CHAPTER THREE

CASH AND RECEIVABLES

3.1 CASH
What Is Cash: Cash is a financial asset—it is also a financial instrument. A financial instrument is
defined as any contract that gives rise to a financial asset of one entity and a financial liability or equity
interest of a n other entity. Examples of financial are: Cash, Loans and receivables, Investments in debt
securities Investments in equity securities and non-financial assets are Inventory, Prepaid expenses,
Property, plant, and equipment and Intangible assets. Cash, the most liquid of assets, is the standard
medium of exchange and the basis for measuring and accounting for all other items. Companies generally
classify cash as a current asset. Cash consists of coin, currency, and available funds on deposit at the bank.
Negotiable instruments such as money orders, certified checks, cashier’s checks, personal checks, and
bank drafts are also viewed as cash. What about savings accounts? Banks do have the legal right to
demand notice before withdrawal. But, because banks rarely demand prior notice, savings accounts
nevertheless are considered cash. Some negotiable instruments provide small investors with an
opportunity to earn interest. These items, more appropriately classified as temporary investments than as
cash, include money market funds, money market savings certificates, certificates of deposit (CDs), and
similar types of deposits and “short-term paper.” These securities usually contain restrictions or penalties
on their conversion to cash.
Money market funds that provide checking account privileges, however, are usually classified as cash.
Certain items present classification problems: Companies treat postdated checks and I.O.U.s as
receivables. They also treat travel advances as receivables if collected from employees or deducted from
their salaries. Otherwise, companies classify the travel dance as a prepaid expense. Postage stamps on
hand are classified as part of office supplies inventory or as a prepaid expense. Because petty cash funds
and change funds are used to meet current operating expenses and liquidate current liabilities,
companies include these funds in current assets as cash.
Reporting Cash: Although the reporting of cash is relatively straightforward, a number of issues merit
special attention. These issues relate to the reporting of:
1. Cash equivalents.
2. Restricted cash.
3. Bank overdrafts
Cash Equivalents: A current classification that has become popular is “Cash and cash equivalents.” Cash
equivalents are short-term, highly liquid investments that are both (a) readily convertible to known
amounts of cash, and (b) so near their maturity that they present insignificant risk of changes in value due
to changes in interest rates. Generally, only investments with original maturities of three months or less
qualify under these definitions. Examples of cash equivalents are Treasury bills, commercial paper, and
money market funds. Some companies combine cash with temporary investments on the statement of
financial position. In these cases, they describe the amount of the temporary investments either
parenthetically or in the notes.
Most individuals think of cash equivalents as cash. Unfortunately, that is not always the case. Some
companies found out the hard way and have taken sizable write-downs on cash equivalents. Their losses
resulted because they purchased auction-rate notes that declined in value. These notes carry interest rates
that usually reset weekly and often have long-maturity dates (as long as 30 years). Companies argued that
such notes should be classified as cash equivalents because they can be routinely traded at auction on a
daily basis. (In short, they are liquid and risk-free.) Auditors agreed and permitted cash-equivalent
treatment even though maturities extended well beyond three months. But when the 2008 credit crunch hit,
the auctions stopped and the value of these securities dropped because no market existed. In retrospect,
the cash-equivalent classification was misleading. It now appears likely that the cash-equivalent

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classification will be eliminated from financial statement presentations altogether. Companies will now
report only cash. If an asset is not cash and is short-term in nature, it should be reported as a temporary
investment. An interesting moral to this story is that when times are good, some sloppy accounting may
work. But in bad times, it quickly becomes apparent that sloppy accounting can lead to misleading and
harmful effects for users of the financial statements
.Restricted Cash: Petty cash, payroll, and dividend funds are examples of cash set aside for a particular
purpose. In most situations, these fund balances are not material. Therefore, companies do not segregate
them from cash in the financial statements. When material in amount, companies segregate restricted
cash from “regular” cash for reporting purposes. Companies classify restricted cash either in the current
assets or in the non-current assets section, depending on the date of availability or disbursement.
Classification in the current section is appropriate if using the cash for payment of existing or maturing
obligations (within a year or the operating cycle, whichever is longer). On the other hand, companies
show the restricted cash in the non-current section of the statement of financial position if holding the
cash for a longer period of time.
Examples of restricted cash
Cash and Cash Equivalents (000,000). Cash and cash equivalents as of March 31, 2013 and
March 31, 2012 include restricted cash and bank balances of 3,050 and 2,680, respectively. The
restrictions are primarily on account of cash and bank balances held as margin money deposits against
guarantees, cash and bank balances held by irrevocable trusts controlled by the Company and
unclaimed dividends.
Restricted Deposits (000,000). Deposits with financial institutions as at March 31, 2013 include 7,980
(5,500 as at March 31, 2012) deposited with Life Insurance Corporation of India to settle employee-
related obligations as and when they arise during the normal course of business. This amount is
considered as restricted cash and hence not considered “cash and cash equivalents.

Banks and other lending institutions often require customers to maintain minimum cash balances in
checking or savings accounts. These minimum balances, called compensating balances, are “that portion
of any demand deposit (or any time deposit or certificate of deposit) maintained by a corporation which
constitutes support for existing borrowing arrangements of the corporation with a lending institution.
Such arrangements would include both outstanding borrowings and the assurance of future credit
availability
To avoid misleading investors about the amount of cash available to meet recurring obligations,
companies should state separately legally restricted deposits held as compensating balances against
short-term borrowing arrangements among the “Cash and cash equivalent items” in current assets.
Companies should classify separately restricted deposits held as compensating balances against long-
term borrowing arrangements as non-current assets in either the investments or other assets sections,
using a caption such as “Cash on deposit maintained as compensating balance.” In cases where
compensating balance arrangements exist without agreements that restrict the use of cash amounts shown
on the statement of financial position, companies should describe the arrangements and the amounts
involved in the notes.
Bank overdrafts: occur when a company writes a check for more than the amount in its cash account.
Companies should report bank overdrafts in the current liabilities section, adding them to the amount
reported as accounts payable. If material, companies should disclose these items separately, either on the
face of the statement of financial position or in the related notes.1 Bank overdrafts are included as a
component of cash if such overdrafts are repayable on demand and are an integral part of a company’s
cash management (such as the common practice of establishing offsetting arrangements against other
accounts at the same bank Overdrafts not meeting these conditions should be reported as a current
liability.

