Accounting: The Language of Business (Part 45)

“Happiness is debit = credit.” —Unknown

Receivables (Part D)

by

Charles Lamson

Direct Write-off Method of Accounting for Uncollectibles

The allowance method emphasizes reporting uncollectible accounts expense in the period in which the related sales occur. This emphasis on matching expenses with related revenue is the preferred method of accounting for uncollectible receivables.

There are situations, however, where it is impossible to estimate, with reasonable accuracy, the uncollectibles at the end of the period. Also, if a business sells most of its goods or services on a cash basis, the amount of receivables is also likely to represent a small part of the current assets. Examples of such a business are a restaurant, an attorney's office, and a small retail store such as a hardware store. In such cases, the direct write-off method of recording uncollectible expense may be used.

Under the direct write-off method, uncollectible accounts expense is not recorded until an account has been determined to be worthless. Thus, an allowance account and an adjusting entry are not needed at the end of the period. The entry to write off an account that has been determined to be uncollectible is as follows:

What if a customer later pays on an account that has been written off? If this happens, the account should be reinstated. The account is reinstated by reversing the earlier write-off entry. For example, assume that the account written off in the May 10 entry is collected in November of the same fiscal year. The entry to reinstate the account is as follows:

Cash received in payment of the reinstated amount is recorded in the usual manner. That is, cash is debited and accounts receivable is credited for $420. 

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 it according to the terms listed. A note is therefore a stronger 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. It is signed by the person or firm that makes the promise. The one to whose order the note is payable is called the payee, and the one making the promise is called the maker. In the example in Exhibit 4, Judson Company is the payee and Willard Company is the maker.

EXHIBIT 4 Promissory Note

Notes have several characteristics that affect how they are recorded and reported in the financial statements. We describe these characteristics next.

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 of a note is stated in days, the due date is the specified number of days after its issuance. To illustrate, the due date of the 90-day note in Exhibit 4 is determined as follows:

The term of a note may be stated as a certain number of months after the issuance date. In such cases, the due date is determined by counting the number of months from the issuance date. In such cases, the due date is determined by counting the number of months from the issuance date. For example, a 3-month note dated June 5 would be due on September 5. A 2-month note dated July 31 would be due on September 31.

Interest

A note normally specifies that interest be paid for the period between the issuance date and the due date. Notes covering a period of time longer than one year normally provide that the interest be paid semi-annually, quarterly, or at some other stated interval. When the term of the note is less than one year, the interest is usually payable on the due date of the note.

The interest rate on notes is normally stated in terms of a year, regardless of the actual period of time involved. Thus, the interest on $2,000 for one year at 12% is $240 (12% of $2,000). The interest on $2,000 for 1/4 of one year at 12% is $60 (1/4 of $240).

The basic formula for computing interest is as follows:

Face amount (or principle) * rate * time = interest

To illustrate the formula, the interest rate on the note in Exhibit 4 is computed as follows:

$2,500 * 0.10 * 90 / 360 = $62.50 interest

In computing interest for a period of less than one year, agencies of the federal government and many financial institutions use the actual number of days in the year, 365. In the preceding computation, for example, the time would have been stated as 90 / 365 of one year. To simplify computations, however, 360 days is often used in accounting.

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 note in Exhibit 4, the maturity value is $2,562.50 ($2,500 face amount plus $62.50 interest).

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 325-328*

end