Chapter 7 – Receivables (2)

Topics:
 Valuing and reporting accounts receivable
 Estimating expected credit loss
 Accounting for notes receivable
 Foreign currency transactions (skip this part; it
will be included in Exam 3)
Valuing and Reporting Accounts Receivable

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Extending Credit to Customers
 Benefit: generating more sales and following
competitor’s practices
 Cost: some people eventually won’t pay (i.e. there
will be uncollectible accounts or bad debts)

 How do we account for potential bad debts?

 Direct write-off method is not acceptable for financial
reporting purpose.
 Use the Allowance Method

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Direct Write-off Method (not allowed under IFRS)
Assume that one year later, the company writes off the customer’s
$400 remaining balance as uncollectible. The journal entry is
(intuitive but wrong):

Bad debts expense 400

Accounts receivable 400

Theoretically undesirable:
 No matching.
 Receivable not stated at cash realizable value.
 Not acceptable for financial reporting.

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 Allowance Method
 Expected credit loss is
 an estimate of uncollectible accounts (or bad debts)
 reported as an adjusting entry at the end of the accounting
period.
 In the past, it was called bad debt expense.

 When certain that a specific customer’s account receivables will

be uncollectible, write off the amount from the “Accounts
Receivable” and “Loss Allowance” (Contra Asset account).

We had “allowance for doubtful accounts” and “allowance for

bad debts” in the past.
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Recording Expected Credit Loss
 Assume that Hot Pot Bakery estimated that due to the economic
downturn and financial difficulties of its customers, the value of
accounts receivable is impaired by $4,500.
Expected Credit Loss 4,500
Loss Allowance 4,500

 Later, Jake Palmer’s receivable for $1,500 is specifically identified

as being uncollectible; Hot Pot Bakery prepared the entry:
Loss Allowance 1,500
Accounts Receivable 1,500
To write off the uncollectible account of Jake Palmer, one of the customers of
Hot Pot Bakery.

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Recording Expected Credit Loss
 Note, the write-off entry has NO effect on Net Income or Total
Assets!!!

Before Write-Off Entry After Write-Off Entry

Accounts receivable $50,000 Accounts receivable $48,500
($50,000 – $1,500)
Less loss allowance 4,500 Less loss allowance 3,000
($4,500 – $1,500)
Net accounts receivable $45,500 Net accounts receivable $45,500

Accounts receivable – Loss allowance = Net accounts receivable

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Reinstate Accounts Receivable
 Later, the customer who filed for bankruptcy gets help from a bank
and resumes operations. He is back in business and it is likely that
he will pay the $1,500 that he owed.
 We need to ‘re-instate’ his account
Accounts Receivable 1,500
Loss Allowance 1,500
To reinstate the balance previously written offs as uncollectible.
There is no income effect and no change in net A/R when we re-instate an account that was previously
written-off.

 Several months later, the customer makes a cash payment:

Cash 1,500
Accounts Receivable 1,500
Received payment in full previously written-off accounts receivable.
(1) No income effect. (2) A/R decreases. (3) No change in total assets (cash increases, and A/R decreases.)

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When to Record Expected Credit Loss?

Recognize expected credit loss

FYE= Fiscal Year End

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Exercise
 You are given the following information for a company:
 The ending balance for loss allowance is $18M
 At the end of the year, the company recorded $4M as
expected credit loss
 $2M were re-instated because customer A came out of
bankruptcy
 There were $3M written-off during the year because customer
B went bankrupt
 Find the beginning balance of loss allowance?

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Solutions

Loss Allowance
Write-off 3M Beginning balance ?
Re-instatement 2M
Expected credit loss 4M
Ending balance 18M

Ans : 18 – 4 – 2+ 3 = $15M

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Estimating Expected Credit Loss

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Methods for Estimating Credit Loss
 Percentage of Receivables
 Method 1: % of Accounts Receivable
 Method 2: Aging of Accounts Receivable

 Percentage of Credit Sales (not allowed under IFRS)

 Why?