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3.2. Internal Control over Cash
The need to safeguard cash is crucial in most businesses because cash is mostly exposed to
embezzlement. Firms address this problem through the internal control system. An internal control system
is a set of policies and procedures designed to protect assets, provide accurate accounting records and
evaluate performances.
A sound internal control system for cash increases the likely hood that the reported values for cash are
accurate.
The following are the most common elements of internal control over cash:
1. Maintaining a bank account system,
2. Maintaining a petty cash fund,
3. A voucher system,
4. Change fund, and
5. Cash short and over.
1. Control over cash through a bank account
One of the major devises/tools for control over cash is maintaining a bank account. The forms used
by a business in connection with a bank account are a signature card, deposit ticket, check, and record of
checks drawn.
Signature Card: At the time the account is opened, an identifying number is assigned to the account,
and a signature card must be signed by each person authorized to sign checks drawn on the account.
The card is used by the bank to determine the authenticity of the signature on checks presented to it
for payment.
Deposit Ticket: The details of a deposit are listed by the depositor on a printed form supplied by the
bank. Deposit tickets may be prepared in duplicate, in which case the copy is stamped or initialed by
the bank’s teller and given to the depositor as a receipt. The receipt of a deposit may be indicated by
means other than a duplicate deposit ticket, but all methods give the depositor written proof of the
date and the total amount of the deposit.
Checks: A check is a written instrument signed by the depositor, ordering the bank to pay a certain
sum of money to the order of the designated person. There are three parties in a check transaction:
the Drawer, the one who signs the check; the Drawee, the bank on which the check is drawn; and the
Payee, the one to whose order the check is drawn. When checks are issued to pay bills, they are
recorded as credits to cash on the day issued, even though they are not presented to the drawer’s bank
until some later time. When checks are received from customers, they are recorded as debits to cash,
on the assumption that the customer has enough money on deposit. Checks are usually pre-numbered.
Whenever cash is received by an enterprise it is deposited in a bank account using the deposit tickets.
And whenever payment is made a check is ordered against the enterprise account to the payee
ordering the bank (drawee) to make payment of the specified amount.
Records of checks drawn: A memorandum record of the basic details of a check should be prepared
at the time the check is written. The record may be a stub from which the check is detached or it may
be small booklet designed to be kept with the check forms. Each type of record also provides spaces
for recording deposits and the current bank balance.
A bank account is one of the most important means of controlling cash that provide several advantages
such as:
Cash is physically protected by the bank,
A separate record of cash is maintained by the bank, and
Customers may remit payments directly to the bank.
If a company uses a bank account, monthly statements are received from the bank showing beginning and
ending balances and transactions occurred during the month including checks paid, deposits received, and
service charges. These monthly statements (reports) received from the bank are called bank statements.
Bank statements generally are accompanied by checks paid and charged to the accounts during the month,
debit and credit memos, which inform the company about changes in the cash accounts. For a bank, the

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depositor’s cash balance is a liability, the amount the bank owes to the firm. Therefore, a debit memo
describes the amount and nature of decrease in the company’s cash accounts. A credit memo indicates an
increase in the cash balance of the depositor that it has with the bank.
Bank Reconciliation: It is a schedule prepared by the depositor to bring the balance shown in the bank
statement and the balance shown in the depositor’s accounting record into agreement. Monthly
reconciling of the bank balance with the depositor’s cash accounts balance is essential cash control
procedure. To reconcile a bank statement means to verify that the bank balance and the accounting
records of the depositor are consistent. The balance shown in a monthly bank statement seldom equals the
balance appearing in the depositor’s accounting records. Certain transactions recorded by the depositor
may not have been recorded by the bank and vice versa.
The most common examples that cause disparity between the two balances are:
a) Deposits in transit: Cash receipts recorded by the depositor, but not reached the bank to be included
in the bank statement for the current month.
b) Outstanding checks: Checks issued and recorded by the company, but not yet presented to the bank
for payment.
c) Notes collected by bank: If the bank collects a note receivable on behalf of the depositor, it credits
the depositor’s account and issues a credit memorandum for the depositor.
d) Charges for depositing NSF- checks: NSF stands for “Not Sufficient Funds.” When checks are
deposited in an account, the bank generally gives the depositor immediate credit. On occasion, one of
these checks may prove to be uncollectible because the maker of the check does not have sufficient
funds in his or her account. In such a case, the bank will reduce the depositor’s account by the amount
of this uncollectible item and return the check to the depositor marked “NSF”.
e) Service charges: Banks often charge a fee for handling checking accounts. The amount of this
charge is deducted by the bank form bank balance and debit memo is issued for the depositor.
When the depositor prepares bank reconciliation, the balances shown in the bank statement and in the
accounting records both are adjusted for any unrecorded transactions. Additional adjustments may be
required to correct any errors discovered in the bank statements or in the accounting records.
Steps in Preparing Bank Reconciliation
The steps to prepare bank reconciliation are:
1. The deposits listed on the bank statement are compared with the deposits shown in the accounting
records. Any deposits not yet recorded by the bank are deposits in transit and should be added to
the balance shown in the bank statements.
2. The paid and received checks from the bank are compared with the check stubs. Any checks
issued but not yet paid by the bank are outstanding checks and should be deducted from the
balance reported in the bank statements.
3. Any credit memorandums issued by the bank that have not been recorded by the depositor, are
added to the balance per depositor’s record.
4. Any debit memorandums issued by the bank that have not been recorded by the depositor are
deducted from the balance per depositor’s record.
5. Any errors in the bank statement or depositor’s accounting records are adjusted.
6. The equality of adjusted balance of the bank statement and adjusted balance of the depositor’s
record is compared.
7. Journal entries are prepared to record any items delayed by the depositor.
Illustration:
The January bank statement sent by Awash Bank to ABC Company shows Birr 5,000.17 assume also that
on January 31, 2012, the Cash account of ABC Company shows a balance of Birr 4,262.83. The
accountant of ABC Company has identified the following items:
1. A deposit of Birr 410.90 made after banking hours on Jan. 31 does not appear on the bank statement.
2. Two checks issued in January have not yet been paid by the bank:
Check No. 301 Birr 110.25
Check No. 342 607.50

