Accounts Receivable 149 Chapter 4 Accounts Receivable Related standards: PERS 9 Financial Instruments PERS 15 Revenue from Contracts with Customers Learning Objectives 1. Classify receivables as either current or noncurrent assets. 2. State the timing of recognition and measurement of trade receivables. 3. Estimate the recoverable historical cost of trade receivables. Introduction Receivables are assets that represent contractual rights to receive cash or other asset from another entity. Examples of receivables: a. Accounts receivable - receivables supported by oral or informal promises to pay. These are not supported by formal promissory notes. b. Notes receivable — receivables supported by written or formal promises to pay in the form of promissory notes. Some notes receivable are supported by postdated checks. c. Loans receivable — receivables arising from loans extended by financial institutions, such as banks, financing companies, and lending institutions. Loans receivable are also supported by promissory notes and are generally backed by collateral securities or postdated checks. d. Advances - receivables arising from advances to officers and employees, advances to suppliers, and advances to affiliates. Accrued income — receivables arising from income earned but not yet collected, such as interest income, dividend income, and the like. Scanned with CamScannerDeposits — receivables from reimbursable deposits paid 4, cover potential damages or losses, deposits for guarantee ot performance or payment, and deposits for returnable items (e.g., crates, containers, etc.). ; ; ; g. Claims receivable - receivables from insurance companies fo, casualties sustained, defendants under suit, governmen, agencies for refundable taxes and other remittances, common carriers for damaged or lost goods, and suppliers for retumeg or damaged goods. Trade and Non-trade receivables For non-financial institutions, receivables are classified into (a) Trade receivables and (b) Non-trade receivables. Trade receivables are receivables arising from the sale of goods or services in the ordinary course of business. They include trade accounts receivables and trade notes receivables. Non-traie receivables are receivables arising from other sources. > Trade receivables are classified as current assets when they are expected to be realized in cash within the normal operating cycle or one year, whichever is longer. > Non-trade receivables are classified as current assets only when they are expected to be realized in cash within one year. The normal operating cycle of an entity is the time between the acquisition of assets for processing and their realization in cash or cash equivalents. When the entity’s normal operating cyce is not clearly identifiable, it is assumed to be 12 months. Financial institutions need not classify their receivables trade or non-trade because their statement of financial position is presented based on liquidity, ie,’ no current and noncurrett distinction. However, receivables expected to be realized withi* one year and beyond one year are disclosed in the notes. Financial statement Presentation Trade and non-trade receivables that are currently collectible are combined and presented on the statement of financial position in? Scanned with CamScanner“Accounts Receivable 151 single line item described as “Trade and other receivables.” The preakdown is disclosed in the notes. Abnormal balances in accounts A basic accounting concept is that an asset should never have a credit balance and a liability should never have a debit balance. When such instance occurs, adjustment is needed to eliminate the abnormal balance prior to the preparation of financial statements. Credit balance in accounts receivable Customers’ accounts (accounts receivable) may at times have credit balances resulting from overpayments, advance payments, or errors. Credit balances in customers’ accounts are presented as current liabilities and not offset against receivables. In daily transactions, customers’ accounts in the subsidiary ledger are credited for all cash receipts regardless of whether the cash receipt is for the collection of recorded receivables or as an advance payment for future delivery of goods. When a customer's account is credited for an amount exceeding * the outstanding debit balance; a credit balance would result. For example, ABC Co. has an outstanding receivable of P10,000 from Customer A. Subsequently, Customer A remits P16,000 to. ABC Co. representing payment for the existing receivable and the excess as advance payment for the future delivery of goods. Ina daily transaction basis, ABC Co. will record the collection as follows: Date | Cash “16,000 Accounts receivable - Customer A. 16,000 After recording the above entry, the subsidiary ledger will have the following balance: Scanned with CamScanner152 ___ Chapter g ‘Accounts receivable - Customer A beg. bal. 10,000 16,000 __ collection (6,000) _ end. bal. The following adjusting journal entry (AJE) is needed to eliminate the credit balance in Customer A’s account. Date | Accounts receivable - Customer A 6,000 Advances from customers 6,000 After posting the adjusting entry, the credit balance is eliminated and the account receivable from Customer A will have a zero balance. The “Advances from customers” account is included in current liabilities as part of non-trade payables. Accounts receivable - Customer A beg. bal. 10,000 AJE 6,000 16,000 collection yn bal. Debit balance in accounts payable Suppliers’ accounts (accounts payable) may at times have debit balances resulting also from overpayments, advance payments, or errors. Debit balances in suppliers’ accounts are