CHAPTER SIX ACCOUNTING FOR CASH AND RECEIVABLE

6.1 INTRODUCTION
Since cash is the asset most likely to be diverted and used improperly by employees, exposed
for embezzlement and many business transactions either directly or indirectly affect the
receipt or payment of cash. It is therefore necessary that cash be effectively safeguarded by
special controls.

6.2 MEANING OF CASH

Cash includes money on deposit in banks and other items that a bank will accept for
immediate deposit. Money on deposit in banks includes checking and saving accounts. Other
items such as ordinary checks received from customers, money orders, coins and currency and
petty cash also are included as cash. Banks do not accept postage stamps, travel advances to
employees, notes receivable or post-dated checks as cash.

6.3 CHARACTERISTICS OF CASH

The following are some of the characteristics of cash:
a) Cash is used as medium of exchange
b) Cash is the most liquid asset
c) Cash is mostly affected by business transactions
d) Cash is used to measure the value of other assets
e) Cash is mostly exposed to embezzlements

6.4 MANAGEMENT OF CASH

Cash management refers to planning, controlling and accounting for cash transactions and
cash balances. Efficient management of cash is essential to the survival and success of every
business organization. Managing cash requires planning wisely so that there will not be
excess cash held on hand at any point in time; or there is no shortage of cash at any point in
time to meet the business’s needs.

6.5 INTERNAL CONTROL OF 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.
Internal control for cash should include the following procedures:
a) The individuals who receive cash should not also disburse (pay) cash
b) The individuals who hold cash should not access accounting records
c) Cash receipts are immediately recorded and deposited and are not used directly to
make payments.
d) Disbursements are made by serially numbered checks, only upon proper authorization
by someone other than the person writing the check
e) Bank accounts are reconciled monthly.

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The following are the most common elements of cash control and managements: bank
account system, petty cash fund, voucher system, change fund, and cash short and over.
6.5.1 Control of Cash through Bank Accounts
Bank accounts are 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 occurring 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 credited memos, which
inform the company about changes in the cash accounts. For a bank, the 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 is the company’s cash accounts. A credits memo indicates
an increase in the cash balance of the depositor that it has with the bank.
6.5.1.1 Reconciliation of Bank and Book Cash Balances
When all cash receipts are deposited in the bank and all payments are made by check, the
cash account is often called cash in bank. Cash in bank in the depositor’s ledger is an asset
with a debit balance, and the account with the depositor in the bank’s ledger is a liability with
a credit balance. It might seem that the two balances should be equal, but they are not likely to
be equal on any specific date because of either or both of the following: (1) delay by either
party in recording transactions and (2) errors by either party in recording transactions.

Ordinarily, there is a time lag of one day or more between the date a check is written and the
date that it is presented to the bank for payment. If the depositor mails deposits to the bank or
uses the night depository, a time lag between the date of the deposits and the date that it is
recorded by the bank is also probable. Conversely, the bank may debit or credit the
depositor’s account for transactions about which the depositor will not be informed until later.
Examples are service or collection fees charged by the bank and the proceeds of note
receivable sent to the bank for collection.

To determine the reasons for any difference and to correct any errors that may have been
made by the bank or the depositor, the depositor’s own records should be reconciled with the
bank statement. The bank reconciliation is divided in to two major sections: one section
begins with the balance according to the bank statement and ends with the adjusted
balance; the other section begins with the balance according to the depositor’s records and
also ends with the adjusted balance. The two amounts designated as the adjusted balance must
be equal.
The most common examples that cause disparity between the two balances are:
a) Outstanding checks: deducted from bank statement
Checks issued and recorded by the company, but not yet presented to the bank for
Payment.
b) Deposits in transit: added on the bank statement