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3. A credit memorandum was included in the bank statement, which was for proceeds from collection of
a non-interest-bearing note receivable to ABC Company Birr 524.74.
4. Two debit memorandums accompanied the bank statement, a check of Birr 50.25 received from a
customer, XYZ Company & deposited by ABC Company was charged back as NSF & service charge
by the bank for the month January amounts Birr 17.00
5. Check No. 305 was issued by ABC Company for payment of telephone expense in the amount of Birr
85 but was erroneously recorded in the cash payments journal as Birr 58.
The January 31 bank reconciliation for ABC Company is shown below:
ABC Company
Bank Reconciliation
January 31, 2012

Balance per bank statement, Jan. 31, 2012 Br. 5,000.17

Add: Deposit of Jan. 31 not recorded by bank 410.90
Subtotal Br.5, 411.07
Deduct: outstanding checks:
No. 301 Br. 110.25
No. 342 607.50 (717.75)
Adjusted bank balance Br. 4,693.32
Balance per depositor’s record, Jan. 31, 2012 Br. 4,262.83
Add: Note Receivable collected by bank 524.74
Subtotal Br. 4,787.57
Deduct: NSF check of XYZ Company 50.25
Bank Service charge 17.00
Error on check stub No. 305 27.00 (94.25)
Adjusted book balance Br. 4,693.32
The following are journal entries related to the bank reconciliation.
2012 Cash in bank……………….. Birr 524.74
Jan. 31 Notes Receivable………………….. Birr 524.74
(To record Note Receivable collected by bank)

2012 Miscellaneous Expense………………………….Birr 17.00

Jan.31 Accounts Receivable-XYZ Co.…………………..Birr 50.25
Utilities Expense………………………………….Birr 27.00
Cash in bank………………………………………….Birr 94.25
(To record bank service charges, NSF check and error in recording Check No. 305)

3.3 ACCOUNTS RECEIVABLE

Receivables are also financial assets—they are also a financial instrument. Receivables (often referred to
as loans and receivables) are claims held against customers and others for money, goods, or services.).
For purposes of discussion, we will simply use the term receivables to mean loans and receivables. For
financial statement purposes, companies classify receivables as either current (short-term) or non-
current (long-term). Companies expect to collect current receivables within a year or during the current
operating cycle, whichever is longer. They classify all other receivables as non-current. Receivables are
further classified in the statement of financial position as either trade or non-trade receivables. Customers
often owe a company amounts for goods bought or services rendered.
A company may subclassify these trade receivables, usually the most significant item in its current
assets, into accounts receivable and notes receivable. Accounts receivable are oral promises of the
purchaser to pay for goods and services sold. They represent “open accounts” resulting from short-term
extensions of credit. A company normally collects them within 30 to 60 days. Notes receivable are

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written promises to pay a certain sum of money on a specified future date. They may arise from sales,
financing, or other transactions. Notes may be short-term or long-term. Non-trade receivables arise from
a variety of transactions. Some examples of non trade receivables are:
1. Advances to officers and employees.
2. Advances to subsidiaries.
3. Deposits paid to cover potential damages or losses.
4. Deposits paid as a guarantee of performance or payment.
5. Dividends and interest receivable.
6. Claims against, Insurance companies for casualties sustained., Defendants under suit.
Governmental bodies for tax refunds., Common carriers for damaged or lost goods., Creditors for
returned, damaged, or lost goods., Customers for returnable items (crates, containers, etc.).
Because of the peculiar nature of non-trade receivables, companies generally report them as
separate items in the statement of financial position.
The basic issues in accounting for accounts and notes receivable are the same: recognition and valuation.
We discuss these basic issues for accounts and notes receivable next.
3.4. Recognition of Accounts Receivable
In most receivables’ transactions, the amount to be recognized is the exchange price between the two
parties. The exchange price is the amount due from the debtor (a customer or a borrower). Some type
of business document, often an invoice, serves as evidence of the exchange price. Two factors may
complicate the measurement of the exchange price: (1) the availability of discounts (trade and cash
discounts), and (2) the length of time between the sale and the due date of payments (the interest element).
Trade Discounts: Prices may be subject to a trade or quantity discount. Companies use such trade
discounts to avoid frequent changes in catalogs, to alter prices for different quantities purchased, or to
hide the true invoice price from competitors. Trade discounts are commonly quoted in percentages. For
example, say your textbook has a list price of $90, and the publisher sells it to college bookstores for list
less a 30 percent trade discount. The publisher then records the receivable at $63 per textbook. The
publisher, per normal practice, simply deducts the trade discount from the list price and bills the customer
net. As another example, a major coffee roaster at one time sold a 10-ounce package of its coffee listing at
€5.85 to supermarkets for €5.05, a trade discount of approximately 14 percent. The supermarkets in turn
sold the coffee for €5.20 per package. The roaster records the receivable and related sales revenue at
€5.05 per package, not €5.85.
Cash Discounts (Sales Discounts): Companies offer cash discounts (sales discounts) to induce prompt
payment. Cash discounts generally presented in terms such as 2/10, n/30 (2 percent if paid within 10 days,
gross amount due in 30 days), or 2/10, E.O.M., net 30, E.O.M. (2 percent if paid any time before the tenth
day of the following month, with full payment received by the thirtieth of the following month).
Companies usually take sales discounts unless their cash is severely limited. Why? A company that
receives a 1 percent reduction in the sales price for payment within 10 days, total payment due within 30
days, effectively earns 18.25 percent (.01 4 [20/365]), or at least avoids that rate of interest cost.
Companies usually record sales and related sales discount transactions by entering the receivable and sale
at the gross amount. Under this method, companies recognize sales discounts only when they receive
payment within the discount period.

