Notes receivables

Account Receivable

Notes receivables are written promissory notes which give the holder or bearer the right to receive the amount mentioned in the agreement. It is treated as an asset by the holder of the note receivable. Sometimes accounts receivables are converted into notes receivables to allow more time for the debtors to pay the balance.

If the note receivable is due within a year, its treated as a current asset, else treated as non-current assets.

What are the important components of notes receivables?

Important components of notes receivable:

• Principal value: The face value of the note mentioned in the note

• Maker: The person who makes the note and who promises to pay the holder of the note. He regards this note as notes payable.

• Payee: The person who holds the note and who is entitled to receive the payment

• Interest: The notes include the rate of interest to be charged on the due amount, the holder has to pay the principal with interest on the due date mentioned in the note itself.

• Due date of payment: The notes itself contain the due date of payment and its issue date.

Specimen of notes receivable:

Classification of notes receivable:

Notes receivables should be classified as a current asset if it is due within a year and non-current asset if it is due in more than a year.

If the note has a duration of more than a year and the customer doesn’t pay interest in the first year, unpaid interest should be added to the beginning principal balance in the second year and interest is to be calculated on this new value.

Example:

The maker owes Rs 100,000 to the payee at 12% p.a. and he pays no interest in the first year. The interest earned would be Rs. 12000 for the first year. So, the interest would be calculated on the new principal Rs. 112,000 in the second year. So, the interest would be Rs.13440.

This is how the interest is calculated for notes receivables.

Notes receivable accounting:

Let us take an example and learn accounting for notes receivables.

MPC Co. sells goods to RSP for Rs.60000 with payment due in 30 days. After 60 days of non-payment, notes payable is issued to MPC by RSP Co. for Rs. 60000 at an interest rate of 10% per annum and with a payment of Rs 20000 due at the end of each of the next 90 days.

The accounting entry to record the conversion of accounts receivable to notes receivable is:

At the end of the month, RSP pays Rs. 20000 along with the interest due amount which is calculated as 60000*10%*30/365= Rs. 494

The entry would be passed as

At the end of the second month, RSP pays another Rs.20000 as well as interest of 40000*10/100*30/365= Rs. 328.

The entry would be:

At the end of final month, RSP pays interest of 20000*10/100*30/365= Rs.165 along with the payment of Rs. 20,000.

The entry would be:

Now the note has been completely discharged, MPC has recorded interest income of Rs. 987

The interest income would be recognized as:

First month

Second month

Third month

When the maturity of the note rises after completion of 90 days, the interest amount is paid to MPC.

This is recorded as:

Assume if RSP was unable to pay the final installment of R.20000 and the related interest of Rs.165 and MPC has been accruing this interest income, then MPC has to write off the remaining balance of the note with the interest due.

The entry would be passed as:

Discounting notes receivables:

Notes can be converted to cash by discounting them with the financial institutions. If the maker dishonors the note, the company discounting the note pays to the financial institutions.

When notes are sold with conditions, the company creates contingent liability and it is disclosed in the notes to financial statements.

The discount fee that the bank charges on discounting of notes receivables can be found by:

Discount= Maturity value of note* Discount rate*Discount period 

The following entry is passed:

Note Receivable

Account Receivable

Definition

Notes receivables describe promissory notes that represent loans paid from a company or business to another party. The note comes with a promise from the borrower that it will repay the lender at a future point in time.

Similarly, a note receivable gives the holder, or the lender, the right to receive the amount from the borrower.

A note receivable shows a legal binding agreement between two parties. Usually, companies pay loans in exchange for a note for a short-term.

Therefore, note receivables are current assets. However, if any note is repayable after a year’s time, companies must qualify it as non-current assets. At each reporting date, a company should evaluate all its note receivables for classification.

Notes receivable can come from different sources. For example, a company may provide a loan to another company in exchange for a note. Mostly, however, it comes from customers who transfer or convert their overdue accounts receivable balance to notes.

Explanation

Notes receivable come in the form of a written document that borrowers pay to their lenders. Unlike usual trading balances and credits, notes receivable balances come with additional terms.

Notes receivables are similar to loans given by a company rather than credit due to its operations. Therefore, they have characteristics of a loan.

