1

STUDY UNIT SIX

RECEIVABLES

6.1 Accounts Receivable -- Fundamentals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

6.2 Trade Receivables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
6.3 Transfers of Receivables and Other Financial Assets............................................................. 10
6.4 Notes Receivable ..................................................................................................................... 13

This study unit primarily covers accounts and notes receivable, assets less liquid than
available-for-sale securities but more liquid than inventories. Accounts receivable often are short-
term, unsecured, and informal credit arrangements (open accounts). Notes receivable are evidenced
by a formal instrument, such as a promissory note. A formal document provides its holder with a
stronger legal status than does an account receivable.

6.1 ACCOUNTS RECEIVABLE -- FUNDAMENTALS

1. Definition
a. A receivable is an asset recognized to reflect a claim against another party for the receipt
of money, goods, or services. For most accounting purposes, the claim is expected to be
settled in cash.
b. The recording of a receivable, which often coincides with revenue recognition, is
consistent with accrual accounting.
2. Current vs. Noncurrent Receivables
a. A receivable is a current asset if it is reasonably expected to be collected within the longer
of 1 year or the entity’s normal operating cycle.
1) Otherwise, it should be classified as noncurrent. Noncurrent receivables are
measured at the present value of expected cash flows.
3. Trade vs. Nontrade Receivables
a. Trade receivables, the majority of receivables, are current assets resulting from credit
sales to customers in the normal course of business and due in customary trade terms.
1) They are normally unsecured and noninterest-bearing.
2) They represent unconditional rights to consideration from contracts with customers.
b. Nontrade receivables are all other receivables. They include among others
1) Lease receivables
2) Interest, dividends, rent, or royalties accrued

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2 SU 6: Receivables

4. Trade Discounts
a. Trade discounts adjust the gross (list) price for different buyers, quantities, and costs.
Net price after the trade discount is the basis for recognition.

EXAMPLE 6-1 Trade Discount

An item with a list price of $1,000 may be subject to a 40% trade discount in sales to wholesalers. Thus,
$400 is subtracted from the list price in arriving at the actual selling price of $600. Only the $600 is recorded.
The accounts do not reflect trade discounts.

b. Some sellers offer chain-trade discounts such as 40%, 10%, which means certain
buyers receive both a 40% discount and a 10% discount.

EXAMPLE 6-2 Chain-Trade Discount

In Example 6-1, an additional discount of $60 reduces the actual selling price to $540. All journal entries by
the buyer and seller are for $540, with no recognition of the list price or the discount. The two discounts are
not added but are calculated sequentially.

c. Trade discounts are solely a means of calculating the sales price. They are not recorded.
5. Cash Discounts
a. Cash discounts (prompt payment discounts) accelerate cash collection by rewarding
customers for early payment.
1) A common example of prompt payment discount is 2/10, n/30. It means a
2% discount if the invoice is paid within 10 days, or the entire balance is due in
30 days.
b. Because of the uncertainty as to whether customers will pay during the discount period
and receive the discount, the consideration in this type of contract is variable.
1) At contract inception, an entity should estimate the number of customers that are
expected to receive the discount and recognize revenue based on the expected
amount of consideration to which it will be entitled.
6. Measurement
a. Accounts receivable are presented at the net amount expected to be collected. They are
measured using the amortized cost basis and reported minus the allowance for credit
losses (previously called the allowance for uncollectible accounts).
b. The amortized cost basis is the amount at which an account receivable is originated
or acquired, adjusted for applicable accrued interest and amortization of premium or
discount (in the case of noncurrent receivables), cash and trade discounts, collection of
cash, and write-offs.
c. The allowance for credit losses on accounts receivable must be recorded at the
reporting date. It represents the portion of accounts receivable that the entity does not
expect to collect.
1) The allowance for credit losses is a valuation account that is deducted from the
accounts receivable balance.
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d. Initial recognition of the allowance for credit losses and subsequent changes in the
allowance balance are recognized immediately in the income statement in the credit
loss expense (previously called bad debt expense) account.
1) An increase in the balance of the allowance for credit losses is recognized as a
credit loss expense.
Credit loss expense $XXX
Allowance for credit losses $XXX
2) A decrease in the balance of the allowance for credit losses is recognized as a
reversal of credit loss expense.
Allowance for credit losses $XXX
Credit loss expense $XXX
e. The allowance for credit losses should be estimated based on entity’s past experience
taking into account current and forecasted economic conditions.
7. Balance Sheet Presentation
a. On the face of the balance sheet, the carrying amount of accounts receivable is presented
net of any allowance for credit losses.
b. The allowance for credit losses must be separately presented as a deduction from the
balance of accounts receivable.
Balance sheet:
Accounts receivable $X,XXX
(Allowance for credit losses) (X,XXX)
Accounts receivable, net $X,XXX

