A receivable is an amount due from another party.

Accounts receivable are amounts due from

customers for credit sales (not credit card sales). Credit sales are recorded by increasing (debiting)
Accounts Receivable.

In addition to keeping track of the full amount owed by its customers, a company should also maintain a
separate account for each customer that tracks how much a specific customer purchases, has already
paid, and still owes. The general ledger has a single Accounts Receivable account along with its other
financial statement accounts. Then, a supplementary record is created to maintain a separate account
for each customer. This supplementary record is called the accounts receivable ledger (which is also
called the accounts receivable subsidiary ledger).

Returning to our simple illustration, this company's transactions are mainly in cash, but it does make
credit sales to two customers, RDA Electronics and CompStore. On July 1, two journal entries are
recorded in the company's journal. The first is a credit sale of $950 made to CompStore. The second is a
collection of $720 from RDA Electronics from a prior credit sale. (We omit the entry to Dr. Cost of Sales
and Cr. Merchandise Inventory to focus on sales and receivables.)

Journal entries are posted to the ledger. The credit sale is posted with a debit to the Accounts
Receivable account (and a credit to Sales) in the general ledger. The collection is posted with a credit to
the Accounts Receivable (and a debit to Cash) in the general ledger.
In an additional step, we post the amounts affecting our customer accounts to the subsidiary ledger. The
credit sale is posted with a debit to the CompStore account in the accounts receivable ledger. The
collection is posted with a credit to the RDA Electronics account in the accounts receivable ledger. After
computing the account balances, we know that RDA Electronics currently owes $280 (computed from
their beginning balance of $1,000 – the cash collection of $720) and that CompStore currently owes
$2,950 (computed from their beginning balance of $2,000 + the credit sale of $950).

We can also prepare a Schedule of Accounts Receivable, which is a list of the customer account balances
in the Accounts Receivable Ledger. After totaling the customer account balances on the Schedule of
Accounts Receivable, we should make sure that it agrees to the Accounts Receivable account balance in
the general ledger. This check helps ensure that the posting process was performed correctly.

Many sellers, especially retailers, commonly accept credit cards, which is different than credit sales.
Some sellers accept credit cards that are issued by banks and financial institutions, which we cover later.
Other sellers, including many large retailers such as Best Buy, offer their own credit cards directly to
customers. These seller-issued credit cards identify those card-carrying customers as approved credit
customers at the cash register. The entries to record those seller-issued credit card sales, collections
from customers, and the posting of entries to the general ledger and the accounts receivable ledger
generally match the ones that we just discussed.

A customer who uses a seller-issued credit card is charged interest if the full balance owed is not paid
within a specified period of time. When a seller charges interest to a credit card customer, a debit is
recorded to Accounts Receivable and a credit is recorded to Interest Revenue. Those interest charges
are usually referred to as finance charges on the customer's statement.
Another source of customer purchases is to enable customers to pay for products and services using
third-party credit cards, such as Visa, MasterCard, or American Express, and debit cards (also called ATM
or bank cards). This practice gives customers the ability to make purchases without cash or checks.

Numerous retailers allow customers to use third-party credit cards and debit cards instead of granting
credit directly for several reasons.

 First, the seller does not have to decide who gets credit and how much.

 Second, the seller avoids the risk of extending credit to customers who cannot or do not pay;
this risk is transferred to the company issuing the credit card.

 Third, the seller typically receives cash from the card company sooner than if it granted credit
directly to customers.

 Fourth, allowing a variety of credit options for customers has the potential to increase sales
volume.

There are guidelines in how companies account for third-party credit card and debit card sales. When a
customer uses certain credit cards or debit cards, the seller deposits a copy of each card sales receipt in
its bank account just as it deposits a customer's check. The seller then receives the cash immediately
upon deposit. The majority of credit cards, however, require the seller to remit a copy (often
electronically) of each receipt to the card company. Until payment is received from the card company,
the seller has an account receivable from that card company. In both cases, the seller pays a fee for
services provided by the card company, often ranging from 1 percent to 5 percent of card sales. This
charge is deducted from the credit to the seller's account or the cash payment to the seller.

The procedures used in accounting for third-party credit card sales depend on whether cash is received
immediately on deposit or cash receipt is delayed until the credit card company makes the payment.