A note receivable will mention the two parties involved, the payee and the payer. The payee is the party that provides the loan, also known as the borrower.

The payee holds the note and is, therefore, due to receiving a payment from the payer. The payer, or the marker, is the borrower who gets the loan from the payee. The maker promises to pay the holder in the future.

A note receivable also comes with a predetermined interest rate after a mutual agreement of both the parties. The note may also consist of the terms of interest payments.

The maker of the note receivable, along a principal amount, must also pay interest on it. The principal amount of the note receivable represents its face value or the value that the payee will receive.

Finally, a note receivable will also mention the timeframe of the loan. It is similar to the maturity date of loans, which represents a future point in time at which the borrower will repay the lender.

For note receivable, the timeframe is the time before or on which the maker must reimburse the holder. Unlike other loans, note receivables do not usually come with prepayment penalties.

Journal entry

The journal entry for recording note receivable is straightforward. If a company pays another party directly in exchange for a note receivable, the journal entry will be as follows.

However, if the company converts an accounts receivable balance to a note receivable, the accounting entry will be as follows.

As mentioned above, the company must determine, using the timeframe of the note receivable, whether it classifies as a current asset or non-current.

For non-current asset classification, the company must reevaluate the note receivable at the end of each accounting period to identify if its classification has changed.

On repayment, the note holder will record the receipt and any associated interest on the note. The accounting entry to record repayment is as follows.

Example

A company, ABC Co., has total receivables of $20,000. Among these, one customer with a balance of $5,000 wants to convert the balance to a note receivable.

ABC Co. agrees to do so and changes the balance to note. The customer promises to repay the amount after one year. Both parties also agree that the customer must reimburse the principal amount and a 10% interest on the note.

To record the conversion of account receivable balance to note receivable, ABC Co. uses the following double entry.

After a year’s time, when the customer repays the loan, ABC Co. must record the receipt. However, the customer will also pay an interest of $500 ($5,000 x 10%) on the note. Assuming the customer makes the repayment to ABC Co.’s bank account, ABC Co. can use the following journal entry to record the receipt.

Conclusion

A note receivable is a promissory note made by a maker to a payee promising to repay a specified amount at a future point in time.

Characteristically, notes are similar to loans because they come with an interest and principal amounts. Recording notes receivable is straightforward, as mentioned above.

How to Calculate Bad Debt Expense?

Account Receivable

Meaning of bad debts

When a company makes sales, it doesn’t collect cash from all the customers. Some customers pay at the time of purchase itself and some pay on credit terms. When customers fail to pay on due date and company assume that the money can’t be collected, then it is treated as bad debts. Due to the frequency of bad debts occurring in business, the company prepares provision for bad and doubtful debts.

Bad debt is treated as an expense in Profit and Loss Account since it is treated as loss to the company and the value of debtors is equally deducted with the amount of such bad debts. There are two methods of recording bad debts viz.

• Bad debts write-off method
• Bad debts allowance method

The two methods used in bad debts estimation are:

• Percentage of sales
• Percentage of receivables

Percentage of sales method:

It is an income statement approach. Bad debt expense shows the direct relationship in percentage to the sales revenue made by the company. This method gives a better way of matching expenses with the revenue. It involves the determination of the percentage of uncollectible net credit sales. It is determined by the company’s credit policy and past bad debt estimation behavior of the company.

Once the company determines the percentage, they multiply by the total credit sales to estimate the bad debt expense. This method does not consider the balance in provision for doubtful debts because such balances are not used while calculating bad debt expense.

Either net sales or credit sales can be used for calculation of bad debts. However, if the credit sales fluctuate much from one accounting period to others, using credit sales would be more accurate than the net sales method.

Example: A company estimated net credit sales of Rs 1,00,000. Using the percentage of sales method, they estimated 0.5% of sales to be uncollectible. So, the bad debt incurred here is 0.5% of Rs 100000= Rs 500.

The accounting for the above calculation is:

It becomes irrelevant in this method what balance was there in provision for doubtful debts because bad debt is solely calculated based on credit sales.

While writing off the bad debts, the company has to debit the provision for doubtful debts and credit the debtors or accounts receivables account.

