Lecture: Receivables
Lecture script · about 15–20 minutes spoken · Week 10
Opening
Picture three businesses that let customers pay later. A landscaping company mows office parks all month and sends each client a bill at the end. A tutoring business bills families for the month's sessions. And our bicycle shop, now in Year 3, repairs and sells bicycles on account to businesses and groups. All three are owed money. And all three know, deep down, that some of it will never arrive. This lecture is about how a business is honest with its readers about that.
Let me remind you where we are. In Week 2 you met Accounts Receivable as an asset, the account for what customers owe. In Week 3 you learned normal balances and met your first contra account, Accumulated Depreciation. In Week 4 you learned that an expense belongs in the period whose revenue it helped earn, and you made adjusting entries. And in Week 9 you found the shop's true cash with a bank reconciliation. This week does for receivables what Week 9 did for cash.
Here's the plan. We'll separate two kinds of receivable. We'll compare two ways of recording the accounts that go bad. We'll meet a new contra account, estimate it with an aging schedule, and record the expense. Then we'll write off an account, collect a note with interest, and read the result on the balance sheet. Next week, in Long-Lived Assets, we move down the balance sheet to the things a business uses for years.
1. Accounts receivable and notes receivable
Start with something you've likely done. You lend a friend some money, and nobody writes anything down. Your friend owes you because you handed over the cash. Now picture a bigger loan, where your friend signs a short note saying how much they'll repay and by when. Both are debts. One is informal, and one is on paper.
A business has the same two kinds. Accounts receivable are amounts customers owe on account. Notes receivable are written promises to pay a sum, often with interest. An account receivable usually comes from an ordinary sale on account and is collected within weeks, with no interest. A note spells out its terms: the amount, the date it comes due, and the rate.
Here's the shop's picture at the end of Year 3, from Dataset G, which is illustrative. Its customers owe it $40,000 on account. Separately, a youth cycling program signs a $6,000, 6 percent, 3-month note to the shop. The $40,000 sits in Accounts Receivable. The $6,000 sits in Notes Receivable.
Pause and try this. A customer has a repair done on account and promises, out loud, to pay next month. Is that an account receivable or a note receivable?
Decide which, and give yourself one reason.
Here's the answer. It's an account receivable. The customer owes the shop because of a sale on account, and nobody signed a written promise with a rate and a due date.
One more thing to hold on to: a receivable is a claim, not cash. The shop can't pay its rent with what customers owe until they pay.
2. Two ways to record bad debts
Some customers never pay. So when should that loss show up in the books? Think about a café that lets a regular run a tab. Months later, the regular moves away without paying. Did the café lose that money when it served the coffee, or when it finally gave up?
There are two methods. 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. And here is a rule, stated as a rule: the direct write-off method is not acceptable under GAAP when bad debts are material.
Why does the allowance method fit? Remember Week 4's expense recognition. An expense belongs in the period whose revenue it helped earn. This year's bad debts come from this year's credit sales, so the allowance method puts the expense in the same year as those sales. The direct write-off method waits until someone gives up, which can be a later year.
Let's compare them on one account. Later this week the shop gives up on a customer's $350 balance. Under the direct write-off method, the $350 becomes bad debt expense in the period of the write-off. Under the allowance method, the loss was already part of Year 3's estimate. Same $350, different periods. Neither description is a ranking. They're two effects on the statements, and GAAP's materiality rule decides which one a business with real bad debts uses.
Pause and try this. Under the direct write-off method, in which period does the shop record the $350 as bad debt expense?
Think about when the shop actually gives up.
Here's the answer. In the period of the write-off. The direct write-off method records the expense only when a specific account is written off, not when the sale happened.
3. A contra asset for what won't arrive
Imagine a store owner who tells you, "My customers owe me about this much, and I expect most of it." She doesn't know which customers will fail to pay. She only knows that some will. So she can't cross out any one customer's balance yet.
That's what Allowance for Doubtful Accounts is for. It's a contra asset account with a credit balance that holds the estimate of the receivables the business does not expect to collect. It's the receivables' version of Accumulated Depreciation. Accounts Receivable keeps every customer's full balance, and the allowance sits beside it and reduces it.
Subtract one from the other and you get a new figure. The net realizable value of receivables is Accounts Receivable minus Allowance for Doubtful Accounts: the amount the business expects to collect. For the shop, after this year's adjustment, that's $40,000 minus a $1,460 allowance, which leaves $38,540.
Pause and try this. The allowance has a credit balance. Does that make it a liability?
Picture which side of the balance sheet it sits on.
Here's the answer. No. The shop owes nobody this amount. It's a contra asset that reduces Accounts Receivable on the asset side, the same way Accumulated Depreciation reduces Equipment.
4. The aging schedule
Think about a phone bill. A week late, you probably forgot. Three months late, something's wrong. Everyone who lends or bills knows that the older a debt gets, the less likely it is to 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.
Here's the shop's schedule in words. $28,000 is not yet due, and the shop expects 1 percent of it to go bad, which is $280. $7,000 is 1 to 30 days past due, at 4 percent, which is also $280. $3,000 is 31 to 60 days past due, at 10 percent, which is $300. And $2,000 is over 60 days past due, at 30 percent, which is $600. The balances add to $40,000. The estimates add to $280 plus $280 plus $300 plus $600, which is $1,460.
Notice the shape. The newest group is by far the biggest, $28,000, yet it supplies only $280 of the estimate. The oldest group is the smallest, $2,000, and it supplies $600. Age, not size, drives the estimate. One honest caveat: those percentages are estimates the shop sets from its own experience, so another business could age the same balances and reach a different allowance.
