Accounting Principles: A Business Perspective

First Global Text Edition, Volume 1 Financial Accounting

James Don Edwards, PhD, D.H.C. J.M. Tull Professor Emeritus of Accounting

Terry College of Business University of Georgia

Roger H. Hermanson, PhD Regents Professor Emeritus of Accounting

Ernst & Young-J. W. Holloway Memorial Professor Emeritus Georgia State University

Funding for the first Global Text edition was provided by

Endeavour International Corporation, Houston, Texas, USA.

The Global Text Project is funded by the Jacobs Foundation, Zurich, Switzerland.

This book is licensed under a Creative Commons Attribution 3.0 License

This book is licensed under a Creative Commons Attribution 3.0 License

9. Receivables and payables Learning objectives

After studying this chapter, you should be able to:

• Account for uncollectible accounts receivable under the allowance method.

• Record credit card sales and collections.

• Define liabilities, current liabilities, and long-term liabilities.

• Define and account for clearly determinable, estimated, and contingent liabilities.

• Account for notes receivable and payable, including calculation of interest.

• Account for borrowing money using an interest-bearing note versus a non interest-bearing note.

• Analyze and use the financial results—accounts receivable turnover and the number of days' sales in accounts

receivable.

A career in litigation support What is litigation support? It does not mean working in an attorney's office. It involves assisting legal counsel in

attempting to gain favorable verdicts in a court of law. Persons involved in litigation support generally work for a

public accounting firm, a consulting firm, or as a sole proprietor or in partnership with others. An experienced

litigation support person can expect to earn an income well into six figures.

Litigation support in a broad sense encompasses fraud auditing, valuation analysis, investigative accounting,

and forensic accounting. The practice of litigation support involves assisting legal counsel in such things as product

liability disputes, shareholder disputes, contract breaches, and major losses reported by entities. These

investigations require the accountant to gather and evaluate evidence to assess the integrity and dollar amounts

surrounding the aforementioned situations.

The accountant can be, and often is, requested to serve as an expert witness in a court of law. This experience

requires knowledge of accounting and auditing in addition to possessing good communication skills, appropriate

credentials, relevant experience, and critical information that could result in successful resolution of the issue.

What kind of person pursues litigation support as a career? It takes a very special individual. The person must

be part accountant, part auditor, part lawyer, and part skilled businessperson. An undergraduate accounting

degree, an MBA, and a law degree would be the perfect educational background needed for such a career. Many

universities offer a combined MBA/JD program. Such a program fulfills the graduate needs of the litigation support

person.

In addition to the degree, work experience in the business sector is essential. A career in public accounting,

industry, or with a government agency would serve as valuable experience in pursuing a career in litigation support.

Accounting Principles: A Business Perspective 396 A Global Text

9. Receivables and payables

Much of the growth of business in recent years is due to the immense expansion of credit. Managers of

companies have learned that by granting customers the privilege of charging their purchases, sales and profits

increase. Using credit is not only a convenient way to make purchases but also the only way many people can own

high-priced items such as automobiles.

This chapter discusses receivables and payables. For a company, a receivable is any sum of money due to be

paid to that company from any party for any reason. Similarly, a payable describes any sum of money to be paid by

that company to any party for any reason.

Primarily, receivables arise from the sale of goods and services. The two types of receivables are accounts

receivable, which companies offer for short-term credit with no interest charge; and notes receivable, which

companies sometimes extend for both short-and long-term credit with an interest charge. We pay particular

attention to accounting for uncollectible accounts receivable.

Like their customers, companies use credit, which they show as accounts payable or notes payable. Accounts

payable normally result from the purchase of goods or services and do not carry an interest charge. Short-term

notes payable carry an interest charge and may arise from the same transactions as accounts payable, but they can

also result from borrowing money from a bank or other institution. Chapter 4 identified accounts payable and

short-term notes payable as current liabilities. A company also incurs other current liabilities, including payables

such as sales tax payable, estimated product warranty payable, and certain liabilities that are contingent on the

occurrence of future events. Long-term notes payable usually result from borrowing money from a bank or other

institution to finance the acquisition of plant assets. As you study this chapter and learn how important credit is to

our economy, you will realize that credit in some form will probably always be with us.

