Many companies sell services and products on credit. This is done to sell more services or products. The results of such sales creates a receivable for the company (usually either accounts receivable or notes receivable). The term receivables is used to represent money claims against other entities including people, businesses, and other organizations. They are usually a significant portion of a company's assets.

Accounts Receivables are the most common type of receivable. These are created from selling services or merchandise on credit. They are expected to be collected in a relatively short time, such as 30 or 60 days. They are classified as an asset on the balance sheet.

Notes Receivables are amounts owed that a formal written credit has been issued. As long as they are expected to be collected within a year, they are classified as an asset on the balance sheet. Usually, they are for periods longer than 60 days. They usually have monthly payments, and often have interest attached. An example of a notes receivable would be if you were to buy furniture on account. Sometimes a notes receivable will be used to settle a debt from an accounts receivable. Notes receivables and accounts receivables that are the result of sales transactions are often called trade receivables. The entity that is to receive the money is known as the payee, and the one making the promise is known as the maker. The date that the note is to be paid by is the due date, or maturity date.

A note normally specifies that interest is to be paid between the issue date and the due date. Interest rates are usually expressed in terms of a year, regardless of the actual length of time on the note. The amount due at the maturity of the note is the maturity value. The maturity value of a note is the sum of the amount of the note receivable and the interest. For example, a note of $10,000.00 with an interest rate of 10% would have a maturity value of $11,000.00 ($10,000.00 plus interest of $1,000.00).

For example, a company accepts the note above for $10,000.00 for a customer, John Smith. When the note matures, the company receives the payment of $11,000.00. The transaction would be recorded as follows:

 Notes Receivable - John Smith 10,000
 Interest Revenue 1,000

If the maker fails to make payment on the note, then the note is considered a dishonored note receivable. The company transfers the note plus interest owed to an accounts receivable for the customer. For example, if John Smith failed to pay the note, then the company would move the account with the following transaction:

Accounts Receivable - John Smith11,000 
 Notes Receivable - John Smith 10,000
 Interest Revenue 1,000

The company has earned interest of $1,000, even though it has actually not been collected, and the note was dishonored. If the account receivable is uncollectible, the company will write off the $11,000 as described below.

The interest revenue account is closed at the end of each accounting period. The amount in the interest revenue account is reported in the other income section of the income statement.

Other Receivables include interest receivable, taxes receivable, and receivables from officers or employees. They are listed separately on the balance sheet. If they are expected to be collected within one year, they are classified as current assets. If collection is expected to take longer than a year, they are classified as non-current assets and reported as investments.

Uncollectable Receivables

When selling on credit, there is always a chance that the receivable will not be collected. Many retailers shift the risk of uncollectable receivables to other companies by accepting only cash or credit cards. Some companies sell their receivables to other companies. Selling receivables is called factoring. The buyer of the receivable is called a factor. The benefit of this is that the selling company receives immediate cash for operating and other needs. Usually, depending upon the agreement, the risk of uncollectible accounts may be shifted to the factor.

No matter how careful a company is in granting credit and the collection procedure used, a part of the credit sales will not be collectible. The operating expense recorded from uncollectible receivables is called Bad Debt Expense. This is sometimes referred to as uncollectible accounts expense or doubtful accounts expense.

Direct Write-Off Method

There are two methods of recording the bad debt. The first is called the direct write-off method. This is generally used only for tax purposes, but is also used by some businesses that sell most of their goods and services for cash and credit cards. For these businesses, receivables are a very small part of the current assets, and any bad debt expenses would be extremely small. In this method, the bad debt expense is recorded only when an account is judged to be uncollectible and is written off. The major problem with this method is that almost all of these debts were first incurred, and recorded as assets, in previous accounting periods. This results in a misstatement in those accounting periods.

As an example of how the direct write-off method works, let's assume that a business sold merchandise for $500 to a customer named John Smith. After many attempts to collect, the customer's account is determined to be uncollectible and is written off. The entry to write off the account is as follows:

Bad Debt Expense500.00 
 Accounts Receivable - John Smith 500.00

Later, however, John Smith decides to pay the account. In such cases, the account is reinstated by an entry that reverses the write-off entry. Then, the entry of payment can be recorded. The two entries would be recorded at the same time as follows:

Accounts Receivable - John Smith500.00 
 Bad Debt Expense 500.00
 Accounts Receivable - John Smith 500.00

Allowance Method

The second method of recording bad debt is the allowance method. This method uses estimating uncollectible accounts at the end of the accounting period. This method allows for the matching principle to be used, matching the bad debt in the period that the transaction occurred. This method is required by GAAP for companies with large accounts receivables.

