1

Chapter -5
CASH & RECEIVABLES
 5.1 Accounting for Cash 2

Most liquid asset: means can easily transfer from one

person to another and one can not have an ownership
title on cash.
Standard medium of exchange
Basis for measuring and accounting for all items
Current asset
Cash is a financial asset
Examples: Coin, currency, available funds on deposit at the bank,
money orders, checks and savings accounts.
 Internal control over cash
3

What is internal control?

 It is a system (like plans, methods, procedures, etc) designed to safeguard the
assets of a business and to ensure the accuracy and reliability of the accounting
records.

Why control over cash?

 Special controls required over cash, because of;
 It’s high value in relation to its mass
 It’s easy transferability without any legal document
 It’s sensitivity (high liquidity), readily convertible in to any other type of
assets
 Many transactions either directly or indirectly affect the receipts or
payments of cash
 Cont…d
4

What control techniques

could be used to effectively
safeguard cash?
 Principles of internal control
5
To safeguard its assets and enhance the accuracy
and reliability of its accounting records a
company follows specific control principles.
1. Establishment of responsibility:-assignment of responsibility
to a specific individuals.
2. Segregation of duties(separation of function or division of
work):- the responsibility for related activities should be
assigned to different individuals
 The rationale for segregation of duties is that the work of one
employee should, provide a reliable basis for evaluating the
work of another employee.
 Cont…d
6

3.Documantation procedure:- provide evidence that transactions

and events have been occurred.
Procedures
a. Documents should be pre-numbered and all documents should be
accounted for- helps to prevent a transaction from being record or
to prevent the transactions from not being recorded.
b. Documents that are source documents for accounting entries
should be promptly forwarded to the accounting department to
help ensure timely recording of the transaction or events.
 Cont…d
7

4. Physical, mechanical and electrical controls:-

physical control relate primarily to the safeguarding of assets.
 Mechanical and electronic controls safeguard the assets and
enhance the accuracy and reliability of the accounting
records.
5. Independent internal verification:- involves the review,
comparison, and reconciliation of data prepared by one or
several employees.
6. Human Resource Controls:-includes
a. Bond employees who handle cash. Bonding involves
obtaining insurance protection against theft by employees.
 8

b. Rotate employees’ duties and require employees to take

vacations.
 These measures deter employees from attempting thefts since
they will not be able to permanently conceal their improper
actions.

c. Conduct thorough background checks.

 Many believe that the most important and
inexpensive measure any business can take to
reduce employee theft and fraud is for the
human resources department to conduct
thorough background checks.
 Internal control on cash receipts
9

 Since cash can be easily lost or stolen, the system of internal

control over cash receipts should be set by business organizations.

 promptly depositing daily cash receipts in the bank and assigning

the duties of receiving, recording, and depositing cash among

different persons.
 Therefore, it involves immediate counting, daily recording, and

intact deposit.
Application of principles of internal control to cash receipt
10
 Cont…d
11
 Cash short and over
12

 The amount of cash actually received (available in the cash drawer)

during the day often does not agree with the records of cash receipts
(recorded amount on the cash register tape).
 Whenever, there is a difference between the record and the actual cash
on hand and no error can be found in the record, it must be assumed
that the mistake occurred in making changes.
 In this case, the cash shortage or overage is recorded in an account
entitled cash short and over account.
 It is an account used to record the d/ce b/n the recorded balance on the
registered machine and the actual cash on hand
 Cont…
 At the time of cash shortage (i.e., recorded balance is greater than
actual balance).
 Debit the cash short and over account.= misc expense
 At the time of cash overage (i.e., actual balance is greater than
recorded balance).
 Credit the cash short and over account= other income
 To record cash shortage To record cash overage
Cash in bank…………….xxx Cash in bank …………...xxx
Cash short and over……..xxx Sales ……………………xxx
Sales ………………..xxx Cash short and over…….xxx
 Cash Disbursements Controls
14

 Cash is disbursed to pay expenses and liabilities or to purchase

assets.
 Generally, internal control over cash disbursements is more
effective when companies pay by check, rather than by cash.
 many of the internal control for cash disbursement deals with
checks and authorization for cash payments.
 For this purpose the company;
 Maintain a bank account
 Maintain special fund, petty cash fund
 The principles of internal control apply to cash
disbursements
15

i. Establishment of responsibility- Only designated personnel

(treasurer) are authorized to sign checks.
ii. Segregation of duties- Different individuals approve and make
payments; check signers do not record disbursements.
iii. Documentation procedures- Use pre-numbered checks and
account for them in sequence; each check must have approved
invoice.
iv. Physical, mechanical, and electronic controls- Store blank
checks in safes with limited access; print check amounts by
machine with indelible ink.
v. Independent internal verification- Compare checks to invoices;
reconcile bank statement monthly.
vi. Other controls- Stamp invoices PAID.
 Methods of Disbursing and/or safeguarding Cash:
16