Accounts receivable In Chapter 3, you learned that most companies use the accrual basis of accounting since it better reflects the

actual results of the operations of a business. Under the accrual basis, a merchandising company that extends credit

records revenue when it makes a sale because at this time it has earned and realized the revenue. The company has

earned the revenue because it has completed the seller's part of the sales contract by delivering the goods. The

company has realized the revenue because it has received the customer's promise to pay in exchange for the goods.

This promise to pay by the customer is an account receivable to the seller. Accounts receivable are amounts that

customers owe a company for goods sold and services rendered on account. Frequently, these receivables resulting

from credit sales of goods and services are called trade receivables.

When a company sells goods on account, customers do not sign formal, written promises to pay, but they agree

to abide by the company's customary credit terms. However, customers may sign a sales invoice to acknowledge

purchase of goods. Payment terms for sales on account typically run from 30 to 60 days. Companies usually do not

charge interest on amounts owed, except on some past-due amounts.

Because customers do not always keep their promises to pay, companies must provide for these uncollectible

accounts in their records. Companies use two methods for handling uncollectible accounts. The allowance method

provides in advance for uncollectible accounts. The direct write-off method recognizes bad accounts as an expense

at the point when judged to be uncollectible and is the required method for federal income tax purposes. However,

since the allowance method represents the accrual basis of accounting and is the accepted method to record

397

This book is licensed under a Creative Commons Attribution 3.0 License

uncollectible accounts for financial accounting purposes, we only discuss and illustrate the allowance method in

this text.

Even though companies carefully screen credit customers, they cannot eliminate all uncollectible accounts.

Companies expect some of their accounts to become uncollectible, but they do not know which ones. The matching

principle requires deducting expenses incurred in producing revenues from those revenues during the accounting

period. The allowance method of recording uncollectible accounts adheres to this principle by recognizing the

uncollectible accounts expense in advance of identifying specific accounts as being uncollectible. The required entry

has some similarity to the depreciation entry in Chapter 3 because it debits an expense and credits an allowance

(contra asset). The purpose of the entry is to make the income statement fairly present the proper expense and the

balance sheet fairly present the asset. Uncollectible accounts expense (also called doubtful accounts expense

or bad debts expense) is an operating expense that a business incurs when it sells on credit. We classify

uncollectible accounts expense as a selling expense because it results from credit sales. Other accountants might

classify it as an administrative expense because the credit department has an important role in setting credit terms.

To adhere to the matching principle, companies must match the uncollectible accounts expense against the

revenues it generates. Thus, an uncollectible account arising from a sale made in 2010 is a 2010 expense even

though this treatment requires the use of estimates. Estimates are necessary because the company sometimes

cannot determine until 2008 or later which 2010 customer accounts will become uncollectible.

Recording the uncollectible accounts adjustment A company that estimates uncollectible accounts

makes an adjusting entry at the end of each accounting period. It debits Uncollectible Accounts Expense, thus

recording the operating expense in the proper period. The credit is to an account called Allowance for Uncollectible

Accounts.

As a contra account to the Accounts Receivable account, the Allowance for Uncollectible Accounts (also

called Allowance for doubtful accounts or Allowance for bad debts) reduces accounts receivable to their net

realizable value. Net realizable value is the amount the company expects to collect from accounts receivable.

When the firm makes the uncollectible accounts adjusting entry, it does not know which specific accounts will

become uncollectible. Thus, the company cannot enter credits in either the Accounts Receivable control account or

the customers' accounts receivable subsidiary ledger accounts. If only one or the other were credited, the Accounts

Receivable control account balance would not agree with the total of the balances in the accounts receivable

subsidiary ledger. Without crediting the Accounts Receivable control account, the allowance account lets the

company show that some of its accounts receivable are probably uncollectible.

