last 12 months
 Customer activities listing value of sales per month
 Customer activities listing value of sales per product
 Categorization of customers according to sales representative or geographic location
 Overdue accounts

Self Study Question
Which of the following information can be found in the accounts receivable subledger?
a. The amount owed by each customer
b. Satisfaction rating by each customer
c. The amount owed to each supplier
d. Geographic location of each supplier

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CHAPTER 2

In Summary
Exercise

Another approach to measuring the effectiveness of the company’s collection efforts is through the use
of financial ratios.
Days Sales Outstanding
Days sales outstanding tracks how long customers take to pay their bills. This is done by using two basic
figures from the financial records: average net accounts receivable and net credit sales for the past 12
months.
Average Net Accounts Receivable

Days Sales Outstanding = x 365
Net Credit Sales

Company 1
Assume that the total average net accounts receivable amount for Company 1 is $200,000, and the total
net credit sales amount for the past year was $1,200,000. The DSO ratio is calculated as shown below.
Days Sales Outstanding = ($200,000 ÷ $1,200,000) x 365
= 61 days

Company 2
Assume that the total average net accounts receivable amount for Company 2 is $135,000, and the total
net credit sales for the past year was $1,650,000. The DSO ratio is calculated as shown below.
Days Sales Outstanding = ($135,000 ÷ $1,650,000) x 365
= 30 days

Accounts Receivable Turnover Ratio
The accounts receivable turnover (ART) ratio measures how often during the year a company will collect
its entire accounts receivable amount. The formula is shown below.
Net Credit Sales

Accounts Receivable Turnover =
Average Net Accounts Receivable

Company 1
In the previous example, Company 1 had an average net accounts receivable of $200,000 and net
credit sales of $1,200,000. The accounts receivable turnover is calculated as shown below.
ART = ($1,200,000 ÷ $200,000)
= 6 times

Company 2
In the example above, Company 2 had an average net accounts receivable of $135,000 and net credit
sales of $1,650,000. The accounts receivable turnover is calculated as shown below.
ART = $1,650,000 ÷ $135,000)
= 12.2 times

Self Study Question
How many days is it taking on average, to collect outstanding accounts?
Cash = $40,000
Average Accounts Receivable = $100,000
Gross Profit = $520,000
Credit Sales = $1,000,000.
a. 34.5 days
b. 36.5 days
c. 40 days
0% 0% 0% 0%
d. There is insufficient information to calculate
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Self Study Question
How many days is it taking on average to collect outstanding accounts?
Cash = $82,000
Average Accounts Receivable = $265,813
Gross Profit = $840,000
Sales = $1,270,000
a. 66.4 days
b. 94.6 days
c. 76.4 days
0% 0% 0% 0%
d. 68.2 days
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Self Study Question
Which company is more efficient collecting from customers?
a. Company 1
b. Company 2
Company 1
Net Credit Sales $4,275,845
Average Net Accounts Receivable $1,048,375
DSO 89
Company 2
Net Credit Sales $6,349,583 0% 0%
DSO 77
y1
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Co
Self Study Question
Which company is more efficient collecting from customers?
a. Company 1
b. Company 2
Company 1
Net Credit Sales $3,648,560
Average Net Accounts Receivable $954,625
ART 3.82
Company 2
Net Credit Sales $5,295,482 0% 0%
ART 5.12
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Co
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CHAPTER 2

In Summary
Exercise

The purpose of accounts receivable internal controls is to help a company get the most out of one of its
largest and most crucial asset
 Credit Policies  Terms of Sale
 Credit Approval  Credit Collection
 Credit Information  Setting Firm Credit Terms

CHAPTER 2

In Summary
Exercise

A promissory note is a written promise to pay a specified amount of money at some date in the future.
Usually, the customer will be required to pay interest on the amount owing. This is to compensate the
company for the extended payment terms.

