Measurement:

Receivables
Exam Update

(to be provided in class)

Key Relations Among F/S – Summary
Statement of Cash Flows
Cash from Operations Balance Sheet
+ Cash from Investing XX/XX/20XX
+ Cash from Financing
= Net Cash Flow Assets: Liabilities:
Statement of S/E
+ BB Cash Current Assets Short-term Payables BB Shareholders’ Equity
= EB Cash Cash Unearned Revenue + Stock Issued
Receivables Contingencies + Net income
Inventory Long-term Liab. - Dividends
- Stock repurchased
Focus of today’s Prepaid Accts Shareholders’ = EB Shareholders’ Equity
class etc. Equity:
Non-current Assets Contributed Capital
Overarching PP&E, net Retained Earnings
Income Statement
theme: how do Intangibles
+ Revenues
we measure and etc. - Expenses
report A = L + SE + Gains
receivables? - Losses
= Net Income

Notes to the Financials

Receivables and Bad Debts: A Personal Example
Professor John Balance Sheet as of August 31, 2009
Assets:
Cash / Bank Account $1,951
• Professor John circa 2009: Receivable - Tommy 410
Human Capital 0
➢ Poor undergrad, living in a
house on campus with 5 Liabilities:
Credit Card 470
other guys Student Loan Debt
➢ Collecting cash from
roommates to pay landlord Equity/Net Worth:
for rent & utilities
• Roommate Tommy:
➢ Fired from job at Tim Horton’s
due to incompetence
➢ Owes me $410 for last
month’s rent and utilities
➢ How to measure and TOMMY
The account for collectability
“Lemon”
of this receivable?
Receivables and Bad Debts Basics
• Collectability is the major business problem associated with accounts
receivable
➢ Uncollectible accounts are a cost of doing business (bad debt expense)

• Two accounting methods to record uncollectible accounts:

➢ Specific write-off method – wait and see which receivables will not
be paid and expense (write off) them at that time

➢ Allowance method – estimate the portion of accounts receivable that

will not be collected and record an expense for that estimate
➢ Do not wait until the accounts cannot be collected to record an expense!
Receivables – “FinTech” Companies
Affirm Background: Recent IPO

Max Levchin
Founder & CEO of Affirm
+ Background

Affirm S-1 Risk Factor Disclosures:

A large percentage of our revenue is concentrated
with a single merchant partner, and the loss of this
merchant partner…would materially and adversely
affect our business, results of operations, financial
condition, and future prospects.
Our top merchant partner, Peloton, represented
approximately 28% of our total revenue for the fiscal
year ended June 30, 2020…

the significance of Peloton in our portfolio has

increased as a result of consumer spending trends on
home fitness equipment, and there can be no
assurance that such trends will continue or that the
levels of total revenue and merchant network revenue
that we generate from Peloton will continue.
Specific Write-Off Method

• During Year 1, three customers each purchase a $2,000 Peloton bike and
finance the purchase through ; charges Peloton a 3.33% fee.
Accounts Debit Credit
Accounts Receivable (+A) 6,000
Cash (-A) 5,800
Merchant Network Revenue (+Rev, +SE) 200

• In Year 1, does not collect any cash payments (No entry)

• In Year 2, determines that a customer who owes $2,000 will not be

able to make payments

Accounts Debit Credit Record expense when

Bad Debt Expense (+Exp. -SE) 2,000 determined to be
Accounts Receivable (-A) 2,000 uncollectible
Specific Write-Off Method
• Write-off accounts receivable when they become uncollectible and record bad
debt expense
• Advantages
➢ Simple and easy to implement!
➢ Discretion only with respect to when to write-off the receivables
• Disadvantages
➢ Overstates Accounts Receivable balance on the balance sheet
➢ Does not record the bad debt expense in the same period as the revenue, so
overstates net income (and violates matching principle)

• Companies are permitted to use the Specific Write-Off Method only if bad
debt expense is immaterial (not significant)

What should firms do if bad debt expense is material?