To illustrate the adjusting entry for uncollectible accounts, assume a company has USD 100,000 of accounts

receivable and estimates its uncollectible accounts expense for a given year at USD 4,000. The required year-end

adjusting entry is:

Dec. 31 Uncollectible Accounts Expense (-SE) 4,000 Allowance for Uncollectible Accounts (-A) 4,000 To record estimated uncollectible accounts.

The debit to Uncollectible Accounts Expense brings about a matching of expenses and revenues on the income

statement; uncollectible accounts expense is matched against the revenues of the accounting period. The credit to

Allowance for Uncollectible Accounts reduces accounts receivable to their net realizable value on the balance sheet.

Accounting Principles: A Business Perspective 398 A Global Text

9. Receivables and payables

When the books are closed, the firm closes Uncollectible Accounts Expense to Income Summary. It reports the

allowance on the balance sheet as a deduction from accounts receivable as follows:

Brice Company Balance Sheet

2010 December 31 Current assets Cash $21,200 Accounts receivable $ 100,000 Less: Allowance for uncollectible accounts 4,000 96,000

Estimating uncollectible accounts Accountants use two basic methods to estimate uncollectible accounts

for a period. The first method—percentage-of-sales method—focuses on the income statement and the relationship

of uncollectible accounts to sales. The second method—percentage-of-receivables method—focuses on the balance

sheet and the relationship of the allowance for uncollectible accounts to accounts receivable.

Percentage-of-sales method The percentage-of-sales method estimates uncollectible accounts from the

credit sales of a given period. In theory, the method is based on a percentage of prior years' actual uncollectible

accounts to prior years' credit sales. When cash sales are small or make up a fairly constant percentage of total

sales, firms base the calculation on total net sales. Since at least one of these conditions is usually met, companies

commonly use total net sales rather than credit sales. The formula to determine the amount of the entry is:

Amount of journal entry for uncollectible accounts – Net sales (total or credit) x Percentage estimated as

uncollectible

To illustrate, assume that Rankin Company's uncollectible accounts from 2008 sales were 1.1 per cent of total

net sales. A similar calculation for 2009 showed an uncollectible account percentage of 0.9 per cent. The average

for the two years is 1 per cent [(1.1 +0.9)/2]. Rankin does not expect 2010 to differ from the previous two years.

Total net sales for 2010 were USD 500,000; receivables at year-end were USD 100,000; and the Allowance for

Uncollectible Accounts had a zero balance. Rankin would make the following adjusting entry for 2010:

Dec. 31 Uncollectible Accounts Expense (-SE) 5,000 Allowance for Uncollectible Accounts (-A) 5,000 To record estimated uncollectible accounts ($500,000 X 0.01).

Using T-accounts, Rankin would show:

Uncollectible Accounts Expense Allowance for Uncollectible Accounts Dec. 31 Bal. before Adjustment 5,000 adjustment -0-

Dec. 31 Adjustment 5,000 Bal. after adjustment 5,000

Rankin reports Uncollectible Accounts Expense on the income statement. It reports the accounts receivable less

the allowance among current assets in the balance sheet as follows:

Accounts receivable $ 100,000 Less: Allowance for uncollectible accounts 5,000 $ 95,000 Or Rankin's balance sheet could show: Accounts receivable (less estimated uncollectible accounts, $5,000) $95,000

On the income statement, Rankin would match the uncollectible accounts expense against sales revenues in the

period. We would classify this expense as a selling expense since it is a normal consequence of selling on credit.

399

This book is licensed under a Creative Commons Attribution 3.0 License

The Allowance for Uncollectible Accounts account usually has either a debit or credit balance before the year-

end adjustment. Under the percentage-of-sales method, the company ignores any existing balance in the allowance

when calculating the amount of the year-end adjustment (except that the allowance account must have a credit

balance after adjustment).