The income statement shows sales discounts as a deduction from sales to arrive at net sales.
Some contend that sales discounts not taken reflect penalties added to an established price to encourage
prompt payment. That is, the seller offers sales on account at a slightly higher price than if selling for cash.
The cash discount offered offsets the increase. Thus, customers who pay within the discount period
actually purchase at the cash price. Those who pay after expiration of the discount period pay a penalty
for the delay—an amount in excess of the cash price. Per this reasoning, companies record sales and
receivables net. They subsequently debit any discounts not taken to Accounts Receivable and credit to

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Sales Discounts Forfeited. The entries in Illustration 7-5 show the difference between the gross and net
methods.

If using the gross method, a company reports sales discounts as a deduction from sales in the income
statement. Proper expense recognition dictates that the company also reasonably estimates the expected
discounts to be taken and charges that amount against sales. If using the net method, a company considers
Sales Discounts Forfeited as an “Other income and expense” item. Theoretically, the recognition of Sales
Discounts Forfeited (net method) is correct. The receivable is stated closer to its realizable value, and the
net sales figure measures the revenue earned from the sale. As a practical matter, however, companies
seldom use the net method because it requires additional analysis and bookkeeping. For example, the net
method requires adjusting entries to record sales discounts forfeited on accounts receivable that have
passed the discount period.
3.5. Valuation of Accounts Receivable
Reporting of receivables involves (1) classification and (2) valuation on the statement of financial
position. Classification involves determining the length of time each receivable will be outstanding.
Companies classify receivables intended to be collected within a year or the operating cycle, whichever is
longer, as current. All other receivables are classified as non-current. Companies value and report short-
term receivables at cash realizable value—the net amount they expect to receive in cash. Determining
cash realizable value requires estimating both um-collectible receivables and any returns or allowances to
be granted.
3.6. Uncollectible Accounts Receivable
As one revered accountant aptly noted, the credit manager’s idea of heaven probably would be a place
where everyone (eventually) paid his or her debts. Unfortunately, this situation often does not occur. For
example, a customer may not be able to pay because of a decline in its sales revenue due to a downturn in
the economy. Similarly, individuals may be laid off from their jobs or faced with unexpected hospital
bills. Companies record credit losses as debits to Bad Debt Expense (or Uncollectible Accounts Expense).
Such losses are a normal and necessary risk of doing business on a credit basis

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Two methods are used in accounting for uncollectible accounts:
 the direct write-off method and
 the allowance method. The following sections explain these methods.
A) Direct Write-Off Method for Uncollectible Accounts: Under the direct write-off method,
when a company determines a particular account to be uncollectible, it charges the loss to Bad
Debt Expense. Assume, for example, that on December 10 ABC Co. writes off as uncollectible
Yusado’s $8,000 balance. The entry is: December 10
Bad Debt Expense………………………………………8,000
Accounts Receivable (Yusado) ……………………………….8,000
(To record write-off of Yusado account)
Under this method, Bad Debt Expense will show only actual losses from uncollectibles. The company
will report accounts receivable at its gross amount. Supporters of the direct write-off-method (which is
often used for tax purposes) contend that it records facts, not estimates. It assumes that a good account
receivable resulted from each sale, and that later events revealed certain accounts to be uncollectible and
worthless. From a practical standpoint, this method is simple and convenient to apply. But the direct
write-off method is theoretically deficient: It usually fails to match costs with revenues of the period. Nor
does it result in receivables being stated at cash realizable value on the statement of financial position. As
a result, using the direct write-off method is not considered appropriate, except when the amount
uncollectible is immaterial.
b). 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 a better measure of
income. It also ensures that companies state receivables on the statement of financial position at their cash
realizable value. Cash 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 statement of financial position by the amount of estimated uncollectible receivables. IFRS requires the
allowance method for financial reporting purposes when bad debts are material in amount.
This method has three essential features:
1. Companies estimate uncollectible accounts receivable. They record this estimated expense in the
same accounting period in which they record the revenues.
2. Companies debit estimated uncollectibles to Bad Debt Expense and credit them to Allowance for
Doubtful Accounts (a contra asset account) through an adjusting entry at the end of each period.
3. When companies write off a specific account, they debit actual uncollectibles to Allowance for
Doubtful Accounts and credit that amount to Accounts Receivable.
Recording Estimated Uncollectibles. To illustrate the allowance method, assume that TANA
Furniture has credit sales of $1,800,000 in 2015. Of this amount, $ 150,000 remains uncollected at
December 31. The credit manager estimates that £10,000 of these sales will never be collected. The
adjusting entry to record the estimated uncollectibles is: December 31, 2015
Bad Debt Expense……………………10,000
Allowance for Doubtful Accounts …………10,000
(To record estimate of uncollectible accounts)
TANA reports Bad Debt Expense in the income statement as an operating expense.
Thus, the estimated uncollectible are recorded with sales in 2015. That is, Tana records
the expense in the same year it made the sales. As Illustration below shows, the company deducts the
allowance account from accounts receivable in the current assets section of the statement of financial
position.
Tana furniture