a. Electronic Funds Transfer(EFT) System: A new approach

developed to transfer funds among parties without the use of
paper (deposit tickets, checks, etc.).
 The approach, called electronic funds transfers (EFT),uses
wire, telephone, telegraph, or computer to transfer cash from
one location to another.
b. Petty Cash Fund- A cash fund used to pay relatively small
amounts. Involves:
 establishing the fund,
 making payments from the fund, and
 replenishing the fund.
 Cont…d
17

c. Voucher System Controls

Companies use vouchers as part of their internal control over

cash disbursements.
A voucher system is the methods and procedures employed

in verifying and recording liabilities and paying and

recording cash payments.
 The basic idea of this system is that every transaction which will result in a

cash payment must be verified, approved in writing, and recorded before a

check is issued.
 Cont…d
18

A written authorization called a voucher is prepared for

every transaction that will require cash payment, regardless
of whether the transaction is for payment of an expense,
purchase of merchandise or a plant asset, for payment of
liability.
The use of a voucher system would enable that:
(a) the approval of invoices for payment be clearly separated
from the issuance of checks to make such payment.
(b) Every transaction requiring a cash disbursement be
verified and approved before payment is made.
 Control of Cash through Bank Accounts
19

Bank accounts are an important means of cash control and

provide several advantages:
 Cash is physically protected by the bank
 A separate record of cash is maintained by bank
 Cash handling and theft risk are summarized
 Customers may remit payments directly to the bank
 Cont…d
20

There are certain forms used by a business in connection with a bank

account. These are: signature card, deposit ticket, check, and record
of checks drawn
1. Signature card - when you open a bank account, an identifying
number is assigned to your account, and a signature card must
be prepared and signed by you the account holder or any other
person(s) authorized to sign checks drawn on the account.
 The bank later used the signature card to determine the authenticity
of the signature on checks presented to it for payment .
 If the signature presented on the check is not identical with the
signature on the signature card, the bank may refuse to make
payment.
 Cont…d
21

2. Deposit ticket - It is a printed form supplied by the bank

to fill the detail of the deposit.
 A deposit ticket, often called a deposit slip or receipt, is a
list of currency and checks provided by the bank as proof a
deposit was made.
 In other words, it’s a receipt that banks give you for
depositing funds into your account.
3. Check - A check is a written instrument signed by the
depositor, ordering the bank to pay a certain sum of money
to the order of a specified person(s).
 Cont…d
22

Three parties are involved in a check issuance:

(1) The drawer, the one who signs the check. In simple
terms, the drawer is the person or firm who owns the
bank account (the account holder),
(2) The drawee, the bank on which the check is drawn; the
drawee refers to the bank (branch) in which the account
is deposited
(3) The payee, the one to whose order the check is drawn. the
payee refers to the person or firm to whom order the
payment is made.
 Bank Statement
23

A bank statement- contains all checking account

transactions made by the depositor in a given period of
time, usually a month.
A bank statement is prepared by the bank at the end of each
month for all checking account depositors and includes:
 The beginning balance of the cash account,
 All deposits and other credits to the depositor’s account,
(additions by the bank),
 All payments (checks) and other deductions by the bank,
and
 The balance of the cash account at the end of the month.
 Bank Reconciliation24

1.The bank and the company maintain independent records of

the checking account.
The two balances are not often the same because of:
a. Time lags that prevent one of the parties from recording
the transaction in the same period.
 Days elapse between the time a check is written dated and
the date it is paid by the bank.
b. Errors by either party in recording transactions. The
incidence of errors depends on the effectiveness of internal
controls maintained by the company and the bank.
 Cont…d
25

Since the bank and the depositor maintain independent

records regarding a single amount of cash the balance as per
the two is to be expected to be equal, but it is not likely to
be equal on a specific date
 The process of bringing the two balances to one is called
bank reconciliation.
 Cont…d
26

Delay in recording transactions

1. Outstanding checks: These are Issued checks recorded by
the company that have not been paid by the bank. Thus it
should be deducted from the balance per bank statement.
2. Deposit in transit: These are deposits made after the bank
closes its records for statement period. Deposits recorded by
the depositor that have not been recorded by the bank. Thus
it should added to the balance per bank.
 Cont…d
27

3. Bank charges and other deductions by bank: these

are deductions by the bank without the depositor’s
knowledge. These are items reduced only by bank,
but not by the depositor. Then the bank statement
accompanied by debit memorandum.
Debit memorandums include: bank service
charge, non sufficient funds (NSF) checks,
interest expense, cost of checks, and any other
transactions that decrease the depositor’s bank
account balance.
 Cont…d
28
 NSF (non-sufficient funds) checks: you may made collection from a customer through

checks and, it is common that you prefer to deposit the checks you received from

the client in your bank account, your bank initially credits your bank account for

the deposited amount with the assumption that the client has sufficient funds.

 However, later on, the client who issued the check may not have sufficient fund in his

bank account.

 When this happens, the bank debits ( deducts) the depositor’s account for the amount and

return the check with the statement to the depositor.