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 Cash receipts recorded by the depositor, but not reached the bank to be included in the
bank statement for the current month.
c) Service charges: deducted from depositors balance
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.
d) Charges for depositing NSF- checks: deducted from depositors balance
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) Notes collected by bank: added on the depositors balance
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.
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.
6.5.1.2 Steps in Preparing Bank Reconciliation
Bank reconciliation 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 into agreement.
The steps to prepare bank reconciliation are:
a) 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.
b) 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.
c) Any credit memorandums issued by the bank that have not been recorded by the
depositor, are added to the balance per depositor’s record.
d) Any debit memorandums issued by the bank that have not been recorded by the
depositor are deducted from the balance per depositor’s record.
e) Any errors in the bank statement or depositor’s accounting records are adjusted.
f) The equality of adjusted balance of statement and adjusted balance of the depositor’s
record is compared.
g) Journal entries are prepared to record any items delayed by the depositor.
6.5.1.3 Illustration of Bank Reconciliation
The January balance in cash in bank in RAM Company ledger as of January 31 shows Br.
4,262.83. Assume also that on January 31, 2000, the bank statement for RAM Co. shows a
balance of Br. 5,000.17. The accountant of RAM Company has identified the following items:
1. A deposit of Br. 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 Br. 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 from MAN Company Br.
524.74.
4. Three debit memorandums accompanied the bank statement: Fee charged by bank for
handling collection of notes receivable Br.5; a check of Br. 50.25 received from a
customer, RON company, and deposited by RAM company was charged back as NSF;
and service charge by bank for the month of January amounts to Br. 12.00.
5. Check No. 305 was issued by RAM Company for payment of telephone expense in the
amount of Br. 85 but was erroneously recorded in the cash payments journal as Br. 58.
The January 31 bank reconciliation for RAM Company is shown below:

RAM Company
Bank Reconciliation
January 31, 2000
Balance per bank statement, Jan. 31, 2000 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 cash balance Br. 4,693.32

Balance per depositor’s record, Jan. 31, 2000 Br. 4,262.83

Add: Note Receivable collected by bank 524.74
Subtotal Br. 4,787.57
Deduct: collection fee Br. 5.00
NSF check of Ron Co. 50.25
Service charge 12.00
Error on check stub No. 305 27.00 94.25
Adjusted cash balance Br. 4,693.32
After a bank reconciliation has been prepared, the items which appear in the section of the
bank reconciliation beginning with the balance according to the depositor’s records must be
entered in to the accounting records through the use of adjusting journal entries.

The following are journal entries related to the bank reconciliation.

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2000
Jan. 31 cash 524.74
Notes Receivable 524.74
To record collection of Note Receivable
Collected by bank
31 Miscellaneous Expense 17.00
Accounts Receivable-RON Co. 50.25
Utilities Exp. 27.00
Cash 94.25
To record bank service charges,
NSF check and error in recording
Check No. 305

6.5.2 Petty Cash Fund

Petty cash fund, which is part of the total cash balance, is used to handle many types of small
payments such as employee transportation costs, purchase of office supplies, purchase of
postage stamps, and delivery charges. Many businesses find it convenient to make minor
expenditures instead of writing checks. The petty cash amount various from Br. 50 or less
to more than Br. 1,000, which will cover small expenditures for a period of two or three
weeks.

5.5.2.1 Establishment of Petty Cash

To establish a petty cash fund a check is issued to a bank. This check is cashed and the money
is kept on hand in a petty cash box. One employee is designated as custodian of the fund. The
issuance of the check for establishment is recoded by debiting petty cash account and
crediting cash. Each time a disbursement is made from the fund, the employee records the
essential details on receipt form, obtains the signature of the payee as proof of the payment,
and initials the completed form.
7.5.2.2 Replenishment of Petty Cash
When the amount of money in the petty cash fund is reduced to the predetermined amount,
the fund is replenished. During the period, the custodian makes small payments form the petty
cash fund and obtains a receipt or prepares a petty cash voucher. This petty cash voucher
explains the nature and amount of every expenditure and is kept with the fund. When
the fund runs low or at the end of the company’s fiscal period, a check is issued to reimburse
the fund for the expenditures made during the period. The issuance of this check is recorded
by debiting the appropriate expense accounts and crediting account or vouchers payable.