For example, assume Rankin's allowance account had a USD 300 credit balance before adjustment. The

adjusting entry would still be for USD 5,000. However, the balance sheet would show USD 100,000 accounts

receivable less a USD 5,300 allowance for uncollectible accounts, resulting in net receivables of USD 94,700. On the

income statement, Uncollectible Accounts Expense would still be 1 per cent of total net sales, or USD 5,000.

In applying the percentage-of-sales method, companies annually review the percentage of uncollectible accounts

that resulted from the previous year's sales. If the percentage rate is still valid, the company makes no change.

However, if the situation has changed significantly, the company increases or decreases the percentage rate to

reflect the changed condition. For example, in periods of recession and high unemployment, a firm may increase

the percentage rate to reflect the customers' decreased ability to pay. However, if the company adopts a more

stringent credit policy, it may have to decrease the percentage rate because the company would expect fewer

uncollectible accounts.

Percentage-of-receivables method The percentage-of-receivables method estimates uncollectible

accounts by determining the desired size of the Allowance for Uncollectible Accounts. Rankin would multiply the

ending balance in Accounts Receivable by a rate (or rates) based on its uncollectible accounts experience. In the

percentage-of-receivables method, the company may use either an overall rate or a different rate for each age

category of receivables.

To calculate the amount of the entry for uncollectible accounts under the percentage-of-receivables method

using an overall rate, Rankin would use:

Amount of entry for uncollectible accounts – (Accounts receivable ending balance x percentage estimated as

uncollectible) – Existing credit balance in allowance for uncollectible accounts or existing debit balance in

allowance for uncollectible accounts

Using the same information as before, Rankin makes an estimate of uncollectible accounts at the end of 2010.

The balance of accounts receivable is USD 100,000, and the allowance account has no balance. If Rankin estimates

that 6 per cent of the receivables will be uncollectible, the adjusting entry would be:

Dec. 31 Uncollectible Accounts Expense (-SE) 6,000 Allowance for Uncollectible Accounts (-A) 6,000 To record estimated uncollectible accounts ($100,000 X 0.06).

Using T-accounts, Rankin would show:

Uncollectible Accounts Expense Allowance for Uncollectible Accounts Dec. 31 Bal. before Adjustment 6,000 Adjustment -0-

Dec. 31 Adjustment 6,000 Bal. after Adjustment 6,000

If Rankin had a USD 300 credit balance in the allowance account before adjustment, the entry would be the

same, except that the amount of the entry would be USD 5,700. The difference in amounts arises because

Accounting Principles: A Business Perspective 400 A Global Text

9. Receivables and payables

management wants the allowance account to contain a credit balance equal to 6 per cent of the outstanding

receivables when presenting the two accounts on the balance sheet. The calculation of the necessary adjustment is

[(USD 100,000 X 0.06)-USD 300] = USD 5,700. Thus, under the percentage-of-receivables method, firms consider

any existing balance in the allowance account when adjusting for uncollectible accounts. Using T-accounts, Rankin

would show:

Uncollectible Accounts Expense Allowance for Uncollectible Accounts Dec. 31 Bal. before Adjustment 5,700 Adjustment 300

Dec. 31 Adjustment 5,700 Bal. after Adjustment 6,000

ALLEN COMPANY Accounts Receivable Aging Schedule

2010 December 31

Customer

Accounts Receivable Balance

Not Yet Due

Days Past Due

1-30 31-60 61-90 Over 90

X $ 5,000 $ 5,000 Y 14,000 $ 12,000 $2,000 Z 400 $200 200 All others 808,600 $ 560,000 240,000 2,000 600 6,000