To illustrate the accounting for credit card sales when cash is received immediately on deposit, let's
assume a store accepts a third-party credit card for sales of $100. The credit card company charges a 4
percent fee and cash is received immediately on deposit. The entry to record this sales includes a debit
to Cash for $96 (computed as $100 – ($100 x 4%)), a debit to Credit Card Expense for $4 (computed as
$100 x 4%), and a credit to Sales for $100. (We ignore any sales tax that is collected and omit the entry
to Dr. Cost of Sales and Cr. Merchandise Inventory to focus on the credit card expense.)
When a company makes credit sales to customers, management knows that some customers will
probably not pay what is owed. When a customer's account becomes past due, the company will try to
collect by contacting the customer and, if unsuccessful, might retain a lawyer or collection agency. If,
after these efforts, the company still cannot collect, the account is considered uncollectible. Such
uncollectible accounts are referred to as bad debts. Why do companies sell on credit if they expect some
accounts to be uncollectible? The answer is that companies believe that granting credit will increase
total sales and net income enough to offset and exceed bad debts.

Companies use two methods to account for uncollectible accounts: (1) direct write-off method and (2)
allowance method. This learning module describes the direct write-off method. The direct write-off
method of accounting for bad debts records the loss from an uncollectible account receivable at the
time it is determined to be uncollectible.

To illustrate, assume that a company determines on January 23 that it cannot collect $520 owed to it by
one of its customers named J. Kent. The entry to recognize (or record) this assumed loss using the direct
write-off method is to debit Bad Debt Expense for $520 and credit Account Receivable––J. Kent for
$520.

When it is posted, the debit will reflect the uncollectible amount in the current period's Bad Debts
Expense account. The credit removes the customer's balance from the Accounts Receivable account in
the general ledger (and the accounts receivable ledger).
Although uncommon, sometimes an account written off is later collected. This can be due to factors
such as continual collection efforts or a customer's good fortune. Let's assume that J. Kent ultimately
sends a check for $520 on March 11. When an account that was written off is later collected in full, two
entries are recorded.

The first entry reverses the January 23 write-off. As such, it includes a debit to Account Receivable––J.
Kent for $520 and a credit to Bad Debt Expense for $520. The second entry records the collection on
account and involves a debit to Cash for $520 and a credit to Account Receivable––J. Kent for $520.

These two entries include a debit to Account Receivable––J. Kent and then a credit to that same
account. The debit and credit will cancel each other out. One might ask: Why not prepare one entry that
includes a debit to Cash and a credit to Bad Debt Expense? The reason is that when we prepare and then
post the two entries, the recovery will then be reflected in the customer account in the accounts
receivable ledger; with one entry, this information would not be captured. Thus, a more complete
customer history will result.
The expense recognition (matching) principle requires expenses to be reported in the same accounting
period as the sales they helped produce. This means that if a company extends credit to customers to
generate more sales, the bad debts expense linked to those sales must be matched and reported in the
same period. Instead of recording bad debts expense in the period in which the sale occurs, the direct
write-off method records that expense when the account becomes uncollectible. Because the sale might
be reported in one period and the bad debt expense in a later period, the direct write-off method is not
allowed by generally accepted accounting principles.

The materiality constraint, which states that an amount can be ignored if its effect on financial
statements is unimportant to users' business decisions, does permit the use of the direct write-off
method if bad debts expense is not material.
When a company makes credit sales to customers, management understands that it is unlikely that
every customer will pay what is owed. When a customer's account becomes past due, the company will
try to collect by contacting the customer and, if unsuccessful, might retain a lawyer or collection agency.
If, after all these efforts, the company still cannot collect, the account will be considered uncollectible.
Such uncollectible accounts are referred to as bad debts. Why do companies sell on credit if they expect
some accounts to be uncollectible? The answer is that companies believe that granting credit will
increase total sales and net income enough to offset bad debts.

Companies use two methods to account for uncollectible accounts: (1) direct write-off method and (2)
allowance method. This learning module describes the allowance method.

