Chapter 10 — Receivables
The module's primary reading · ~35–45 minutes · Objective 6 (describe internal control and its components, and account for cash, including the bank reconciliation, and for receivables, including the allowance method and notes receivable), with Objective 3 (apply accrual accounting: recognize revenue and expenses in the right period, prepare adjusting entries for deferrals and accruals, and prepare an adjusted trial balance) called back · Read it first this week; the lecture, the slides, the tutorial, the quiz, and the workshop all build on it.
In plain language
When a business lets customers pay later, it is owed money, and not all of that money will arrive. This week you learn to record receivables (amounts other people owe the business) in a way that is honest about the part that will never be paid. You will meet the allowance method (estimating, at the end of each period, how much customers will fail to pay) and an aging schedule (a table that sorts what customers owe by how late it is). You will also compute the interest (the extra amount a borrower pays for the use of money) on a written promise to pay. By the end, you can show a lender both what customers owe and what the business expects to collect.
Why you already care about this
Picture the bicycle shop at the end of Year 3. It now repairs and sells bicycles on account to businesses and groups, and its customers owe it $40,000. Most of those bills are not yet due. Some are a month late. A few are more than two months late. Will all $40,000 really arrive?
You have seen this from the other side. Maybe a friend borrowed $20 and you are no longer sure you will see it again. Maybe you run a tutoring business that bills families at the end of each month, and one family has not paid for three months. The longer a bill sits unpaid, the less likely it is to be paid at all. This chapter turns that hunch into the way accountants measure it.
By the end of this chapter you will be able to:
- tell accounts receivable from notes receivable;
- compare the direct write-off method and the allowance method by their effects;
- estimate the allowance a business needs with an aging schedule;
- record bad debt expense, a write-off, and a recovery with balanced entries;
- compute the simple interest and maturity value of a note receivable;
- report receivables at their net realizable value.
Carry this sentence with you: estimate the loss early; the write-off later is not a new loss.
Where we are
- Already covered: Week 2 met Accounts Receivable as an asset. Week 3 gave every account a normal balance and introduced contra accounts. Week 4 taught expense recognition and adjusting entries. Week 9 found the shop's true cash with a bank reconciliation.
- This week: accounts and notes receivable, the direct write-off and allowance methods, the aging schedule and bad debt expense, write-offs and recoveries, and simple interest on a note.
- How they connect: the bad debt adjustment is a Week 4 adjusting entry, and Allowance for Doubtful Accounts is a Week 3 contra account; both keep the shop's Week 2 equation in balance.
- Where we're going next: Week 11, Long-Lived Assets, moves down the balance sheet to the equipment and vehicles a business uses for years.
Week 2 told you that a sale on account raises Accounts Receivable, an asset, and Service Revenue at the same time. Week 3 told you that a contra account reduces another account and carries the opposite balance. Accumulated Depreciation was your first one, and this week you meet the second. Week 4 told you that an expense belongs in the period whose revenue it helped earn. Hold on to that idea: it is the reason the allowance method exists. Week 9 kept Cash honest. This week you do the same for what customers owe.
1. Tell accounts receivable from notes receivable
Think about a landscaping company that mows and trims for office parks. It does the work all month and sends each commercial client a bill at the month's end. Nobody signs a loan for this. The client owes the company because it received the service.
That is the first kind of receivable. The second kind feels more formal. Suppose a commercial client asks for more time on a large bill and signs a written promise to pay it in six months, with interest. Now the company holds a piece of paper with a sum, a date, and a rate on it.
Here are the course's two definitions:
- Accounts receivable are amounts customers owe on account.
- Notes receivable are written promises to pay a sum, often with interest.
Both are assets, and both are claims on cash the business has not received yet. An account receivable is usually collected within weeks and carries no interest. A note receivable spells out its terms in writing: how much, when, and at what rate.
Worked example — the shop's two receivables. At the end of Year 3, the bicycle shop (illustrative, Dataset G) has two kinds of claim. Its customers owe it $40,000 on account, recorded in Accounts Receivable. Separately, a youth cycling program signs a $6,000, 6 percent, 3-month note to the shop, recorded in Notes Receivable. In words: the $40,000 is owed because the shop did work on account, and the $6,000 is owed because a borrower signed a written promise.
Misconception check. Students often think a receivable is the same as cash, because both sit near the top of the balance sheet. A receivable is a claim, not money in hand. The shop cannot pay its rent with the $40,000 its customers owe until they pay, and some of them never will.