Example: Continuing with the above example, during December 2020 they learnt that debtors of Rs 2000 made in August became uncollectible then following journal entry is passed

Provision for doubtful debts is a contra asset that decreases the account receivables. It is recorded in the balance sheet on the assets side as a reduction from debtors.

It looks like this:

If the doubtful debt turns into bad debt, then it is recorded as an expense in the income statement.

Bad debt allowance method:

This method is employed to prevent the overstatement of the accounts receivable. It involves the use of contra account of Allowance for doubtful debts in the balance sheet and bad debts account in the profit and loss statement.

The bad debt allowance method requires recording through several entries:

• The adjusting entry is passed at the close of the accounting period. It records bad debts on the debit side and credits the allowance for bad debts.

The entry is passed as

• The bad debt to be written off requires the recording through the following entry

This entry impacts the balance sheet only as the bad debt has already been expensed in P/L.

Recovery of bad debts:

Sometimes those debts which have been expensed in P/L get recovered as the debtors come and clear the debt amount.

The entry to be recorded is:

The advantages of the allowance method are given below:

• It is based on the matching principle such that the bad debts are recorded as expenses in the year they generate.
• It depicts the accurate value of accounts receivables because its value is not overstated in the balance sheet.

The disadvantages of the allowance method are as follows:

• It requires more accounting work than the bad debts write-off method.
• It always risks misstatement due to the inaccurate estimation of bad debts.

Journal Entry Bad Debt Expense

Account Receivable

Introduction

Bad debts are unavoidable for companies. Any company that offers credit sales will also have bad debts associated with them. It is because when a company offers credit sales, it accumulates accounts receivables. Accounts receivables are a group of balances that represents payments owed by third parties, usually customers, to the company.

Every company has its own credit policies. These policies depend on several factors, such as the size of the company, its nature, the industry it operates in, policies of its competitors, etc. Some companies may not offer credit terms at all and transact in cash only. However, for some others, not offering credit sales may not be an option.

Definition

Bad debt is a concept closely related to accounts receivable. Bad debts represent any balance that a company determines is unrecoverable. Bad debts can happen due to several reasons. For example, if a customer goes bankrupt or liquidates, it may not be able to repay its liabilities. Similarly, if the company does not evaluate the creditworthiness of a customer properly, it may result in bad debts.

Bad debt is an expense for a company. That is why it is a part of its Income Statement. However, bad debts also affect the Balance Sheet of the company. It is because bad debts cause a reduction in its accounts receivable balances, which is a Balance Sheet item. Overall, bad debts are bad for any company as they can result in significant losses.

Explanation

When it comes to bad debts, there are not many controls that companies can implement. It is because, for almost all companies around the world, bad debts are inevitable. Some companies may introduce credit policies and have a dedicated credit control department to tackle the issue. However, these still cannot prevent bad debts from happening.

Bad debts impact a company negatively in various ways. First of all, it results in sales without any proceeds. Furthermore, it can disrupt the cash management process of a company when expected cash inflows from accounts receivable fail to realize. Likewise, bad debts also increase the expenses of a company, which may result in losses for them.

For companies, generating revenues is a primary goal. It is because higher sales mean more profits and cash inflows. However, if they fail to recover the associated receipt with those sales, generating revenues is futile. Therefore, bad debts can be problematic for any company. The lower that companies can maintain their bad debts, the better it is for them.

Double-entry or Journal entry

There are two ways in which companies may record bad debts. First of all, bad debts may relate to specific accounts or customers. In that case, the expense is direct as it affects the company’s accounts receivable directly. When the company can identify the particular balance to which bad debts relate, it can write it off from the specific customer’s account. It is known as the direct method. In the case of a direct write-off, the double-entry is as follows.

In other circumstances, a company may also determine the percentage of its expected bad debts. In that case, the company estimates its bad debts for the period based on past experiences. Once it determines the amount, the company records it as a bad debt expense while also recognizing an allowance for doubtful debt. It is known as the bad debt allowance method. The double entry for it is as follows.

