BUS103 Study Guide

Unit 7: Accounting for Receivables and Payables

7a. Perform the accounting entries to record and write-off accounts receivable 

  • How are sales on credit recorded by the company?
  • What entry must a company make when a customer is unable to pay the amount due?

Accounts receivable are amounts that customers owe a company for goods and services sold on account. When a company sells its goods or services and bills the customer later, they are said to have extended credit to the customer. The initial accounting entry for this transaction would be:

(debit) Accounts Receivable

$$

 

(credit) Sales

 

$$
 
When it has been determined that a customer will never pay us back, we must ensure that our accounting statements show that we do not expect repayment. To do this, we must "write off" the account that we have determined is uncollectible. The entry to do this is:

(debit) Allowance for Bad Debts

$$

 

(credit) Accounts Receivable

 

$$
 
Since we know that not all customers will be able to pay us, we set up an allowance account, which is a contra-asset account, to reflect this fact. A contra-asset account reduces the amount of the asset it is associated with (in this case, accounts receivable), so that the actual total we expect is shown.
 
To review, see Receivables and Payables.
 

7b. Calculate the accounts receivable turnover ratio and the average collection period

  • How is the accounts receivable turnover ratio calculated?
  • How is the average collection period calculated?
  • What factors influence these ratios?
Accounts receivable turnover is defined as Net credit sales/Average net accounts receivable. The higher the number, the faster the firm is collecting its receivables. In general, companies would like to collect their receivables as quickly as possible. However, both credit terms and collections policies affect turnover. A very stringent credit policy might yield a high a/r turnover, but at the expense of increased sales. Likewise, a generous extension of credit might increase sales but create a low a/r turnover ratio. Managers must balance their policies to optimize sales and collections.
 
The average collection period is calculated by taking 365/accounts receivable turnover ratio. It translates the a/r turnover ratio into the number of days to collect. In general, a lower number is desired. The faster a firm collects its receivables, the more liquid they are and the higher the quality of its accounts receivable.
 
To review, see Receivables and Payables.
 

7c. Describe sources of short term financing for a company

  • What are some scenarios that would cause a company to need short-term financing?
  • What are the main sources of short-term financing for a company?
Companies may need short-term financing for reasons including delayed payments from customers, to finance the need for seasonal inventories, to take advantage of a short-term opportunity, and to cover emergency situations.
 
Companies generally can utilize trade credit from suppliers (accounts payable) for some short-term needs. They may also choose to issue an interest-bearing note or utilize their line of credit if they have one established at their bank.
 
To review, see Receivables and Payables.
 

7d. Construct journal entries for notes receivable and payable

  • How are notes receivable recorded?
  • How are notes payable recorded?
A note receivable occurs when a customer agrees to pay us via a signed note, usually with interest. The initial entry is:

(debit) Notes Receivable

$$

 

(credit) Sales

 

$$

The difference from accounts receivable is that we must record the accrued interest owed at the end of the accounting period:

(debit) Interest receivable

$$

 

(credit) Interest Revenue

 

$$

When the note is paid off with interest, the transaction is:
 
(debit)     Cash
(credit)        Interest receivable
(credit)        Notes receivable
(credit)        Interest revenue
 
A note payable occurs when we agree to borrow money short-term, with a note, usually with interest. It is essentially the opposite transaction of the note receivable.
 
When the note is issued:

(debit) Cash

$$

 

(credit) Note Payable

 

$$

At year-end when interest is accrued:

(debit) Interest Expense

$$

 

(credit) Interest Payable

 

$$

When the note is paid off:

(debit) Notes Payable

 $$

(debt) Interest Payable

 $

(debit) Interest Expense

 $

(credit) Cash

 $ $ $ $

To review, see Receivables and Payables.
 

7e. Calculate estimated bad debts

  • Why must companies estimate their bad debts?
  • How are bad debts estimated?
No matter how well companies screen potential customers, they can not ensure that all customers pay their bills. All companies deal with uncollectible accounts. The matching principle requires that companies match their expenses to the revenues they generate. Since uncollectible accounts are an expense they know they will incur, they are required to estimate it and reduce their anticipated revenue accordingly. However, since they do not know which customers will default, they must use a method to estimate their anticipated bad debts.
 
The only method that satisfies the matching principle is the allowance method. This requires the company to estimate their uncollectible accounts, usually by aging their accounts receivable or using the percentage of sales method.
 
Using the aging method, each account receivable is categorized by the number of days it has been outstanding. Percentages estimated to be uncollectible (from past experience) are determined and calculated for each category. The total is then the appropriate balance in the Allowance for Bad Debts accounts, and the adjusting entry is made to make the total in the account equal to that balance.
 
The percentage of sales method is a much simpler calculation. The amount of sales on credit is simply multiplied by the expected % that will be uncollectible (based on history). That amount is then added to the balance in the Allowance for Bad Debts Account.
 
To review, see Receivables and Payables.
 

7f. Perform the accounting entries to record and adjust bad debts expense

  • How are the journal entries for bad debts made using the aging of receivables method?
  • How are the journal entries for bad debts made using the percent of credit sales method?
When using the aging method, the bad debts calculation becomes the correct balance for the Allowance for Bad Debts account. The account would then be credited to make the total match the calculation. So, for example:
 
Bad debts expense estimate from the aging schedule: $50,000
Current balance in Allowance for Bad Debts: $40,000
 
Adjusting entry:

(debit) Bad debts expense

$10,000

 

(credit) Allowance for bad debts

 

$10,000 (bringing total to 50,000)
 
With the percent of credit sales method, you simply add the bad debts estimate to the existing account balance. So, for example, if you sold 100,000 in credit sales and determine that 1% will be uncollectible, you would make the following entry:

(debit) Bad Debts Expense

$1,000

 

(credit) Allowance for Bad Debts

 

$1,000

To review, see Receivables and Payables.
 

Unit 7 Vocabulary

This vocabulary list includes terms you will need to know to successfully complete the final exam.

  • accounts receivable
  • accounts receivable turnover
  • aging accounts receivable
  • allowance method
  • average collection period
  • contra-asset account
  • note payable
  • note receivable
  • percentage of sales method