This method estimates the accounts receivables that will not be collected and records bad debt expense at the end of each accounting period. Based on this estimate, Bad Debt Expense is then recorded as an adjusting entry.

As an example, let's assume that Driden Enterprises has an accounts receivable of $100,000.00 that includes some accounts that are past due at the end of the accounting cycle. Driden Enterprises doesn't know exactly which accounts will be uncollectible. Based upon industry data, it is assumed that 4% of accounts will be uncollectible, which is $4,000.00. using this estimate, the following adjusting entry can be made.

Bad Debt Expense4000.00 
 Allowance for Doubtful Accounts 4000.00

In the direct write-off method we were able to use the actual accounts receivable accounts because we knew which accounts would be uncollectible. In the allowance method, we use Allowance for Doubtful Accounts due to not knowing exactly which accounts will be uncollectable. Allowance for Doubtful Accounts is a contra asset account, and is increased with a credit instead of a debit.

As with all adjustments, this affects the balance sheet. The $4,000.00 of bad debt expense is matched against the related revenues of the period. This reduces the value of the receivables to the amount of cash expected to be realized in the future. This is called the net realizable value of the receivables. This is reported on the balance sheet.

Note that Accounts Receivable still has a balance of $100,000.00. This represents the total amount owed by customers, and is supported by the individual accounts receivable accounts. The contra account of Allowance for Doubtful Accounts has a credit balance of $4,000.00.

When an account becomes uncollectible, it is written off against the Allowance for Doubtful Accounts instead of Bad Debt Expense. In the above example for John Smith, the write-off entry would be as follows:

Allowance for Doubtful Accounts500.00 
 Accounts Receivable - John Smith 500.00

At the end of a period, the Allowance for Doubtful Accounts will have a balance. The balance will be a credit balance if the amount of write-offs during the period is less than the beginning balance. The balance will be a debit balance if the amount of write-offs during the period exceeds the beginning balance.

To illustrate using the above example, the beginning balance of the allowance was $4,000.00. John Smith's account was written-off in the amount of $500.00. This leaves a credit balance of $3,500.00 in the Allowance for Doubtful Accounts.

Allowance for Doubtful Accounts
 March 1 beginning balance 4,000.00
March 15 John Smith 500.00 
 March 31 Unadjusted balance 3,500.00

This is before the end-of-period adjustments, which is why the balance is listed as the unadjusted balance. The final balance in the Allowance for Doubtful Accounts must be a credit. If the amount of write-offs is more than the amount in the allowance, then you will end up with a debit balance, and an additional entry will need to be made during the end-of-period adjustments. We'll discuss that when we look at the estimating process.

Going back to our example, what do we do when the Accounts Receivable has been written-off, and then later collected? As with the direct write-off method, a reversal entry must first be done to reinstate the accounts receivable by reversing the write-off. Then the entry for the collection can be recorded. The entries would look as follows:

Accounts Receivable - John Smith500.00 
 Allowance for Doubtful Accounts 500.00
 Accounts Receivable - John Smith 500.00

Estimating Uncollectible Receivables

As indicated earlier, the allowance method estimates the bad debt expense at the end of the period. The estimate of uncollectibles at the end of a fiscal period is based on past experience and forecasts of the future. When the economy is doing good, the estimate is usually less than if the economy is doing poorly. Two methods are commonly used to estimate the uncollectible receivables. The first is as a percentage of sales. The second is an analysis of the receivables.

Estimate Based on Percentage of Sales

Accounts receivables are created from credit sales. Therefore, bad debt can be estimated as a percentage of these sales. to illustrate, assume that Driden Enterprises has a credit balance in Allowance for Doubtful Accounts of $5,000.00 at the end of the year. The business estimates that 2% of all credit sales for the year will be uncollectible. The total credit sales for the year is $1,000,000.00. The adjusting entry for uncollectible accounts on December 31 would be:

Bad Debt Expense20,000.00 
 Allowance for Doubtful Accounts 20,000.00

After this adjusting entry, Bad Debt Expense has a debit balance of $20,000.00, which is 2% of the $1,000,000.00. Allowance for Doubtful Accounts will have a credit balance of $25,000.00 - the original $5,000.00 plus the $20,000.00 from the adjusting entry.