In the case of allowances, the company does not deduct the bad debt from a specific customer’s balance. Instead, it keeps it in a different allowance account, which causes a reduction in accounts receivable. However, it does not affect the accounts receivable balance of a company directly.

Sometimes, companies may also recover the balances they recorded as bad debts. In that case, the net double entry will be as follows.

Example

A company, ABC Co., has total accounts receivable balance of $100,000. Out of this balance, the company considers $10,000 from a specific customer, XYZ Co., to be uncollectable. Similarly, ABC Co. expects a further 10% of the remaining amount to be irrecoverable based on past experiences. Therefore, ABC Co. must record both these transactions as bad debts.

Firstly, ABC Co. must recognize the specific bad debt related to XYZ Co. The double entry will be as follows.

After this double entry, the remaining balance in accounts receivable will be $90,000 ($100,000 – $10,000). From this amount, the company can calculate the allowance for bad debts, which will be $9,000 ($90,000 x 10%). The double entry for it will be as follows.

The accounts receivable balance on ABC Co.’s Balance Sheet will be as follows.

Conclusion

Bad debts are an inevitable part of the business for companies that offer credit sales. These represent balances that a company considers uncollectable. Bad debts can negatively impact a company as they increase expenses while decreasing assets.

Bad Debt Expense

Account Receivable

What is bad debt?

When a company sells products to its customers, it can either collect the payment at the time or allow the customer to pay at a later date. In the case of credit sales, the company must record the sale and the associated receivable balance.     

When the customer repays the amount at a later date, the company records the receipt against the accounts receivable balance.

Sometimes, however, the customer may not be willing to repay due to various reasons. For example, a customer may go bankrupt and cannot afford to pay the related balance. If the company identifies an unrecoverable or uncollectable balance, it must expense out the balance. This expense is called bad debt.

Bad debts are a common type of expense for companies that offer credit sales. Therefore, all companies must record bad debts when they deem necessary. With experience, a company may also estimate the value of its bad debts based on a percentage.

According to accounting standards, the company must also record a bad debt allowance based on estimated amounts.

Therefore, there are two methods of writing off bad debts, the direct and the allowance methods. Given below is a comparison between both of them.

Bad debt write-off method

The bad debt write-off method, also known as the direct method, consists of writing off bad debts associated with specific account balances.

When a company determines that a customer is unable to pay their accounts receivable balance, it can write off the balance. In this method, the specific amount of bad debt is clear to the company.

Example

A company, ABC Co., has total receivables of $20,000. Among these, there is a customer, XYZ Co., that has liquidated. The balance owed by XYZ Co. to ABC Co. was $3,000. ABC Co. believes that the customer cannot repay the balance in the future. Therefore, ABC Co. must write off the $3,000 owed from XYZ Co.

To write off the balance, ABC Co. can use the following double entry.

Since the value of the balance owed by XYZ Co. is known, ABC Co. can write off the balance as bad debt. The bad debt expense will be a part of the company’s Income Statement for the period. On the other hand, the reduction in accounts receivable will be a part of its Balance Sheet.

Bad debt allowance methods

The bad debt allowance method allows companies to estimate the bad debts expense for the next accounting period. Once they calculate the allowance, they can write it off as bad debts. The bad debt allowance method follows the matching principle in accounting.

With direct bad debt write-offs, companies may expense out the balance that relates to other accounting periods. In contrast, with the bad debt allowance method, companies only expense out bad debts based on the current period.

The bad debts written off using this method should be probable and calculated accurately. The bad debts allowance method also follows the prudence concept of accounting.

Bad debts recognized through this account do not reduce the accounts receivable balance of a company directly. Instead, companies use a specific account for it, known as Allowance for doubtful debts.

At the end of the period, companies must calculate their accounts receivable balance by deducting the balance in the Allowance for doubtful debt account from the accounts receivable balance.

 Lastly, companies can estimate the allowance based on two methods, the ageing method and the percentage of sales method. Both of them require the company to make estimates based on past experiences. However, one method considers the timing of accounts receivable as a base while the other considers sales.

Example

A company, ABC Co., has total accounts receivable of $20,000. The company has had some experience with bad debts in the past.