Pause and try this. Which age group adds the most to the shop's required allowance?
Think back to the four estimates.
Here's the answer. The over 60 days group, at $600. It holds the least money but carries the highest rate, 30 percent, because the oldest bills are the least likely to be paid.
5. Bad debt expense
Here's an image that helps. You're filling a tank to a line painted on the side. If there's already water in it, you don't pour in the full amount the line marks. You pour in the difference.
Bad debt expense is the expense for the receivables a business does not expect to collect. Under the allowance method, it's the amount that brings the allowance to its required balance. The aging schedule paints the line at $1,460. And the allowance already holds a $260 credit balance from earlier years. So the shop pours in $1,460 minus $260, which is $1,200.
The entry, at the end of Year 3, debits Bad Debt Expense for 1,200 and credits Allowance for Doubtful Accounts for 1,200. Walk it the usual way. What happened: the shop estimated its uncollectible accounts. Which accounts change: Bad Debt Expense rises and the allowance rises. The effect: Year 3's income statement shows $1,200 of expense, and the allowance now holds $1,460. And this is a Week 4 adjusting entry. It touches one income statement account and one balance sheet account, and it never touches Cash.
Pause and try this. Why isn't the bad debt expense the full $1,460 that the aging schedule shows?
Think about what's already in the tank.
Here's the answer. Because $260 of that balance is already in the allowance. The $1,460 is the balance the shop needs, and the $1,200 is what it adds to reach it.
6. Writing off an account
Later, the shop's owners look at one customer's $350 balance. Calls and letters have gone unanswered for months, and they decide they won't 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 entry debits Allowance for Doubtful Accounts for 350 and credits Accounts Receivable for 350. Follow both accounts. Accounts Receivable falls from $40,000 to $39,650. The allowance falls from $1,460 to $1,110. And net realizable value? $39,650 minus $1,110 is still $38,540. Nothing the shop expects to collect has changed, because it already counted this loss back in Year 3.
That's the heart of the week. A write-off under the allowance method is not an expense, and it doesn't lower net realizable value. It moves $350 out of an asset and out of that asset's contra account at the same time.
Sometimes a written-off customer pays after all. A recovery is the collection of an account that was written off, recorded by reversing the write-off and then recording the cash. First, the shop debits Accounts Receivable and credits the allowance for 350, which puts the customer's balance back. Then it debits Cash and credits Accounts Receivable for 350. The allowance returns to $1,460, and the customer's file shows they paid in the end.
Pause and try this. After the $350 write-off, what is the shop's net realizable value of receivables?
Run the subtraction in your head.
Here's the answer. It's $38,540, the same as before. Accounts Receivable and the allowance each fell by $350, so their difference didn't move.
7. Interest on a note
Picture lending a friend money for a whole year and agreeing they'll add a little extra as thanks for the wait. If they repay after only a few months, you wouldn't expect the whole year's extra. You'd expect a share that fits the time.
That's simple interest: interest figured on the face of a note alone. The chapter writes it as Interest equals Face times Rate times Time. The face is the principal amount a note promises to pay, before interest. The rate is the note's annual rate. And Time is the note's term as a fraction of a year, so 3 months is three twelfths of a year.
Let's do the youth cycling program's note. The face is $6,000, the rate is 6 percent, and the time is three twelfths. Six percent of $6,000 for a full year would be $360. A quarter of that is $90. So the interest is $90. The maturity value is the face of a note plus its interest, so it's $6,000 plus $90, which is $6,090. When the program pays, the shop debits Cash for 6,090, credits Notes Receivable for 6,000, and credits Interest Revenue, the revenue account for interest a business earns, for 90.
Pause and try this. A classmate says the note earns $360 of interest. What did they forget?
Think about how long the note runs.
Here's the answer. They used a full year. The rate is stated per year, but the note runs only 3 months, so the shop earns three twelfths of $360, which is $90.
8. Receivables on the balance sheet
Imagine a lender reading the shop's balance sheet before a loan decision. The lender wants two answers. How much do customers owe? And how much does the shop really expect to collect?
The balance sheet gives both, on three lines in current assets. Accounts Receivable, $40,000. Less Allowance for Doubtful Accounts, $1,460. And net realizable value of receivables, $38,540. A reader sees the full amount owed, the estimate of what won't arrive, and what's left.
Why show all three, and not only the $38,540? Because the middle line carries news. If the allowance grows quickly from one year to the next, a lender wants to see that, and it would be hidden inside a single net figure.
Pause and try this. Which of the three lines tells a reader what the shop expects to collect?
Name the line, not the number.
Here's the answer. The net realizable value line. It's Accounts Receivable minus the allowance, the amount the shop expects to turn into cash.
Closing
Let me pull it together. Accounts receivable come from sales on account, and notes receivable are written promises, often with interest. The direct write-off method records the expense only at the write-off, and GAAP doesn't accept it when bad debts are material. The allowance method estimates the loss in the period of the sales, and the allowance is a contra asset with a credit balance. The aging schedule set the shop's required allowance at $1,460. Bad debt expense was the $1,200 that filled the allowance to that line. The $350 write-off moved amounts between two asset accounts and left net realizable value at $38,540. And the note earned $90 for its three months, for a maturity value of $6,090.
Here's the sentence to keep: 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.
Next in this module come the slide deck, the Readings and Resources page, the lecture tutorial, the practice set, the quiz, the discussion, and the assignment. Next week, in Long-Lived Assets, you'll spread the cost of the shop's van across the years it serves.
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