The allowance method of accounting for bad debts matches the estimated loss from uncollectible
accounts receivable against the sales they helped produce. We must use estimated losses because when
sales occur, management does not know which customers will not pay their bills. This means that at the
end of each period, the allowance method requires that management estimate the bad debts expected
to result from that period's sales. This method has two advantages over the direct write-off method: (1)
It records estimated bad debts expense in the period when the related sales are recorded and (2) it
reports accounts receivable on the balance sheet at the estimated amount of cash to be collected.
The allowance method estimates bad debts expense at the end of each accounting period and records it
with an adjusting entry.

To illustrate, assume that a company reports credit sales of $300,000 during its first year of operations.
At the end of the first year, $20,000 of credit sales remained uncollected. Based on the experience of
similar businesses, management estimates that $1,500 of its accounts receivable will be uncollectible.
This estimated expense is recorded with a December 31 adjusting entry that includes a debit to Bad
Debt Expense for $1,500 and a credit to Allowance for Doubtful Accounts for $1,500. The estimated Bad
Debts Expense of $1,500 is reported on the income statement (as either a selling expense or an
administrative expense) and is matched against the $300,000 credit sales.

The Allowance for Doubtful Accounts is a contra asset account. A contra account is used instead of
reducing accounts receivable directly because at the time of the adjusting entry, the company does not
know which customers will not pay. After the bad debts adjusting entry is posted, Accounts Receivable
has an account balance of $20,000, which represents the total amount owed by its customers, and the
Allowance for Doubtful Accounts has an account balance of $1,500, which represents the amount that
the company does not expect to collect. The Allowance for Doubtful Accounts credit balance has the
effect of reducing accounts receivable to its estimated realizable value. Realizable value refers to the
expected proceeds from converting an asset into cash.

Frequently, the balance sheet lists Accounts Receivable and then subtracts the Allowance for Doubtful
Accounts to arrive at the estimated realizable value of $18,500. That latter amount represents the cash
that the company expects to collect from customers.

More frequently, the balance sheet does not separately report the Allowance for Doubtful Accounts on
a separate line, but instead as a parenthetical comment as part of Accounts Receivable.
When specific accounts are identified as uncollectible, those specific accounts are written off against the
Allowance for Doubtful Accounts.

To illustrate, assume that a company determines that it cannot collect $520 owed to it by its customer J.
Kent. The entry to recognize (or record) the loss using the allowance method involves a debit to
Allowance for Doubtful Accounts for $520 and a credit to Accounts Receivable––J. Kent for $520.

Because management does not expect to collect from this customer, the amount due from this
customer no longer meets the test for an asset (because no future benefit is expected). Posting this
write-off entry to the Accounts Receivable account removes that amount from this asset account. (It is
also posted to the accounts receivable subsidiary ledger.)

Recall that the $1,500 in the Allowance for Doubtful Accounts represents the estimate of the amount
that the company did not expect to collect from credit customers. We now know that a specific
customer is not expected to pay. As such, when the write-off is posted to the Allowance account, the
balance in that account will represent what we presently expect not to collect.

We see that the write-off does not affect the realizable value of the accounts receivable asset account.
Further, neither total assets nor net income is affected by the write-off of a specific account.
Although uncommon, sometimes an account written off is later collected. This can be due to factors
such as continual collection efforts or a customer's good fortune. Let's assume that J. Kent, who we
wrote off, ultimately sends a check for $520. When an account that was written off is later collected in
full, two entries are prepared.

The first entry is to reverse the write-off. It involves a debit to Accounts Receivable––J. Kent for $520––
and a credit to Allowance for Doubtful Accounts for $520. The second entry is to record the collection on
account and involves a debit to Cash for $520 and a credit to Accounts Receivable––J. Kent for $520.

We see that these two entries include first a debit to Accounts Receivable––J. Kent––and then second a
credit to that same account. The debit and credit cancel each other out. We might ask: Why not prepare
one entry that includes a debit to Cash and a credit to Allowance for Doubtful Accounts? The answer is
that when we prepare and then post these two entries, the recovery is then reflected in the customer
account in the accounts receivable ledger. This means that a more complete customer history is
prepared.
The allowance method requires an estimate of bad debts expense to prepare the adjusting entry at the
end of each accounting period. There are two common methods for determining that estimate: (1) the
percent of sales method and (2) the accounts receivable methods.