2. Compare the direct write-off and allowance methods
Go back to the tutoring business. One family stopped paying three months ago, and the owner finally gives up on the $240 it owes. When does that $240 loss belong in the books: in the month the owner gives up, or in the months when the sessions were billed?
There are two ways to answer.
- The direct write-off method records bad debt expense only when the business gives up on a specific account and writes it off.
- The allowance method estimates the uncollectible accounts at the end of each period and records bad debt expense with a credit to Allowance for Doubtful Accounts.
An uncollectible account is a customer's balance the business does not expect to collect. Bad debt expense is the expense for those accounts.
Here is a rule, stated as a rule: the direct write-off method is not acceptable under GAAP when bad debts are material. You will see it used for small amounts, but a business whose bad debts are large enough to matter uses the allowance method.
Why does the allowance method fit GAAP? Recall Week 4's expense recognition. An expense belongs in the period in which the business uses resources to earn that period's revenue. The bad debts come from this period's credit sales, so the allowance method's estimate puts the expense in the same period as those sales.
Worked example — the same $350 account, two ways. Later in this chapter, the bicycle shop gives up on a customer's $350 balance. Compare how each method records it.
| Effect | Direct write-off method | Allowance method |
|---|---|---|
| When the expense is recorded | In the period of the write-off: Bad Debt Expense 350 | In Year 3, as part of the $1,200 estimate |
| Entry at the write-off | Debit Bad Debt Expense 350; credit Accounts Receivable 350 | Debit Allowance for Doubtful Accounts 350; credit Accounts Receivable 350 |
| Receivables before the write-off | Shown at the full $40,000 | Shown at $40,000 less a $1,460 allowance |
In words: the two methods record the same $350 loss in different periods, and only the allowance method shows receivables at what the shop expects to collect.
Misconception check. Students often treat the two methods as two names for the same thing, because both end with the bad account removed. Their effects differ. The direct write-off method moves the expense to whatever period the business gives up, which may be a later year than the sale. The allowance method keeps the expense in the period of the sale.
3. Read the allowance as a contra asset
Picture a store owner who says, "My customers owe me $10,000, but I expect to collect about $9,500." She does not know which customer will fail to pay. She only knows that some will.
That is the job of Allowance for Doubtful Accounts. It is a contra asset with a credit balance, the receivables' version of Accumulated Depreciation. It holds the estimate without naming which customers will not pay. So Accounts Receivable keeps every customer's full balance, and the allowance sits beside it and reduces it.
The net realizable value of receivables is Accounts Receivable minus Allowance for Doubtful Accounts. It is the amount the business expects to collect.
Worked example — the shop's net realizable value. After this year's adjustment, the shop's Accounts Receivable is $40,000 and its allowance is $1,460. Net realizable value is 40,000 − 1,460 = $38,540. In words: customers owe the shop $40,000, and the shop expects to collect $38,540 of it.
Misconception check. Students often read Allowance for Doubtful Accounts as a liability, because it has a credit balance. The shop owes nobody this amount. It is a contra asset that reduces Accounts Receivable on the asset side, the same way Accumulated Depreciation reduces Equipment.
4. Estimate the allowance with an aging schedule
Think about a phone bill. If it is one week late, you probably forgot. If it is three months late, something is wrong. Lenders, landlords, and businesses all know that a bill's age says a lot about whether it will be paid.
An aging schedule groups receivables by how long they are past due and applies a higher estimated uncollectible percentage to older groups. Its total is the balance the allowance should have.
Worked example — the shop's aging schedule. The bicycle shop (illustrative, Dataset G) sorts its $40,000 of receivables into four groups at the end of Year 3. You multiply each group's balance by its percentage.
- Not yet due: 1 percent of $28,000 is 28,000 × 0.01 = $280.
- 1 to 30 days past due: 4 percent of $7,000 is 7,000 × 0.04 = $280.
- 31 to 60 days past due: 10 percent of $3,000 is 3,000 × 0.10 = $300.
- Over 60 days past due: 30 percent of $2,000 is 2,000 × 0.30 = $600.
| Age group | Balance | Estimated uncollectible | Estimate |
|---|---|---|---|
| Not yet due | $28,000 | 1 percent | $280 |
| 1 to 30 days past due | $7,000 | 4 percent | $280 |
| 31 to 60 days past due | $3,000 | 10 percent | $300 |
| Over 60 days past due | $2,000 | 30 percent | $600 |
| Total | $40,000 | $1,460 |
Foot both columns. The balances are 28,000 + 7,000 + 3,000 + 2,000 = $40,000. The estimates are 280 + 280 + 300 + 600 = $1,460. In words: the shop should carry an allowance of $1,460, and the largest share of it, $600, comes from the $2,000 that is more than 60 days late.