c. Material receivables should be segregated. Among the usual categories are

1) Notes receivable (with disclosure of the effective interest rates)
2) Trade receivables
3) Nontrade receivables
d. Receivables should be separated into current and noncurrent portions.
e. Discount or premium resulting from a present value measurement directly decreases or
increases the face amount of a note.
f. Disclosure should be made of
1) Related party receivables, e.g., those arising from loans to employees or affiliates
2) Pledged or assigned receivables
3) Concentrations of credit risk (described in Study Unit 4, Subunit 6)
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6.2 TRADE RECEIVABLES

1. Overview
a. Trade receivables are current, noninterest-bearing accounts receivable that are reported
at the net amount expected to be collected, i.e., net of an allowance for credit losses.
1) Interest recognition (except for late payment) and present value calculations are not
relevant.
b. The principal measurement issue for accounts receivable is the estimation of the
allowance for credit losses and calculation of credit loss expenses for the period.
1) The two approaches to accounting for credit losses are the direct write-off method
and the allowance method. However, only the allowance method is acceptable
under GAAP.
2. Direct Write-Off Method (not allowed under GAAP)
a. The direct write-off method expenses bad debts when they are determined to be
uncollectible. It is not acceptable under GAAP because
1) It does not match revenue and expense when the receivable and the write-off are
recorded in different periods.
2) It does not state receivables at the net amount expected to be collected.
b. This method is acceptable for tax purposes.
3. Allowance Method (required under GAAP)
a. The allowance method attempts to match credit loss expense with the related revenue.
This method is required under GAAP.
1) The periodic journal entry to record credit loss expense is
Credit loss expense $XXX
Allowance for credit losses $XXX
2) As specific accounts receivable are written off, they are charged to the allowance
account.
Allowance for credit losses $XXX
Accounts receivable $XXX
3) Thus, the write-off of a particular account has no effect on expenses.
a) Write-offs do not affect the carrying amount of the net accounts receivable
balance because the reductions of gross accounts receivable and the
allowance are the same.
4) In the balance sheet, the carrying amount of accounts receivable is reported at the
net amount expected to be collected.
Gross accounts – Allowance for = Carrying amount of
receivable credit losses accounts receivable
b. Under the allowance method, the two approaches to calculating the amount charged to
credit loss expense are the income statement approach and the balance sheet approach.
 SU 6: Receivables 5

4. Income Statement Approach (Percentage of Sales)

a. Under the income statement approach, the entity estimates the periodic credit loss
expense as a percentage of sales on credit. The journal entry is
Credit loss expense $XXX
Allowance for credit losses $XXX
b. The ending balance of the allowance for credit losses is determined after all the activity in
the allowance account is recorded during the period.

EXAMPLE 6-3 Income Statement Approach

Midburg Co. has the following unadjusted account balances at year end:
Cash $ 85,000 Dr.
Accounts receivable 100,000 Dr.
Allowance for credit losses 2,000 Cr.
Sales on credit 500,000 Cr.
Based on its experience, Midburg expects credit losses to average 2% of credit sales. Thus, the estimated
credit loss expense is $10,000 ($500,000 × 2%). The year-end adjusting entry is
Credit loss expense $10,000
Allowance for credit losses $10,000
The year-end adjusted balance of allowance for credit losses is a $12,000 credit ($10,000 + $2,000).
Balance sheet presentation
Accounts receivable $100,000
(Allowance for credit losses) (12,000)
Accounts receivable, net $ 88,000
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5. Balance Sheet Approach (Percentage of Receivables)

a. Under this approach, the ending balance of the allowance for credit losses is a percentage
of the ending balance of accounts receivable.
1) Credit loss expense reflects the adjustment of the allowance to its correct ending
balance.