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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 credit balance in the
allowance account will absorb the specific write-offs when they occur. The amount of £140,000 in above
Illustration represents the cash realizable value of the accounts receivable at the statement date.
Companies do not close Allowance for Doubtful Accounts at the end of the fiscal year.
Recording the Write-Off of an Uncollectible Account. When companies have exhausted all means of
collecting a past-due account and collection appears impossible, the company should write off the account.
In the credit card industry, for example, it is standard practice to write off accounts that are 210 days past
due. To illustrate a receivables write-off, assume that the financial vice president of Tana Furniture
authorizes a write-off of the £1,000 balance owed by Randall Co. on March 1, 2016. The entry to record
the write-off is: March 1, 2016
Allowance for Doubtful Accounts ……………………….1,000
Accounts Receivable (Randall Co.) ………………………….1,000
(Write-off of Randall Co. account)
Bad Debt Expense does not increase when the write-off occurs. Under the allowance method, companies
debit every bad debt write-off to the allowance account rather than to Bad Debt Expense. A debit to Bad
Debt 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.
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, Randall Co. pays the
£1,000 amount that Tana had written off on March 1. These are the entries: July 1, 2016
Accounts Receivable (Randall Co.) ……………………..1,000
Allowance for Doubtful Accounts………………………….1,000
(To reverse write-off of account)
Cash………………………………………….1,000
Account receivable………………………….1,000
(Collection of account)
Note that the recovery of a bad debt, like the write-off of a bad debt, affects only statement of financial
position accounts. The net effect of the two entries above is a debit to Cash and a credit to Allowance for
Doubtful Accounts for £1,000.
Bases Used for Allowance Method. To simplify the preceding explanation, we assumed we knew the
amount of the expected uncollectibles. In “real life,” companies must estimate that amount when they use
the allowance method. 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. It
depends on the relative 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. The choice is whether to

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emphasize income statement or statement of financial position relationships. compares the two bases as
follow

The percentage-of-sales basis results in a better matching of expenses with revenues— an income
statement viewpoint. The percentage-of-receivables basis produces the better estimate of cash realizable
value—a statement of financial position viewpoint. Under both bases, the company determines the
amount of bad debt expense based on its past experience with bad debt losses.
Percentage-of-sales (income statement) approach. In the percentage-of-sales approach, 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. To illustrate, assume that Godere 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 2015 are $800,000, the estimated bad debts expense is $8,000 (1% $800,000). The adjusting
entry Is
December 31, 2015
Bad Debt Expense ……………………………………8,000
Allowance for Doubtful Accounts………………………………..8,000
After the adjusting entry is posted, assuming the allowance account already has a credit balance of $1,723,
the accounts of Godere Company will show the following:

The amount of bad debt expense and the related credit to the allowance account are unaffected by any
balance currently existing in the allowance account. Because the bad debt expense estimate is related to a
nominal account (Sales Revenue), any balance in the allowance is ignored. Therefore, the percentage-of-
sales method achieves a better matching of cost and revenues. This method is frequently referred to as the
income statement approach.
Percentage-of-receivables (statement of financial position) approach. Using past experience, a company
can estimate the percentage of its outstanding receivables that will become uncollectible, without
identifying specific accounts. This procedure provides a reasonably accurate estimate of the receivables’
realizable value. But, it does not fit the concept of matching cost and revenues. Rather, it simply reports

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receivables in the statement of financial position at cash realizable value. Hence, it is referred to as the
percentage of receivables (or statement of financial position) approach. Companies may apply this
method using one composite rate that reflects an estimate of the uncollectible receivables. Or, companies
may set up an aging schedule of accounts receivable, which applies a different percentage based on past
experience to the various age categories. An aging schedule also identifies which accounts require special
attention by indicating the extent to which certain accounts are past due. The schedule of Wilson & Co. in
Illustration is shown blow.

 Wilson reports bad debt expense of €37,650 for this year, assuming that no balance existed in the
allowance account.
 To change the illustration slightly, assume that the allowance account had a credit balance of
€800 before adjustment. In this case, Wilson adds €36,850 (€37,650 2 €800) to the allowance
account, and makes the following entry.
Bad Debt Expense …………………………….36,850
Allowance for Doubtful Accounts………………36850

 Wilson therefore states the balance in the allowance account at €37,650. If the allowance
balance before adjustment had a debit balance of €200, then Wilson records bad debt expense
of €37,850 (€37,650 desired balance €200 debit balance). In the percentage of-receivables
method, Wilson cannot ignore the balance in the allowance account because the percentage is
related to a real account (Accounts Receivable).
3.7. Impairment Evaluation Process
For many companies, making appropriate allowances for bad debts is relatively straightforward. The
IASB, however, provides detailed guidelines to be used to assess whether receivables should be
considered uncollectible (often referred to as impaired). Companies assess their receivables for
impairment each reporting period and start the impairment assessment by considering whether objective
evidence indicates that one or more loss events have occurred. Examples of possible loss events are:
1. Significant financial problems of the customer.
2. Payment defaults.
3. Renegotiation of terms of the receivable due to financial difficulty of the customer.
4. Measurable decrease in estimated future cash fl ows from a group of receivables since initial
recognition, although the decrease cannot yet be identified with individual assets in the group.

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A receivable is considered impaired when a loss event indicates a negative impact on the estimated future
cash flows to be received from the customer. The IASB requires that the impairment assessment should
be performed as follows.
1. Receivables that are individually significant should be considered for impairment separately. If
impaired, the company recognizes it. Receivables that are not individually significant may also be
assessed individually, but it is not necessary to do so.
2. Any receivable individually assessed that is not considered impaired should be included with a group
of assets with similar credit-risk characteristics and collectively assessed for impairment.
3. Any receivables not individually assessed should be collectively assessed for impairment
To illustrate, assume that Hector Company has the following receivables classified into individually
significant and all other receivables.

Hector determines that Yaan’s receivable is impaired by €15,000, and Blanchard’s receivable is totally
impaired. Both Randon’s and Fernando’s receivables are not considered impaired. Hector also determines
that a composite rate of 2% is appropriate to measure impairment on all other receivables. The total
impairment is computed as follows

Hector therefore has an impairment related to its receivables of €78,200. The most controversial part of
this computation is that Hector must include in the collective assessment the receivables from Randon and
Fernando that were individually assessed and not considered impaired. The rationale for including
Randon and Fernando in the collective assessment is that companies often do not have all the information
at hand to make an informed decision for individual assessments.