The first method is based on the income statement relation between bad debts expense and sales. This
percent of sales method, which is also referred to as the income statement method, uses the sales
number that is reported on the income statement to determine the bad debts expense number that is
also reported on the income statement.

The percent of sales method is based on the idea that a given percent of a company's credit sales for the
period is uncollectible. To illustrate, let's assume that, based on past experience, management estimates
that 0.6 percent of credit sales will be uncollectible. That percent is commonly determined by
considering the company's experience over the past few years. Net write-offs (that is, write-offs less
recoveries) for the chosen period of time are compared to credit sales over that same period. After this
historical loss percent is determined, managers adjust the percent to ensure that it is not too high or too
low given current economic and operating conditions.
Extending our illustration, let's assume that the company has credit sales of $400,000 in the current
year. The estimated bad debt expense for this year is then $2,400 (computed as $400,000 x 0.006). The
period-end adjusting entry to record this estimated expense involves a debit to Bad Debt Expense for
$2,400 and a credit to Allowance for Doubtful Accounts for $2,400

This method requires only limited data (credit sales, write-offs, and recoveries) to be collected by the
company. Then, after determining the loss estimate, we simply use that estimate for the period-end
adjusting entry.
900000*6%=18000

Now, we describe the second method, which is based on the balance sheet relation between accounts
receivable and the allowance for doubtful accounts.

The goal of the bad debts adjusting entry for this method is to adjust the Allowance for Doubtful
Accounts balance so that it equals the portion of accounts receivable that is estimated to be
uncollectible. The estimated balance for the allowance account is obtained in one of two ways: (1)
computing the percent uncollectible from the total accounts receivable or (2) aging accounts receivable.

For this method, the company must maintain, collect, and work with a large set of data to estimate the
expected allowance for uncollectibles. Then, the company must review the current balance in the
Allowance account, compare it to the estimate, and determine the amount of the adjustment required
to make the Allowance account balance equal to that estimate.

The accounts receivable methods, also referred to as balance sheet methods, use balance sheet
relations to estimate bad debts—mainly the relation between accounts receivable and the allowance
amount. The goal of these methods is to adjust the Allowance for Doubtful Accounts balance so that the
adjusted balance in that account is equal to the estimate of the uncollectible accounts receivable.

We start by looking at the total accounts receivable approach to arrive at our estimate.

The percent of accounts receivable approach assumes that a given percent of a company's receivables is
uncollectible. This percent is based on past experience and is impacted by current conditions such as
economic trends and customer difficulties. The total dollar amount of all receivables is multiplied by this
percent to get the estimated dollar amount of uncollectible accounts—reported in the balance sheet as
the Allowance for Doubtful Accounts.
 To illustrate, assume that a
company has $50,000 of accounts receivable at December 31, 2015. Experience suggests 5 percent of its
receivables is uncollectible. This means that after the adjusting entry is posted, we want the Allowance
for Doubtful Accounts to show a $2,500 credit balance.

The company's Allowance for Doubtful Accounts had a $2,200 balance at the beginning of the year.
During 2015, accounts of customers were written off on February 6, July 10, and November 20. Thus, the
account has a $200 credit balance before adjustment. Recall that this account should have a $2,500
adjusted balance (based on our previous estimate) at December 31, 2015. Therefore, we must enter a
credit of $2,300 to turn the $200 unadjusted credit balance into the desired $2,500 adjusted credit
balance.

Thus, the year-end adjusting entry requires a debit to Bad Debt Expense for $2,300 and a credit of
$2,300 to the Allowance for Doubtful Accounts.
The second accounts receivable method, known as the aging of accounts receivable method, uses both
past and current receivables information to estimate the allowance amount. Specifically, each receivable
is classified by how long it is past its due date. Then estimates of uncollectible amounts are made
assuming that the longer an amount is past due, the less likely it is to be collected. After the amounts
are classified (or aged), experience is used to estimate the percent of each uncollectible class. These
percents are applied to the amounts in each class and then totaled to get the estimated balance of the
Allowance for Doubtful Accounts.

This schedule illustrates the computations for the aging of receivables. Each customer's outstanding
invoice amounts are assigned to one of several classes based on its days past due. The amounts in each
class are totaled. Then, each of those amounts is multiplied by the historical loss percents, which are
reviewed regularly to reflect changes in the company and economy, for each class. The total estimated
uncollectible amount for each class are then summed to arrive at a total estimated uncollectible
amount. The final total of $2,270 is the total estimated uncollectible. We must adjust the Allowance for
Doubtful Accounts so that its adjusted account balance equals $2,270.