EXAMPLE 6-4 Balance Sheet Approach

Using the data from Example 6-3, assume that, based on Midburg’s experience, 6% of accounts receivable
are determined to be uncollectible. Thus, the ending balance of the allowance for credit losses is $6,000
($100,000 × 6%). Because the allowance currently has a balance of $2,000, the following journal entry is
required:
Credit loss expense ($6,000 – $2,000) $4,000
Allowance for credit losses $4,000
Balance sheet presentation
Accounts receivable $100,000
(Allowance for credit losses) (6,000)
Accounts receivable, net $ 94,000

b. An entity rarely experiences a single rate of uncollectibility on all its accounts. For this
reason, entities using the balance sheet approach to estimate expected credit losses for
accounts receivable generally prepare an aging schedule.

EXAMPLE 6-5 Balance Sheet Approach with Aging Schedule

Midburg prepares the following aging schedule of its accounts receivable:
Less than 31-60 61-90 Over 90 Total
Balance Range 30 Days Days Days Days Balances
$0 - $100 $ 5,000 $ 200 $ 100 $ 100 $ 5,400
$100 - $1,000 8,000 3,800 11,800
$1,000 - $5,000 20,000 2,000 1,900 23,900
$5,000 - $10,000 38,000 8,000 900 46,900
Over $10,000 12,000 12,000
Totals $71,000 $18,000 $10,000 $1,000 $100,000

-- Continued on next page --

 SU 6: Receivables 7

EXAMPLE 6-5 -- Continued

Midburg then applies an appropriate percentage to each stratum based on experience.
Estimated Ending
Aging Intervals Balance Uncollectible Allowance
Less than 30 days $ 71,000 2% $1,420
30-60 days 18,000 12% 2,160
61-90 days 10,000 15% 1,500
Over 90 days 1,000 20% 200
Total $100,000 $5,280

Because the allowance currently has a balance of $2,000, the following journal entry is required to establish
the proper measurement:
Credit loss expense ($5,280 – $2,000) $3,280
Allowance for credit losses $3,280
Balance sheet presentation
Accounts receivable $100,000
(Allowance for credit losses) (5,280)
Accounts receivable, net $ 94,720

6. Collection of Accounts Previously Written Off

a. Occasionally, a customer pays an account that was previously written off and was not
expected to be recovered. The journal entry is
Cash $XXX
Allowance for credit losses $XXX

The following equation illustrates the reconciliation of the beginning and ending balances of the
allowance for credit losses:
Beginning allowance for credit losses $XXX
Credit loss expense recognized for the period XXX
Accounts receivable written off (XXX)
Collection of accounts receivable previously written off XXX
Ending allowance for credit losses $XXX

Under the income statement approach, credit loss expense is a percentage of sales on credit,
and the ending balance of the allowance is calculated using the equation above.
Under the balance sheet approach, the ending balance of the allowance is a percentage of
the ending balance of accounts receivable, and credit loss expense is calculated using the
equation above.
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EXAMPLE 6-6 Collection of Written-Off Accounts

A retailer had the following account balances on January 1, Year 1:
• Accounts receivable 145,000 Dr.
• Allowance for credit losses 8,000 Cr.
The following information pertains to the retailer’s accounts receivable in Year 1:
• Credit sales for the year $400,000
• Collections of current-year credit sales 240,000
• Accounts written off on 7/1/Year 1 5,000
• Collection of accounts that were written off last year
that the retailer did not expect to collect 6,000
Based on past experience and considering current and forecasted economic conditions, the retailer
estimates that 4% of year-end accounts receivable are expected to be uncollectible. The retailer recorded the
following journal entries in Year 1:
Sales on credit:
(A) Accounts receivable $400,000
Sales $400,000
Collections on credit sales:
(B) Cash $240,000
Accounts receivable $240,000
Accounts considered uncollectible written off:
(C) Allowance for credit losses $5,000
Accounts receivable $5,000
Account previously written off collected:
(D) Cash $6,000
Allowance for credit losses $6,000
After the Year 1 activity is recorded, the year-end balance of accounts receivable is calculated as follows:
Accounts Receivable
1/1/Year 1 $145,000
(A) 400,000 $240,000 (B)
5,000 (C)
12/31/Year 1 $300,000

