Chapter 5: Receivables

Most businesses sell on credit: the customer receives the goods or service now and pays later. That creates a receivable, a right to receive cash in the future. Some customers never pay, so the company must decide how to account for uncollectible accounts. This chapter covers the direct write-off method, the allowance method with its three estimation techniques, notes receivable and interest, and three ratios that show how well a company manages its receivables.

Types of receivables

A receivable is a monetary claim against a business or a person. The creditor holds the receivable; the debtor must pay later.

• Accounts receivable (trade receivables): amounts due from customers for goods or services, usually collected within 30 to 60 days; a current asset.
• Notes receivable (promissory notes): a written promise to pay a fixed principal plus interest on a maturity date; usually longer terms than accounts receivable.
• Other receivables: dividends receivable, interest receivable, taxes receivable. Each receivable is current if it will be collected within a year and long-term otherwise.

A sale on account: Dr Accounts receivable, Cr Service revenue (or Sales revenue). Collection: Dr Cash, Cr Accounts receivable. To speed up collection and shift credit risk to someone else, a company can accept credit and debit cards (the card company pays, minus a fee) or use factoring (selling receivables to a finance company at a discount) or pledging (using receivables as collateral for a loan).

The direct write-off method

Under the direct write-off method no estimate is made. Bad debts expense is recorded only when a specific customer's account is found to be uncollectible:

If the customer unexpectedly pays later, the company first reverses the write-off (Dr Accounts receivable, Cr Bad debts expense) and then records the collection (Dr Cash, Cr Accounts receivable).

The method is simple but violates the matching principle: the sale is recorded in one year and the related bad debt often in the next. Net income and accounts receivable of the sales year are then overstated, and net income of the following year is understated. It is acceptable only for small companies with very few uncollectibles.

The allowance method

Most companies, and GAAP, use the allowance method. At the end of each period the company estimates how much of its receivables will not be collected and records the bad debts expense in the same period as the sales. Because it is not yet known which customer will default, the credit goes to a contra asset account, Allowance for bad debts, which reduces accounts receivable to its net realizable value (the amount expected to be collected).

Example: on 31 December Smart Touch Learning estimates that $80 of its $4,400 receivables will be uncollectible: Dr Bad debts expense 80, Cr Allowance 80. Net realizable value = 4,400 − 80 = $4,320. When on 10 January a customer's $25 account is written off, receivables and allowance both fall by 25, and NRV stays $4,320.

Estimating bad debts

Percent-of-sales method (income statement approach). Bad debts expense is a percentage of net credit sales. The existing balance in the allowance is ignored.

Credit sales of $60,000 and an expected loss rate of 0.5% give a bad debts expense of $300.

Percent-of-receivables method (balance sheet approach). Step 1: compute the target balance of the allowance, a percentage of ending accounts receivable. Step 2: the expense is the amount needed to bring the allowance to that target:

Example: receivables $6,375, 4% expected uncollectible, so the target is $255. The allowance already has a credit balance of $55, so the adjustment is 255 − 55 = $200. Second example: receivables $40,000 at 2% gives a target of $800; the allowance has a debit balance of $150 (more was written off than estimated), so the expense is 800 + 150 = $950.

Aging-of-receivables method (balance sheet approach). Receivables are grouped by how long they have been outstanding (for example 1 to 30 days, 31 to 60, 61 to 90, over 90), and a higher percentage is applied to older groups because old debts are less likely to be paid. The sum is the target balance; the expense is computed exactly as in the percent-of-receivables method.

Notes receivable

Key terms: the maker of the note is the debtor who signs it; the payee is the creditor. The principal is the amount lent. Interest is revenue to the payee and expense to the maker. The interest period (note term) runs from the issue date to the maturity date. The maturity value is principal plus interest.

Interest rates are annual, so time is a fraction of a year: months / 12 or days / 365.

• $2,000 at 10% for nine months: 2,000 × 0.10 × 9/12 = $150.
• $5,000 at 12% for 60 days: 5,000 × 0.12 × 60/365 = $98.63.

Maturity date. If the term is in months, the note matures on the same day of the month. If the term is in days, count the actual days, excluding the issue date and including the maturity date. A 180-day note dated 16 February matures on 15 August (12 days left in February, then 31, 30, 31, 30, 31 and 15).

Accruing interest. A $1,000, one-year, 6% note was received on 30 September. On 31 December three months of interest are accrued: 1,000 × 0.06 × 3/12 = $15 (Dr Interest receivable, Cr Interest revenue). At maturity the company receives the maturity value of $1,060: Dr Cash 1,060, Cr Note receivable 1,000, Cr Interest receivable 15, Cr Interest revenue 45 (nine months in the new year). The note is then honored.

If the maker does not pay at maturity, the note is dishonored. The payee moves the full maturity value (principal plus earned interest) to accounts receivable and keeps trying to collect.

Ratios for receivables

The acid-test (quick) ratio is stricter than the current ratio: it leaves out inventory and prepaid expenses, which cannot quickly pay debts. A value of 1.00 or more is generally considered safe, depending on the industry. Amazon in 2018: (31,750 + 9,500 + 16,677) / 68,391 = 0.85.

Turnover shows how many times a year the average receivables balance is collected; higher means faster collection. Days' sales in receivables (the collection period) should be close to the credit terms. Amazon: 232,877 / ((16,677 + 13,164) / 2) = 15.61 times, and 365 / 15.61 = 23 days.