 The company usually reclassifies the NSF check from Cash to Accounts Receivable

because it must now collect from the person or company that wrote the check.
 Cont…d
29

4. Collections by bank: these are additions by the bank

without the depositor’s knowledge. Then the bank
statement accompanied by credit memorandum. Thus,
these are items additions only by bank, but not by the
depositor.
5. Errors in recording transactions by the bank or by the
depositor:
 error discovered during the process of making
comparisons are listed separately on the reconciliation.
Example: Omission, Transposition, Double Recording,
slide errors, over sight, etc.
 Cont…d
30

+ Notes collected by bank

+ Deposit in Transit
- NSF (bounced) checks
- Outstanding Checks
- Check printing or other
+/- Bank Errors
service charges
+/- Book Errors
CORRECT BALANCE CORRECT BALANCE
 Entries based on bank reconciliation
31

Adjustment items made to depositors balance on the bank

reconciliation requires journal entries to;
A. Adjust the accounting records for errors committed by
depositor
B. Make the depositor’s cash in bank account up to date
representing the correct cash balance
C. Accordingly, all reconciling items necessitate journal
entries in to the depositor’s record except; deposit in
transit, outstanding checks and errors committed by banks.
 Cont…d
32

Example: The cash account of ABC Company showed a ledger

balance of Br 16,170 on December 31, 2011. The bank
statement as of that date showed a balance of Br 18,260. Up on
comparing the bank statement with the cash records of the shop,
the following facts were revealed:
1. Checks outstanding on December 31 totaled Br 7,310
2. Deposit of the last day of the month, not recorded by the bank Br
6,170
3. Check number 144 in the amount of Br 210 had been entered in
the cash book as Br 120. The Checks had been issued to pay debt
to Misrak Enterprise.
4. A deposit for Br 125 was erroneously recorded by the bank as
Br 260
 Cont…d
33

5. A bank memo stated that ABC Company's note for Br

1,000 and interest of Br 10 had been collected on
December 30.
6. There was bank service charge for the month of Br 5
7. Not sufficient fund (NSF) totaling Br 100. This is
obtained from BCD enterprise to settle its previous
purchase on account from Alex stationary shop.
Required:
a. Prepare a bank reconciliation dated December 31, 2011
b. Prepare the necessary journal entries in relation to the
bank reconciliation you have prepared.
 ABC company Cont…d
Bank Reconciliation
34
December 31, 2011
Beginning Balance per Birr 18, 260 Beginning Balance per co. Birr 16, 170
bank
Add:- Deposit in transit 6, 170 Add:- Bank credit memo
for
Notes 1, 010
Receivable……..1000
Interest
income……….....10
Sub total 24, 430 Sub total 17, 180
Less:- Less:- Bank debit memo
Outstanding for:
checks..7,310 NSF………………..100
Bank error…………....135 (7, 445) Service charge……….5 (195)
Error………………….90
Adjusted Balance 16, 985 Adjusted Balance 16, 985
 Journal entries
35

Cash in Bank …………………………1,010

Notes Receivable ……………………. 1,000
Interest Income ……………………………10
(To record notes collected by bank including interest)
Account payable………………………… 90
Cash in Bank………………………. …………90
(To record depositor’s error in recording checks)
Administrative Miscellaneous Expense ……… 5
Accounts Receivable (ABC Co.,) ……………. 100
Cash in Bank …………………………… 105
(To record bank service charges and NSF checks)
 36

Eg.2 The cash in bank account for ABC company at June 30 of

the current year indicated a balance of $19,650.30 after both
the cash receipts journal and the check register for June had
been posted. The bank statement indicated a balance of
$30,606.30 on June 30.Comparison of the bank statement and
accompanying canceled checks and memorandums with the
records revealed the following reconciling items.
a. Checks outstanding totaled $14,941.50
b. A deposit of $6,467.75 representing receipts of June 30,
had been made too late to appear on the bank statement.
c. The bank had collected $3,090 on a note left for collection.
The face of the note was $3,000.
 37

d. A check for $91 returned with the statement had been

recorded erroneously in the check register as $19. The
check was for the payment of an obligation to Y supply
company for the purchase of equipment on account.
e. A check drawn for $55 had been erroneously charged
by the bank as $550.
f. Bank service charges for June amounted to $40.75.
Required: i. prepare bank reconciliation
ii. Record the necessary entries
 Petty Cash Funds
38

Q1. What do you understand by a petty cash

funds?
Q2. Why firms maintain petty cash funds?
 Cont…d
39

 A petty cash fund is a type of imprest fund,

providing ready currency for routine disbursements.