Notice how the oldest group behaves. It holds only $2,000 of the $40,000, yet it supplies $600 of the estimate. The newest group holds $28,000 and supplies only $280. Age, not size, drives the estimate.
In practice (your tools). In a free spreadsheet such as Google Sheets, put the age groups in column A, the balances in column B, and the percentages as decimals in column C. In D2 enter =B2*C2 and fill it down to D5. Total the balances with =SUM(B2:B5) and the estimates with =SUM(D2:D5). Type each balance once, and the formulas will foot the schedule for you.
One caveat: the percentages are estimates. A business sets them from its own experience with late customers, so two businesses can age the same balances and reach different allowances.
Misconception check. Students often apply one percentage to the whole $40,000, because it feels simpler. That throws away the information in the ages. A bill 60 days late is far less likely to be paid than one not yet due, so each group gets its own rate.
5. Record bad debt expense
Think of a tank you are filling to a line. If the tank already holds some water, you only pour in the difference. You do not pour in the full amount the line marks.
Bad debt expense under the allowance method is the amount that brings the allowance to its required balance. The aging schedule tells you where the line is. The allowance's current balance tells you how much is already in the tank.
Worked example — the shop's bad debt adjustment. The aging schedule requires $1,460. The allowance already has a $260 credit balance from earlier years. So bad debt expense is 1,460 − 260 = $1,200.
| Date | Account | Debit | Credit |
|---|---|---|---|
| End of Year 3 | Bad Debt Expense | 1,200 | |
| Allowance for Doubtful Accounts | 1,200 | ||
| Records the estimated uncollectible accounts. |
The entry balances: debits 1,200 = credits 1,200. After it, the allowance holds 260 + 1,200 = $1,460, the balance the aging schedule requires. Net realizable value is 40,000 − 1,460 = $38,540.
Walk it the same way you walk every entry. What happened: the shop estimated its uncollectible accounts. Which accounts change: Bad Debt Expense rises, and Allowance for Doubtful Accounts rises. The debit and the credit: debit Bad Debt Expense 1,200; credit Allowance for Doubtful Accounts 1,200. The effect on the statements: Year 3's income statement shows $1,200 of expense, and the balance sheet shows receivables at $38,540.
This is a Week 4 adjusting entry. It touches one income statement account and one balance sheet account, and it never touches Cash. No customer paid or refused to pay on the day you made it.
Misconception check. Students often record the schedule's $1,460 as the expense, because it is the biggest number on the page. That would push the allowance to 260 + 1,460 = $1,720, more than the schedule calls for. The $1,460 is the balance you need, and the $1,200 is what you add to reach it.
Pause and think (choose one). (a) Imagine you lend money to small businesses. Would you rather see a borrower's receivables at the full amount owed or at net realizable value, and why? (b) Imagine you are one of the shop's founders. How would you explain to your co-founder why the shop records $1,200 of expense before any customer has refused to pay?
6. Write off an account, and record a recovery
Later, the shop's owners face one customer's $350 balance. Letters and calls have gone unanswered for months. They decide they will not collect it. That decision is a write-off: the entry that removes a specific customer's balance the business no longer expects to collect.
Under the allowance method, the write-off debits Allowance for Doubtful Accounts and credits Accounts Receivable. It uses up part of the estimate the shop already made.
Worked example — the $350 write-off. You record the decision with one entry.
| Date | Account | Debit | Credit |
|---|---|---|---|
| Later | Allowance for Doubtful Accounts | 350 | |
| Accounts Receivable | 350 | ||
| Removes a customer's balance the shop no longer expects to collect. |
The entry balances: debits 350 = credits 350. Now compare the balances before and after.
| Line | Before the write-off | After the write-off |
|---|---|---|
| Accounts Receivable | 40,000 | 39,650 |
| Less: Allowance for Doubtful Accounts | (1,460) | (1,110) |
| Net realizable value | 38,540 | 38,540 |
After the write-off, Accounts Receivable is 40,000 − 350 = $39,650, the allowance is 1,460 − 350 = $1,110, and net realizable value is 39,650 − 1,110 = $38,540, unchanged. In words: both accounts fell by $350, so the amount the shop expects to collect did not move, because the loss was already counted in Year 3.
Under the direct write-off method, you would record the same account with a debit to Bad Debt Expense 350 and a credit to Accounts Receivable 350. That expense lands in the period of the write-off, with no allowance and no Year 3 estimate.
