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NOVEMBER 30, 2009
The sale and purchase of merchandise involves exchanges cash for goods or services. Goods are
exchanged usually before cash is actually given. Oakley, Inc allows its distributors to purchase
sunglasses on account as receivables.
Individuals might build up a trusted financial history with a company or store that allows
purchases on account. Purchases on account are recorded as account receivables and are current assets
to many businesses. In classifying receivables, sales on account are normally accounts receivables or
notes receivables. Receivables includes all money claims and are significant portion of the total current
Accounts receivable is the most common transactions creating a receivable by selling
merchandise or services on credit or on account. Account receivable are normally recorded as a debit.
Receivables are collected within a short period of time, usually within 30 days or net 30 according to
the video. They are recorded on the balance sheet as a current asset.
Notes receivable are formal, written instructions of credit that customers owe. Interest is added
to notes receivables due to status of current assets that usually last more than 60 days. Notes usually
have a monthly payment agreement such as mortgages and car payments. Notes can be used to settle a
customer's account receivable account. These are sometimes called trade receivables.
Other receivables include interest,taxes, and from officers or employee, and are reported
separately on the balance sheet. They are expected to be collected within a year. They are classified as
non-current assets and reported under the caption Investments.
Uncollectible receivables are incurred when customers refuse or do not pay their accounts.
These account receivable will be uncollectible. Companies may shift the risk of uncollectible
receivables to other companies. Some retailers do not accept sales on account, but will accept cash or
credit cards. This gives the risk to credit card companies.
Companies may sell their receivables. These companies issues their own credit cards such as
Macy's and JCPenney. Selling receivables is called factoring. The buyer is called the factor. The seller
receives the advantage of factoring immediately in cash for operating and other needs. Some of the risk
is shifted to the factor.
Regarding of how careful a company is in granting credit, some will still be uncollectible. The
operating expense will be recorded as bad debt expense, uncollectible accounts expense, or doubtful
accounts expense.
Some indications that an account may become uncollectible include:
(1) The receivable is past due.
(2) The customer does not respond to the company's attempts to collect.
(3) The customer files for bankruptcy.
(4) The customer closes its business.
(5) The company cannot locate the customer.
(6) If a customer doesn't pay, a company may sent the account to a collection agency.
(7) The remaining balance becomes worthless.
There are two methods of accounting for uncollectible receivables. One is the direct write-off
method that records bad debt expense only when an account is worthless.
The other method is the allowance method that records bad debt expense by estimating
uncollectible accounts at the end of the accounting period.
The direct method is used by small companies and companies with few receivables. GAAP
require companies with a large amount of receivables to use the allowance method. Most well-known
companies use the allowance method.
The direct write-off method is not recorded until the customer's account is worthless. When it is
determined as worthless, it is written off. The Bad Debt Expense is debited. The account receivable is
credited. An account receivable that has been written off may or can be collected later. If this happens,
the account is reinstated by entering the reverses of the write-off entry. The cash received is recorded as
a receipt on account. The account receivable is debited and the bad debt expense is credited. Cash is
debited and accounts receivable is credited.
The direct write-off method is used by businesses that sell for cash or accept only VISA or
MasterCard recorded as cash sales. Meaning that receivables are a small part of the current assets and
any bad debt expense is small. These businesses include some restaurants, convenience stores, and
small retail stores.
The second method for uncollectible accounts is the allowance method. It estimates the
uncollectible accounts receivable at the end of the accounting period. In this case, the Bad Debt
Expense is an adjusting entry. The balance includes some past due accounts.
Specific accounts can not be decreased or credited. This calls for a contra asset account,
Allowance for Doubtful Accounts, and is credited for the estimated bad debts.
The adjusting entry reduces receivables to their net realizable value. It matches the uncollectible
expense with revenues. The adjusting entry affects the income statement and balance sheet.
On the balance sheet, the value of the receivables is reduced to the amount that is expected to be
collected or realized. The balance is the total amount owed by customers on account and should be
supported by the accounts receivable subsidiary ledger. The accounts receivable contra account is the
Allowance for Doubtful Accounts.
According to the video, the good news is the allowance method is consistent with the matching
principle. However, the direct method is not. It is considered the bad news.
Write-offs to the Allowance Account are considered when a customer's account is identified as
uncollectible. The company has to remove the specific accounts receivable and an equal amount from
the allowance account. The Allowance for Doubtful Accounts is debited and Account Receivables is
At the end of a period, the Allowance for Doubtful Accounts will have a balance because it is
based on an estimate. The total write-offs will during the period rarely equal the balance of the account
at the beginning of the period. The balance at the end of the period will be credit if the write-offs during
the period are less than the beginning. If write-offs exceeds the beginning balance it will be debit.
In other words, the allowance method fills the bucket with the adjusting entry and writing off
empties the bucket. After the period ends and is recorded, Allowance for Doubtful Accounts always
have a credit balance.
Estimating collectibles is required by the allowance method at the end of the period. Estimates
are based on past experience, industry averages, and future forecasts. This is done by the percentage
method or the analysis of the receivables method. Under percentage,the portion of sales to sales is
constant, the total sales may apply to total sales or net sales. The adjusted entry is posted to the ledger.
The estimate is added to any balance in Allowance of Doubtful Accounts.
Analysis of Receivables Method is based on assumption that the longer the account receivable
is outstanding, the less likely it will be collected. This includes the due date determination and the
number of days each account is past due(including the date of analysis). Each account is placed in a age
class. The total is determined and multiplied by an estimated percentage for that class. The estimated is
determined as the sum. This is the overall age process called aging the receivables.
Notes receivables have a maturity value which is the amount that must be paid at the due date of
the note which is the sum of the face amount and the interest. A promissory note may be received by a
company from a customer to replace an account receivable and is recorded as a note receivable.
All receivables are expected to be realized in cash within a year are reported in the Current
Assets on the balance sheet, in order of liquidity.