To illustrate the entries that would be made in accounting for petty cash, assume that a
voucher system is used and that a petty cash fund of $100 is established on august 1. At the
end of august, the petty cash receipts indicate expenditures for the following items: office
supplies, $28; postage, $22; store supplies, $35; and daily newspaper, $3.70. to record the
establishment and replenishment of the petty cash fund, the entries in general journal form
would be as follows:

Aug. 1 Petty cash………………………………100.00

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 Account payable ………………………………….100.00
1 Account payable …………………………100.00
Cash in bank …………………………………………..100.00
31 Office supplies …………………………..50.00
Store supplies ………………………….. 35.00
Misc. expense ……………………………3.70
Account payable …………………………….. 88.70

31 Account payable ………………………88.70

Cash in bank ……………………………………….88.70
Replenishing the petty cash fund restores it to its original amount. It should be noted that the
only entry in the petty cash account will be the initial debit, unless at some later time the
standard amount of the fund is increased or decreased.
6.5.3 Voucher System
One method to control cash disbursements is a voucher system. A voucher is a special form,
which contains relevant data about a liability and its payment.
In a voucher system, a voucher is prepared for each expenditure and approved by the
designated officials. Each approved voucher represents liability and recorded in a voucher
register, which is similar to purchases journal. Those registered vouchers are filed according
to their payment date in an unpaid vouchers file. The vouchers and supporting documents then
are sent to the treasure or other official is the finance department before issuing checks. When
the checks are signed, the paid vouchers are recorded in a check register which is similar to
cash payments journal. Those paid vouchers are filed in paid vouchers file according to their
serial number for future reference.
6.5.4 Change Fund
Some businesses that receive cash directly from customers should maintain a fund of currency
and coins in order to make change (Amharic=>”zirzir”). This fund, which is part of the total
cash balance, is called change fund. A change fund is established by issuing a check to the
bank and transferring the cash to the custodian. The issuance of a check to establish a change
fund is recorded by debiting cash on hand and crediting cash or voucher payable.
Once a change fund is established, there will be no change in its balance unless there is a
decision by management to increase or decrease the fund balance.

6.5.5 Cash Short and Over

In handling cash receipts from daily sales, a few errors in making changes will occur. These
errors may cause a cash shortage or overage at the end of the day. The account cash short and
over is debited if there is shortage and credited if there is overage. At the end of the period
if the account had a debit balance, it appears in the Income statement as miscellaneous
expense; if it has a credit balance, it is shown as miscellaneous revenue.
For example, assume that the total cash sales recorded during the day amounts to Br. 12,420.
However, the cash receipts in the cash register drawer (actual cash count) total Br. 12,415.
The following entry would be made to adjust the accounting records for the shortage in the
cash receipts:

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 Cash Short and Over 5.00
Cash 5.00

To record a Br. 5.00 (Br. 12,420 – 12,415)

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7. Accounting for Receivables
7.1 INTRODUCTION

In this unit, we emphasize on how companies account for and report receivables. We have
discussed the importance of estimating uncollectible in order to determine the reasonable
balance of receivables on the balance sheet.

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.

7.2 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 60 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.

7.3 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.

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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.

7.4 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: -

 Due Date
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

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 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 Computation
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.
 Maturity Value
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. where MV= Maturity value
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 MV = FV + I FV = Face value
I = Interest

7.5 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

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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
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 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.

7.6 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.

Maker Goods (1) Payee

Note (2)
Cash (3) cash less discount
Bank
Note (2)

Notes Receivable is discounted with or without recourse. When a note is discounted without
recourse, the bank assumes the risk of a bad debt loss and the original payee doesn’t have a
contingent liability. A contingent liability is an obligation to make a future payment if and
only if an uncertain future event occurs. A note discounted without recourse is like an outright
sale of an asset. If a note is discounted with recourse and the original maker of the note fails
to pay the bank when it matures, the payee of the note must pay for it. This means a company
discounting a note (an endorser) with recourse has a contingent liability until the bank is paid.