Allowance Method for Bad Debt
• Estimates the portion of Gross Accounts Receivable that will not be
collected from as-yet unidentified customers (matching principle)
• Use a contra asset account that reduces the balance in Gross Accounts
Receivable
➢ Called “Allowance for Bad Debt”, “Allowance for Doubtful Accounts”, “Reserve
for Uncollectibles”

Gross Accounts Receivable Amount owed by customers

Amount of receivables estimated to

(Allowance for Bad Debt) be uncollectible
Net Accounts Receivable Amount expected to be collected.
Appears on Balance Sheet
Allowance for Bad Debt: Contra Asset
Customer A: $2,000 A/R Customer B: $2,000 A/R Customer C: $2,000 A/R
Year 1

+ Accounts Receivable -
BB 0
Sales 6,000
EB Y1 6,000
Allowance for Bad Debt: Contra Asset
Customer A: $2,000 A/R Customer B: $2,000 A/R Customer C: $2,000 A/R
Year 1

+ Accounts Receivable -
BB 0 Estimated Bad Debt = $2,000.
Sales 6,000 But we don’t know which Customer won’t pay?
➢ So where do we put the credit??
EB Y1 6,000 ➢ How do we show that A/R is lower??
Allowance for Bad Debt: Contra Asset
Customer A: $2,000 A/R Customer B: $2,000 A/R Customer C: $2,000 A/R
Year 1

(Contra Account)
+ Accounts Receivable - - Allowance for Bad Debt + + Bad Debt Expense -
BB 0 0 BB BB 0
Sales 6,000 2,000 2,000
EB Y1 6,000 2,000 EB Y1 2,000

Journal Entry
Accounts Debit Credit
BAd Debt Expense (-SE) 2,000
Allowance for Bad Debt (-A) 2,000
Allowance for Bad Debt: Contra Asset
Customer A: $2,000 A/R Customer B: $2,000 A/R Customer C: $2,000 A/R
Year 1

(Contra Account)
+ Accounts Receivable - - Allowance for Bad Debt + + Bad Debt Expense -
BB 0 0 BB BB 0
Sales 6,000 2,000 2,000
EB Y1 6,000 2,000 EB Y1 2,000

Gross Accounts Receivable 6,000 Revenue 200 Income

Balance
(Allowance for Bad Debt) (2000) Sheet Bad Debt Expense (2,000) Stmt
Net Accounts Receivable 4000 Net Income (1,800)
Allowance for Bad Debt: Write-Offs
Customer A: $2,000 A/R Customer B: $2,000 A/R Customer C: $2,000 A/R
Year 2

We learn customer
(Contra Account) C won’t pay.
+ Accounts Receivable - - Allowance for Bad Debt +
BB Y2 6,000 2,000 BB Y2
Sales 0 2,000 Write-off 2,000 0
EB Y2 4,000 0 EB Y2

Journal Entry Notice that writing off a

Accounts Debit Credit receivable under the allowance
method does NOT net income
Allow. For Bad Debt (+A,-XA) 2,000
Account Receivable (-A) 2,000 or total assets!
Allowance for Bad Debt: Write-Offs
Customer A: $2,000 A/R Customer B: $2,000 A/R Customer C: $2,000 A/R
Year 2

We learn customer
(Contra Account) C won’t pay.
+ Accounts Receivable - - Allowance for Bad Debt +
Journal Entry
BB Y2 6,000 2,000 BB Y2
Accounts Debit Credit
Sales 0 2,000 Write-off 2,000 0 Allow. for Bad Debt. 2,000
EB Y2 4,000 0 EB Y2 Accounts Receiv. 2,000

Balance Sheet Y1 Y2 Income Statement Y1 Y2

Gross Accounts Receivable 6,000 4,000 Revenue 200 0
(Allowance for Bad Debt) (2,000) (0) (Bad Debt Expense) (2,000) (0)
Net Accounts Receivable 4,000 4,000 Net Income (1,800) 0
Allowance for Bad Debt: Journal Entries
• Allowance Method sequence of events:

1. Record credit sales for the period

2. Record estimate for bad debt expense
➢ Bad debt expense on the income statement also called “provision for bad
debt” or “provision for credit losses”
➢ Two approaches:
(1) Accounts Receivable Aging
(2) Percentage of Credit Sales
3. In the future: Write-off bad debts
4. Even further in the future: Add back any recoveries (rare)
Two Approaches to Estimate Allowance