presented as patt of current assets and not offset against payables. In daily transactions, suppliers’ accounts in the subsidiary ledger are debited for all cash payments regardless of whether the cash payment is for the settlement of recorded payables or @ advance payment for future purchase of goods. When a supplier's account is debited for an amount exceeding the outstanding credit balance, a debit balance would result. For example, ABC Co. has an outstanding payable of P12,000 to Supplier B. Subsequently, ABC Co. pays 17,000 Supplier B representing settlement of the existing payable and thé Scanned with CamScanner‘Accounts Receivable 153 excess as advance payment for the future purchase of goods. In a daily transaction basis, ABC Co. will record the payment as follows: Date | Accounts payable ~ Supplier B 17,000 Cash 17,000 After recording the above entry, the subsidiary ledger will have the following balance: Accounts payable - Supplier B 12,000 beg. bal. payment 17,000 end. bal. (5,000) [ The following adjusting journal entry (AJE) is needed to eliminate the debit balance in Supplier B’s account. Date | Advances to suppliers 5,000 Accounts payable ~ Supplier B 5,000. After posting the adjusting entry, the debit balance is eliminated and the account will have a zero balance. The “Advances to suppliers” account is included in current assets as part of non-trade receivables. The identification of abnormal balances in accounts is normally included as part of audit procedures because of the basic accounting concept that accounts should not have abnormal balances, In a typical audit engagement, ‘theauditor performs an analytical procedure called “scanning” whereby accounts are Scanned for’ abnormal balances. In an audit utilizing computer assisted audit techniques (CAATs), data from the client’s database is uploaded to the auditor’s computer and the CAATs app identifies abnormal balances. These are adjusted before further audit procedures are performed. Scanned with CamScanner154 Chapter 4 Illustration: Trade and other receivables Information from the records of ABC Company is shown below- * Accounts receivable - net of P10,000 credit balance 50,009 e Notes receivable (trade) 5,000 © Notes receivable (non-trade) - P5,000 due in one year 25,000 e Dividends receivable 1,000 ¢ Subscriptions receivable 2,000 * Advances to officers and employees - due in 18 months 4,009 ¢ Accounts payable - net of P6,000 debit balance 3,000 Requirements: Compute for (a) total trade receivables and (b) total current receivables. Solution: Trade receivables: Accounts receivable 50,000 Add back: Credit balance in customers’ accounts 10,00 “Adjusted accounts receivable 60,000 Notes receivable (trade) 5,000 Total trade receivables - Requirement (a) 65,000 Non-trade receivables currently collectible: Notes receivable (non-trade) - current portion only 5,000 Dividends receivable 1,000 Advances to suppliers (from debit balance in accounts payable) _ 6,000 Total current non-trade receivables 12,000 Trade and other receivables - Requirement (b) 7,000 ev Observe the following: : ® Only the current portion of the non-trade notes receivable included because non-trade receivables are classified * current only when they are collectible within one year. ® Dividends receivable are classified as current bec™®’ although dividend receivables are non-trade receivables, they are normally collectible within one year. Scanned with CamScannerAccounts Receivable 155 @ Subscription receivables are presented as contra-equity account (deduction) in shareholders’ equity. Initial measurement Receivables are initially recognized at fair value plus transaction costs. However, trade receivables that do not have a significant financing component are measured at their transaction price in accordance with PFRS 15 Revenue from Contracts with Customers. Transaction price is “the amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties (e.g., some sales taxes).” (PFRS 15.Appdx.A) Moreover, as a practical expedient, PFRS 15 allows the non-discounting of the amount of consideration if it is due within 1 year from the date of transfer of the goods or services. Example: An entity sells goods with a regular selling price of P10,000 for P12,000. Payment is due after 12 months. Under the practical expedient allowed under PFRS 15, the entity may recognize the accounts receivable at P12,000 (ie., the amount of consideration to which the entity expects to be entitled for transferring the goods). Recognition of trade receivables Trade receivable is recognized when the entity has right to consideration that is unconditional. This is normally the case when the control over the promised goods or services is transferred to the customer. However, there may be instances where receivable is Tecognized before control over a promised good or service is transferred to the customer, such as when the unconditional right Tesults from a contractual provision. Scanned with CamScanner156 Chapter 4 A right to consideration is unconditional if only the Passage | of time is required before payment of that consideration is due even if the amount is subject to refund in the future. Terms of sale contract The terms of a sale contract are considered when determining the timing of transfer of control over the goods sold. The following are relevant contract terms: 1. FOB shipping point -.Under FOB shipping point, ownership over the goods sold is transferred to the buyer upon shipment, Accordingly, sales and accounts receivable are recognized on shipment date. 2. FOB destination — Under FOB destination, ownership is ‘transferred only when the buyer receives the * goods. Accordingly, sales and accounts