-- Continued on next page --

 SU 6: Receivables 9

EXAMPLE 6-6 -- Continued

The year-end balance of the allowance for credit losses is $12,000 ($300,000 × 4%). The credit loss expense
for Year 1 is calculated below as an adjustment of the allowance to its ending balance.
Allowance for Credit Losses
(C) $5,000 $ 8,000 1/1/Year 1
6,000 (D)
3,000 Credit loss expense (E)
$12,000 12/31/Year 1

Year-end adjustment of the allowance and credit loss expense recognition:

(E) Credit loss expense $3,000
Allowance for credit losses $3,000
On the balance sheet, the carrying amount of accounts receivable is reported as follows:
12/31/Year 1 balance sheet:
Accounts receivable $300,000
(Allowance for credit losses) (12,000)
Accounts receivable, net $288,000

In practice, the collection of accounts previously written off also may be recorded directly as a reduction of
credit loss expense. However, both methods result in the same amounts of allowance for credit losses and
credit loss expense for the period.
Account previously written off collected and recorded in the credit loss expense account:
(D) Cash $6,000
Credit loss expense $6,000
The year-end allowance is still $12,000 ($300,000 × 4%), and the adjustment to its ending balance is $9,000.
Allowance for Credit Losses
(C) $5,000 $ 8,000 1/1/Year 1
9,000 Credit loss expense (E)
$12,000 12/31/Year 1

Year-end adjustment of the allowance and credit loss expense recognition:

(E) Credit loss expense $9,000
Allowance for credit losses $9,000
Thus, the credit loss expense for Year 1 is $3,000 ($9,000 E – $6,000 D).
10 SU 6: Receivables

6.3 TRANSFERS OF RECEIVABLES AND OTHER FINANCIAL ASSETS

1. Factoring
a. Factoring is a transfer of receivables to a third party (a factor) who assumes the
responsibility of collection.
b. Factoring discounts receivables on a nonrecourse, notification basis. Thus, payments
by the debtors on the transferred assets are made to the factor. If the transferor (seller)
surrenders control, the transaction is a sale of accounts receivable.
1) If a sale is with recourse, the transferor (seller) may be required to make payments
to the transferee or to buy back receivables in specified circumstances. For
example, the seller may become liable for defaults up to a given percentage of the
transferred receivables.
a) The sale proceeds are reduced by the fair value of the recourse obligation.
b) If the transfer with recourse does not qualify as a sale, the parties account for
the transaction as a secured borrowing with a pledge of noncash collateral.
2) If a sale is without recourse, the transferee (credit agency) assumes the risks and
receives the rewards of collection. This sale is final, and the seller has no further
liabilities to the transferee.
c. A factor usually receives a high financing fee plus a fee for collection. Furthermore, the
factor often operates more efficiently than its clients because of the specialized nature of
its services.

EXAMPLE 6-7 Transfer of Accounts Receivable

A factor charges a 2% fee plus an interest rate of 18% on all cash advanced to a transferor of accounts
receivable. Monthly sales are $100,000, and the factor advances 90% of the receivables submitted after
deducting the 2% fee and the interest. Credit terms are net 60 days. What is the cost to the transferor of this
arrangement?
Amount of receivables submitted $100,000
Minus: 10% reserve (10,000)
Minus: 2% factor’s fee (2,000)
Amount accruing to the transferor $ 88,000
Minus: 18% interest for 60 days (2,640) [$88,000 × 18% × (60 ÷ 360)]
Amount to be received immediately $ 85,360

