Receivables and payables

In depth

Accounts receivable over a year

Accounts Receivable is a control account: behind it sits a subsidiary ledger with one account for each client, so that Lantern knows who owes what and since when. The balance moves in a simple pattern, which the formula card calls the receivables roll-forward: what was owed at the start, plus credit sales, minus collections, minus write-offs. Lantern began in March with nothing owed, so its year is $0 + 59{,}920 - 51{,}720 - 820 = 7{,}380$. A business that knows three of the four movements can always find the fourth, a quick reasonableness check that auditors use on collections.

Why the direct write-off method is not enough

The simplest approach, the direct write-off method, records nothing until a particular customer is known not to pay, and then debits Bad Debt Expense and credits Accounts Receivable. Small businesses that keep their books for tax often work this way. It fails as financial reporting for two reasons. The expense lands in the period when the customer gives up, which is often a later year than the sale that earned the revenue. And until then the balance sheet shows receivables at the full amount owed, although some of that amount is not expected to be collected.

For these reasons US GAAP and IFRS require receivables to be measured net of expected losses, which means an allowance. The direct write-off method survives only where bad debts are immaterial: the Codification itself says that its provisions need not be applied to immaterial items (ASC 105-10-05-6), so a business whose losses are trivially small may expense them when they occur. Tax rules are different. The IRS lets a business deduct a bad debt when it becomes wholly or partly worthless, so the tax deduction follows the write-off, not the estimate, and a company’s books and tax return will show different bad debt figures for the same year.

The allowance method, entry by entry

Three kinds of entry run through the allowance account. The estimate is an adjusting entry at the period end: debit Bad Debt Expense, credit Allowance for Doubtful Accounts. The write-off of a named customer removes the balance from both the subsidiary ledger and the control account: debit the allowance, credit Accounts Receivable. A recovery, when a customer who was written off later pays after all, is recorded in two steps: first reverse the write-off for the amount recovered (debit Accounts Receivable, credit the allowance), then record the cash received (debit Cash, credit Accounts Receivable). Reinstating the receivable first keeps the customer’s history complete, so the credit file shows that the customer did pay.

In a business that keeps its allowance up to date, a write-off changes neither total assets nor net receivables: receivables and the allowance fall by the same amount. With receivables of $10,000 and an allowance of $900, net receivables are $9,100; writing off $820 leaves $9,180 less $80, still $9,100. Lantern’s position was different: it prepares annual statements and made its first estimate only at 31 December, so when Quayline was written off in November there was nothing in the allowance to absorb it. The account went into a debit balance of $820, which means only that a loss happened before any had been expected. The year-end adjustment must cover that loss as well as building the $584 needed for the receivables still held.

Estimating the allowance

There are two ways to arrive at the estimate. The income statement approach applies a loss rate to the period’s credit sales and records that amount as the expense; whatever is left in the allowance afterwards is the balance. The balance sheet approach starts from the receivables still held at the period end, decides how large the allowance must be, and records whatever expense brings the account to that balance. Its most common form is an aging of receivables, which sorts each customer’s balance by how long it has been outstanding and applies a higher loss rate to older balances, because the longer an invoice is overdue the less likely it is to be paid.

The rates are the accountant’s estimates. With no history of its own, a new business bases them on industry experience and on what it knows about each client, and refines them as its own record builds up. The $820 more than 60 days overdue is another client’s September event, not Quayline’s invoice, which was written off in November and is no longer in receivables.

The aging says that $584 of the $7,380 should be held as an allowance. Before the adjustment the allowance has a debit balance of $820, so the entry must first bring it back to zero and then build the $584 credit: bad debt expense is $584 + 820 = 1{,}404$ (adjustment e6). Had the allowance started with a credit balance, say $200 left over from earlier estimates, the expense would have been only $584 - 200 = 384$. The rule is the same in every case: expense = required balance − the balance already there, with a debit balance counted as a negative. After e6, net receivables are $7{,}380 - 584 = 6{,}796$.