receivable are recognized when the buyer receives the goods. *FOB stands for “free on board.” Example: A seller ships goods on December 29, 20x1 and the customer receives them on January 2, 20x2. Scenario #1: FOB shipping point If the sales term is FOB shipping point, accounts receivable and sales are recognized on December 29, 20x1 (i.e., date of shipment) Consequently, the goods are excluded from the seller’s year-end inventory. Scenario #2: FOB destination If the sales term is FOB destination, accounts receivable and sales are recognized only on January 2, 20x2 (ie., date of receipt delivery). Consequently, the goods in transit are included in seller’s Dec. 31, 20x1 inventory. Scanned with CamScanner“Accounts Receivable 7 Accounting for freight charges ‘Another matter that should be addressed is the accounting for freight charges. Relevant terms follow: 4, Freight prepaid - means the freight is already paid in advance by the seller before shipment. Thus, freight is actually paid by the seller but this does not mean that the seller is the one who is supposed to pay for the freight charges. 2. Freight collect — means the freight is not yet paid upon shipment. The carrier will collect the shipping costs from the buyer upon delivery. Thus, freight is actually paid by the buyer but this does not mean that the buyer is the one who is supposed to pay for the freight charges. * Asarule, the entity who owns the goods being shipped should pay for the shipping costs. No special accounting is necessary if the term of the sales contract is either “FOB shipping point, Freight collect” or “FOB destination, Freight prepaid” because the owner of the goods in transit is also the one who pays for the freight charges. Special accounting arisés when the terms of the sale contract is either (a) “FOB shipping point, Freight prepaid” or (b) “FOB destination, Freight collect.” a. Under FOB shipping point, freight prepaid, the buyer owns the goods being shipped but the seller already paid the shipping costs. b. Under FOB destination, freight collect, the seller owns the goods being shipped but the carrier will be collecting the shipping Costs from the buyer. Mlustration: Goods in-transit On December 27, 20x1, ABC Co. received a sale order for a credit Sale of goods with selling price of 1,000. ABC Co. shipped the 80ods on December 31, 20x1. The buyer received the goods on Scanned with CamScannerChapter 4 hapten 4 January 2, 20x2. The related shipping, costs amounted to 10, Ago Co. collected the receivable on January 5, 20x2. The pertinent entries in the books of ABC Co. under the different terms of sale are as follows: a. FOB shipping point, freight collect Dec. 27, y | oa No entry | -——- - —| Dec. 31, | Accounts receivable 1,000 | ao Sales 1,000 | i to record sale on account | yan 2, r j 20x2 No entry Jan.5, | Cash 1,000 202 | Accounts receivable 1,000 to record settlement of accounts receivable Gv Notice that no journal entry is made for the receipt of sales order (Dec. 27, 20x1). b. FOB destination, freight prepaid Dec.31, | Prepaid freight 10 a = Cash 0 to record prepayment of freight to the carrier Jan.2, | Accounts receivable 1,000 | 202 | Sales 100 to record sale on account Jmn.2, | Freight-out 10 202 Prepaid freight : . 10 to charge prepaid freight to expense Jan.5, | Cash 1,000 a Accounts receivable 10 to record settlement of accounts receivable “Freight-out) only when the related revenue is recognized. ; For proper matching of cost with revenue, the freight pa is deferred (as “Prepaid freight”) and charged to expense ( Scanned with CamScanneraccounts Receivable ia ¢. FOB shipping point, freight prepaid peat, | Accounts receivable 1,010 201 Sales 1,000 Cash 10 to record sale on account and freight paid on behalf of the buyer ba No entry a ym.5, | Cash 1,010 a Accounts receivable 1,010 40 record collection of account receionble inclusive of reimbursement for the freight paid The seller does not recognize freight-out for the freight paid because the buyer is the one who is supposed to pay for the shipping costs. The seller charges the buyer for a reimbursement of the freight through an increase in accounts receivable. Alternatively, a “reimbursement receivable” account may be debited in lieu of “accounts receivable,” most especially when the freight cost is material. d. FOB destination, freight collect Dec. 31, * 20x1 No entry = 2 | Accounts receivable 990 "2 | Freight-out 10 Sales 1,000 to record sale on account and freight accommodated by the buyer fan 5, | Cash 990 Accounts receivable 990 to record collection of account receivable net of reimbursement for the freight a The seller debits freight-out for the shipping costs paid by 'e buyer because the seller is the one who is supposed to pay for the Scanned with CamScanner160 Chapter 4 = aa al iil. . "lc =< shipping costs. The seller reimburses the buyer for the freigh, through a decrease in accounts receivable. Trade discounts and Cash discounts Trade discounts are given to encourage orders in large quantities or to avoid frequent changes in catalogs, to alter prices fo, different quantities purchased, or to hide the true invoice price from competitors. Trade discounts are deducted from the list price when determining the invoice price. Trade discounts are not recorded or not accounted for separately by either the buyer or the seller. Cash discounts are given to encourage prompt payment, Cash discounts are deducted from the invoice price when determining the net amount collectible within the discount period, Cash discounts are accounted for separately. Accounting for Cash discounts There are two accounting treatments for cash discounts — one is in accordance with PFRS 15 