3.10. NOTES RECEIVABLE

A note receivable is supported by a formal promissory note, a written promise to pay a certain sum of
money at a specific future date. Such a note is a negotiable instrument that a maker signs in favor of a
designated payee who may legally and readily sell or otherwise transfer the note to others. Although all
notes contain an interest element because of the time value of money, companies classify them as interest-
bearing or non-interest-bearing. Interest-bearing notes have a stated rate of interest. Zero-interest-

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bearing notes (non-interest-bearing) include interest as part of their face amount. Notes receivable are
considered fairly liquid, even if long-term, because companies may easily convert them to cash (although
they might pay a fee to do so).
Companies frequently accept notes receivable from customers who need to extend the payment period of
an outstanding receivable. Or, they require notes from high-risk or new customers. In addition, companies
often use notes in loans to employees and subsidiaries, and in the sales of property, plant, and equipment.
In some industries (e.g., the pleasure and sport boat industry) notes support all credit sales. The majority
of notes, however, originate from lending transactions. The basic issues in accounting for notes receivable
are the same as those for accounts receivable recognition and valuation.
Recognition of Notes Receivable
Companies generally record short-term notes at face value (less allowances), ignoring the interest implicit
in the maturity value. A general rule is that notes treated as cash equivalents (maturities of three months
or less and easily converted to cash) are not subject to premium or discount amortization due to
materiality considerations. However, companies should record and report long-term notes receivable on a
discounted basis. When the interest stated on an interest-bearing note equals the effective (market) rate of
interest, the note sells at face value. When the stated rate differs from the market rate, the cash exchanged
(present value) differs from the face value of the note. Companies then record the note at present value
and amortize any discount or premium over the life of a note to approximate the effective-interest (market)
rate. This illustrates one of the many situations in which time value of money concepts are applied to
accounting measurement.
Note Issued at Face Value: To illustrate the discounting of a note issued at face value, assume that Bitew
Corp. Lends Tadu Co Imports €10,000 in exchange for a €10,000, three-year note bearing interest at 10
percent annually. The market rate of interest for a note of similar risk is also 10 percent. computes the
present value or exchange price of the note as follows

In this case, the present value of the note equals its face value because the effective and stated rates of
interest are the same. Bitew records the receipt of the note as follows.
Notes Receivable…………………………………….10,000
Cash…………………………………………….10,000
Bitew recognizes the interest earned each year as follows.
Cash ………………………………..1000
Interest revenue ………………………………..10,000
Note Not Issued at Face Value
Zero-Interest-Bearing Notes. If a company receives a zero-interest-bearing note, its present value is the
cash paid to the issuer. Because the company knows both the future amount and the present value of the
note, it can compute the interest rate. This rate is often referred to as the implicit interest rate.
Companies record the note at the present value (cash paid) and amortize the discount to interest revenue
over the life of the note.
To illustrate, Jemity Company receives a three-year, $10,000 zero-interest-bearing note, the present value
of which is $7,721.80. The implicit rate that equates the total cash to be received ($10,000 at maturity) to

13
the present value of the future cash flows ($7,721.80) is 9 percent (the present value of for three periods
at 9 percent is .77218) Jemity debits the notes receivable for the present value ($7,721.80) as follows.
Notes Receivable ………………………………….7,721.80
Cash……………………………………………………… 7,721.80
Companies amortize the discount, and recognize interest revenue annually, using the effective-interest
method. Illustration shows the three-year discount amortization and interest revenue schedule for the
Jeremiah note

Jemity records interest revenue at the end of the first year using the effective interest method as follows.
Notes Receivable…………………………………. 694.96
Interest Revenue ($7,721.80 3 9%)…………………………….. 694.96
At the end of each year, Jemity increases notes receivable and interest revenue. At maturity, Jemity
receives the face value of the note
Interest-Bearing Notes. Often the stated rate and the effective rate differ. The zero interest-bearing note
is one example. To illustrate a more common situation, assume that Morgan Corp. makes a loan to Marie
Co. and receives in exchange a three-year, €10,000 note bearing interest at 10 percent annually. The
market rate of interest for a note of similar risk is 12 percent. Morgan computes the present value of the
two cash flows as follows

In this case, because the effective rate of interest (12 percent) exceeds the stated rate (10 percent), the
present value of the note is less than the face value. That is, Morgan exchanged the note at a discount.
Morgan records the present value of the note as follows.
Notes Receivable ……………………………9,520
Cash ……………………………………….9,520
Morgan then amortizes the discount and recognizes interest revenue annually using the effective-interest
method. Illustration shows the three-year discount amortization and interest revenue schedule.

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On the date of issue, the note has a present value of €9,520. As a result, additional interest revenue spread
over the three-year life of the note is €480 (€10,000 - €9,520). At the end of year 1, Morgan receives
€1,000 in cash. But its interest revenue is €1,142 (€9,520 * 12%). The difference between €1,000 and
€1,142 is the additional interest revenue (€142) using the effective-interest rate. Morgan records receipt of
the annual interest and amortization of the discount for the first year as follows (amounts per amortization
schedule).
Cash ………………………………1,000
Note receivable …………………….142
Interest revenue ……………….1,142
The carrying amount of the note is now €9,662 (€9,520 + €142). Morgan repeats this process until the end
of year 3. When the present value exceeds the face value, the note is exchanged at a premium. The
premium increases the Notes Receivable account. The increase is then amortized over the life of the note
using the effective-interest method. The amortization reduces both notes receivable and interest revenue.
Notes Received for Property, Goods, or Services. When a note is received in exchange for property,
goods, or services in a bargained transaction entered into at arm’s length, the stated interest rate is
presumed to be fair unless:
1. No interest rate is stated, or
2. The stated interest rate is unreasonable, or
3. The face amount of the note is materially different from the current cash sales price for the same or
similar items or from the current market value of the debt instrument.
In these circumstances, the company measures the present value of the note by the fair value of the
property, goods, or services or by an amount that reasonably approximates the fair value of the note. To
illustrate, Tagel Development Co. sold a corner lot to Rusty Pelican as a restaurant site. Tagel accepted in
exchange a five-year note having a maturity value of £35,247 and no stated interest rate. The land
originally cost Tagel £14,000. At the date of sale, the land had a fair value of £20,000. Given the criterion
above, Tagel uses the fair value of the land, £20,000, as the present value of the note. Tagel therefore
records the sale as:
Notes Receivable……………………………….. 20,000
Land ………………………………………………..14,000
Gain on Sale of Land (£20,000 2 £14,000) …………….6,000
Tagel amortizes the discount to interest revenue over the five-year life of the note using the effective-
interest method.
Valuation of Notes Receivable
The computations and estimations involved in valuing short-term notes receivable and in recording bad
debt expense and the related allowance exactly parallel that for trade accounts receivable. As a result,