$ 828,000 $ 560,000 $252,000 $4,000 $800 $11,200

Percentage estimated as uncollectible Estimated amount uncollectible

1% 5% 10% 25% 50%

$ 24,400 $ 5,600 $ 12,600 $ 400 $200 $ 5,600

Exhibit 77: Accounts receivable aging schedule

As another example, suppose that Rankin had a USD 300 debit balance in the allowance account before

adjustment. Then, a credit of USD 6,300 would be necessary to get the balance to the required USD 6,000 credit

balance. The calculation of the necessary adjustment is [(USD 100,000 X 0.06) + USD 300] = USD 6,300. Using T-

accounts, Rankin would show:

Uncollectible Accounts Expense Allowance for Uncollectible Accounts Dec. 31 Bal. before Dec. 31 Adjustment 6,300 Adjustment 300 Adjustment 6,300

Bal. after Adjustment 6,000

No matter what the pre-adjustment allowance account balance is, when using the percentage-of-receivables

method, Rankin adjusts the Allowance for Uncollectible Accounts so that it has a credit balance of USD 6,000—

equal to 6 per cent of its USD 100,000 in Accounts Receivable. The desired USD 6,000 ending credit balance in the

Allowance for Uncollectible Accounts serves as a "target" in making the adjustment.

So far, we have used one uncollectibility rate for all accounts receivable, regardless of their age. However, some

companies use a different percentage for each age category of accounts receivable. When accountants decide to use

a different rate for each age category of receivables, they prepare an aging schedule. An aging schedule classifies

accounts receivable according to how long they have been outstanding and uses a different uncollectibility

percentage rate for each age category. Companies base these percentages on experience. In Exhibit 77, the aging

schedule shows that the older the receivable, the less likely the company is to collect it.

401

This book is licensed under a Creative Commons Attribution 3.0 License

Classifying accounts receivable according to age often gives the company a better basis for estimating the total

amount of uncollectible accounts. For example, based on experience, a company can expect only 1 per cent of the

accounts not yet due (sales made less than 30 days before the end of the accounting period) to be uncollectible. At

the other extreme, a company can expect 50 per cent of all accounts over 90 days past due to be uncollectible. For

each age category, the firm multiplies the accounts receivable by the percentage estimated as uncollectible to find

the estimated amount uncollectible.

The sum of the estimated amounts for all categories yields the total estimated amount uncollectible and is the

desired credit balance (the target) in the Allowance for Uncollectible Accounts.

Since the aging schedule approach is an alternative under the percentage-of-receivables method, the balance in

the allowance account before adjustment affects the year-end adjusting entry amount recorded for uncollectible

accounts. For example, the schedule in Exhibit 77 shows that USD 24,400 is needed as the ending credit balance in

the allowance account. If the allowance account has a USD 5,000 credit balance before adjustment, the adjustment

would be for USD 19,400.

The information in an aging schedule also is useful to management for other purposes. Analysis of collection

patterns of accounts receivable may suggest the need for changes in credit policies or for added financing. For

example, if the age of many customer balances has increased to 61-90 days past due, collection efforts may have to

be strengthened. Or, the company may have to find other sources of cash to pay its debts within the discount

period. Preparation of an aging schedule may also help identify certain accounts that should be written off as

uncollectible.

An accounting perspective:

Business insight

According to the Fair Debt Collection Practices Act, collection agencies can call persons only

between 8 am and 9 pm, and cannot use foul language. Agencies can call employers only if the

employers allow such calls. And, they can threaten to sue only if they really intend to do so.

Write-off of receivables As time passes and a firm considers a specific customer's account to be uncollectible,

it writes that account off. It debits the Allowance for Uncollectible Accounts. The credit is to the Accounts

Receivable control account in the general ledger and to the customer's account in the accounts receivable subsidiary

ledger. For example, assume Smith's USD 750 account has been determined to be uncollectible. The entry to write

off this account is:

Allowance for Uncollectible Accounts (-SE) 750 Accounts Receivable—Smith (-A) 750 To write off Smith's account as uncollectible.