 Sometimes it becomes very difficult to make small

payments that arise frequently during a day through
checks.
 Apart from its inconvenience it is considered very
expensive to write a check for every single payment.
 Therefore, it is advisable for firms to make small
payments that are frequently made by maintaining a
petty cash fund.
 Cont…d
40

 The operation of a petty cash fund involves

 establishing the fund:-
 The first step in establishing a petty cash fund is to estimate
the size of the fund required for disbursement of a
specified period of time, say for a month.
 After determining the size of the fund a check should
be prepared and issued for the required amount there
comes recording the establishment of the petty cash fund by
debiting petty cash account and crediting the cash in
bank account.
 Petty cash funds are intended to handle many types of
small payments, including employee transportation costs,
postage, office supplies, and delivery charges.
 Cont…d
41

To illustrate normal petty cash fund entries, assume

that a petty cash fund of Birr 100 is established on
August 1. The entry to record this transaction is as
follows:
 Cont…d
42

2. making payments from petty cash

 The custodian of the petty cash fund has the authority to
make payments from the fund that conform to prescribed
management policies. Usually, management limits the size
of expenditures that come from petty cash and does not
permit use of the fund for certain types of transactions
(such as making short-term loans to employees).
 Each payment from the fund must be documented on a
pre numbered petty cash receipt (or petty cash voucher).
 The signatures of both the custodian and the individual
receiving payment are required on the receipt.
 Cont…d
43

 The custodian keeps the receipts in the petty cash box

until the fund is replenished.
 As a result, the sum of the petty cash receipts and
money in the fund should equal the established total at
all times.
 The company does not make an accounting entry to
record a payment at the time it is taken from petty
cash.
 It is considered both inexpedient and unnecessary to
do so.
 Instead, the company recognizes the accounting
effects of each payment when the fund is replenished.
 Cont…d
44

3. replenishing the petty cash fund

 When the money in the petty cash fund reaches a minimum
level, the company replenishes the fund.
 The petty cash custodian initiates a request for reimbursement.
 This individual prepares a schedule (or summary) of the
payments that have been made and sends the schedule,
supported by petty cash receipts and other documentation, to
the treasurer’s office.
 The receipts and supporting documents are examined in the
treasurer’s office to verify that they were proper payments from
the fund.
 The treasurer then approves the request, and a check is
prepared to restore the fund to its established amount.
 Cont…d
45

To illustrate, assume that at the end of August the

petty cash custodian requests a check for Birr 88. The
fund contains office supplies, Br 28; postage (office
supplies), Br 22; store supplies, Br 35; and daily
newspapers (miscellaneous administrative expense),
Br 3.
 Cont…d
46

Occasionally, in replenishing a petty cash fund the

company may need to recognize a cash shortage or
overage.
To illustrate, assume in the preceding example that the
custodian had only Br 11 in cash in the fund plus the
receipts as listed. The request for reimbursement
would therefore be for Br 89, and the following entry
would be made.
 Cont…d
47

August 31 Office supplies 50

Store supplies 35
M. adm. expense 3
Cash over and short 1
Cash 89
 48

Eg2. a. On January 1,2020 ABC Company sets up a petty cash

fund for $200.
b. On January 31,2020 cash of 24.90 is remaining in the cash
box. The receipts are postage $53.00, freight-out $45.00, office
Supplies $56.78 and miscellaneous $20.32
i. Assume the remaining cash is $22.90
ii.Assume the remaining cash is $ 26.90
c. The management has decided to increase the petty cash fund
by $100
d. The management has decided to decrease the petty cash fund
by $50
Required: Pass the necessary journal entries.
 5.2 Classification and Internal Control of Receivables
49

 The term receivables include all money claims against

people, organizations and other debtors.
 Receivables represent expected future cash inflows for the
creditor (to the lending party).
 Receivables are acquired by a business enterprise in
various kinds of transactions, the most common being the
sale of merchandise (goods) or services on a credit basis.
 Receivables can be classified into two groups, viz, (i) trade
receivables and (ii) non-trade receivables. The trade
receivables are those receivables which result from the sale
of products or services to different groups of customers
(individuals, firms, government organizations, etc).
 Cont…d
50

On the other hand, the non-trade receivables

originated from other events and transactions (other
than sale of products and services) and include
among others; advances to employees, accrued
receivables, and deposits with utilities.
Notes and accounts receivable that result from sales

transactions are called trade receivables.

 5.2.1 Accounts receivables
51

 The most common transaction creating a receivable is

selling merchandise or services on credit.
 accounts receivable are normally expected to be
collected within a relatively short period, such as 30 or
60 days.
 They are classified on the balance sheet as a current
asset.
 Entry is recorded to increase both Sales and Accounts
Receivable.
 Receivable may be reduced by sales discount and/or
sales return.
 Accounting for Accounts Receivables
52

Three accounting issues associated with accounts

receivable are:
1. Recognizing accounts receivable.
 Recognizing accounts receivable is relatively straightforward
 A service organization records a receivable when it provides
service on account.
 A merchandiser records accounts receivable at the point of
sale of merchandise on account.
 When a merchandiser sells goods, it increases (debits)
Accounts Receivable and increases (credits) Sales Revenue.
 Cont…d
53