15
companies often use one of the collective assessment methods (percentage-of-sales or percentage-of-
receivables) to measure possible impairments. Long-term receivables, however, often involve additional
estimation problems. For example, the value of a note receivable may change over time as a discount or
premium is amortized. In addition, because these receivables are outstanding for a number of periods,
significant differences between fair value and amortized cost often result. In the case of long-term notes
receivable, impairment tests are often done on an individual assessment basis rather than on a collective
assessment basis.
In this situation, impairment losses are measured as the difference between the carrying value of the
receivable and the present value of the estimated future cash flows discounted at the original effective-
interest rate. For example, assume that Tesco Inc. has a note receivable with a carrying amount of
€200,000. The debtor, Morganese Company, has indicated that it is experiencing financial difficulty.
Tesco decides that Morganese’s note receivable is therefore impaired. Tesco computes the present value
of the future cash flows discounted at its original effective interest rate to be €175,000. The computation
of the loss on impairment is as follows

The present value of the note discounted at the original effective-interest rate will generally not be
equal to the fair value of the receivable. That is, the market rate of interest used for discounting will
generally be different than the original effective rate. The IASB indicates that this approach results in the
receivable being reported at amortized cost.

3.11. SPECIAL ISSUES RELATED TO RECEIVABLES

Companies generally follow the recognition and valuation principles discussed in the previous section of
this chapter. Additional issues related to receivables are:
1. Use of fair value option.
2. Derecognition of receivables.
3. Presentation and analysis.
Fair Value Option
As indicated earlier, receivables are generally measured at amortized cost. However, companies have the
option to record fair value in their accounts for most financial assets and liabilities, including receivables.
The IASB believes that fair value measurement for financial instruments provides more relevant and
understandable information than historical cost. It considers fair value to be more relevant because it
reflects the current cash equivalent value of financial instruments.
Fair Value Measurement
If companies choose the fair value option, receivables are recorded at fair value, with unrealized holding
gains or losses reported as part of net income. An unrealized holding gains or loss is the net change in
the fair value of the receivable from one period to another, exclusive of interest revenue recognized but
not recorded. As a result, the company reports the receivable at fair value each reporting date. In addition,
it reports the change in value as part of net income. Companies may elect to use the fair value option at
the time the receivable is originally recognized or when some event triggers a new basis of accounting
(such as when a business acquisition occurs). If a company elects the fair value option for a receivable, it
must continue to use fair value measurement for that receivable until the company no longer owns this
receivable. If the company does not elect the fair value option for a given receivable at the date of
recognition, it may not use this option on that specific receivable in subsequent periods.

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Recording Fair Value Option
Assume that Escobar Company has notes receivable that have a fair value of R$810,000 and a carrying
amount of R$620,000. Escobar decides on December 31, 2015, to use the fair value option for these
receivables. This is the first valuation of these recently acquired receivables. Having elected to use the fair
value option, Escobar must value these receivables at fair value in all subsequent periods in which it
holds these receivables. Similarly, if Escobar elects not to use the fair value option, it must use its
carrying amount (measured at amortized cost) for all future periods. When using the fair value option,
Escobar reports the receivables at fair value, with any unrealized holding gains and losses reported as part
of net income. The unrealized holding gain is the difference between the fair value and the carrying
amount at December 31, 2015, which for Escobar is R$190,000 (R$810,000 - R$620,000). At December
31, 2015, Escobar makes an adjusting entry to record the increase in value of Notes Receivable and to
record the unrealized holding gain, as follows.

December 31, 2015

Notes Receivable ………………………………………………………………190,000
Unrealized Holding Gain or Loss—Income…………………………………190,000
As a result of this entry, Escobar reports the notes receivable at fair value on its statement of financial
position, with the unrealized holding gain reported in “Other income and expense” on its income
statement. In subsequent periods, the company will report any change in fair value as an unrealized
holding gain or loss. For example, if at December 31, 2016, the fair value of the note’s receivable is
$800,000, Escobar would recognize an unrealized holding loss of R$10,000 (R$810,000 2 R$800,000)
and reduce the Notes Receivable account.
Derecognition of Receivables: due to the following reasons company may derecognition receivable.
first when the receivable no longer has any value; that is, the contractual rights to the cash flows of the
receivable no longer exist. For example, if ABC co has a receivable from a customer who declares
bankruptcy, the value of this receivable has expired. Similarly, when ABC co collects a receivable when
due, it removes this receivable from its books. In both cases, ABC no longer has any contractual rights to
these receivables. As a result, the receivables are derecognized. A second situation often occurs if ABC
transfers (e.g., sells) a receivable to another company, thereby transferring the risks and rewards of
ownership to this other company. As an example, if Garcia Company sells its receivables to Holt Inc. and
transfers all the risks and rewards of ownership to Holt, the receivables are derecognized.

