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Financial Accounting Unit 6: Receivables and Bad Debts

Most companies sell on credit, so some customers will never pay. This unit covers how to record receivables, estimate bad debts with the allowance method, handle notes receivable and judge how quickly a company collects.

Covers: Types of receivables, Direct write-off vs allowance method, Percentage-of-sales method, Aging and percentage-of-receivables, Write-offs and recoveries, Notes receivable and interest, Credit cards and factoring, Receivables turnover

Study guide

Receivables are amounts owed to a company. Accounts receivable arise from selling goods or services on credit and are usually due in 30 to 60 days. Notes receivable are written promises to pay a set amount, usually with interest, and may be current or long-term. Other receivables include interest, loans to employees and tax refunds. Because some customers will not pay, receivables are reported at net realizable value, the amount the company expects to collect. Companies may also convert receivables into cash quickly by accepting credit cards, which carry a fee, or by factoring, selling receivables to a finance company at a discount.

There are two ways to account for uncollectible accounts. The direct write-off method records Bad Debt Expense only when a specific account is judged worthless. It is simple, but it often records the expense in a later period than the sale and reports receivables at an amount the company will not fully collect, so it is allowed only when bad debts are immaterial. The allowance method, required by GAAP otherwise, estimates uncollectibles at the end of each period: debit Bad Debt Expense and credit Allowance for Doubtful Accounts, a contra-asset. Net realizable value equals Accounts Receivable minus the Allowance.

Two estimation approaches are common. The percentage-of-sales method multiplies credit sales by a historical loss rate to get the expense directly; it emphasizes matching on the income statement and ignores the allowance's existing balance. The percentage-of-receivables method estimates how much of ending receivables won't be collected, often with an aging schedule that applies higher rates to older accounts. That estimate is the required ending allowance, so the adjustment equals the target minus an existing credit balance, or the target plus an existing debit balance. A debit balance appears when write-offs during the year exceeded the allowance.

When a specific account is written off under the allowance method, debit the Allowance and credit Accounts Receivable. This has no effect on expense or net realizable value, because both accounts fall by the same amount; the expense was recorded when the estimate was made. If a written-off customer later pays, reverse the write-off (debit Accounts Receivable, credit Allowance) and then record the collection. For notes receivable, interest equals face value × annual rate × time, often using a 360-day year. Interest earned but not collected at year end is accrued. If the maker dishonors a note but collection is still expected, the principal and interest are moved to Accounts Receivable.

Analysts judge receivables with two linked ratios. Receivables turnover equals net credit sales divided by average net accounts receivable; it shows how many times per year the company collects its average receivables. The average collection period, or days sales outstanding, equals 365 divided by turnover. Comparing the collection period with the company's credit terms shows whether customers pay on time. A lengthening collection period can warn of loose credit policies or weak customers, while early-payment discounts and tighter credit checks usually shorten it. Because bad debt estimates rely on judgment, they are also a common place for earnings management, so auditors test them closely.

Key ideas

• Receivables are reported at net realizable value: gross receivables minus the allowance.
• The allowance method records estimated bad debts in the same period as the related sales.
• The percentage-of-sales method computes the expense; the receivables (aging) method computes the target allowance.
• Writing off an account under the allowance method does not change expense or net realizable value.
• A recovery reverses the write-off and then records the cash collection.
• Interest on notes = principal × rate × time; accrue interest earned at year end.
• Receivables turnover and the average collection period measure how quickly cash is collected.

Formulas and rules

Common mistakes

• Debiting Bad Debt Expense when writing off an account under the allowance method.
• Subtracting the existing allowance balance when using the percentage-of-sales method.
• Forgetting that a debit balance in the allowance must be added to the target, not subtracted.
• Thinking a write-off lowers net realizable value.
• Using 12 months instead of the stated days when computing interest on a short-term note.

Before the test, make sure you can

• Explain why GAAP prefers the allowance method to direct write-off.
• Calculate bad debt expense using the percentage-of-sales method.
• Calculate bad debt expense from an aging schedule, with credit or debit allowance balances.
• Journalize write-offs and recoveries and explain their effects on net realizable value.
• Compute interest and maturity value on notes and record accrued interest and dishonored notes.
• Record credit card sales and factoring.
• Calculate and interpret receivables turnover and the average collection period.

Words to know

Accounts receivable

Amounts customers owe for goods or services sold on credit, usually due within 30 to 60 days.

Notes receivable

Written promises from others to pay a specific amount, usually with interest, by a set date.

Direct write-off method

Records bad debt expense only when a specific account is determined to be uncollectible; not GAAP unless immaterial.

Allowance method

Estimates uncollectible accounts each period and records them in a contra-asset account.

Allowance for Doubtful Accounts

A contra-asset account that reduces receivables to the amount expected to be collected.

Bad Debt Expense

The expense for estimated or actual uncollectible accounts receivable.

Net realizable value

Accounts receivable minus the allowance; the cash the company expects to collect.

Percentage-of-sales method

Estimates bad debt expense as a percentage of credit sales; an income statement approach.

Percentage-of-receivables method

Estimates the needed ending allowance as a percentage of receivables; a balance sheet approach.

Aging schedule

A list of receivables grouped by how long they are past due, with higher loss rates for older balances.

Write-off

Removing a specific uncollectible account by debiting the allowance and crediting receivables.

Recovery

Collection of a previously written-off account; the write-off is reversed before recording cash.

Maturity value

The amount due on a note at maturity: principal plus interest.

Dishonored note

A note the maker fails to pay at maturity.

Factoring

Selling receivables to a finance company for cash, less a fee.

Receivables turnover

Net credit sales divided by average net accounts receivable.

Average collection period

365 divided by receivables turnover; the average days to collect a receivable.

Sample practice questions

30 more questions like these, from level 1 to 5, are in the practice set.