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Method 1: % of Accounts Receivable
 Step 1: Find the desired balance of loss allowance.
 Total A/R * Estimated % that will be uncollected
= Desired balance of loss allowance.

 Step 2: Use t-accounts to find the amount of expected credit loss.

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Method 1: % of Accounts Receivable
 Example: Past experience indicates that 15% of the ending
balance for A/R of $600,000 is not collected (Percentage of A/R
Method). 15% *$600,000 = $90,000
1. Balance before adjusting entry at
fiscal year end (FYE)
Loss Allowance
3. Now expected credit loss is Beginning balance 79,000
calculated as the difference.
+?

Ending balance 90,000

**Note that the ending 2. The focus is on determining the desired

balance of loss allowance balance in the loss allowance on the B/S.
is equal to the estimate
based on the aging (or %)
of A/R.

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Method 1: % of Accounts Receivable
What’s the adjusting entry at year-end?

Expected Credit Loss 11,000

Loss Allowance 11,000

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Method 2: Aging of Accounts Receivable
 A refined method of % of A/R.
 Each customer’s account is aged by breaking down the balance
by showing the age (in number of days) of each part of the
balance.

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Method 2: Aging of Accounts Receivable
Assumption: Older A/R are more likely to become uncollectable.

Amount Estimated % Allowance

Uncollectible Required
Current $42,000 2 =$840
0-30 days past due 4,000 3 =$120
31-60 days past due 2,000 5 =$100
61-120 days past due 1,000 20 =$200
121days-6mths past due 800 25 =$200
Over 6 months past due 200 50 =$100
Total expected uncollectible: $1,560

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Method 2: Aging of Accounts Receivable
 Assume loss allowance has a $400 credit balance before the
adjusting entry at year-end (write-offs and reinstatements have
already occurred during the year). What’s the adjusting entry at
year-end?
Expected Credit Loss 1,160
Loss Allowance 1,160

Loss Allowance
Beginning balance 400
Expected credit loss 1,160

Ending balance 1,560

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Method 2: Aging of Accounts Receivable
 Assume loss allowance has a $350 debit balance before the
adjusting entry at year-end (write-offs and reinstatements have
already occurred during the year). What’s the adjusting entry at
year end?
Expected Credit Loss 1,910
Loss Allowance 1,910

Loss Allowance
Beginning balance 350
Expected credit loss 1,910

Ending balance 1,560

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Loss Allowance Bad Debts Balance
 The balance for the loss allowance, before the end-of-period
expected credit loss adjusting entry, can be a:
 Credit – if fewer specific accounts were written-off than
previously estimated; or
 Debit – if more specific accounts were written-off than
previously estimated.

 After the end-of-period adjusting entry the allowance will always

have a credit balance.

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Accounting for Notes Receivable

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Notes Receivable
Companies may grant credit in exchange for a promissory note. A
promissory note is a written promise to pay a specified amount of
money on demand or at a definite time.

Promissory notes may be used

1. when individuals and companies lend or borrow money,
2. when amount of transaction and credit period exceed normal
limits, or
3. in settlement of accounts receivable.

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Notes Receivable
 The face amount: the amount that is written on the note
 The issuance date: the date when the note is issued
 The due date or maturity date: when the note is to be paid
 Interest: the interest rate is often presented on the annual basis

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Notes Receivable
Computing Interest
How to determine maturity date?
When it is expressed in terms of days:
omit the date the note is issued, but include the due date.
When it is expressed in months:
count months.

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Notes Receivable
Recognizing Notes Receivable
Assume that HoHo Tea Co. accepted a 90-day, 12% note that is
dated May 1, to settle an open account of accounts receivable from
CoMo Computer Co., which has a balance of $5,000.

May 1 Notes Receivable - CoMo 5,000

Accounts Receivable - CoMo 5,000

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 Assume there are 360 days in a year; however,
Notes Receivable there are 31 days in May.