Approach 1: Approach 2:
A/R Aging Schedule Percentage of Credit Sales

Estimates likelihood of collecting Estimates some percentage of all

different receivables based on time credit sales will be uncollectible
outstanding

- Allowance for Uncollectible Accts + - Allowance for Uncollectible Accts +

BB BB

Write-Off Provision for Bad Write-Off Provision for Bad

Debt Debt
EB EB

What do companies actually use? Some combination of these two

Two Approaches to Estimate Allowance

Approach 1:
A/R Aging Schedule

Determine ending allowance, “Plug”

to find bad debt expense

Then use beginning balance,

- Allowance for Uncollectible Accts + write-offs, and ending
BB balance to find bad debt
expense
Write-Off X = Provision for
Bad Debt
EB Estimate this at the end of
the year using an “A/R Aging
Schedule”
 Gross
Accounts
Receivables
(let’s use face
value
amount)

Allowance for
doubtful
accounts
(contra asset)
Receivables @ afterpay
Actual Unpaid Invoices From Last Year
(Consumer Receivables)
Estimate of Uncollectible Accts
+ Gross Receivables - - Allowance for Uncollectible Accts +

BB 816,812 33,951 BB

Credit Sales Cash Receipts

EB 1,555,774 99,605 EB

BB EB
Gross Accounts Receivable 816,812 1,555,774
(Allowance for Bad Debt) (33951) (99,605)
Net Accounts Receivable 782,861 1,456,169
Accounts Receivable Aging

How did afterpay determine the appropriate allowance at the end of 2021?
• 2021 Gross A/R = $1,555,774
• 2021 Allowance = $99,605 How did management estimate this??

One common approach is based on an “A/R Aging Schedule” (approach 1)

Gross A/R - 2021 Gross Balance % of Gross Estimated Loss % Estimated Uncollectable

Not due yet 1,447,729 93.06% 1.130% 16,365

Past due: 1 – 61 days 81,579 5.24% 70.789% 57,749

Past due: Over 61+ days 26,466 1.70% 96.316% 25,491

Total 1,555,774 100% 99,605

Estimate based on history &

Data from accounting system Estimated Ending Allowance
judgment
How do they estimate the
Allowance?

Lots goes into

these estimates!
Measurement in
accounting often
requires data
analysis across
multiple different
information
sources.
When to Write Off?
How does management know when to write off accounts receivable?

“When available information confirms

that specific loans or portions thereof are
“Receivables are written off when uncollectible, identified amounts are
the Group has no reasonable charged against the allowance... The
expectation of recovery.” pg. 101 following criteria will generally confirm
that a loss has been incurred: the loan is
significantly delinquent, and the
borrower has not demonstrated the
ability or intent to bring the loan
current..” S-1 pg. 117
Writing Off Receivables
2021: Write-Offs

+ Gross Receivables - - Allowance for Uncollectible Accts +

BB 816,812 33,951 BB

Credit Sales Cash Receipts

Write-offs Write-offs
EB 1,555,774 99,605 EB

Effect on I/S: No effect Question

True or False: Under the allowance
method, writing off an accounts
Effect on B/S: No effect receivable as uncollectible lowers a
company's assets.
Write-offs
Finding Write-Offs

+ Gross Receivables - - Allowance for Uncollectible Accts +

BB 816,812 33,951 BB
Credit Sales Cash Receipts 94,493 Provision for
129,402 Write-offs Write-offs 129,402 Bad Debt.
EB 1,555,774 99,605 EB

Bad Debt Expense (I/S)

BB 0

Provision 94,493
for Bad Debt.
EB
Provision for
bad debt
Finding Bad Debt Expense

+ Gross Receivables - - Allowance for Uncollectible Accts +

BB 816,812 33,951 BB
Credit Sales Cash Receipts 195,056 Provision for
129,402 Write-offs Write-offs 129,402 Bad Debt.
EB 1,555,774 99,605 EB