The credit balance in Allowance for Uncollectible Accounts before making this entry represented potential

uncollectible accounts not yet specifically identified. Debiting the allowance account and crediting Accounts

Receivable shows that the firm has identified Smith's account as uncollectible. Notice that the debit in the entry to

write off an account receivable does not involve recording an expense. The company recognized the uncollectible

Accounting Principles: A Business Perspective 402 A Global Text

9. Receivables and payables

accounts expense in the same accounting period as the sale. If Smith's USD 750 uncollectible account were

recorded in Uncollectible Accounts Expense again, it would be counted as an expense twice.

A write-off does not affect the net realizable value of accounts receivable. For example, suppose that Amos

Company has total accounts receivable of USD 50,000 and an allowance of USD 3,000 before the previous entry;

the net realizable value of the accounts receivable is USD 47,000. After posting that entry, accounts receivable are

USD 49,250, and the allowance is USD 2,250; net realizable value is still USD 47,000, as shown here:

Before Entry for After Write-Off Write-Off Write-Off

Accounts receivable $ 50,000 Dr. $750 Cr. $ 49,250 Dr. Allowance for uncollectible accounts 3,000 Cr. 750 Dr. 2,250 Cr. Net realizable value $47,000 $ 47,000

You might wonder how the allowance account can develop a debit balance before adjustment. To explain this,

assume that Jenkins Company began business on 2009 January 1, and decided to use the allowance method and

make the adjusting entry for uncollectible accounts only at year-end. Thus, the allowance account would not have

any balance at the beginning of 2009. If the company wrote off any uncollectible accounts during 2009, it would

debit Allowance for Uncollectible Accounts and cause a debit balance in that account. At the end of 2009, the

company would debit Uncollectible Accounts Expense and credit Allowance for Uncollectible Accounts. This

adjusting entry would cause the allowance account to have a credit balance. During 2010, the company would again

begin debiting the allowance account for any write-offs of uncollectible accounts. Even if the adjustment at the end

of 2009 was adequate to cover all accounts receivable existing at that time that would later become uncollectible,

some accounts receivable from 2010 sales may be written off before the end of 2010. If so, the allowance account

would again develop a debit balance before the end-of-year 2010 adjustment.

Uncollectible accounts recovered Sometimes companies collect accounts previously considered to be

uncollectible after the accounts have been written off. A company usually learns that an account has been written

off erroneously when it receives payment. Then the company reverses the original write-off entry and reinstates the

account by debiting Accounts Receivable and crediting Allowance for Uncollectible Accounts for the amount

received. It posts the debit to both the general ledger account and to the customer's accounts receivable subsidiary

ledger account. The firm also records the amount received as a debit to Cash and a credit to Accounts Receivable.

And it posts the credit to both the general ledger and to the customer's accounts receivable subsidiary ledger

account.

To illustrate, assume that on May 17 a company received a USD 750 check from Smith in payment of the account

previously written off. The two required journal entries are:

May 17 Accounts Receivable—Smith (+A) Allowance for Uncollectible Accounts (-A) To reverse original write-off of Smith account.

750 750

May 17 Cash (+A) Accounts Receivable—Smith (-A) To record collection of account.

750 750

The debit and credit to Accounts Receivable—Smith on the same date is to show in Smith's subsidiary ledger

account that he did eventually pay the amount due. As a result, the company may decide to sell to him in the future.

403

This book is licensed under a Creative Commons Attribution 3.0 License

When a company collects part of a previously written off account, the usual procedure is to reinstate only that

portion actually collected, unless evidence indicates the amount will be collected in full. If a company expects full

payment, it reinstates the entire amount of the account.

Because of the problems companies have with uncollectible accounts when they offer customers credit, many

now allow customers to use bank or external credit cards. This policy relieves the company of the headaches of

collecting overdue accounts.

A broader perspective:

GECS allowance for losses on financing receivables

Recognition of losses on financing receivables. The allowance for losses on small-balance

receivables reflects management's best estimate of probable losses inherent in the portfolio

determined