Returning to our illustration, if the Allowance account has a $200 credit balance before adjustment, and
we know that this account must have a $2,270 adjusted balance, then we must enter a credit of $2,070
to turn the $200 unadjusted credit balance into a $2,270 adjusted credit balance.

Therefore, the necessary year-end adjusting entry should have a debit to Bad Debt Expense for $2,070
and a credit of $2,070 to the Allowance for Doubtful Accounts.

The aging of accounts receivable method examines specific accounts and is usually the most accurate of
the estimation methods.
Next, let's assume that the Allowance account had an unadjusted debit balance of $500 (instead of the
$200 credit balance). A contra asset account normally has a credit balance. So, how can it have an
unadjusted debit balance? Again, let's assume that the beginning balance was a credit of $200. If the
current year's write-offs totaled $700, those write-offs are debited to the Allowance account resulting in
an ending debit balance of $500.

Once again, let's presume that the Allowance account has a $500 debit balance before adjustment.
Recall that we have estimated the uncollectible accounts to be $2,270. As such, this account must end
up with a $2,270 adjusted credit balance. We must therefore enter a credit of $2,770 to turn the $500
unadjusted debit balance into a $2,270 adjusted credit balance.

Thus, the necessary year-end adjusting entry has a debit to Bad Debt Expense for $2,770 and a credit of
$2,770 to the Allowance for Doubtful Accounts.
Grey Corporation has $100,000 of accounts receivable on December 31, 2015. The unadjusted balance
of its Allowance for Doubtful Accounts is a credit of $1,000. Experience suggests 5 percent of its
receivables will be uncollectible. The amount that should be debited to Bad Debt Expense and credited
to Allowance for Doubtful Accounts in the year-end adjusting entry is _____.

correct answer:

$4,000

feedback:

The desired balance in the Allowance for Doubtful Accounts is $5,000 (computed as $100,000 x 5%).
Because the unadjusted balance of the Allowance for Doubtful Accounts is a credit of $1,000, a credit of
$4,000 must be entered to this account to bring the balance to an adjusted credit balance of $5,000.
(The adjusting entry involves a debit to Bad Debt Expense for $4,000 and a credit to Allowance for
Doubtful Accounts for $4,000.)

Bailey Company has $200,000 of accounts receivable on December 31, 2015. The unadjusted balance of
its Allowance for Doubtful Accounts is a debit of $9,000. An aging of its accounts receivable suggests
that $12,000 of its receivables will be uncollectible. The amount that should be debited to Bad Debt
Expense and credited to Allowance for Doubtful Accounts in the year-end adjusting entry is _____.

correct answer:

$21,000

feedback:

The desired balance in the Allowance for Doubtful Accounts is $12,000 (computed as $200,000 x 6%).
Because the unadjusted balance of the Allowance for Doubtful Accounts is a debit of $9,000, then a
credit of $21,000 must be entered to this account to bring the balance to an adjusted credit balance of
$12,000. (The adjusting entry involves a debit to Bad Debt Expense for $21,000 and a credit to
Allowance for Doubtful Accounts for $21,000.)

A promissory note (or note) is a written promise to pay a specified amount of money, usually with
interest, either on demand or at a stated future date. Promissory notes are used in many transactions,
including paying for products and services, and lending and borrowing money. Sellers sometimes ask for
a note to replace an account receivable when a customer requests additional time to pay a past-due
account. For legal reasons, sellers generally prefer to receive notes when the credit period is long and
when the receivable is for a large amount. If a lawsuit is needed to collect from a customer, a note is the
buyer's written acknowledgment of the debt, its amount, and its terms. Because accounts receivable
and notes receivable have different legal standings, they are accounted for separately.

Let's assume that Julia Browne met with a loan office at First National Bank. They agreed upon the
following terms, which are evidenced in the note that Julia signed on July 10. As the one who signed the
note and promised to pay it at maturity, Browne is the maker of the note. First National is the payee of
the note. To Browne, the note is a liability called a note payable. To First National Bank, the same note is
an asset called a note receivable.