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A Co. should disclose contingent liabilities in the accompanying notes to its financial
statements.

To illustrate, assume that a 90-day, 12%, Br. 20,000 N/R from Hiwot Co. dated Jan.1, 20x2 is
discounted at the payee’s bank on February 12, 20x2 at the discount rate of 15%. The steps to
determine the proceeds (-the amount to be received by the payee from the bank upon
discounting) are as follows:

Step 1 – Determine the maturity date & maturity value.

MD = April –1 & MV = FV + I = 20,000 + [20,000 X 12% X 90/360]
= 20,600
Step 2 – Determine the Bank Discount (Bank discount is an interest that is charged by
the bank and is computed based on the maturity value of the note for the discount
period. Discount Period is the time the bank must hold the note) before it becomes
due.
Bank Discount = MV X DR X DP where MV = Maturity value ( 20,600)
DR = Discount Rate (15%)
Discount = 20,600 X 15% X 48/360 DP = Discount period ( from
February12 to April 1)
= 412

Step 3- Determine proceed (proceed is the amount of cash paid to the endorser after
deducting discount)
i.e. proceed = MV – D
= 20,600 – 412 = 20188
Step 4 – Record the necessary journal entry at the date of discount. (Here, record interest
revenue which is the excess of proceeds from the face value or record interest
expense when the proceed is less than the face value of the note)
Feb 12. Cash---------------------------------20,188
N/R -----------------------------------------20,000
I. Rev. --------------------------------------188.00
Discounted Br. 20,000, 90-day, 12% note at 15%

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The length of the discount period and the difference between the interest rate and the discount
rate determine whether interest expense or interest revenue will result from discounting.
When a discounted Notes Receivable is dishonored, the bank notifies the endorser and asks
for payment if there is no statement that limits the responsibility of the endorser. In some
cases, the bank may charge a protest fee of notifying the endorser that a note has been
dishonored. The entire amount paid to the bank by the endorser, including the interest and
protest fee, should be debited to the A/R of the maker. For example, assume that the maker,
Hiwot Co, dishonored the above discounted note at maturity. The bank charges a protest fee
of Br. 25. The endorser’s entry to record the payment to the bank is as follows:

April 2. A/R Hiwot Co----------------- 20,625

Cash-----------------------------------20, 625
Paid dishonored, discounted note
July-20. Received the amount due on the dishonored note plus interest for 20-days,
at12% on the amount charged to Adama Co. on April-30.

7.7 ACCOUNTING FOR UNCOLLECTIBLE ACCOUNTS RECEIVABLE

When credit is extended, some amount of uncollectible receivables is generally inevitable

regardless of the care taken in granting credit and the control procedures used. The operating
expense incurred because of the failure to collect receivables is called Uncollectible Accounts
Expense or Bad Debts Expense or Doubtful Accounts Expense.

When does an account as a note become uncollectible? There is no general rule for
determining when an account receivable becomes uncollectible. The fact that a debtor fails to
pay an account receivable according to a sales contract or fails to pay a note on the due date
does not necessarily mean that the account receivable will be uncollectible. The debtor’s
bankruptcy is one of the most significant indications of partial or complete uncollectibility.
Other indications include the closing of the customer’s business and the failure of repeated
attempts to collect.
There are two methods of accounting for uncollectible receivables. The allowance method,
which provides an expense for uncollectible receivables in advance of their write-off (removal

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from the ledger) and the direct write-off method, which recognizes the expense only when
accounts receivable are judged to be worthless. We will discuss each of these methods next.