Honor of Notes Receivable (Maker pays it in full at its maturity date.)

On July 30, the due date, HoHo Tea Co. records the receipt of $5,150 from
CoMo Computer Co.
July 30 Cash 5,150
Due date: Notes receivable 5,000
30 (May) +30 (June) +30 (July)
Interest revenue 150
(5,000 x 12% x 90/360 = 150)
(Independent from above) If Hoho prepares f/s on June 30, they need to
record the following:
June 30 Interest receivable 100
Interest revenue 100
(5,000 x 12% x 60/360 = 100)
July 30 Cash 5,150
Interest receivable 100
Interest revenue 50 27
Notes Receivable
Dishonor of Notes Receivable (Not paid in full at maturity.)
Assume that CoMo Computer on July 30 indicates that it cannot pay
at the present time. If HoHo Tea does expect eventual collection, it
would make the following entry at the time the note is dishonored
(assuming no previous accrual of interest).

July 30 Accounts receivable - CoMo 5,150

Notes receivable - CoMo 5,000
Interest revenue 150

If does not expect final payment, just write-off notes receivable.

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Foreign Currency Transactions

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Foreign Currency Transactions
 Foreign currency transactions: a sale in which the price is
denominated in a currency other than the currency of the seller’s
home country.
 Receivable is entered at date of sale using current exchange rate.
 Receivable is adjusted at period end to reflect change in
exchange rate. A gain or loss is recognized.
 A gain or loss is recognized when the receivable is paid reflecting
movement in exchange rate since period end.

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Foreign Currency Transactions Example
 Example:
Assume that American Company sold goods with a price of
20,000,000 Korean won on April 23 to one of its Korean
customers. Payment in Korean won is due July 12. American
Company prepares quarterly financial statements on June 30.
The following exchange rates apply:

U.S. Dollar Value of

One Korean Won Event
April 23 $ 0.0010 Sale
June 30 0.0007 Financial Statement prepared
July 12 0.0008 Payment Received on account

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Foreign Currency Transactions Example
 April 23: American Company records the sale and the account
receivable as follows:
Accounts Receivable (fc) 20,000
Sales Revenue 20,000

 The (fc) indicates that the Accounts Receivable asset is

denominated in a foreign currency and, thus, subject to exchange
rate fluctuations.

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Foreign Currency Transactions Example
 June 30: American Company must recognize an exchange loss of
$6,000.
 Old value of A/R = 20,000
 New Value of A/R on 6/30 = 14,000 (A loss)
Foreign Exchange Loss 6,000
Accounts Receivable (fc) 6,000

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Foreign Currency Transactions Example
 July 12: Cash collected from customers
 Old Value of A/R on 6/30 = 14,000
 New value of A/R on July 12 (cash receipt) = 16,000
Cash 16,000
Accounts Receivable (fc) 14,000
Foreign Exchange Gain 2,000

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Foreign Currency Transactions
 This information would be reported in American Company’s three
primary financial statements in the second quarter (ending June 30)
and the third quarter (beginning July 1) as follows:
Second Quarter:

Statement of Comprehensive Income Balance Sheet Statement of Cash Flows

Sales revenue $20,000 Accounts receivable $14,000 Cash collected from customers $ 0
Foreign exchange loss (6,000)

Third Quarter:

Statement of Comprehensive Income Balance Sheet Statement of Cash Flows

Sales revenue $ 0 Cash $16,000 Cash collected from customers $ 16,000

Foreign exchange gain 2,000 Accounts receivable 0

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Assessing How Well Companies Manage Their Receivables
 Please skip this part.
FYI…

Allowance method 備抵法

Direct write-off method 直接沖銷法
% of accounts receivable method 應收帳款餘額百分比法
Aging of accounts receivable method 帳齡分析法
Expected credit loss 預期信用損失
Loss Allowance 備抵壞帳
Contra asset account 資產備抵賬戶

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