What if, however, during the year there had been more write-offs than what was originally in the Allowance for Doubtful Accounts, causing a debit balance of $5,000.00 instead of a credit balance in the above example? In this case, the bad debt expense entry would still be done as above. However, instead of adding the $20,000.00 to the original $5,000.00 balance, the original balance would be treated as a negative number. Thus, the final balance in the Allowance for Doubtful Accounts would be $15,000.00 - the original negative balance of $5,000.00 plus $20,000.00.

Estimate Based on Analysis of Receivables

The longer that an account is outstanding, the less likely that it is it will be collected. As a result, we can base the estimate of uncollectible accounts on how long specific accounts have been outstanding. For this, we use a process called aging the receivables.

Receivables are aged by preparing a schedule that classifies each customer's receivable by its due date. The number of days an account is past due is the number of days between the due date and the date the aging is prepared. Below is an example of an aging

Let's say that Driden Enterprises uses a sliding scale based on industry or company experience to estimate the uncollectibles in each aging classification. The percentages of uncollectible accounts are calculated as follows:

Over 36580%

Using the aging above, the company would calculate the estimate as follows:

AgingBalanceAllowance %Allowance $
Over 36580080%640
Total$86,000 $4,070

Looking at the above, the amount that should be in the Allowance for Doubtful Accounts should be $4,070. Let's assume that before beginning this process, the allowance was a credit balance of $500.00. The amount to be added to the allowance to achieve the correct number is $3,570 ($4,070 minus the initial balance of $500). The adjusting entry would be as follows:

Bad Debt Expense3,570.00 
 Allowance for Doubtful Accounts 3,570.00

After this entry, Bad Debt will have a debit balance of $3,570.00. Allowance for Doubtful Accounts will have a credit balance of $4,070.00. The net realized value of the receivables is $81,930 ($86,000 minus $4,070).

It is important to note that a company may not necessarily be limited to only the Direct Write-Off Method or Allowance Method. GAAP requires that companies use the allowance method for reporting on the income statement and balance sheet. However, tax authorities do not want estimates - they want actual numbers. Therefore, in order to properly account for bad debt write-offs for tax purposes, the company may also track the receivables through the direct write-off method.

Reporting Receivables on the Balance Sheet

All receivables that are expected to be realized in cash within a year are presented in the current assets section of the balance sheet. It is normal to list the assets in order of their liquidity, which is the order they are expected to be converted to cash during normal operations. An example is as follows:

The balance of the notes receivable, accounts receivable, and interest receivable are reported int he current assets. The allowance for doubtful accounts is subtracted from the accounts receivable. An alternative way of reporting this is to report accounts receivable at the net realized value of $43,000.00 with a note showing the amount of the allowance. Other disclosures related to receivables should be presented either on the balance sheet or in the accompanying notes. These disclosures include the fair market value of the receivables, and unusual credit risks. Unusual credit risks include if the majority of the receivables are from one customer or are due from customers located in one area of the country or one industry.

Interest on Notes Receivables

Many times you will see that a note will be, for example, 90 days with 12% interest. Let's assume for this illustration that the original amount of the note is $2,000.00. 12% of $2,000.00 is $240.00. However, that's a lot of money for just a 90 day note. Even though it usually says this in the description, or in the foot notes, of the loan, the interest is actually APR, or Annual Percentage Rate. That means that it's the interest as if the loan were for a year.

So how much is the percentage for the 90 day loan? To figure this out, we have to assume that there are 360 days in a year. The reason we use 360 instead of 356 is (a) leap year changes the number of days in the year, and (b) it's easier to use a round number. Assuming there are 360 days in this yearly rate, we are only using 90 of them for the note. Therefore, we can calculate the how much of the yearly rate we are using by taking the number of days we're going to have this note (90) and divide by 360. This gives us a total of .25. We can then multiply our yearly interest amount of $240.00 by .25 to get the amount of interest for 90 days - $60.00.

In summary, the interest on $2,000.00 of a 90 day note with 12% interest would be $2000.00 multiplied by 12% multiplied by (90 days divided by 360 days). With just numbers, it would be 2000 X 0.12 X (90 / 360).