8.7.1 Allowance Method

The allowance method of accounting for bad debts matches the expected loss from
uncollectible A/R against the sales they helped produce. We must use expected losses since
management can’t exactly identify the customers who won’t pay their bills at the time of sale.
This means at the end of each period the allowance method requires us to estimate the total
bad debts expected to result from that period’s sales. An allowance is then recorded for this
expected loss. This method has two advantages over the direct write-off method:

(1) Bad debt expense is charged to the period in which the related sales are recognized, and
(2) A/R is reported on the Balance Sheet at the estimated amount of cash to be collected.

The allowance method estimates bad debt expense at the end of each accounting period and
records it through an adjusting entry. To illustrate this method, assume the A/R account has a
balance of Br. 50,000 and based on careful study of the experience of other companies, Nile
Co. estimates that a total of Br. 2000 will be uncollectible.

This estimated expense is recorded through the following adjusting entry.

Dec. 31 Uncollectible Accounts Expense 2000
Allowance for Doubtful Accounts 2000
To record estimated bad debts

The amount Br. 2000 is an estimated reduction in A/R;but it cannot be credited to specific
customer accounts or to the A/R controlling account. Instead, a contra asset account entitled
Allowance for Doubtful Accounts is credited.

As with all periodic adjustments the above entry serves two purposes. First, it reduces the
value of the receivable to the amount of cash expected to be realized in the future. This
amount, which is Br. 48,000 (Br. 50,000 – Br. 2,000), is called the Net Realizable value of the
receivables. Second, the adjusting entry matches the Br. 2000 expense of uncollectible
account with the related revenues of the period.

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Write-off to the Allowance Account
When specific accounts are identified as uncollectible, they are written-off against the
Allowance for Doubtful Accounts. Assume after spending some time trying to collect from
Shalla Co., Nile Co. decides that Shalla’s Br. 200 accounts receivable is uncollectible and
makes the following entry to writ-it off.
Jan. 25 Allowance for Doubtful Accounts 200
A/R-Shalla Co. 200
To write-off uncollectible accounts.

Note two aspects of this entry and its related accounts

Before Write-off After Write-off
A/R 50,000 49,800
Less Allowance for D. a/cs 2,000 1,800
NRV 48,000 48,000
Neither total assets nor net income are affected by the Write-off of a specific account. But
both total assets and net income are affected by the recognized bad debts expense for the year
in the adjusting entry.

Recovery of Uncollectibles Accounts

When a customer fails to pay and the account is written-off as uncollectibles, his or her credit
standing is jeopardized. To help restore credit standing, a customer may later choose to
voluntarily pay all or part of the amount owed. A company makes two entries when collecting
an account previously written-off. The first is to reverse the original write-off and reinstate the
customer’s account. For example, assume the amount written-of in the preceding entry is later
collected on February 15.

On Feb. 15- The entries to record this recovery are:

Feb. 15- A/R Shalla Co. 200
Allowance for Doubtful Accounts 200
To reinstate accounts previously written-off

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Feb. 15- Cash 200
A/R-Shalla Co. 200
To record full payment of account

7.7.2 Estimating Uncollectible

The allowance method of accounting for bad debts requires an estimate of bad debts expense
to prepare the adjusting entry at the end of each accounting period. How does a company
estimate bad debts expense? There are two common methods. One is based on the Income
Statement relationship between bad debts expense and sales. The second is based on the
Balance Sheet relationship between A/R and the Allowance for Doubtful Accounts. Both
methods require an analysis of past experience.
7.7.2.1 ESTIMATING BASED ON SALES
Accounts receivable are created by credit sales. The amount of credits sales during the period
may therefore be used to estimate the amount of uncollectible accounts expense. The amount
of this estimate is added to whatever balance exists in Allowance for Doubtful Accounts. To
illustrate, assume Wonji Co. has credit sales of Br. 500,000 in 20X2. Based on past
experience and the experience of other Cos, Wonji Co. estimated 0.007% of credit sales are
uncollectible. Using this prediction, the adjusting entry for uncollectible accounts at the end of
the period, 20X2 is as follows.

