Accounts Receivable

Accounts Receivable for many companies is not always fully collected. Thus, companies will recognise an expense for those amounts that become uncollectible. This expense account is called Uncollectible account expense or bad debt expense.

There are 2 methods of recognising uncollectible accounts:

The Allowance Method:

A company will estimate, based on past expense or industry average, the amount of uncollectible account expense as a percentage of receivables or sales on account.

At the end of the accounting cycle, the company will then debit Uncollectible account expense and credit Allowance for doubtful accounts (a contra-asset account that appears on the BS after Accounts Receivable and is subtracted from it). E.g.:

Mar 31

 Uncollectible account expense $4,000
Allowance for doubtful accounts $4,000

Net receivables = Accounts Receivable - Allowance for doubtful accounts

When specific accounts have later been found to be uncollectible, they are credited and Allowance for doubtful accounts is debited. E.g.:

Apr 9

 Allowance for doubtful accounts $ 3,000
Accounts Receivable - J. Jones $ 500
Accounts Receivable - C. Love $ 1,000
Accounts Receivable - M. Clone $ 1,500



The Direct Write-off Method:

Companies wait for accounts to become uncollectible & expense them @ that time, regardless of when the revenue was earned. This does not best match expenses to the period in which the revenues were earned because the company may not find out until the next accounting cycle.

This can lead to errors such as these:

With this method, the company simply debits the Uncollectible account expense and credits all the accounts that have become uncollectible. E.g.:

Apr 9 Uncollectible account expense $ 1,500
Accounts Receivable - J. Jones $ 500
Accounts Receivable - C. Love $ 1,000

Notes Receivable

Def.: A promise to pay (with interest).

The person who signs a promissory note is the person who is paying the funds and is referred to as the Maker (payer) of the note. The company receiving payment is the Payee.

Example 1:

A merchandising company that purchases inventory of $15000, using the perpetual method, and signs a note for 3 months @ 8% on May 1.

Journal of Maker:

May 1

 Inventory $15,000
Notes Payable $15,000

Journal of Payee:

May 1 Notes Receivable $15,000
Sales $15,000

When payment is made, the following transactions occur:

Journal of Maker:

Aug 1

 Notes Payable $ 15,000
Interest expense ($15000 * 0.08 * 0.25) $ 300
Allowance for doubtful accounts $ 15,300



Journal of Payee:

Aug 1

 Bank $ 15,300
Notes Receivable $ 15,000
Interest revenue $ 300



Example 2:

A merchandising company purchases furniture on June 10 & signs a promissory note for $22000, payable in 90 days @ 7%.

Journal of Maker:

Jun 10

 Furniture $22,000.00
Notes Payable $22,000.00

Sept 8 Notes Payable $ 22,000.00
Interest expense ($22000 * 0.07 * 90/365) $ 379.73
Allowance for doubtful accounts $ 22,379.73


Journal of Payee:

Jun 10 Notes Receivable $22,000.00
Sales revenue $22,000.00


Sept 8

 Bank $ 15,379.73
Notes Receivable $ 15,000.00
Interest revenue $ 379.73



Adjustment

At the end of the accounting cycle, the adjustments include:

  • Depreciation
  • Prepaid expenses
  • Accrued revenue
  • Unearned revenue
  • Accrued expenses (e.g. interest that has not yet been paid)


Assuming the Maker in the previous example has an accounting cycle that ends July 31, the adjusting entries & and payment entries will be as follows:

Jul 31

 Interest expense ($22000 * 0.07 * 51/365) $ 215.18
Interest payable $ 215.18
Sept 8 Interest Payable $ 215.18
Notes Payable $ 22,000.00
Interest expense ($22000 * 0.07 * 39/365) $ 164.55
Bank $ 22,379.73

The corresponding entries for the Payee will be as follows:

Jul 31 Interest receivable $ 215.18
Interest revenue ($22000 * 0.07 * 51/365) $ 215.18
Sept 8 Bank $ 22,379.73
Interest receivable $ 215.18
Notes Payable $ 22,000.00
Interest revenue $ 164.55