The operating expense incurred because of the failure to collect receivables
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In this unit, we emphasize on how companies account for and report receivables. We have discussed the importance of estimating uncollectibles in order to determine the reasonable balance of receivables on the balance sheet. Show Most of the companies sell goods and services on credit in order to earn more profits. Receivables represent claims for money, goods, services, and non-cash assets from other firms. Receivables may be current or non-current depending on the expected collection date.
8.2 Classification of Receivables Receivables can be broadly classified into Trade Receivables and Non-trade Receivables. Trade Receivables describe amounts owed to the company for goods and services sold in the normal course of business. Non-trade Receivable arise from many other sources, such as advance to employees, interest receivables, rent receivables and loan to affiliated companies. Unless we indicate otherwise, we will assume that all receivables in this unit are trade receivables. Based on the above broad classification, receivables can be further classified into Account Receivable and Notes Receivables. Account Receivable refers to amounts due from customers for credit sales. These receivables are supported by sales invoices or other documents rather than any formal written promises. Such Account Receivables are normally expected to be collected within relatively short period, such as 30 or 60 days. They are classified on the balance sheet as a current asset. On the other hand, Notes Receivable refers to amounts that customers owe, for which a formal, written instrument of credit has been issued. Notes are usually used for credit periods of more than sixty days and for transactions of relatively large value. Notes may also be used in settlement of an open account and in borrowing or lending money.
8.3 Internal Control Over Receivables The principles of internal control that we saw in chapter 5 are required by organizations to safeguard their assets from any kind of error and misconduct. These control procedures should apply on receivables because they are one of the asset elements for the organization. For example, the individual responsible for sales should be separate from the individual accounting for the receivables and approving credit. By doing so, the accounting and credit approval functions serve as independent checks on sales. Separation of responsibility for related functions reduces the possibility of errors and misuse of funds. Adequate control over Accounts Receivable begins with the approval of the sales by a responsible company official or the credit department, after the customer’s credit rating has been reviewed. Likewise, adjustments of Account Receivable, such as for sales return and allowance, and sales discount, should be authorized or reviewed by a responsible party. Effective collection procedure should also be established to ensure timely collection of receivables and to minimize losses from uncollectible accounts.
8.4 Characteristics of Notes Receivable A claim supported by a note has some advantages over a claim in the form of an Account Receivable. By signing a note, the debtor recognizes the debt and agrees to pay according to the terms listed. A note is therefore a strong legal claim if there is a court action. A promissory note is a written promise to pay a sum of money on demand or at a definite time. It is payable to the order of a person or firm or to the bearer or holder of the note. The person or firm that makes the promise signs it. The one to whose order the note is payable is called the payee, and the one making the promise is called the maker. Notes have several characteristics that affect how they are recorded and reported in the financial statements. The characteristics are described in the following paragraphs: -
The date a note is to be paid is called the Due Date or Maturity date. 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 on a note is expressed in days, the maturity date is the specified number of days after the note’s date. As an example, a five-day note dated January-1 matures and is due on Jannuary-6. A 90-day notes dated March-10, matures on Jun-8. This due date, June-8, is computed as below: -
Term of the Note--------------------------------------------90 Days in March---------------------------31 Minus the date of the note-------------10 Days remaining in March------------------------21 Add days in April---------------------------------30 Add days in May----------------------------------31 82 Number of days remaining to equal 90-days (90 – 82 = 8)------------------------------------------------8 Therefore, Due date is June-8.
The period of a note is sometimes expressed in months. When months are used, the note matures and is payable in the month of its maturity on the same date of the month as its original date
A three-month note dated March-10, for instance, is payable on June-10.
Interest is the cost of borrowing money for the borrower. It is the profit from lending money for the lender. The interest rate on notes is normally stated in terms of per year, regardless of the actual period of time involved. The formula for computing interest is as follows: -
Interest = Principal X Annual X Time (Face Amount interest Rate of the Note)
To illustrate the formula, the interest on a Br. 10,000, 12%, 60 day note is computed as:- Br. 10,000 X 12% X 60/360 = 200
N.B. To simplify interest computations for notes with periods expressed in days, it is common to treat a year as having 360 days.