Misconception check. Students often think a write-off is an expense under the allowance method, and that it lowers net realizable value. Neither is true. The expense was recorded when the shop made its estimate. The write-off only moves $350 from one asset account to its contra account, so it changes neither the expense nor the $38,540.
A recovery. Sometimes a written-off customer pays after all. A recovery is the collection of an account that was written off. Suppose the customer whose $350 was written off later pays it in full. The shop records two entries:
- First, reverse the write-off: debit Accounts Receivable 350; credit Allowance for Doubtful Accounts 350. The customer's balance is back on the books.
- Then record the collection: debit Cash 350; credit Accounts Receivable 350. The customer has paid.
Each entry balances, and the allowance returns to 1,110 + 350 = $1,460. Why two entries instead of one? The first restores the customer's record, so the file shows that this customer did pay in the end. That history matters the next time the customer asks to buy on account.
7. Compute simple interest on a note receivable
Think about a friend who borrows $100 and promises to repay $105 in a year. The extra $5 is the price of using your money for that year. If your friend repaid after only three months, you would not expect the whole $5.
Simple interest is interest figured on the face of a note alone:
Interest = Face × Rate × Time
The face is the principal amount the note promises to pay, before interest. The rate is the note's annual interest rate. Time is the note's term as a fraction of a year, so 3 months is 3⁄12 of a year. The maturity value is the face plus the interest, the amount due when the note comes due.
Worked example — the youth cycling program's note. A youth cycling program signs a $6,000, 6 percent, 3-month note to the bicycle shop (illustrative, Dataset G).
- Interest = Face × Rate × Time = 6,000 × 0.06 × 3⁄12 = $90.
- The note's maturity value: 6,000 + 90 = $6,090.
At maturity, the program pays, and the shop records one entry.
| Date | Account | Debit | Credit |
|---|---|---|---|
| Maturity | Cash | 6,090 | |
| Notes Receivable | 6,000 | ||
| Interest Revenue | 90 | ||
| Collects the note's face and its 3 months of interest. |
The entry balances: debits 6,090 = credits 6,000 + 90 = 6,090. Interest Revenue is the revenue account for interest a business earns. In words: the shop collects $6,090, of which $6,000 returns the amount it was owed and $90 is revenue it earned by waiting three months.
Misconception check. Students often figure a 3-month note's interest as a full year's, because the rate is stated per year. The full-year figure the note does not earn: 6,000 × 0.06 = $360, which is four times the 3-month interest, because 360 ÷ 90 = 4. So $360 versus $90 is a 4-fold error. Always multiply by the fraction of the year the note runs.
Here is a limitation worth naming. This course keys only simple interest on short notes. Longer loans that compound interest, or that are repaid in installments, use other arithmetic, and you will meet installment notes in words in Week 13.
8. Report receivables on the balance sheet
Imagine a lender reading the shop's balance sheet before a loan decision. The lender wants two numbers: how much customers owe, and how much the shop really expects to collect. The balance sheet can show both on three lines.
| The bicycle shop — Balance Sheet (current assets, in part) — End of Year 3 | ||
|---|---|---|
| Accounts Receivable | $40,000 | |
| Less: Allowance for Doubtful Accounts | (1,460) | |
| Net realizable value of receivables | $38,540 |
The three lines foot: 40,000 − 1,460 = 38,540. A reader sees the full amount owed, the estimate of what will not arrive, and the amount the shop expects to collect.
Now say the whole week in one plain sentence. The allowance method puts $1,200 of bad debt expense in Year 3, the year of the sales, and shows receivables at the $38,540 the shop expects to collect; the later write-off changes neither figure.
Misconception check. Students often think the balance sheet should show only the $38,540, because that is the number that matters. Showing all three lines tells the reader more. A jump in the allowance from one year to the next is a warning sign a lender wants to see, and it would be hidden if only the net figure appeared.