Question + Bad Debt Expense (I/S) -

True or False: BB 0 How did they know how
Recording bad debt much provision to record?
expense decreases Provision 195,056
net income and Steps:
for Bad Debt. 1) Calculate desired EB
decreases assets.
EB 195,056 using Aging Schedule
2) Plug provision to fit
Two Approaches to Estimate Allowance
Approach 2:
Percentage of Credit Sales

Determine bad debt expense, use

math to calculate ending allowance

- Allowance for Uncollectible Accts +

BB

Write-Off Provision for Bad Estimate this directly

Debt
X = EB Then use beginning balance,
write-offs, and bad debt
expense to find ending
balance
% of Sales Approach
Assume afterpay estimates that bad debts
are 0.9% of underlying sales (approach 2)
1. Record afterpay’s journal entries for year-
end 6/30/2021

Accounts Debit Credit

Bad Debt Expense (+Exp, -SE)

Allowance for Bad Debt (+XA, -A)

2. Affirm estimates that bad debts are typically 1.66% of total credit revenues.
Why do you think affirm and afterpay have different bad debt expense as a
% of credit sales?
Provision/Allowance Adequacy

Do you think afterpay’s provision is adequate? Let’s change assumptions…

Scenario #1: In 2020, afterpay’s bad debt expense was 1.12% of sales, decreasing to 0.9%
in 2021. What would the expense have been in 2021 if they used the same 1.12% of sales?
• 2021 Credit Sales: $21,087.40
• Provision = $21,087.40 * 1.12% = $236.179 Difference in Provision:
$236,179 - $189,787 = $______
Hypothetical based on 1.12%
Effect on B/S:
- Allowance for Uncollectible Accts +
33,951 BB Assets down $46,392
Retained Earnings down $46,392
Write-Off 129,402 ______ Provision
Effect on I/S:
140,728 EB
Expense up $46,392
Net income down $46,392
Provision/Allowance Adequacy

Do you think afterpay’s provision is adequate? Let’s change assumptions…

Scenario #2: In 2020, afterpay’s ending allowance was 4.2% of A/R, increasing to 6.4% in
2021. What would the expense have been in 2021 if they used the same 4.2% of A/R?
• 2021 Gross A/R: $1,555,774
• 2021 Allowance EB = $1,555,774 * 4.2% = $65,343 Difference in Provision:
$160,794 - $195,605 = _______
Hypothetical based on 4.2%
- Allowance for Uncollectible Accts + Effect on B/S:
33,951 BB Assets up $34,811
Retained Earnings up $34,811
Write-Off 129,402 ______ Provision

65,343 EB Effect on I/S:

Expense down $34,811
Net income up $34,811
Scenario Comparison

Scenario # 0 1 2
As reported PY Provision / Sales PY Allowance / A/R
More (Less) Bad Debt ________ ________
Expense

2021 Net Loss $ (156,298) $ (202,690) $ (121,487)

Earnings Per Share (EPS) $ (0.55) $ (0.71) $ (0.43)

Analyst Consensus $ (0.55) $ (0.55) $ (0.55)
Earnings Surprise $ 0.00 $ (0.16) $ 0.12
“Meet” earnings “Miss” earnings “Beat” earnings
benchmark benchmark benchmark
Incentives for Under/Overstating
• What might be the incentives for understating the provision/allowance?

• What might be the incentives for overstating the provision/allowance?

Summary of Allowance Method
• Required if uncollectible accounts are material. Can use the following
allowance approaches: 1) aging method or 2) % of credit sales
➢ Journal entries are the _______ in both methods
➢ The calculations to get the amount of bad debt expense and ending balances
are _____________

• Advantages over specific write-off method

➢ Better matching of revenues and bad debt expenses
➢ Does not overstate the value of accounts receivable on the balance sheet

• But: requires managers to estimate the expected amount of receivables

that will be uncollectible ! discretion and judgment
➢ Sacrifice some representational faithfulness for relevance
➢ Estimates of future write-offs are ____________________!
For Next Class
• Thursday, September 29th
➢ Topic: Measurement issues related to inventory and cost of goods sold

• Suggested textbook readings:

➢ Ch. 7, pgs. 342 – 360, 369 – 371

• Module #3 homework due Friday,

September 30th!
TOMMY