 To review, assume that Jordana Co. on July 1, 2012,

sells merchandise on account to Peter Company for Br.
1,000, terms 2/10, n/30.
 On July 5, Peter returns merchandise worth Br. 100 to
Jordana Co.
 On July 11, Jordana receives payment from Peter
Company for the balance due.
The journal entries to record these transactions on the
books of Jordana Co. are as follows. (Cost of goods
sold entries are omitted.)
 Cont…d
54

Accounts Receivable— Peter Company 1,000

Sales Revenue 1,000
(To record sales on account)
Sales Returns and Allowances 100
Accounts Receivable Peter Company 100
(To record merchandise returned)
Cash (Br.900 - Br.18) 882
Sales Discounts (Br.900X.02) 18
Accounts Receivable— Peter Company 900
(To record collection of accounts receivable)
 Cont…d
55

2. Valuing accounts receivable.

Once companies record receivables in the accounts, the
next question is how should they report receivables in the
financial statements?
Companies report accounts receivable on the statement of
financial position as an asset.
Determining the amount to report is sometimes difficult
because some receivables will become uncollectible.
 For example, a corporate customer may not be able to pay
because it experienced a sales decline due to an economic
downturn, laid off from their jobs or be faced with
unexpected hospital bills, disappearance of creditors….
 Cont…d
56

The seller records these losses that result from

extending credit as Bad Debts Expense.

Such losses are a normal and necessary risk of doing

business on a credit basis.

 Cont…d
57

UNCOLLECTIBLE RECEIVABLES
When merchandise or services are sold without the
immediate receipt of cash, a part of the claim against
customers usually proves to be uncollectible.
Regardless of how thorough and efficient its credit
control system is, a company will always have some
customers who cannot or will not pay.
The main reason for the fail to pay is bankruptcy, closing of
the customer’s business etc…..
The operating expense incurred because of the failure
to collect receivables is called an expense, or a loss form
uncollectible accounts, doubtful accounts, or Bad Debts.
 Cont…d
58

Methods of Recognizing Uncollectible

There are two methods of accounting for receivables
that appear to be uncollectible.
The allowance method provides an expense for
uncollectible receivables in advance of their write-off.
The other procedure, called the direct write-off
method, recognizes the expense only when accounts
are judged to be worthless.
 Cont…d
59

1. DIRECT WRITE-OFF METHOD FOR

UNCOLLECTIBLE ACCOUNTS
 Under the direct write-off method, Bad Debt Expense is
not recorded until the customer’s account is determined to
be worthless.
 when a company determines a particular account to be
uncollectible, it charges the loss to Bad Debts Expense.
 Assume, for example, that W. Co. writes off as
uncollectible M. E. D Br 200 balance on December 12. W’s
entry is:
Dec. 12 Bad Debts Expense 200
Accounts Receivable—M. E. D 200
(To record write-off of M. E. D account)
 Cont…d
60

2. ALLOWANCE METHOD FOR UNCOLLECTIBLE

ACCOUNTS
The allowance method of accounting for bad debts involves
estimating uncollectible accounts at the end of each period.
This provides better matching on the income statement.
It also ensures that companies state receivables on the balance
sheet at their cash (net) realizable value.
Cash (net) realizable value is the net amount the
company expects to receive in cash.
It excludes amounts that the company estimates it will not
collect.
Thus, this method reduces receivables in the balance sheet by
the amount of estimated uncollectible receivables.
 Cont…d
61

This method has three essential features:

1. Companies estimate uncollectible accounts receivable.
They match this estimated expense against revenues in the
same accounting period in which they record the revenues.
2. Companies debit estimated uncollectible to Bad Debts
Expense and credit them to Allowance for Doubtful
Accounts through an adjusting entry at the end of each
period. Allowance for Doubtful Accounts is a contra
account to Accounts Receivable.
3. When companies write off a specific account, they debit
actual uncollectible to Allowance for Doubtful Accounts
and credit that amount to Accounts Receivable.
 Cont…d
62

Recording Estimated Uncollectible.

To illustrate the allowance method, assume
that Habtamu Furniture has credit sales of Br
1,200,000 in 2012. Of this amount, Br 200,000
remains uncollected at December 31. The credit
manager estimates that Br 12,000 of these sales will be
uncollectible. The adjusting entry to record the
estimated uncollectibles increases (debits) Bad Debts
Expense and increases (credits) Allowance for
Doubtful Accounts, as follows.
 Cont…d
63

Dec. 31 Bad Debts Expense 12,000

Allowance for Doubtful Accounts 12,000
(To record estimate of uncollectible accounts)
 Allowance for Doubtful Accounts shows the estimated amount of
claims on customers that the company expects will become
uncollectible in the future.
 Companies use a contra account instead of a direct credit to
Accounts Receivable because they do not know which customers
will not pay
 The amount of Br 188,000(200,000-12,000) in the above example
represents the expected cash realizable value of the accounts
receivable at the statement date.
 Companies reports Bad Debts Expense in the income statement as
an operating expense (usually as a selling expense).
 Cont…d
64