The amount that is due at the maturity or due date is called the maturity value. The maturity value of a note is the sum of the face amount and the interest. In the above example, the maturity value is Br. 10,200 (which is Br. 10,000 face amount plus Br. 200 interest) I.e. MV = FV + I where MV= Maturity value FV = Face value I = Interest 8.5 ACCOUNTING for Notes Receivable Notes Receivable are usually recorded in a single note Receivable account to simplify record keeping. We need only one account because the original notes are kept on file. This means the maker; rate of interest, due date, and other information can be learned by examining the actual note. To illustrate the recording of the receipt of a note, assume that on Jannuary-10, Nile Co. sales merchandise on account to Tana Co. and receive a Br. 5,000, 90-day, 12% promissory note. This transaction is recorded as: - Jan. 10. Notes Receivable ------------------------5000 Sales--------------------------------------5000 The maker of the note usually honors the note and pays it in full. The entry required to record the receipt of cash by Nile Co. from Tana Co. is as follows:
April-10 Cash------------------------------5150 Notes Receivable-----------------------5000 Interest Revenue (500 X 12/100 X 90/360)----150
Companies can sometimes accept a note for an overdue customer as a way of granting a time extension on a past-due account Receivable. To illustrate, assume that a 60-day, 10% note dated September 5, 20x1 is accepted by Awash Co. in settlement of the account of Happy co, which is past due and has a balance of 10,000. The entry to record the transaction is as follows: September 5 N/R---------------------------------------------10, 000 A/R ----------------------------------------------10,000 Received a note to settle account Recording a dishonored note When a note’s maker is unable or refuses to pay at maturity, the note is dishonored. The act of dishonoring a note doesn’t relieve the maker of the obligation to pay. The payee should use every legitimate means to collect. But how do companies report this event? The balance of the Notes Receivable account normally includes only those notes that have not matured. When a note is dishonored, we therefore remove the amount of this note from the Notes Receivable account and charge it back to an Accounts Receivable from its maker. Assume for instance Nile Co., holds a Br. 1000, 12%, 30-day note of Ato Alemu. At maturity, Alemu dishonored the note. Nile Co. records this dishonoring of its N/R, on Oct. 25, as follows:
Oct.25, A/R---------------Ato Alemu 1010 N/R---------------------------1000 Int. Rev.-------------------------10 To record dishonored note & interest of 1000 X 12% X 30/360 =10 The above entry records interest of Br. 10, which has been earned, even though the note has been dishonored. End-Of-Period interest Adjustment When notes receivable are outstanding at the end of an accounting period, accrued interest is computed and recorded. For example, on December 20, 20x1, Nile Co. accepted a Br. 2000, 60-day, 12% note from a customer in granting an extension of a past-due account. Assuming that the accounting period ends on Dec. 31, the entries to record the receipt of the note, accrued interest, and payment of the note at maturity are shown below: -
Dec. 19. N/R -------------------------------------2000 A/R- customer-X --------------------------------2000 Received note in settlement of A\R Dec. 31. Interest Receivable-------------------------8 Int. Revenue------------------------------------8 Adjusting entry for ace need Interest, Br. 2000 X 12% X 12/360 = 8 Feb. 17. Cash----------------------------------2040 N/R---------------------------------------------2000 Int. Rec.--------------------------------------------8 Int. Revenue-------------------------------------32 Received pyt of note & interest at maturity
The adjusting entry above on Dec. 31, 20X1,was required to show the interest earned for the period on the Income Statement. 8.6 Converting Receivables to cash before Maturity Sometimes, companies convert receivables to cash before they are due. Reasons for this include the need for cash or a desire not to be involved in collection activities. Converting receivable is usually done either (1) by selling them, or (2) by using them as security for a loan. The topic of using notes as security for a loan will be discussed in future courses. Notes Receivable can be converted to cash by discounting them at a financial institution such as a Bank. The process has three steps as indicated in the following diagram. In the first step, the maker receives goods, service or cash from the payee in exchange for the note. In the second step, the payee discounts the note with a bank and receives the maturity value of the note less a discount (a fee) charged by the bank. In the third step, the maker pays the bank at the maturity of the note. What is the operating expense caused because of the failure to collect receivables called?Bad Debt Expense. The operating expense incurred because of the failure to collect receivables. allowance method. The method of accounting for uncollectible accounts that provides an expense for uncollectible receivables in advance of their write-off.
What happens when receivables are not collected?When receivables or debt will not be paid, it will be written off, with the amounts credited to accounts receivable and debited to allowance for doubtful accounts.
What is an account receivable that Cannot be collected called?Accounts uncollectible, also known as uncollectible accounts or bad debts, are credit sales in accounts receivable that are unlikely to be collected from a customer. The term is used in the valuation of accounts receivable on an organization's balance sheet.
Is uncollectible accounts expense an operating expense?If Provision for Doubtful Debts is the name of the account used for recording the current period's expense associated with the losses from normal credit sales, it will appear as an operating expense on the company's income statement. It may be included in the company's selling, general and administrative expenses.
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