Example
On April 1, 2016, Kay Fernandez Alonso has $1,000 of outstanding accounts receivable with Columbo
Company. She cannot pay immediately, so Columbo will give her more time to pay by turning the
accounts receivable into a notes receivable. Interest of 6% will be charged and collected when the
note is due. Kay promises to pay on April 1, 2017.

Example
On October 31, when Columbo Company prepares its financial statements, it will need to accrue the
interest earned from Kay. The interest is 6% of $1,000 that has been earned from April 1 to October 31,
2016.

Example
When Kay pays the amount due on April 1, 2017, the entry is recorded on the statements of Columbo
Company.

Example
It is possible that on April 1, 2017, Kay may not pay the amount owing to Columbo Company. If a note is
not paid at maturity, it is considered a dishonoured note. Thus, it will convert the note back to accounts
receivable.

Self Study Question
A customer, who owes $5,000 on account, is having difficulty paying their obligations. They
have agreed to sign a promissory note. Which of the following is the correct journal entry to
record the promissory note?
Dr. Cr.
Notes Receivable $5,000
a. (a) Account Receivable $5,000


b. (b) Notes Receivable $5,000
-No change to equity
Notes Receivable $5,000

c. (c)
d. Accounts
(d) Receivable $42,500
AFDA $42,500
0% 0% 0% 0%
56
)
(c)
(a
(b
(d
Self Study Question
The promissory note for $5,000 was signed on June 1 at 10% per annum. On June 30, one
months interest is owing but has yet to be received. Which of the following correctly records
the interest owed?
Dr. Cr.
Account Receivable $41.67
a. (a) Account Receivable $41.67
-Equity decreases by $41.67

Accounts Receivable $41.67
b. (b) Interest Receivable $41.67

Interest Receivable $41.67
c. (c)
Interest Revenue $41.67
0% 0% 0%
57
(c)
(a
(b
CHAPTER 2

In Summary
Exercise

An Ethical Approach to Managing Account Receivable
The company and its accounting department are responsible for managing accounts receivable
accurately and ethically. This includes properly recording credit sales and receipt of cash, as well as
properly estimating bad debt. Accounts receivable is an important asset on the balance sheet and
managing and accounting for this asset must be done without unethical manipulation.

CHAPTER 2

In Summary
Exercise

In Summary
Explain the importance of accounts receivable

 Accounts receivable often represent a significant percentage of a company’s assets.
 Allowing the existence of accounts receivable, i.e. allowing customers to buy on credit, is
instrumental in increasing sales in a modern economy.
 While most companies find day-to-day administration of accounts receivable burdensome,
effective and efficient management of accounts receivable can help improve cash flows and
customer satisfaction.
Account for bad debt using the allowance method

 Since a portion of debt from credit sales may be uncollectible, the expense recognition principle
of accounting requires bad debt expense to be estimated and accounted for in the same period
that sales are recorded. The allowance method satisfies expense recognition through the use of
an allowance for doubtful accounts (AFDA), which is a contra account attached to the accounts
receivable account. The allowance method conforms to both ASPE and IFRS rules.

In Summary
Estimate bad debt using income statement and balance sheet approaches
 The income statement approach estimates bad debt based on credit sales of the year.
 The balance sheet approach estimates bad debt based the balance of accounts receivable or
on the aging of accounts receivable at year end.
Utilize reports, including the accounts receivable subledger, to manage accounts receivable information
 The accounts receivable subledger shows accounts receivable balance by customer and by the
length of time the debt has been outstanding. Detailed examination of the accounts receivable
subledger can help the company highlight important areas that require management focus or
changes in credit policies.
 Using computer software, a company can generate various accounts receivable related reports
that are tailored to management’s needs.
Calculate financial ratios pertaining to accounts receivable

 The effectiveness of accounts receivable collections can be gauged with the use of two ratios:
days sales outstanding (DSO) and accounts receivable turnover (ART).