Recording the Write-Off of an Uncollectible Account

When a customer’s account is identified as uncollectible, it
is written off against the allowance account
The authorization to support this entry should come from a
designated manager
To illustrate a receivables write-off, assume that the
financial vice president of Habtamu Furniture authorizes a
write-off of the Br 500 balance owed by Genet on March 1,
2013. The entry to record the write-off is:
Mar. 1 Allowance for Doubtful Accounts 500
Accounts Receivable—Genet 500
(Write-off of Genet account)
 Cont…d
65

Under the allowance method, companies debit every

bad debt write-off to the allowance account rather
than to Bad Debts Expense.
A debit to Bad Debts Expense would be incorrect
because the company has already recognized the
expense when it made the adjusting entry for
estimated bad debts.
Instead, the entry to record the write-off of an
uncollectible account reduces both Accounts
Receivable and Allowance for Doubtful Accounts.
 Cont…d
66

Recovery of an Uncollectible Account.

Occasionally, a company collects from a customer
after it has written off the account as uncollectible.
The company makes two entries to record the
recovery of a bad debt:
(1) It reverses the entry made in writing off the account.
This reinstates the customer’s account.
(2) It journalizes the collection in the usual manner.
To illustrate, assume that on July 1, Genet pays the Br
500 amount that Habtamu had written off on March
1. Habtamu makes these entries:
 Cont…d
67

July 1 Accounts Receivable—Genet 500

Allowance for Doubtful Accounts 500
(To reverse write-off of Genet account)
July 1 Cash 500
Accounts Receivable—Genet 500
(To record collection from Genet)
 Cont…d
68

Estimating the Allowance

In “real life,” companies must estimate expected uncollectibles
amount when they use the allowance method.
 the companies may estimate based on past experience and
forecasts of future business activity.
Two bases are used to determine this amount:
(1) percentage of sales, and
(2) percentage of receivables.
Both bases are generally accepted.
The choice is a management decision (emphasis that
management wishes to give to expenses and revenues on the
one hand or to cash realizable value of the accounts receivable
on the other)
 Cont…d
69

a. Percentage-of-Sales
 In the percentage-of-sales basis, management estimates
what percentage of credit sales will be uncollectible.
This percentage is based on past experience and
anticipated credit policy.
The company applies this percentage to either total
credit sales or net credit sales of the current year.
The amount of this estimate is added to whatever
balance exists in the Allowance for Doubtful Accounts.
This basis of estimating uncollectibles emphasizes the
matching of expenses with revenues.
 Cont…d
70

To illustrate, assume that Gobeze Company elects to

use the percentage-of-sales basis. It concludes that 1%
of net credit sales will become uncollectible. If net
credit sales for 2012 are Birr 800,000, the estimated
bad debts expense is Br 8,000 (1% *Br 800,000). The
adjusting entry is:
Dec. 31 Bad Debts Expense 8,000
Allowance for Doubtful Accounts 8,000
(To record estimated bad debts for year)
 Cont…d
71

b. Percentage-of-Receivables.
 Under the percentage-of-receivables basis, management estimates
what percentage of receivables will result in losses from uncollectible
accounts.
 The company prepares an aging schedule, in which it classifies
customer balances by the length of time they have been unpaid.
 Because of its emphasis on time, the analysis is often called aging the
accounts receivable.
 After the company arranges the accounts by age, it determines the
expected bad debt losses.
 It applies percentages based on past experience to the totals in each
category.
 The longer a receivable is past due, the less likely it is to be collected.
 Thus, the estimated percentage of uncollectible debts increases as the
number of days past due increases.
 Cont…d
72

The number of days an account is past due is the number

of days between the due date of the account and the date
the aging schedule is prepared.
To illustrate, assume that Rodas Company is preparing an
aging schedule as of August 31. Its account receivable for
Saron Company was due on May 29. As of August 31,
Saxon’s account is 94 days past due as shown below.
Number of days past due in May 2 days (31 – 29)
Number of days past due in June 30 days
Number of days past due in July 31 days
Number of days past due in August 31 days
Total number of days past due 94 days
 Cont…d
73

For example- The following shows an aging schedule for Dart

Company. Note that the estimated percentage uncollectible
increases from 2% to 40% as the number of days past due
increases.
 Cont…d
74

 Total estimated bad debts for Dart Company (2,228,000)

represent the amount of existing customer claims the company
expects will become uncollectible in the future.
 This amount represents the required balance in Allowance for
Doubtful Accounts at the reporting date.
 The amount of the bad debt adjusting entry is the difference
between the required balance and the existing balance in the
allowance account.
 If the trial balance shows Allowance for Doubtful Accounts with a
credit balance of 528,000, the company will make an adjusting
entry for 1,700,000 (2,228,000- 528,000), as follows (W in
thousands).
Dec. 31. Uncollectible accounts expense …….. 1,700,000
Allowance for Doubtful …………......... 1,700,000
 Cont…d
75