The transferor also will receive the $10,000 reserve at the end of the 60-day period if it has not been
absorbed by sales returns and allowances. Thus, the total cost to the transferor to factor the receivables
for the month is $4,640 ($2,000 factor fee + interest of $2,640). Assuming that the factor has approved the
customers’ credit in advance (the sale is without recourse), the transferor will not absorb any bad debts.
The journal entry to record the preceding transaction is
Cash $85,360
Due from factor 10,000
Loss on sale of receivables 2,000
Prepaid interest/interest expense 2,640
Accounts receivable $100,000
 SU 6: Receivables 11

d. Credit card sales are a common form of factoring. The retailer benefits by prompt receipt
of cash and avoidance of credit losses and other costs. In return, the credit card company
charges a fee.
1) Two methods of accounting for credit card sales may be necessary depending upon
the reimbursement method used.
a) If payment is after submission of credit card receipts, the retailer initially
records a sale and a receivable. After payment, the entry is
Cash $XXX
Service charge expense XXX
Receivable $XXX
a) If the retailer’s checking account is increased by the direct deposit of credit
card receipts, no receivable is recognized. The entry is to credit sales instead
of a receivable.
Cash $XXX
Service charge expense XXX
Sales $XXX
2. Pledging
a. A pledge (a general assignment) is the use of receivables as collateral (security) for a
loan. The borrower agrees to use collections of receivables to repay the loan.
1) Upon default, the lender can sell the receivables to recover the loan proceeds.
b. Because a pledge is a relatively informal arrangement, it is not reflected in the accounts.
A transfer of financial assets is a sale only when the transferor relinquishes control.
1) If the transfer (e.g., a pledge) of accounts receivable is not a sale, the transaction
is a secured borrowing. The transferor becomes a debtor, and the transferee
becomes a creditor in possession of collateral.
a) However, absent default, the collateral remains an asset of the transferor.
3. Transfers of Financial Assets -- Objectives and Control
a. The accounting for transfers of financial assets is based on a financial-components
approach focused on control.
b. The objective is for each party to
1) Recognize the assets it controls and the liabilities it has incurred,
2) Derecognize assets when control has been given up, and
3) Derecognize liabilities when they have been extinguished.
c. Whether control exists depends, among other things, on the transferor’s continuing
involvement. Continuing involvement is the right to receive benefits from the assets or
an obligation to provide additional assets to a party related to the transfer.
12 SU 6: Receivables

4. Transfers of Financial Assets -- Sales

a. Transfers of financial assets include transfers of (1) an entire financial asset, (2) a group of
entire financial assets, and (3) a participating interest in an entire financial asset.
1) The holder of a participating interest receives cash in proportion to the share of
ownership, and all holders have the same priority.
b. A transfer of financial assets is a sale when the transferor relinquishes control.
The transferor relinquishes control only if certain conditions are met:
1) The transferred assets are beyond the reach of the transferor and its creditors;
2) Transferees may pledge or exchange the assets or interests received; and
3) The transferor does not maintain effective control through, for example,
a) An agreement to reacquire the assets before maturity or
b) An agreement making it probable that the transferee will require repurchase.
c. If the transfer of an entire financial asset (or a group) qualifies as a sale, the financial
components approach is applied. The transferor
1) Derecognizes the financial assets transferred
2) Recognizes and initially measures at fair value the assets obtained and liabilities
incurred
3) Recognizes any gain or loss in earnings

EXAMPLE 6-8 Transfer of a Financial Asset

A company transfers its entire financial interest in its notes receivable for $60,000. The receivable has a
carrying amount of $62,500. The journal entry to record this transfer is
Cash $60,000
Loss on transfer 2,500
Notes receivable $62,500

5. Transfers of Financial Assets -- Secured Borrowings

a. If the transfer is not a sale, the transaction is a secured borrowing. The transferor
becomes a debtor, and the transferee becomes a creditor in possession of collateral.
b. A secured borrowing is a formal borrowing arrangement. The borrower signs a promissory
note and financing agreement, and specific receivables are pledged as collateral.
1) The loan is at a specified percentage of the face amount of the collateral, and
interest and service fees are charged to the borrower.
c. The collateral may be segregated from other receivables on the balance sheet.
Accounts receivable assigned $XXX
Accounts receivable $XXX

1) The note payable is reported as a liability.