The amount borrowed, $1,000, is referred to as the principal of a note. This amount must be repaid on
October 8, referred to as the due date or the maturity date. This note bears interest at 12 percent, as
written on the note. To a borrower, interest is an expense. To a lender, it is revenue.

The maturity date of a note is the day the note (principal and interest) must be repaid. The period of a
note is the time from the note's (contract) date to its maturity date.

Many notes include a maturity period expressed in days. When the time of a note is expressed in days,
its maturity date is the specified number of days after the note's date. Each day (not just business days)
is counted, starting with the day after the date of the note. For example, to determine the maturity date
of a five-day note dated June 15, we count forward five days (that is, June 16, 17, 18, 19, and 20) to
arrive at the maturity date of June 20.

When a time period exceeding 30 days is specified, it might be helpful to set up a schedule to determine
the maturity date. Let's consider a 90-day note dated July 10. Start with the number of days in the
month, which includes the date of the note (July has 31 days). Subtract the date of the note (July 10)
from the number of days in that first month—this leaves 21 days in the month of July. Add the number
of days in the next month (August has 31 days) and then add the number of days in the next month
(September has 30 days). As we approach the number of days in the period of the note (this is a 90-day
note), pause and see how close we are. At this point, we have counted forward 82 days (21 + 31+ 30)
and, accordingly, have only 8 days left (or 90 – 82). As a result, the note matures on the 8th of the
following month (October 8). We have now counted all of the days in the period of the note (or 90
days).

The period of a note is sometimes expressed in months or years. When months are used, the note
matures on the same day of the month as its original date. A three-month note dated January 10, for
instance, is payable on April 10. The same analysis applies when years are used.

Interest is the expense of borrowing money for the borrower or, alternatively, the revenue from lending
money for the lender. Unless otherwise stated, the rate of interest on a note is the rate charged for the
use of the principal for one year (sometimes referred to as annual or per annum interest rate). The
interest due on a note is calculated by multiplying the principal of the note by the annual interest rate
by the time period expressed as a fraction of a year.

Prior to widespread use of calculators and computers, when businesses had to perform interest
calculations manually, it was simpler to assume that a year had 360 (rather than 365 days). For example,
it is much easier to convert 90/360 to 0.25 (than to divide 90 by 365). As such, to simplify computations,
bankers used a 360-day year (called the banker's rule). Even though it is much easier to perform interest
calculations today, many lenders have continued to use the banker's rule. Further, some might argue
this is the primary reason for the use of 360 in the denominator. It means that banks earn higher
interest revenue from notes when contracts are specified using the banker's rule. For these reasons, and
its continued widespread use in practice, we use the banker's rule and treat a year as having 360 days
for interest computations.
To illustrate, let's compute the interest that is due on the promissory note that we introduced earlier.
That note was a 90-day, 12 percent, $1,000 note. Total interest for those 90 days equals $30, computed
as $1,000 x 12% x 90/360.

Let's look at how notes commonly arise and are recorded. Assume that Lansing Products, Inc., accepts a
$1,000, 90-day, 12 percent note from a customer at the time of a product sale. The entry made by
Lansing Products to record this transaction has a debit to Notes Receivable and a credit to Sales. The
note is reported as an asset, a current asset in this case, until it matures.

Let's consider another source of notes receivable. Specifically, a seller can accept a note from an
overdue customer as a way to grant a time extension on a past-due account receivable. The seller might
or might not collect part of the past-due balance in cash and prepare a note for the customer's signature
for the balance due. This partial payment forces a concession from the customer, reduces the
customer's debt (and the seller's risk), and produces a note for a smaller amount.