Occasionally, the allowance account will have a debit

balance prior to adjustment.
This occurs when write-offs during the year have exceeded
previous provisions for bad debts. In such a case, the
company adds the debit balance to the required
balance when it makes the adjusting entry.
Thus, if there had been a 500,000 debit balance in the
allowance account before adjustment, the adjusting entry
would have been for 2,728,000 (2,228,000+500,000) to
arrive at a credit balance of 2,228,000.
The percentage-of-receivables basis will normally result in
the better approximation of cash realizable value.
 76
Cont…d
3. Disposing of Accounts Receivable
In the normal course of events, companies collect
accounts receivable in cash and remove the
receivables from the books.
However, as credit sales and receivables have grown
in significance, the “normal course of events” has
changed.
Companies now frequently sell their receivables to
another company for cash, thereby shortening the
cash-to-cash operating cycle.
Companies sell receivables for two major
reasons.
 Cont…d
77

First, they may be the only reasonable source of

cash.
When money is tight, companies may not be able to
borrow money in the usual credit markets.
Or, if money is available, the cost of borrowing may be
prohibitive.
A second reason for selling receivables is that billing
and collection are often time-consuming and
costly.
It is often easier for a retailer to sell the receivables to
another party with expertise in billing and collection
matters.
 78

SALE OF RECEIVABLES
A common sale of receivables is a sale to a factor.
A factor is a finance company or bank that buys
receivables from businesses and then collects the
payments directly from the customers.
Factoring is a multibillion dollar business.
Factoring arrangements vary widely.
Typically, the factor charges a commission to the
company that is selling the receivables.
This fee ranges from 1–3% of the amount of receivables
purchased.
 79

 To illustrate, assume that Tsai Furniture factors NT$600,000 of

receivables to Federal Factors. Federal Factors assesses a service
charge of 2% of the amount of receivables sold. The journal entry
to record the sale by Tsai Furniture is as follows.
Cash..…….............................588,000
Service Charge Expense....... 12,000
Account Receivable…………......... 600,000
(To record the sale of accounts receivable)
 If the company often sells its receivables, it records the service
charge expense (such as that incurred by Tsai) as a selling
expense.
 If the company infrequently sells receivables, it may report this
amount in the “Other income and expense” section of the income
statement.
 Accounting for note receivable
80

Promissory Notes Receivables

Credit may be granted on open account or on the basis of
a formal instrument of credit, such as a promissory note.
A promissory note is a written promise to pay a sum of
money on demand or at a definite time.
 A Promissory note is frequently referred to as a note, a
written promise to pay a sum of money on demand or at
a definite time (more than 60 days).
Notes may also be used in settlement of an open
account and as a means of borrowing or lending money.
 Cont…d
81

Characteristics of Notes Receivable

(1) Like a check it must be payable to the order of a
certain person or firm, or to the bearer.
(2) It must also be signed by the person or firm that
makes the promise.
 Parties to a note:
1. Payee – The entity to whom payment is to be made.
2. Maker – The entity who signs the note and there by
promises to pay or, the one making the promise.
Notes have several characteristics that have accounting
implications. These are:
 Cont…d
82

(1) Issuance Date: The data a note is issued by the maker.

(2) Due Date: The date a note is to be paid is called the
due date or maturity data.
The period of time between the issuance date and the
due date of a short – term note may be stated in either
days or months.
When the term of a note is stated in days, the due date is
the specified number of days after its issuance.
When the term of note is stated as a certain number of
months after the issuance date, the due date is
determined by counting the number of months from the
issuance date.
 Cont…d
83

Example: To illustrate the due date of a 90 – day

note dated May 19 presented below may be determined
as follows:
Term of the rote …………………………………………………90
Days in May…………………………. 31
Date of Note ………………………….19………………………12
No of days remaining……………………………………….........78
June (days)……………………………………………………….30
No of days remaining……………………………………………48
July (days) ……………………………………………………….31
Due date, August………………………………………………….17
 Cont…d
84

3. Interest: Is an amount received (paid) for the use of the

principal of a note for a period of time between the
issuance date and the due date.
The amount of interest is based on three factors: These
are:
 The amount of money borrowed (lent), [P]
 The loan’s length of time. [T]
 The rate of interest [R]
Notes covering a period of time longer than one year
normally provide that the interest be paid semiannually,
quarterly, or at some other stated interval.
PRINCIPAL * RATE * TIME = INTEREST
 Cont…d
85

4. Maturity Value: The amount that is due at the

maturity or due date is called the maturity value.
The maturity value is the total proceeds of the note at the
maturity date.
Maturity value for an interest bearing note is the face
value of the note plus interest.
For example, the maturity value of a 90 days 10% note
for Birr 2500 would be computed as follows:
Maturity Value = Principal + Interest on Principal Amount
MV = 2500 + (2500 x 0.1 x 90/360)
MV = Birr 2500 + Birr 62.50
MV = Birr 2562.50
 Cont…d
86