Dec. 31 Uncollectible Accounts Exp. (500,000 X 0.007%) 3500

Allowance for Doubtful Accounts 3500
To record estimated Uncoll. Exp.

This entry doesn’t mean that the Dec. 31, 20X2, balance of Allowance for Doubtful Accounts
will be Br. 3500. A Br. 3500 balance results only if the account had a zero balance prior to
posting the adjusting entry. For example, assume that Allowance for Doubtful Accounts has a
credit balance of Br. 1000 before adjustment. Now, what will be the balance of Allowance for
Doubtful Accounts be at the end of 20X2 ? It will be Br. 4500. If there had been a debit
balance of Br. 500 in the Allowance for Doubtful Accounts before the year-end adjustment,
and the amount of adjustment. would still have been Br. 3500. What will have been the end
balance of Allowance for Doubtful Accounts at the end of 20X2? (Find by your own!)

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7.7.2.2 Estimate Based on Analysis of Receivables
The longer an A/R remains outstanding, the less likely that it will be collected. Thus, we can
base the estimate of uncollectible accounts on how long the accounts have been outstanding.
For this purpose, we can use a process called Ageing receivables which examines each A/R to
estimate the amount of uncollectible. Receivables are classified by how long they are past
their due date. Then, estimates of uncollectible are made assuming the longer an amount is
past due the more likely it is to be uncollectible. After the outstanding amounts are classified
and analyzed in the Aging schedule the expected balance for the Allowance for Doubtful
Accounts will be estimated. Let’s assume the amount estimated is Br. 5000. So, do you think
this is the adjustment amount required for the current period? NO!
Because, this estimated amount is the expected balance of the Allowance for Doubtful
Accounts after adjustment rather than the current year provision for Uncollectible Accounts
Expense. Therefore, to determine the current year provision we must take in to account the
balance before adjustment in the Allowance for Doubtful Accounts. To illustrate, assume
there is as credit Balance of Br. 1300 in the allowance account before adjustment. The amount
to be added to this balance is therefore Br. 3800 (Br 5000 – Br. 1200) and the adjustment
entry is as follows:
Dec. 31 Uncollectible Accounts Expense 3800
Allowance for Doubtful Accounts 3800
To record Uncollectible expense.

Alternatively, if the Allowance for Doubtful Accounts had an unadjusted debit balance of Br.
700, then the required adjustment is Br. 5700. (Br. 5000 + 700) and the adjustment entry is as
follows:
Dec. 31 . Uncollectible Accounts Expense 5700
Allowance for Doubtful Accounts 5700
To record Uncollectible expense.
7.7.3 The Direct- Write-Off Method
The Direct Write-off method of accounting for bad debts records the loss from an
uncollectible A/R at the time it is determined to be uncollectible. No attempt is made to
predict uncollectible accounts expense. Bad debt expense is recorded when specific accounts

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are determined to be worthless. If Wonji Co. uses a direct write-off method and determines on
Feb. 20, it can’t collect from a customer- Home Co.- Br. 500. The entry to write-off the
customer’s account is as follows

Feb. 20 Uncollectible Accounts Expense 500

A/R- Home Co. 500
To write-off Uncollectible accounts

Sometimes an amount previously written off is later collected. This can be due to factors such
as continual collection efforts or the good fortune of a customer. If the account of Home Co.
that was written-off directly to Bad Debt Expense is later collected in full, the following two
entries record this recovery.
Mar. 5 - A/R- Home Co. 500
Uncollectible Accounts Expense 500
To reinstate account
Mar. 5 - Cash 500
A/R- Home Co. 500
To record full payment of account

If the recovery is in the year following the writ- off, there is no balance in the Uncollectible
Accounts Expense account related to the previous year’s write-off and no other write-offs are
expected. So the credit portion of the entry recording the recovery can be made to a Bad
Debts Recoveries revenue account.

To conclude this part companies must weigh at least two principles when considering use of
the direct write-off method:
(1) Matching principle, & (2) Materiality principle

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