Revenue from Contracts with Customers and the other one is in accordance with traditional GAAP. PFRS15 When the consideration includes a variable amount (for example, the customer is given a discount), the entity is required to estimate the amount to which it expects to be entitled in exchange for transferring the promised good or service. The entity then assesses whether there is a high probability that the estimated amount will not significantly change once the uncertainty is resolved. (This is referred to in PFRS 15# ‘constraining estimates of variable consideration.’) . The entity recognizes revenue (and receivable) equal to th estimated amount when it satisfies its performance obligation Ls the contract. * Traditional GAAP : Under traditional GAAP, cash discounts are accounted for either the (a) gross method or (b) net method. sin Scanned with CamScanner“accounts Receivable st a. Gross Method - Under this method, accounts receivable and sales are initially recorded at amounts gross of cash discounts. Cash discounts are recorded only when they are taken by the buyer. Cash discounts taken by the buyer are debited to the “Sales discounts” account, which is a contra-revenue account, i.e., deduction from sales when computing for net sales. Cash discounts not taken by the buyer are not accounted for. b. Net Method - Under this method, accounts receivable and sales are initially recorded at amounts net of cash discounts. Cash discounts not taken by the buyer are credited to the “Sales discounts forfeited” account and included as part of “other income” or “finance income.” Cash discounts taken by the buyer are not accounted for. Accounts receivable recorded at net amount are adjusted for sales discounts that have expired. However, sales are not adjusted for discounts not taken. Cash discounts not taken reflect penalties added to the cash price to encourage prompt payment. That is, sale on account is made at a price slightly higher than the cash price. The cash discount offered offsets the increase. Thus, customers who pay within the discount period actually purchase at the cash price. Those who pay beyond the discount period pay a penalty for the delay - an amount in excess of the cash price. This ‘penalty represented by the “sales discounts forfeited” should not be treated as part of sales revenue but rather as “other income.” Some contend that sales discount forfeited Tepresents income arising from the provision of financing and therefore should be presented as “finance income” or “interest” income,” Mlustration 1: Gross method & Net method (Traditional GAAP) An entity sells inventory with a list price of P10,000 on account under credit terms of 20%, 10%, 2/10, n/30. Notes; Scanned with CamScanner162 deducted from the list price price. discount off the invoice price period of 10 days. After 10 day: to 30 days to settle his account Chapter 4 The “20%” and “10%” pertain to trade discounts. These ayy when determining the invoice The “2/10” means that the buyer is entitled to a 2% cash if he pays within the discount 's, the cash discount expires. The “n/30” means that the buyer is given a credit period of up t. Failure to pay within 30 days renders the account as past due. Customers with past due accounts are not extended further credit. Gross method Net method 1. Sale on account Accounts receivable* Sales 7,200 7,200 *(P10,000 x 80% x 90%) Trade discounts are deducted from the list price to determine the invoice price gross of cash discounts. 80% = 100% minus 20% trade discount 90% = 100% minus 10% trade discount Accounts receivable** 7,056 Sales 7,056 **(P10,000 x 80% x 90% x 98%) Trade and cash discounts are deducted from the list price to determine the invoice price net of cash discounts. 98% = 100% minus 2% cash discount 2, Assume collection is made within the discount period Cash 7,056 Cash 7,056 Sales discounts (7,200 x2%) 144 Accounts receivable 7,056 Accounts receivable 7,200 3. Assume collection is made beyond the discount period Cash 7,200 Cash 7,200 Accounts receivable 7,200 Sales discount forfeited 14 Accounts receivable 7,056 Illustration 2: PFRS 15 An entity sells inventory with a list price of P10,000 on accout! under credit terms of 20%, 10%,’ 2/10, n/30. The entity estimal® that only 80% of the cash discount will be taken and conclude Scanned with CamScannerAccounts Receivable 163 that it is highly probable that a significant reversal in the cumulative amount of revenue recognized will not occur as the uncertainty is resolved. Invoice amount (10,000 x 80% x 90%) 7,200 Multiply by: 2% Total available discount 144 Multiply by: 80% Discount expected to be taken 115.20 Invoice amount 7,200 Less: Discount expected to be taken (115.20) Transaction price 7,084.80 1. Sale on account Accounts receivable 7,084.80 Revenue 7,084.80, 2. Portion collected within the discount period Cash (7,200 x 80% x 98%) 5,644.80 Accounts receivable 5,644.80 3. Portion collected beyond the discount period Cash [(7,200 x 20%) or remaining balance] 1,440.00 |: Accounts receivable 1,440.00 Variation: Estimate does not coincide with actual result Assume that only 70% of the discount is actually taken. 2. Portion collected within the discount period Cash (7,200 x 70% x 98%) 4,939.20 Accounts receivable (7,200 x 70% x 98%) 4,939.20 to record the collection of accounts within the Siscount period. Accounts receivable (7,200 x 10% * x 2%) 14.40 Revenue (7,200 x 10% x 2%) 14.40 Scanned with CamScanner164 Chapter to adjust the transaction price for the difference between the estimate and actual result. —| (80% - 70%) = 10% difference between estimate and actual result. 