Cash $XXX
Notes payable $XXX
 SU 6: Receivables 13

6.4 NOTES RECEIVABLE

1. Definition
a. A note receivable is a debt evidenced by a two-party writing (a promissory note). Notes
are more formal promises to pay than accounts receivable.
b. Most notes bear interest (explicitly or implicitly) because they represent longer-term
borrowings than accounts receivable.
c. Notes with original maturities to the holder of 3 months or less are treated as cash
equivalents and accounted for at net realizable value.
1) Because the interest implicit in the maturity amount is immaterial, no interest
revenue is recognized.
d. Notes classified as current assets are usually recorded at face amount and reported
minus an allowance for credit losses.
e. Notes classified as noncurrent assets are recorded at the present value of the
expected future cash flows and reported minus an allowance for credit losses.
1) Any difference between the proceeds and the face amount must be recognized as a
premium or discount and amortized.
f. When the note’s stated interest rate is a reasonable rate (e.g., the market rate), the note is
issued at its face amount, and no discount or premium is recognized.
2. Noninterest-Bearing Notes
a. Sometimes notes are issued with no stated rate and an unknown effective rate. In these
cases, the rate must be imputed from other facts surrounding the transaction. Such facts
include the marketability of the note and the debtor’s creditworthiness.
1) Thus, the interest is implicit.
b. A note may bear no explicit interest because interest is included in the amount to be paid
at maturity. The accounting treatment is to debit notes receivable for its face (maturity)
amount, credit cash (or other appropriate account), and credit discount. The discount is
amortized to interest revenue.
1) The entry for initial recognition is
Notes receivable $XXX
Cash $XXX
Discount on note XXX
a) Notes receivable are reported in the financial statements at their face amount
minus any unamortized discount.
2) At the end of the period, the discount is amortized to interest revenue using the
effective-interest method explained in Study Unit 5, Subunit 6.
a) The entry for recognition of interest is
Discount on note $XXX
Interest revenue $XXX
3) When the note arises in the ordinary course of business and is “due in customary
trade terms not exceeding approximately 1 year,” the interest element need not be
recognized.
14 SU 6: Receivables

3. Unreasonable Interest
a. The term “noninterest-bearing” is confusing. It is used not only when a note bears implicit
interest but also when no actual interest is charged (the cash proceeds equal the face
amount).
1) When a note is noninterest-bearing in the second scenario or bears interest at a rate
that is unreasonable in the circumstances, interest must be imputed (estimated).
A note with imputed interest also results in amortization of discount or premium.
b. When a note is exchanged solely for cash, and no other right or privilege is exchanged,
the proceeds are assumed to reflect the present value of the note. The effective interest
rate is therefore the interest rate implicit in that present value.
c. When a note is exchanged for property, goods, or services, the interest rate
determined by the parties in an arm’s-length transaction is presumed to be fair.
1) That presumption is overcome when (a) no interest is stated, (b) the stated rate is
unreasonable, or (c) the nominal amount of the note materially differs from the cash
sales price of the item or the market value of the note.
a) In these circumstances, the transaction should be recorded at the more clearly
determinable of
i) The fair value of the property, goods, or services or
ii) The market value of the note.
b) Absent established exchange prices or evidence of the note’s market value,
the present value of a note with no stated rate or an unreasonable rate should
be determined by discounting future payments using an imputed rate. The
prevailing rate for similar instruments of issuers with similar credit ratings
normally helps determine the appropriate rate.
d. The stated interest rate may be less than the effective rate applicable in the circumstances
because the lender has received other stated (or unstated) rights and privileges as
part of the bargain.
1) The difference between the respective present values of the note computed at the
stated rate and at the effective rate should be accounted for as the cost of the rights
or privileges obtained.
4. Discounting of Notes Receivable
a. When a note receivable is discounted (sold, usually at a bank), the gain or loss on
disposition of the note must be calculated.
b. The holder of the note receives the maturity amount (Principal + Interest at maturity) of the
note minus the bank’s discount. The bank usually collects the maturity amount from the
maker of the note.