Key terms
- Accounts receivable — Amounts customers owe on account. (first used: 1. Tell accounts receivable from notes receivable)
- Notes receivable — Written promises to pay a sum, often with interest. (first used: 1. Tell accounts receivable from notes receivable)
- Direct write-off method — A way of recording bad debts in which bad debt expense is recorded only when a specific account is written off; it is not acceptable under GAAP when bad debts are material. (first used: 2. Compare the direct write-off and allowance methods)
- Allowance method — A way of recording bad debts in which the business estimates its uncollectible accounts at the end of each period and records bad debt expense with a credit to Allowance for Doubtful Accounts. (first used: 2. Compare the direct write-off and allowance methods)
- Uncollectible account — A customer's balance the business does not expect to collect. (first used: 2. Compare the direct write-off and allowance methods)
- Bad debt expense — The expense for the receivables a business does not expect to collect. (first used: 2. Compare the direct write-off and allowance methods)
- Allowance for Doubtful Accounts — A contra asset account with a credit balance that holds the estimate of the receivables the business does not expect to collect. (first used: 2. Compare the direct write-off and allowance methods)
- Net realizable value of receivables — Accounts Receivable minus Allowance for Doubtful Accounts: the amount the business expects to collect. (first used: 3. Read the allowance as a contra asset)
- Aging schedule — A schedule that groups receivables by how long they are past due and applies a higher estimated uncollectible percentage to older groups. (first used: 4. Estimate the allowance with an aging schedule)
- Write-off — The entry that removes a specific customer's balance the business no longer expects to collect. (first used: 6. Write off an account, and record a recovery)
- Recovery — The collection of an account that was written off, recorded by reversing the write-off and then recording the cash. (first used: 6. Write off an account, and record a recovery)
- Simple interest — Interest figured on the face of a note alone: Interest = Face × Rate × Time. (first used: 7. Compute simple interest on a note receivable)
- Face — The principal amount a note promises to pay, before interest. (first used: 7. Compute simple interest on a note receivable)
- Maturity value — The face of a note plus its interest, the amount due when the note comes due. (first used: 7. Compute simple interest on a note receivable)
- Interest Revenue — The revenue account for interest a business earns. (first used: 7. Compute simple interest on a note receivable)
Summary
- Accounts receivable are owed on account; notes receivable are written promises, often with interest.
- The direct write-off method records the expense at the write-off; GAAP does not accept it when bad debts are material.
- The allowance method estimates the loss in the period of the sales.
- Allowance for Doubtful Accounts is a contra asset with a credit balance.
- An aging schedule sets the allowance's required balance.
- Bad debt expense is the amount that brings the allowance to that balance.
- A write-off under the allowance method changes neither the expense nor net realizable value.
- Interest equals face times rate times the fraction of a year.
Check your understanding
Work these before looking at the answers — they are ungraded, and the answers (with reasoning) are at the bottom of the page.
- A landscaping company (illustrative) ages its receivables: $15,000 not yet due at 2 percent, and $5,000 past due at 10 percent. Its allowance has a $150 credit balance before the adjustment. Compute the required allowance and the bad debt expense, and write the entry.
- A tutoring business (illustrative) has Accounts Receivable of $12,000 and an allowance of $700. It writes off a family's $480 balance. Write the entry, and give net realizable value before and after.
- A dog-grooming service (illustrative) holds a $5,000, 8 percent, 6-month note from a pet-supply store. Compute the interest and the maturity value, and write the entry to collect it.
- A food truck (illustrative) uses the direct write-off method. In its first year it sells $600 of catering on account to a client who never pays, and it gives up on the account in its second year. Explain in which year each method would record the $600 of bad debt expense.
Answers (worked reasoning — read after attempting)
- The required allowance is 15,000 × 0.02 + 5,000 × 0.10 = 300 + 500 = $800. The allowance already holds $150, so bad debt expense is 800 − 150 = $650. Debit Bad Debt Expense 650; credit Allowance for Doubtful Accounts 650. In words: the company pours in only the $650 that brings the allowance up to $800.
- Debit Allowance for Doubtful Accounts 480; credit Accounts Receivable 480. Before, net realizable value is 12,000 − 700 = $11,300. After, it is 11,520 − 220 = $11,300, because Accounts Receivable falls to 12,000 − 480 = $11,520 and the allowance falls to 700 − 480 = $220. The write-off moves amounts but changes nothing the business expects to collect.
- Interest is 5,000 × 0.08 × 6⁄12 = $200, and the maturity value is 5,000 + 200 = $5,200. Debit Cash 5,200; credit Notes Receivable 5,000; credit Interest Revenue 200. A full year would have been 5,000 × 0.08 = $400, twice as much, so the 6⁄12 matters.
- Under the direct write-off method, the $600 is expense in the second year, when the truck gives up on the account. Under the allowance method, the loss would be part of the first year's estimate, the year of the sale. That gap between the sale and the expense is why GAAP does not accept the direct write-off method when bad debts are material.
Next up in this module: the Readings & Resources page, the lecture tutorial, the practice set, the quiz, the discussion, and the assignment; next week the straight-line method spreads a van's cost across its years.
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