3. Portion collected beyond the discount period Cash Accounts receivable (7,200 x 30%) 2,160.00 2,160.00 | The PFRS 15 treatment is similar to the net method of traditional GAAP, except that: * PERS 15 requires the entity to consider the probability that the available discount will be taken by the customer. «Any difference between the estimate and the actual outcome is recognized as a prospective adjustment to the transaction price (and, consequently, to revenue and accounts receivable). Illustration 3: PERS 15 (Use of ‘sales discount’ account) Use the information in Illustration 2 except that the entity uses the “Sales discount” account. 1. Sale on account Accounts receivable 7,200.00 Revenue 7,200.00 Sales discount (see computation above) 115.20 Allowance for sales discount 115.20 2. Portion collected within the discount period Cash (7,200 x 80% x 98%) 5,644.80 Allowance for sales discount 115.20 Accounts receivable (7,200 x 80%) : 5,760.00 3. Portion collected beyond the discount period Cash [(7,200 x 20%) or remaining balance] 1,440.00 Accounts receivable isso Scanned with CamScannerAccounts Reo PFRS 15 does not explicitly prohibit the use of discount” and “Allowance for sales discount” accounts, or similar account descriptions. Regardless of whether the “sales discount” account is used, the amounts recognized in the financial statements are the same. Hlustration2 Illustration 3_ ‘Accounts receivable 7,084.80 7,200.00 Allowance for sales discount : (115.20) Accounts receivable - net 7,084.80 7,084.80 Sales 7,084.80 7,200.00 Sales discount - (115.20) Net sales 7,084.80 7,084.80 Subsequent measurement of accounts receivable Accounts receivable are subsequently measured at recoverable historical cost (or net realizable value). Recoverable historical cost (net realizable value) represents the amount of cash expected to be recovered from the contractual cash flows of the receivable. Net realizable value is normally computed as the transaction price minus subsequent repayments of principal and minus any reduction (directly or through the use of an allowance account) for uncollectability or impairment. Estimating the recoverable historical cost of accounts receivable In estimating the recoverable historical cost (net realizable value) of trade accounts receivable, an entity considers the following: a. Sales discounts b. Doubtful accounts Sales discount en discounts are made available to customers, the amount of Consideration may not be wholly recoverable when it is probable that customers will avail of the cash discounts in the future. Scanned with CamScanner166 Chapter 4 4 it As illustrated above (Illustration 2: PFRS 15), the entity considers any discounts that are expected to be taken }, customers when recognizing accounts receivable. At the end of each reporting period, the entity updates the measurement of the accounts receivable. Any adjustment is ‘accounted fo, prospectively as an adjustment to revenue. Illustration: PFRS 15 An entity sells inventory with a list price of P10,000 on account under credit terms of 20%, 10%, 2/10, n/30. The entity estimates that only 80% of the cash discount will be taken and concludes that it is highly probable that a significant reversal in the cumulative amount of revenue recognized will not occur as’ the uncertainty is resolved. The entry when the goods are delivered to the customer is as follows: Accounts receivable 7,084.80 + Revenue 7,084.80* * (10,000 x 80% x 90%) = 7,200 invoice price; [7,200 — (7,200 x 2% x 80%)] = 7,084.80 % Subsequent measurement . The accounts receivable is not yet settled by the end of the reporting period and the entity changes its estimate of cash discount to be taken to 40%, The adjustment is computed as follows: Invoice amount (10,000 x 80% x 90%) 7,200 Multiply by: . _ Total available discount rn Multiply by: Revised estimate ___ 40% Discount expected to be taken (revised) 57.6, Invoice amount 7,200 Less: Discount expected to be taken (revised) __ 7.60) Transaction price (revised) 7,142.40 Less: Transaction price (initial estimate) (7.08480 Adjustment — increase in transaction price ED Scanned with CamScannercounts | Accounts B ing entry is as follows: The year-end adj ‘Accounts receivab Revenue 57.60 The entity reports account receivable of P7,142.40 in its year-end statement of financial position. Allowance for doubtful accounts Credit is often granted to customers to encourage sales. However, the reward of increased sales entails the assumption of risk of loss when customers fail to pay their dues. The recoverable historical cost of receivables is assessed at each reporting date. When collectability becomes doubtful, an allowance is provided to write-down the receivables to their recoverable amount. A basic accounting concept is that assets should not be recognized at more than their recoverable amount. The resulting allowance, commonly termed as “allowance for doubtful accounts,” is treated as a contra-asset (deduction) to accounts receivables when determining net realizable value. Other similar terms include “allowance for bad debts,” “allowance for uncollectible accounts,” “allowance for probable losses on receivables” and “loss allowance.” Accounting for bad debts There are two methods of accounting for bad debts, namely, (a) Allowance method and (b) Direct write-off method. Allowance method As the name implies, an allowance is recognized for bad debts expense when the collectability of accounts becomes doubtful or questionable. This method conforms to the concepts of accrual basis of accounting, matching, and conservatism in that, bad debts &xpenses are recognized when they become probable so as not to overstate receivables. Scanned with CamScanner168 Chapter g When it becomes certain that