Let's assume that Lansing Products agrees to accept $232 in cash along with a $600, 60-day, 15 percent
note from Jo Cook to settle her $832 past-due account. The entry to record this transaction has a debit
to Cash for $232, a debit to Notes Receivable for $600, and a credit to Accounts Receivable––J. Cook for
$832. This transaction converts the asset accounts receivable to two new assets: cash and notes
receivable.
A note is a written promise to pay a specified amount of money, usually with interest, either on demand
or at a definite future date. The principal and interest of a note are due on its maturity date. The maker
of the note usually honors the written promise by paying the full amount (principal and any interest) due
on that date. If payment is not made on or before the maturity date, the maker of the note has
dishonored the written promise.
Let's consider a situation in which the maker honors the note. Assume that on October 5, Lansing
Products, Inc., agreed to accept a $600, 60-day, 15 percent note from Jo Cook who then honored the
note by making a payment of $615 on December 4. That payment consisted of the principal of $600 plus
interest in the amount of $15 (computed as $600 x 15% x 60/360). Lansing records this transaction with
a debit to Cash for $615, a credit to Notes Receivable for $600, and a credit to Interest Revenue for $15.
The interest revenue, sometimes called interest earned or interest income, is reported on Lansing's
income statement.

Let's consider a situation in which the maker dishonors the note. The act of dishonoring a note does not
relieve the maker of the obligation to pay. The maker's written promise to pay expires on the maturity
date. As such, when a note is dishonored, we now have an oral or implied promise to pay. This means
that when a note is dishonored, we must remove the note from the Notes Receivable account and
classify it instead as Accounts Receivable.

To illustrate, let's assume that Lansing Products held an $800, 12 percent, 60-day note signed by Greg
Hart on August 15. At maturity, Hart dishonors the note. At this point, Hart owes a total of $816, which
consists of the principal of $800 plus interest in the amount of $16 (or $800 x 12% x 60/360). Lansing
Products must record the October 14 dishonoring of the note with a debit to Accounts Receivable––G.
Hart for $816, a credit to Notes Receivable for $800 and a credit to Interest Revenue for $16.

After this October 14 entry, Lansing Products should contact Greg Hart to discuss a new payment plan,
and after the terms are negotiated, Hart should be asked to sign a new note setting forth those terms.
That new note should include a principal amount of $816, the new amount owed that includes interest.
If the new note is signed, Lansing will then move the amount from Accounts Receivable to Notes
Receivable.
When notes receivable are outstanding at the end of a period, any accrued interest (or owed) must be
computed and recorded. This is because the payee of the note has earned interest from the date of the
note through the end of the accounting period.

To illustrate, let's assume that Gustafson, Inc., accepted a $3,000, 60-day, 12 percent note from a
customer in granting an extension on a past-due account on December 16. Gustafson's accounting
period ends on December 31. As such, because 15 days have passed (computed as 31, which is the last
day in the period minus 16, which is the date the note was signed), then Gustafson has earned (maker of
the note) $15 of interest for these 15 days (computed as $3,000 x 12% x 15/360). So that the income
statement shows all revenue earned and the balance sheet shows all amounts owed, Gustafson must
record a December 31 adjusting entry, which has a debit to Interest Receivable for $15 and a credit to
Interest Revenue for $15. The interest receivable is included as a current asset on the balance sheet at
December 31, and the interest revenue is reported on December's income statement.
feedback

Because the note was signed on May 31, the note has been outstanding for 30 days (June 1 through
June 30) as of June 30. The adjusting entry has a debit to Interest Receivable for $125 (computed as
$15,000 x 10% x 30/360) and a credit to Interest Revenue for $125.

Extending our illustration for Gustafson, Inc., let's now assume that the December 16 note is honored on
February 14 of the next year. At this point, another 45 days have passed (31 in January and 14 in
February). Gustafson's entry to record the cash receipt has a debit to Cash for $3,060 (computed as
$3,000 + ($3,000 x 12% x 60/360), a credit to Interest Revenue for $45 (computed as $3,000 x 12% x
45/360), a credit to Interest Receivable for $15 (computed as $3,000 x 12% x 15/360), and a credit to
Notes Receivable for $3,000 (the principal).
eedback

Interest of $750 (computed as $15,000 x 10% x 180/360) is due at maturity. Between June 30 and
November 27, a total of 150 days passed (31 in July + 31 in August + 30 in September + 31 in October +
27 in November). The November 27 entry has a debit to Cash for $15,750 (computed as $15,000 +
$750), a credit to Interest Revenue for $625 (computed as $15,000 x 10% x 150/360), a credit to Interest
Receivable for $125, and a credit to Notes Receivable for $15,000 (the principal).

