Ch. 7 –Receivables and Investments
Accounts Receivable
Accounts receivable: oral promise to pay; usually non-interest bearing
Notes receivable: written promise to pay; usually interest bearing & have
specific due date
Valuation of Accounts Receivable
Should be recorded at the amount we realistically expect to collect
(conservatism concept)
Each period that we make credit sales, we must estimate what we think will
ultimately be uncollected.
This estimate of potential bad debt will be recorded as an expense on the
income statement and a reduction of assets on the balance sheet.
Allowance for doubtful accounts (allowance for bad debt) is used to indicate
the amount of receivables we might not collect.
Balance sheet presentation:
Accounts receivable $ 1,000
Less: Allowance for doubtful accounts (50)
Net accounts receivable 950
Each period the following entry, based on an estimate, must be made:
Bad debt expense $X
Allow. for bad debt $X
A = L + E
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Two ways to estimate bad debts:
1. Income Statement Method
Net credit sales x historic bad debt % = bad debt expense
2. Balance Sheet Method
Ending acct. receivable x % believed to be uncollectible = ending balance
needed in ABD acct. Bad debt expense is a plug to get this!
Example: Credit sales for the year $300,000
12/31 accounts receivable 50,000
Allowance for bad debt 1,000 credit (before adjustment)
The company estimates 1% of credit sales or 3% of receivables will be uncollectible:
Income statement method:
Balance sheet method:
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Journal Entries and T-Accounts for Receivables:
Accounts Receivable
Beg. Bal.
(A) Credit Sales Cash collections from customers (B)
Write-offs (D)
End. Bal.
Allowance for bad debt Bad Debt Exp.
Beg. Bal.
(D) Actual Estimate of this period’s (C) Estimate
Write-offs bad debt expense (C) of this period’s
expense
Collection of prior
Write-off (E)
To record credit sales:
(A) Acct. receivable $X
Sales $X
To collect credit sales:
(B) Cash $X
A/R $X
To estimate bad debt expense each period:
(C) Bad debt expense $X
ABD $X
To write-off uncollectible accounts:
(D) ABD $X
A/R $X
To collect accts. previously written-off:
(E) A/R $X
ABD $X
Cash $X
A/R $X
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Example #1: At the beginning of 2010, Hi-Tech Company's accounts receivable balance was $140,000,
and the balance in the Allowance for Bad Debt account was $5,600 cr.). Hi-Tech's sales during 2010 were
$1,050,000, of which 80% were on credit. Collections on account during the year were $670,000.
Throughout the year, the company was able to specifically identify several bad debt customers and wrote
off a total of $4,000 of uncollectible accounts. One of the accounts written off during the year was for Mr.
Jones who originally owed Hi-Tech $1,000. Hi-Tech wrote off his account when he declared bankruptcy in
February, but by October, 2010, Mr. Jones had recovered financially and repaid his debt to Hi-Tech in
order to clear his good name.
Step 1: Record each of the above transactions and update the A/R and ABD T-accounts.
Step 2: Record year-end adjusting entry for Bad Debt Expense based on the method the company is using.
Income Statement Method Balance Sheet Method
(% of Credit Sales = Estimate) (% of End. A/R = Estimate)
$ estimate is Bad Debt Expense $ estimate is new Ending ABD Bal.
Assume Hi-Tech estimates 2% of credit Assume instead that Hi-Tech estimates
Sales to be uncollectible. 6% of year-end A/R to be uncollectible
To Calculate:
To Record:
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Step 3: Determine Net Realizable Value of Accounts Receivable under each method.
Step 4: Determine the Effect of each of the following transactions on the Financial Statements:
a. What does the effect of writing off an uncollectible account have on Total Assets and Net Income?
b. What effect does the recognition of Bad Debt Expense have on NRV, Total Assets, and Net Income?
More Example Problems:
1. The following balances relate to Smith Company:
Credit Sales $1,000,000
ABD (1/1/10) 2,000 (credit)
Acct. Receivable (1/1/10) 48,000
Collections from customers 985,000
Annual bad debts are estimated to be 3% of credit sales. An account with a balance of $400,
previously written off, is collected during 2010. Furthermore, $800 in the accounts were written
off in 2010 as uncollectible. The balance in the Allowance for Bad Debts account at
December 31, 2010 (after adjustment) would be:
2. At December 31, (before adjusting and closing the accounts) the allowance for bad debts of
Wilson Corp. showed a debit balance of $4,325. An aging of the accounts receivable indicated
that the amount expected to be uncollectible was $3,900. Under these circumstances,
a year-end adjusting entry for bad debt expense would be:
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3. Trenton Company's Accounts Receivable balance at Dec. 31 was $90,000, and there was a
debit balance of $600 in the Allowance for Uncollectible Accounts. The firm estimates that
3% of the A/R will prove to be uncollectible. After the appropriate adjusting entry is made
for estimated credit losses, what is the net realizable value of the accounts receivables at year end?
Accounts Receivable Turnover
Net Credit Sales
Avg. Acct. Receivable
The faster the turnover, the better. Make sure to compare to prior periods and industry averages.
Notes Receivable
Interest is earned between the issue date and the maturity date.
Interest earned must be accrued each period even if it hasn’t been received
Interest = (Principal x Rate x Time) All interest rates reflect an annual percentage!
Investments in Stocks and Bonds
Two forms of investment in another company:
1. Debt Securities: Bonds- Loans to another company
Specific maturity date of principal + interest
2. Equity Securities: Stock – Ownership of another company
No maturity date, no guaranteed return!
Reasons for Investments
1. Investment of idle cash
Bonds- earn interest
Stock – hope for dividends & stock price appreciation
2. Gain influence over another company
Equity method of accounting is used if investor is owns 20% to 50% ownership of investee’s stock
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