accounts are uncollectible or worthless (as opposed to being merely ‘doubtful’ of collection), the accounts are written off. te off “An entity shall directly reduce the gross carrying amount of a financial asset (eg, a ape when the entity has no_reasonable_expectations of recovering a financial asset in ils entirety or a_portion thereof. A waite constitutes a derecognition event.” (PFRS9) When accounts previously written-off are subsequently recovered, the previous entry to record the write-off is reversed or reestablished and the collection is recorded in the customary way. Failure to reverse the write-off before recording the recovery results to credit balance in customer’s accounts. Direct write-off method As the name implies, bad debts expense is directly written-off from the balance of accounts receivable only when the accounts are deemed worthless. No entry is made for accounts that are merely doubtful of collection. ‘This method does not conform to the concepts of accrual basis of accounting, matching, and conservatism because bad debts expenses are recognized only when uncollectability becomes certain and not when loss becomes probable. Consequently, receivables may be overstated prior to the write-off. The direct method is usually not acceptable for financial reporting purposes, except for micro-entities (entities with total assets or total liabilities of below P3,000,000). However, the direct write-off method is favored for taxation purposes because bad debt expenses are tax deductible only when accounts receivable are deemed worthless. When accounts Previously written-off are subsequently recovered, the collection is simply tecognized as gain. Scanned with CamScanneraccounts Receivable — 169 IIlustration 1; Allowance method vs. Direct method ¢ Collectability become doubtful 1. Accounts receivable of P10,000 is found to be doubtful of collection. Allowance method Direct method Bad debt expense 10K No entry Allowance for bad debts 10K to record bad debt expense “ Write-off 2. The 10,000 doubtful account is deemed worthless (uncollectability is certain) and needs to written-off. Allowance method Direct method Allowance for bad debts 10K Bad debt expense 10K Accounts receivable 10K Accounts receivable 10K to record the write-off of accounts to record bad debt expense receivable *% Recovery 3. The P10,000 account previously written off is subsequently recovered. Allowance method Direct method Accounts receivable 10K No entry Allowance for bad debts 10K to reverse the previous write-off Cash 10K | Cash 10K Accounts receivable 10K Gain on recovery 10K to record the collection of accounts to record the collection of accounts receivable receivable . 40 Again, only the allowance method is in accordance with the PERSs; the direct method is not. T-Account e effects of the journal entries under the allowance method aby 5 E ve are summarized in the T-account below: Scanned with CamScanner170 Chapterg Allowance for doubtful accounts xx beg. Write-off xx xx Recovery Xx Bad debts expense end. Xx The beginning balance is placed on the credit side of the T. account because the allowance for doubtful accounts (allowance for bag debts) account is a contra asset account to accounts receivable. Illustration 2: Allowance method - Effect on working capital and current ratio. Q Concept: Under the allowance method, the entry to record bad) debt expense decreases profit, total current assets, working capital and current ratio. However, write-offs and recoveries do not) affect profit, total current assets, working capital and current ratio. | © Working capital = Current assets minus Current liabilities | ¢ Current ratio = Current assets divided by Current liabilities | ABC Co. has the following information as of December 31, 20x1. Current assets Current liabilities Cash & cash equivalents P15,000 Accounts payable 20,000 Accounts receivable 35,000 Allowance for bad debts _ (10,000) __Total current assets P40,000__ Total current liabilities 20,000 * Net accounts recéivable is P25,000 (35,000 - 10,000). ¢ Working capital is P20,000 (40,000 - 20,000). © Current ratio is 2 (40,000 + 20,000). % Write-off * P10,000 accounts receivable become worthless. The write-off # recorded as follows: Date Allowance for doubtful accounts 10,000 wl Accounts receivable z Scanned with CamScannerAccounts Receivable aa After posting the entry above, the accounts of ABC Co. will have the following balances. Current assets Current liabilities Cash & cash equivalents 15,000 Accounts payable 20,000 ‘Accounts receivable 25,000 ‘Allowance for bad debts = Total current assets P40,000 Total current liabilities _%20,000 Note that net accounts receivable, total current assets, working capital, and current ratio were unaffected by the write- off. Only the allowance for doubtful accounts was decreased. % Recovery 10,000 accounts receivable previously written-off was subsequently recovered. The recovery is recorded as follows: Date Accounts receivable 10,000 Allowance for doubtful accounts 10,000 Date Cash 10,000 Accounts receivable 10,000 After recording the recovery, the accounts of ABC Co. will have the following balances. Current assets Current liabilities Cash & cash equivalents P25,000 Accounts payable 20,000 Accounts receivable 25,000 Allowance for bad debts (10,000) Total current assets 40,000 _ Total current lial 20,000 Note that total current assets, working capital and current Tatio were unaffected by the recovery, although the allowance for doubtful accounts was increased to (P10,000) and net accounts Teceivable was decreased to P15,000 (25,000 - 10,000) with a Corresponding increase in cash. Scanned with CamScanner172 —EE ee Write-offs and recoveries