Based on that, it determines that out of the accounts receivable balances, 10% will result in bad debts. Therefore, ABC Co. must calculate the allowance and record it at the time of reporting.

The bad debt allowance that ABC Co. must recognize is $2,000 ($20,000 x 10%). Therefore, the journal entries for the allowance will be as follows.

At the end of the period, ABC Co.’s expenses will increase by $2,000 due to the allowance for bad debts. On the other hand, its accounts receivable in its balance sheet will be as follows.

Conclusion

Companies that offer credit sales may also suffer from bad debts. Bad debts are balances that a company deems irrecoverable or uncollectable.

There are two methods of writing off bad debts. These are the direct write-off method and the allowance method. The method of calculation of bad debts for both of these is different.

What are other receivables?

Account Receivable

Meaning of Other receivables

Other receivables generally come with headings “Trade receivables and others” in the financial statement of large listed public companies. Other receivables are disclosed under the headings “Current Assets”.

These are residual trade or non-Trade receivables that have not been specified by the company or regulations or do not meet the criteria of being classified separately. They are referred to as they are uncommon and insignificant like the major accounts of Current assets as Trade receivables, accounts payable, income taxes payable.

Other receivables are listed under the assets side of the firm’s balance sheet. These come below the headings of Trade receivables. Other receivables are characterized as uncommon or insignificant. Other receivables are rarely recorded in the financial statements, hence, the net balance in Other receivables account is typically small.

Example

The company is running an account of petty expenses. It has paid in advance to coffee shop for 15 days and the coffee shop will reduce all the expenses against the advance.

Even then, at the end of the month, the advances of $ 140 still remain. The company has to show this amount in its balance sheet. It has to show this receivable in “Other receivables”

Understanding Other receivables

Other receivables consist of temporary accounts which even do not repeat every year. Depending on the industry and industry practices, the explanations on Other receivables can be found on the quarterly and annual filings by the company.

To simplify miscellaneous trade and non-Trade receivables of the large sized companies, the term “Other receivables” have been established to represent all the small items of trade and non-Trade receivables. The major components of assets are either long term assets or Current assets.

Long term assets are non-current assets such as plant and machinery, buildings, land, long term investments. These assets have span of more than 1 year and are payable in more than 1 year. On the other hand, Current assets are short term assets which have to be paid within 12 months.

They are the assets that can be easily paid with liquidating current assets in the process of daily operations. Current assets include Trade receivables, accounts payable, income taxes payable. Current assets that are not specified or uncommon won’t be categorized under Current assets.

Instead, they will be thrown into the residual heading of Other receivables. Instead, these assets will be taken to a generic “other” category and would be recognized as Other receivables on the balance sheet.

Examples of Other receivables shall include:

Things to be noted

For publicly listed companies, they have to give clear breakdown of Other receivables in their quarterly and annual filings. However, they represent no so significant amount of money. Hence, the companies may choose to ignore showing Other receivables separately.

However, Other receivables would be placed under footnotes to financial statements. Rarely explanations are needed for Other receivables. However, when needed, the company shall offer the explanations in notes to accounts.

Other receivables are generally assumed to be disposed of within a accounting cycle that would be 12 months. The nature of each Other receivables needs to be determined. It is important for the management to know about the liquidity of Other receivables.

If accounts in Other receivables in the past year become material in the current year, it may need to be disclosed into major defined Current assets accounts. This would slowly create insightful information in the minds of investors.

Formula

There is no formula for computing the Other receivables. Either the small amounts will aggregate to form Other receivables or there won’t be any Other receivables.

Other receivables = Petty expenses receivables + Advance weekly wages to cleaning staff + Advance supplies

Let’s take the example of Sinra Ltd that had recently filed its annual financial statements. The following details about Current assets were available

Petty expenses receivables $ 45

Advance weekly wages to cleaning staff $ 105

Advance supplies $ 95

The Calculation of Other receivables can be done as :

When to disclose Other receivables separately?

The probability of disclosing Other receivables separately stands zero. The large listed companies generally go by the heading “Trade receivables and Other” where Other receivables are incorporated.

However, circumstances change abruptly and management hast to evaluate this question carefully before any disclosure is being made. There are very outside chances that other receivables will become any significant.