Accounting Principles I – Receivables - Quick Guides | Accounting

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Study GuideAccounting Principles I–Receivables1.ReceivablesDefinedWhen a company sells something but doesn’t get paid right away, it creates areceivable.Areceivableis money the company expects to collect in the future.Think of it like this: the company has earned the revenue, but the cash hasn’t arrived yet.Accounts Receivable (A/R)Accounts receivableare amounts thatcustomers owethe company fromnormal credit sales.Example: A customer buys goods today and promises to pay later.Because most accounts receivable are collected withintwo months, they are considered acurrentasset.Where do accounts receivable appear on the balance sheet?Accounts receivable usually show up under current assets:•Below short-term investments•Above inventoryNotes ReceivableNotes receivableare amounts owed to the company by customers (or others) who have signed aformal promissory note.Apromissory noteis a written promise to pay a specific amount of money, usually on a certain date.Why are promissory notes important?Promissory notes make the debt more official andstrengthen the company’s legal claimifsomeone doesn’t pay as promised.Current vs. Long-Term Notes Receivable

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Study GuideWhere a note receivable appears on the balance sheet depends on itsmaturity date(when it mustbe paid):•Due in 1 year or less → Current asset•Due in more than 1 year → Long-term assetTrade Receivables vs. Other ReceivablesReceivables that come fromsales to customersare calledtrade receivables.This includes:•Accounts receivable•Notes receivable(when they come from sales)But not all receivables come from selling products or services. Companies can also havenontradereceivables.Examples of Nontrade ReceivablesHere are some common nontrade receivables:Interest ReceivableIf the company earns interest (from notes or other interest-bearing assets), it may not receive thecash right away.So at the end of the accounting period, the company records the interest it has earned but notcollected yet asinterest receivable.Other Nontrade ReceivablesThese can include:•Wage advances(money given to employees that they must repay)•Formal loans to employees•Loans to other companiesWhy list them separately?If nontrade receivables are important (significant in amount), they are usually shown inseparatebalance sheet categoriesbecause:

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Study Guide•Each type hasdifferent risks•Each type hasdifferent liquidity(how quickly it can be turned into cash)Net Realizable Value (How Receivables Are Reported)Receivables are usually reported on the balance sheet at theirnet realizable value.Net realizable valuemeans:the amount of cash the companyexpects to actually collectIn other words, it’s not always the full amount owed—it's the amount the company realisticallybelieves it will receive.2.Evaluating Accounts ReceivableWhen a business sells products or services on credit, it createsaccounts receivable—moneycustomers promise to pay later.But here’s the reality:not every customer pays.Some customers end up never paying what they owe. These unpaid amounts are calleduncollectible accounts, or more commonly,bad debts.To account for bad debts, companies usetwo methods:1.Direct Write-Off Method2.Allowance Method1.Direct Write-Off MethodWhat it meansUnder thedirect write-off method, a business records bad debtsonly when it is surethe customerwill not pay.This usually happensafter multiple attemptsto collect the money.How the journal entry worksWhen the company finally decides an account won’t be collected:

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Study Guide•Bad Debts Expense increases(because the company lost money)•Accounts Receivable decreases(because the customer no longer owes it on the books)Example: J. Smith owes$225and never pays.Why companies use it for taxesTheInternal Revenue Service (IRS)allows a business to deduct bad debts for tax purposesonlyafter specific accounts are identified as uncollectible.So for taxes, companies must follow this method.Why it’s not usually allowed for financial reportingMost companiescannotuse the direct write-off method on their financial statements unless baddebts areinsignificant.Why?Because it can break thematching principle.Matching principle:expenses should be recorded in thesame periodas the revenue theyhelped generate.The problem with direct write-off is that the bad debt expense might be recordedmonths after thesale happened, so the expense and revenue don’t match.That’s why most companies:•Usedirect write-offontax returns•Use theallowance methodonfinancial statements

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Study Guide2.Allowance Method (Most Common for Financial Statements)What it meansUnder theallowance method, the company estimates bad debtsat the end of each accountingperiod, based on the business activity during that period.This means bad debt expense is recordedbefore the company knows exactly which customerswon’t pay.How companies estimate bad debts•Established companiesuse theirpast experience•New companiesmay rely onindustry averagesuntil they have enough historyWhy AccountsReceivable is NOT reduced directlyCompanies donotcredit Accounts Receivable when estimating bad debts.That’s becauseAccounts Receivable is a control account.Acontrol accountmust always equal the total of all individual customer balances in theaccounts receivable subsidiary ledger.Since the company doesn’t knowwhich specific customerswill fail to pay yet, it can’t reduce individualaccounts.So instead, the company uses a special contra-asset account called:Allowance for Bad Debts(also calledAllowance for Doubtful Accounts)This account is subtracted from Accounts Receivable to show how much the companyexpects tocollect.That expected amount is called the:Net realizable value of Accounts ReceivableAdjusting Entry to Estimate BadDebts

Study GuideSuppose at the end of the company’s first accounting period, it estimates that$5,000of receivableswill become uncollectible.Adjusting entry:•DebitBad Debts Expense … 5,000•CreditAllowance for Bad Debts … 5,000What this accomplishesAfter this entry:•The subsidiary ledger still shows each customer’sfull balance•The Accounts Receivable control account still matches the subsidiary ledger total•Allowance for Bad Debts now has acredit balance•The company can report receivables atnet realizable value•Bad debts expense is recorded in thecorrect period3.Writing Off a Specific Customer (Using the Allowance Method)Once the company identifies a customer who definitely won’t pay, it removes that customer’s balancefrom the books.Example: J. Smith’s balance of$225is uncollectible.

Study GuideImportant idea: Net realizable value does NOT changeUnder the allowance method, writing off an account doesnotchange the net realizable value ofAccounts Receivable.It simply reduces both accounts by the same amount.Posting reminderAny general journal entry that affects thecontrol account(Accounts Receivable) must also beposted to:•Thegeneral ledger Accounts Receivable

Study Guide•The correct customer account in thesubsidiary ledger(like J. Smith)What If a Customer Pays After Being Written Off?This happens more often than you might think!If a customer’s debt was written off and they later decide to pay, the company must record it properly.That requirestwo entries.

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