under the allowance method 4, not affect profit because no expense account is involved jn recording them. Under the direct write-off method, both write-offs ang recoveries affect profit, working capital, and current ratio. Estimating doubtful accounts Bad debt (doubtful accounts) expense is recognized when loss becomes probable and can be measured reliably. There are three methods of estimating doubtful accounts, namely: a. Percentage of net credit sales; b. Percentage of receivables; and c. Aging of receivables. Percentage of credit sales (Single loss-rate approach) Under this method, bad debt expense is computed by applying a percentage on the net credit sales during the period. The bad debt expense is computed without regard to the beginning balance of the allowance for doubtful accounts and write-offs and recoveries recorded during the year. The percentage applied is determined based on the entity’s past experience and careful analysis of the historical relationship between credit sales and bad debts. The percentages normally determined by dividing past bad debt expenses net of past recoveries by past credit sales. A single estimated percentag? is usually sufficient. However, the percentage should b reassessed for appropriateness at least annually. This method favors the income statement in that a strit adherence to the matching principle is attained. Bad debts * based on, and are directly matched to, the sales recognized in? period. The ending balance of the allowance for doubtful accoun’s is equal to the bad debt expense recognized for the period plus ba beginning balance in the allowance account minus write-offs pl recoveries. Scanned with CamScannerAccounts Receivable 173 JIlustration: Percentage of credit sales method ‘ABC Co. has the following information on December 31, 20x1 before any year-end adjustments. Allowance for doubtful accounts, Jan. 1 8,000 Write-offs 5,000 Recoveries 1,000 Sales (including cash sales of P100,000) 600,000 Sales returns and discounts (including P1,000 sales returns on cash sales) 6,000 Accounts receivable, Dec. 31 150,000 Percentage of credit sales 2% Requirements: Compute for the following: a. Bad debt expense b. Allowance for doubtful accounts on December 31 c. Net realizable value of accounts receivable. Solutions: Requirement (a): Bad debt expense - Formula: Bad debt expense = Percentage x Net credit sales Total sales 600,000 Cash sales (100,000) Gross credit sales 500,000 Sales returns and discounts on credit sales (6,000 - 1,000) (5,000) Net credit sales 495,000 Multiply by: Percentage of net credit sales 2% Bad debt expense . __ 9,900 Cash sales are deducted because they are already collected; thus, no allowance for uncollectability is necessary. Sales returns are also deducted because the related receivables have already been derecognized; thus, no allowance is also necessary. Scanned with CamScanner174 7 Chapter 4 Dee.31, | Bad debt expense (Doubtful accounts) 9,900 ge Allowance for doubtful accounts 9,999 The | to record bad debt expense is as follows: —Y Requirement (b): Allowance for doubtful accounts on Dec. 31 The allowance for doubtful accounts on December 31, 20x1 jg computed as follows: Allowance for doubtful accounts 8,000 Jan. 1 Write-off 5,000 | 1,000 Recovery 9,900_ Bad debts expense Dec. 31 (squeeze) 13,900 Requirement (c): Net realizable value of accounts receivable The recoverable historical cost of the accounts receivable as of year-end is computed as follows: Accounts receivable, Dec. 31 - gross 150,000 Allowance for doubtful accounts, Dec. 31 (13,900) Accounts receivable, Dec. 31 -net 136,100 ee Percentage of receivable (Single loss-rate approach) Under this method, the required balance of allowance for doubtful accounts is computed by applying a percentage on the ending balance of the receivables. The difference between the required balance and the unadjusted carrying amount of the allowance fot doubtful accounts (before recognizing bad debt expensé) tepresents the bad debt expense for the period. The percentage applied is determined based on the entity's past experience and careful analysis of the historic! relationship between credit sales and bad debts. The percentage normally determined by dividing past bad debt expenses net 0 Past recoveries by past credit sales. A single estimated percentag? is usually sufficient. However, the percentage should reassessed for appropriateness at least annually. Scanned with CamScannerAccounts Receivable 175 This method favors the statement of financial position in reasonable estimate of the receivables’ net wever, it does not strictly adhere to the because bad debts are recognized based on directly on the sales that it provides a realizable value. Ho concept of matching the ending balance of receivables and not revenue recognized in the period. entage of receivable method Illustration 1: Peres December 31, 20x1 ABC Co. has the following information on before any year-end adjustments. Accounts receivable, Jan. 1 80,000 Net credit sales 270,000 Collections from customers (excluding recoveries) 140,000 Allowance for doubtful accounts, Jan.1 10,000 Write-offs 5,000 Recoveries 1,000 5% Percentage of receivables Requirements: Compute for the following: a. Bad debt expense b. Net realizable value of accounts receivable. Solutions: Requirement (a): Bad debt expense Formula: Required balance of allowance = Percentage x Accounts receivable, end. The ending balance of accounts receivable is computed as follows: Accounts receivable Jan.1 80,000] 5,000 Write-off Collections on accounts Net credit sales 270,000 | 141,000 (140,000+ recovery of 1,000)" Recovery* 1,000 205,000 Dec. 31 — Scanned with CamScanner__ Chapters 176 *Alternatively, recoveries may not be presented on the accounts receivable T-account at all. Remember that the entries to record A recovery involve debiting and crediting accounts receivable, Hence, the recovery of an account previously written off does noy actually affect the balance of gross accounts receivable. Ignoring the recovery, the ending balance of accounts receivable js computed as follows: Accounts receivable Jan.1 80,000 5,000 Write-off Collections on accounts, Net credit sales 270,000 | 140,000 excluding recovery 205,000 Dec. 31 The required balance of allowance for doubtful accounts as of December 31, 20x1 is computed as follows: Accounts receivable, Dec. 31 205,000 Percentage of receivables 5% Allowance for doubtful accounts - Dec. 31 10,250 —_= The bad debt expense for the year is computed as follows: Allowance for doubtful accounts 10,000 Jan.1 1,000 Recovery 4250 Bad debts expense (squeeze) Write-off 5,000 Dec. 31 10,250 The entry to record the bad debts expense is as follows: Dec. 31, es Bad debt expense (Doubtful accounts) 4,250 its Allowance for doubtful account 4,250 Scanned with CamScannerAccounts Receivable in Requirement (b): Net realizable value of accounts receivable ‘accounts receivable, Dec. 31 ~ gross 205,000 ‘Allowance for doubtful accounts, Dec. 31 (10,250) ‘Accounts receivable, Dec. 31 net 194,750 Illustration 2: Computation of percentage ABC Co. has been recognizing bad debt expenses based on the direct write-off method. In 20x4, ABC Co. decided to change to the allowance method and that doubtful accounts shall be estimated using the percentage of receivables method. The percentage is to be computed based on all available historical data up to a maximum of four years. Information for four years is shown below: Year Write-offs __ Recoveries Net credit sales 20x1 7,000 1,000 100,000 20x2 10,000 3,000 160,000 20x3 15,000 5,000 200,000 20x4 28,000 2,000 240,000 60,000 11,000 700,000 The balances of accounts receivables on January 1, 20x4 and December 31, 20x4 are P100,000 and P200,000, respectively. Requirement: Compute for. the doubtful accounts expense to be Tecognized in 20x4. Solution: Formula: Percentage = (Write-offs — Recoveries) ~ (Net credit sales) The percentages to be applied on the beginning and ending balances of receivables in 20x4 are computed as follows: Percentage (Total Write-offs from 20x1 to 20x3) less (Total Gan.1, 20%4) 7 Recoveries from 20x1 to 20x3 Total Net credit sales from 20x1 to 20x3 Scanned with CamScanner178 Chapter 4 = [(7K + 10K + 15K) - (IK +3K + 5K)] + (100K + 160K + 200k) = (32,000 - 9,000) + 460,000 Percentage (Jan. 1, 20x4) = (23,000 + 460,000) = 5% (Total Write-offs from 20x1 to 20x4) less (Total = Recoveries from 20x1 to 20x4) Total Net credit sales from 20x1 to 20x4 = (60,000 - 11,000) + 700,000 Percentage (Dec. 31, 20x4) Percentage (Dec. 31, 20x4) = (49,000 + 700,000) = 7% The doubtful accounts expense is computed as follows: Allowance for doubtful accounts 5,000 Jan. 1, 20x4 (5% x 100,000) 20x4 write-offs 28,000 | 2,000 20x4 recoveries 35,000 Bad debts expense (squeez) Dec. 31, 20x4 (7% x 200,000) 14,000 The entry to record the doubtful accounts in 20x4 is as follows: Dec 31, | Bad debt expense (Doubtful accounts) 35,000 oe Allowance for doubtful accounts 35,000 Aging of receivables (Provision matrix) The aging of receivables method is a variation of the percentage of receivables method. However, under the aging of receivables method, the required balance of allowance for doubtful accounts 1s computed by applying various estimated percentages to the breakdown of the ending receivable according to ages. The age of receivables is determined based either on tH number of days the receivables are outstanding or on the snumbe of days the receivables are past due. scape debt expense is computed similar to the percentage ™ receivables, Scanned with CamScannerAccounts Receivable 179 Entities do not usually prepare an aging schedule solely to determine bad debt expense. Rather, the aging schedule is prepared as a control device to determine the composition of receivables and to identify delinquent accounts. Moreover, PFRS 7 Financial Instruments requires disclosures of past due and not past due receivables. This means that even if entities use either the percentage of credit sales or percentage of receivables, they still need to prepare schedules of aging of receivables. ~The percentages applied to each of the age brackets of receivables are determined based on the entity’s past experience, careful analysis of the historical relationship: between credit sales and bad debts with the advice of credit department personnel, and other available statistics. Normally, larger percentages are applied to older accounts. For regulated entities (e.g., banks), the percentages applied are based on regulations issued by the related regulatory bodies (e.g., Bangko Sentral ng Pilipinas). Just like the percentage of receivables, the aging of receivables method favors the statement of financial position in that it provides a reasonable approximation of the recéivables’ net realizable value. However, it does not strictly adhere to the concept of matching because bad debts are recognized based on the balances of receivables and not directly on the sales revenue recognized in the period. Illustration 1: Aging based on days outstanding ABC Co. has the following information: Days outstanding Receivable balances _% uncollectible 0-60 120,000 1% 61-120 90,000 2% Over 120 100,000 &% etal aceounts receivables 310000 During the year, ABC Co. wrote off P7,000 receivables and "covered P4,000 that had been written-off in prior years. The Scanned with CamScanner