Transfers of Receivables
There are various reasons for the transfer of receivables to another party. For example, in order to
accelerate the receipt of cash from receivables, companies may transfer receivables to other companies
for cash. In addition, for competitive reasons, providing sales financing for customers is virtually
mandatory in many industries. In the sale of durable goods, such as automobiles, trucks, industrial and
farm equipment, computers, and appliances, most sales are on an installment contract basis. Second, the
holder may sell receivables because money is tight and access to normal credit is unavailable or too
expensive. Also, a firm may sell its receivables, instead of borrowing, to avoid violating existing lending
agreements. Finally, billing and collection of receivables are often time-consuming and costly.
Conversely, some purchasers of receivables buy them to obtain the legal protection of ownership rights
afforded a purchaser of assets versus the lesser rights afforded a secured creditor. In addition, banks and
other lending institutions may need to purchase receivables because of legal lending limits. That is, they
cannot make any additional loans, but they can buy receivables and charge a fee for this service.

The transfer of receivables to a third party for cash happens in one of two ways:
1. Secured borrowing.
2. Sales of receivables
Secured Borrowing

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A company often uses receivables as collateral in a borrowing transaction. In fact, a creditor often
requires that the debtor designate (assign) or pledge receivables as security for the loan. If the loan is not
paid when due, the creditor can convert the collateral to cash—that is, collect the receivables.
To illustrate, on March 1, 2015, Meng Mills, Inc. provides (assigns) $700,000 of its accounts receivable
to Sino Bank as collateral for a $500,000 note. Meng Mills continues to collect the accounts receivable;
the account debtors are not notified of the arrangement. Sino Bank assesses a finance charge of 1 percent
of the accounts receivable and interest on the note of 12 percent. Meng Mills makes monthly payments to
the bank for all cash it collects on the receivables. Illustration below shows the entries for the secured
borrowing for Meng Mills and Sino Bank

In addition to recording the collection of receivables, Meng Mills must recognize all discounts, returns
and allowances, and bad debts. Each month, Meng Mills uses the proceeds from the collection of the
accounts receivable to retire the note obligation. In addition, it pays interest on the note.9

Sales of Receivables
Sales of receivables have increased substantially in recent years. A common type is a sale to a factor.
Factors are finance companies or banks that buy receivables from businesses for a fee and then collect
the remittances directly from the customers. Factoring receivables is traditionally associated with the
textile, apparel, footwear, furniture, and home furnishing industries. Illustration shows a typical factoring
arrangement.

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Sale without Guarantee
When buying receivables, the purchaser generally assumes the risk of collectability and absorbs any
credit losses. A sale of this type is often referred to as a sale without guarantee (without recourse)
against credit loss. The transfer of receivables in this case is an outright sale of the receivables both in
form (transfer of title) and substance (transfer of risks and rewards). As in any sale of assets, the seller
debits Cash for the proceeds and credits Accounts Receivable for the face value of the receivables. The
seller recognizes the difference, reduced by any provision for probable adjustments (discounts, returns,
allowances, etc.), as a Loss on Sale of Receivables. The seller uses a Due from Factor account (reported
as a receivable) to account for the proceeds retained by the factor to cover probable sales discounts, sales
returns, and sales allowances.
To illustrate, Crest Textiles, Inc. factors €500,000 of accounts receivable with Commercial Factors, Inc.,
on a non-guarantee (or without recourse) basis. Crest Textiles transfers the receivable records to
Commercial Factors, which will receive the collections. Commercial Factors assesses a finance charge of
3 percent of the amount of accounts receivable and retains an amount equal to 5 percent of the accounts
receivable (for probable adjustments). Crest Textiles and Commercial Factors make the following journal
entries for the receivables transferred without guarantee.

In recognition of the sale of receivables, Crest Textiles records a loss of €15,000. The factor’s net income
will be the difference between the financing revenue of €15,000 and the amount of any uncollectible
receivables.

Sale with Guarantee: To illustrate a sale of receivables with guarantee (with recourse) against credit
loss, assume that Crest Textiles issues a guarantee to Commercial Factors to compensate Commercial
Factors for any credit losses on receivables transferred. In this situation, the question is whether the risks
and rewards of ownership are transferred to Commercial Factors or remain with Crest Textile. In other
words, is it to be accounted for as a sale or a borrowing? In this case, given that there is a guarantee for all

19
defaults, it appears that the risks and rewards of these receivables still remain with Crest Textiles. As a
result, the transfer is considered a borrowing—sometimes referred to as a failed sale. Crest Textiles
continues to recognize the receivable on its books, and the transaction is treated as a borrowing.
Assuming the same information as in Illustration above the journal entries for both Crest Textiles and
Commercial Factors are shown in Illustration

In this case, Crest Textiles records a liability to Commercial Factors. Commercial Factors records an
accounts receivable from Crest Textiles. That is, the accounting for a failed sale is similar to that for a
secured borrowing. As the transferred receivables are collected, the Recourse Liability account on the
books of Crest Textiles is reduced. Similarly, on the books of Commercial Factors, the accounts
receivable from Crest Textiles is also reduced.

3.12. Presentation of Receivables

The general rules in classifying receivables are:
1. Segregate and report the carrying amounts of the different categories of receivables.
2. Indicate the receivables classified as current and non-current in the statement of financial position.
3. Appropriately offset the valuation accounts for receivables that are impaired, including a
discussion of individual and collectively determined impairments.
4. Disclose the fair value of receivables in such a way that permits it to be compared with its
carrying amount.
5. Disclose information to assess the credit risk inherent in the receivables by providing information
on:
a) Receivables that are neither past due nor impaired.
b) The carrying amount of receivables that would otherwise be past due or impaired, whose
terms have been renegotiated.
c) For receivables that are either past due or impaired, disclose an analysis of the
age of the receivables that are past due as of the end of the reporting period.
6. Disclose any receivables pledged as collateral.
7. Disclose all significant concentrations of credit risk arising from receivables

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