The adjustment can also run the other way. If fewer customers default than expected, the allowance may already hold more than the aging requires; the entry then debits Allowance for Doubtful Accounts and credits Bad Debt Expense for the excess, reducing the year’s expense.

The income statement approach would have given a different answer. Suppose Lantern’s accountant had expected losses of 2% of credit sales: the expense would be $0.02 \times 59{,}920 = 1{,}198.40$, and the allowance would end the year at $1{,}198.40 - 820 = 378.40$, about $206 less than the aging says the receivables actually held need. The percentage of sales is quick and keeps the expense in proportion to the year’s sales, but nothing in it tests whether the allowance left on the balance sheet is a sensible estimate. A business may use it for monthly estimates, but at the reporting date the allowance itself has to be supported.

IFRS 9 reaches a similar place by a different route: for trade receivables without a significant financing component, the loss allowance is always measured at lifetime expected credit losses (IFRS 9, paragraph 5.5.15), often using a provision matrix much like an aging schedule. Under either framework the allowance is not zero just because no customer has yet defaulted: some loss is expected on almost any pool of receivables. The older incurred-loss rules, which this course doesn’t use, recorded a loss only once it was probable that it had already happened. For short trade receivables the two models often give similar numbers; the difference shows most in long-term loans, which are a subject for later courses.

Notes receivable

A note receivable is a written promise by a customer or borrower to pay a stated sum on a stated date, usually with interest. Businesses take notes for large sales on longer terms, for loans to suppliers or staff, and sometimes in place of an overdue invoice, because a signed note is easier to enforce and earns interest. Interest is calculated as for a loan, $I = P \times r \times t$, and accrued at each period end as accrued revenue. A note due within a year of the balance sheet date is a current asset; a longer one is noncurrent. If the maker fails to pay at maturity (a dishonoured note), the holder usually transfers the principal and interest due back into Accounts Receivable and pursues it, or writes it off against the allowance.

Accounts payable and accrued liabilities

On the other side of the balance sheet, accounts payable (trade payables under IFRS) are amounts owed to suppliers for goods and services bought on credit. They are recorded when the goods or services are received, at the amount on the invoice, and removed when the supplier is paid. Lantern’s payables come from three sources: the beans bought from Kilnworth Roasting, supplies for events and workshops, and December’s utilities bill.

An accrued liability is the balance sheet side of an accrued expense: a cost incurred but not yet paid, for which no supplier’s invoice may yet exist. Wages earned in the last days of a period, interest building up on a loan, and utilities used but not yet billed are the usual examples. They are recorded by adjusting entries, as in F01. Some companies show them as a single line, “accrued liabilities”; Lantern shows Wages Payable and Interest Payable separately.

Two other current liabilities complete the list. Unearned revenue is cash received for goods or services not yet delivered, called a contract liability in ASC 606 and IFRS 15; the revenue recognition lesson explains how it arises. It will be settled by delivering the service, not by paying cash. Income taxes payable is the tax owed for the period less the estimated payments already made. Lantern’s tax for the year is $9,129, 25% of its income before tax of $36,516; it paid $6,000 during the year, so $3,129 is still owed at 31 December.

The table shows why “current liabilities” is not the same as “cash Lantern must pay”. Of the $26,289, the $6,100 of unearned revenue will be settled by serving customers. The current portion of the van note is the part of a long-term loan due within the next year; the next lesson explains how it is separated from the rest of the note. Every other line will take cash within the next five months.

Paying suppliers early

When a supplier offers terms such as 2/10, n/30, the buyer chooses between paying 98% of the invoice on day 10 and 100% on day 30. Skipping the discount is in effect borrowing 98% of the invoice for 20 days and paying 2% for the privilege. The cost of that borrowing, at a simple annual rate, is $\tfrac{2}{98} \times \tfrac{365}{20} \approx 37.2\%$, far above what most businesses pay a bank. That is why well-run businesses take such discounts whenever they have the cash, and why a business that stops taking them is often short of cash. How a discount taken is recorded in the inventory accounts is covered in the inventory lesson.