The basic issues in accounting for notes receivable are the same
as those for accounts receivable:
1. Recognizing notes receivable.
2. Valuing notes receivable.
3. Disposing of notes receivable.
1. Recognizing Notes Receivable
 The company records the note receivable at its face value, the
amount shown on the face of the note.
 No interest revenue is reported when the note is accepted,
because the revenue recognition principle does not recognize
revenue until earned.
 If a company lends money using a note, the entry is a debit to
Notes Receivable and a credit to Cash in the amount of the loan.
 Cont…d
87

To illustrate the basic entry for notes receivable, we

will use Chala Company’s Br 1,000, two-month, 12%
promissory note dated May 1. Assuming that Chala
Company wrote the note to settle an open account,
Wilma Company makes the following entry for the
receipt of the note.
May 1 Notes Receivable 1,000
Accounts Receivable 1,000
(To record acceptance of Chala Company note)
 Cont…d
88

2. Valuing Notes Receivable

Valuing short-term notes receivable is the same as
valuing accounts receivable.
Like accounts receivable, companies report short-term
notes receivable at their cash (net) realizable value.
The notes receivable allowance account is Allowance
for Doubtful Accounts.
The estimations involved in determining cash
realizable value and in recording bad debts expense
and the related allowance are done similarly to
accounts receivable.
 Cont…d
89

3. Disposing of Notes Receivable

Notes may be held to their maturity date, at which time
the face value plus accrued interest is due.
 In some situations, the maker of the note defaults, and
the payee must make an appropriate adjustment.
In other situations, similar to accounts receivable, the
holder of the note speeds up the conversion to cash by
selling the receivables
 Cont…d
90

1. HONOR OF NOTES RECEIVABLE

 A note is honored when its maker pays in full at its maturity
date. For each interest bearing note, the amount due at maturity
is the face value of the note plus interest for the length of time
specified on the note.
 To illustrate, assume that Wolde Co. lends Haile Co. Br10,000
on June 1, accepting a five-month, 9% interest note. In this
situation, interest is Br375 (Br10,000 *9% *5 /12). The amount
due, the maturity value, is Br10,375 (Br10,000 +Br375).
Nov. 1 Cash 10,375
Notes Receivable 10,000
Interest Revenue (Br10,000 *9% *5 /12) 375
(To record collection of Haile note and interest)
 Cont…d
91

2. DISHONOR OF NOTES RECEIVABLE

A dishonored note is a note that is not paid in full at
maturity.
A dishonored note receivable is no longer negotiable.
However, the payee still has a claim against the maker of
the note for both the note and the interest.
Therefore the note holder usually transfers the Notes
Receivable account to an Account Receivable.
To illustrate, assume that Haile Co. on November 1
indicates that it cannot pay at the present time and If
Wolde expect eventual collection, the following entry is
made at the time the note is dishonored
 Cont…d
92

Nov. 1 Accounts Receivable—Haile 10,375

Notes Receivable 10,000
Interest Revenue 375
(To record the dishonor of Haile note)
if instead, on November 1, there is no hope of collection,
the note holder would write off the face value of the note by
debiting Allowance for Doubtful Accounts.
No interest revenue would be recorded because collection
will not occur.
3. SALE OF NOTES RECEIVABLE
The accounting for the sale of notes receivable is recorded
similarly to the sale of accounts receivable.
 Cont…d
93

Discounting Notes Receivable

Discounting a notes receivable involves selling a note
receivable with recourse to a bank.
The bank deducts the interest from the maturity value
of the note immediately and gives the seller of the note
only the proceeds.
"With recourse" means that the bank will collect the
maturity value of the note from the seller if the
original maker of the note fails to pay to the bank at
maturity.
A contingent liability, therefore, arises when a note is
discounted on recourse.
 Cont…d
94

The bank transfers cash (the proceeds) to the company

after deducting a discount (interest) that is computed
on the maturity value of the note for the discount
period.
The discount period is the time that the bank must
hold the note before it becomes due.
 Cont…d
95

 Example: To illustrate assume that a 120 day, 10% notes

receivable for Birr 3000 dated October 16, is discounted at the
payees bank on December 25 at the rate of 12%. The data used
in determining the effect of the transaction is as follows.
Face value of a note, dated October 16 …………...... Br. 3000.00
Interest on a note 120 days at 10% ……………………….100.00
Maturity value of the note, Feb.13 …...………………........ 3100.00
Discount period, (Dece.25 – Feb.13), 50 days
Discount on maturity value for 50 days at 12% (52.67)
Proceeds received by discounting the note…………… Br. 3048.33
 Cont…d
96

The excess of the proceeds from discounting the note,

Br. 3048.33, over its face value Br. 3000 is recorded as
interest income and the entry for the transaction is as
follows in a general journal form:
Dec. 25. Cash ………………….........................3048.33
Notes Receivable ………………… 3000.00
Interest Income ………………………. 48.33
 97

END OF CHAPTER -5