In Summary
Apply controls relating to accounts receivable

 Credit controls and policies are necessary to manage and protect the accounts receivable asset.
 Examples of controls relating to accounts receivable include setting competitive yet firm credit
terms and getting independent credit information about customers before approving their credit.
Record promissory notes and notes receivable

 Accounts receivable can be converted into promissory notes, or notes receivable, which are
legally binding documents. The conversion from accounts receivable to notes receivable is
recorded in the journal with a debit to notes receivable and a credit to accounts receivable.
 The company that issued the notes receivable must record accrued interest revenue at the end of
an accounting period.
Apply ethics relating to accounts receivable and notes receivable

 Management must ensure that accounts receivable is properly managed and any estimates for
bad debt are recorded as accurately as possible.

CHAPTER 2

In Summary
Exercise

Exercise
Signet Enterprise had a balance of accounts receivable on December 31, 2016 of $400,000. It is
estimated that 1% of accounts receivable will be uncollectable. The AFDA account had a credit
balance of $1,500. Prepare the journal entry to record the estimate of bad debt.
JOURNAL
Date Account Title Debit Credit
?
Dec 31 ?
Bad Debt Expense
?
$2,500
AFDA? ?
$2,500
Record bad debt expense

estimation

Chapter 2

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CHAPTER 2

Accounting for Receivables

Accounts Receivable: An Introduction

Copyright © 2016 AME Learning Inc. 2

Copyright © 2016 AME Learning Inc. 3

a. January, when the contract is signed.

b. February, when the product is received.

c. March, when payment is received.

Accounts Receivable: An Introduction

Copyright © 2016 AME Learning Inc. 5

Copyright © 2016 AME Learning Inc. 6

Copyright © 2016 AME Learning Inc. 7

Copyright © 2016 AME Learning Inc. 8

Copyright © 2016 AME Learning Inc. 9

Copyright © 2016 AME Learning Inc. 10

Copyright © 2016 AME Learning Inc. 11

Two journal entries must be made in this scenario.

1. Reinstate the customer's account balance.

2. Record receipt of payment on account.

Copyright © 2016 AME Learning Inc. 12

Copyright © 2016 AME Learning Inc. 13

Bad Debt Expense $5,000

Accounts Receivable: An Introduction

Copyright © 2016 AME Learning Inc. 17

Income Statement Approach Balance Sheet Approach

Matching Cash Realizable Value

Bad Debt Accounts Allowance

Copyright © 2016 AME Learning Inc. 18

The Income Statement Approach

Copyright © 2016 AME Learning Inc. 19

Copyright © 2016 AME Learning Inc. 20

The Balance Sheet Approach

Copyright © 2016 AME Learning Inc. 21

1. Those who have not paid within 30 days.

Copyright © 2016 AME Learning Inc. 22

Scenario 1: AFDA has a credit balance of $3,000.

Copyright © 2016 AME Learning Inc. 23

Scenario 2: AFDA has a balance of zero.

Copyright © 2016 AME Learning Inc. 24

Scenario 3: AFDA has a debit balance of $1,000.

Copyright © 2016 AME Learning Inc. 25

Bad Debt Expense $7,000

a. (a) Account Receivable $37,500

Bad Debt Expense $5,000

Bad Debt Expense $42,500

Bad Debt Expense $5,000

Bad Debt Expense $1,750

Accounts Receivable: An Introduction

Copyright © 2016 AME Learning Inc. 32

The Accounts Receivable Subledger

Copyright © 2016 AME Learning Inc. 33

Copyright © 2016 AME Learning Inc. 34

Alternative Presentations Formats

The reports that can be generated involving accounts receivable include:

 Current active customers

 Past customers not active for the last 12 months

 Customer activities listing value of sales per month

 Customer activities listing value of sales per product

 Categorization of customers according to sales representative or geographic location

Copyright © 2016 AME Learning Inc. 35

a. The amount owed by each customer

b. Satisfaction rating by each customer

c. The amount owed to each supplier

d. Geographic location of each supplier