A company can sell all or a portion of its receivables to a finance company or bank. The buyer, called a
factor, charges the seller a factoring fee and then the buyer takes ownership of the receivables and
receives cash when those receivables come due. By incurring a factoring fee, the seller receives cash
earlier and can pass the risk of bad debts to the factor. The seller can also choose to avoid costs of billing
and accounting for the receivables.

To illustrate, let's assume that Darvin Furniture sells $20,000 of its accounts receivable and is charged a
4 percent factoring fee. The entry to record the sale has a debit to Cash for $19,200 (computed as
$20,000 x (100% - 4%), a debit to Factoring Fee Expense for $800 (computed as $20,000 x 4%), and a
credit to Accounts Receivable for $20,000. In this case, the asset Accounts Receivable is converted into
the asset Cash, but minus a factoring fee expense.
A company can raise cash by borrowing money and pledging its receivables as security (also called
collateral as security) for the loan. Pledging receivables does not transfer the risk of bad debts to the
lender because the borrower retains ownership of the receivables. If the borrower defaults on the loan,
the lender has a right to be paid from the cash receipts of the receivable when collected.

To illustrate, assume that on August 20, Darvin Furniture borrows $35,000 and pledges $40,000 of its
accounts receivables as security. The entry to record this transaction has a debit to Cash for $35,000
(the amount borrowed) and a credit to Notes Payable for $35,000. Because pledged receivables are
committed as security for a specific loan, the borrower's financial statements must disclose the pledging
arrangement. Darvin's financial statements includes the following footnote: Accounts receivable in the
amount of $40,000 are pledged as security for a $35,000 note payable.
A company that sells on credit should assess both the quality and liquidity of its accounts receivable.
Quality of receivables refers to the likelihood of collection without loss. Experience shows that the
longer receivables are outstanding beyond their due date, the lower the likelihood of collection.
Liquidity of receivables refers to the speed of collection.

Accounts receivable turnover is a measure of both the quality and liquidity of accounts receivable. It
indicates how often, on average, receivables are received and collected during the period. This ratio is
calculated by dividing net sales by average accounts receivable, net. Ideally, if the information is
available, net credit sales should be used in the numerator because cash sales do not create receivables.
However, because financial statements rarely report net credit sales, analysts typically use net sales.

Accounts receivable turnover also reflects how well management is doing in granting credit to
customers in a desire to increase sales. A high turnover in comparison with competitors suggests that
management should consider using more liberal credit terms to increase sales. A low turnover suggests
management should consider stricter credit terms and more aggressive collection efforts to avoid having
its resources tied up in accounts receivable.

Marion Industries has an average accounts receivable turnover ratio of 12 times per year whereas most
of its competitors have a ratio nearer to 8 times. This suggests that Marion’s management should
consider _____.

correct answer: using more liberal credit terms to increase sales

feedback: Accounts receivable turnover also reflects how well management is doing in granting credit to
customers in a desire to increase sales. A high turnover in comparison with competitors suggests that
management should consider using more liberal credit terms to increase sales. A low turnover suggests
management should consider stricter credit terms and more aggressive collection efforts to avoid having
its resources tied up in accounts receivable.
Let's apply accounts receivable turnover to better understand a business. Assume that we operate a
successful neighborhood bakery. We recently expanded operations and now sell baked goods to local
restaurants. Customers who visit our bakery pay with cash or credit cards, but we sell to the
restaurants on credit.

Our net credit sales total $120,000 for 2015. As of December 31, 2014, our balance sheet has accounts
receivable, net of $17,500. Our accounts receivable net grew to $22,500 at December 31, 2015.

Because accounts receivable turnover uses net sales for the entire year, we divide net sales by the
average of receivables from the balance sheet. Average accounts receivable, net equals the sum of
our beginning accounts receivable, net of $17,500 + our ending accounts receivable, net of $22,500
divided by 2, which equals $20,000.

Accounts receivable turnover is then calculated as follows. Net credit sales of $120,000 divided by
average accounts receivable, net of $20,000 equals 6.0.

Our accounts receivable turned over six times during the year. Imagine that we sell on credit, collect
from those customers, sell on credit again, collect again, and so on. (Of course, we would sell on credit
and collect from customers throughout the year, but this visual helps us appreciate what this ratio
measures.) Given that our accounts receivable inventory turnover was 6.0, we would sell on credit
and collect receivables a total of six times this year.

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