Accounts receivable represents the amounts due from customers for services rendered or goods sold in the past. Receivables from customers also are referred to as “trade receivables“; they are the result of routine business transactions in which goods and services are traded for the right to collect cash immediately or not long after-ward. A company may increase its sales volume by allowing customers to buy on credit, but in that case there is a risk that some customers will not pay their balances when due. Accounts receivable initially are recorded on the basis of the amount of sales or services revenue to be received, but when the accounting concept of conservatism is applied, the balance sheet value should reflect the amount the company expects to realize or actually collect in cash. That is what accounts receivable in general look. It becomes more complex when we go deeper.
This post emphasize to discuss accounts receivable in a closer lookbad debt an its allowance, accounts receivable write-off, allowance for discounts, sales returns, collection expenses, notes receivable, accrued receivable, and related party receivable. This post should be bring you into a closer look of accounts receivable. Enjoy!
Estimated Bad Debts Expense and the Allowance for Doubtful Accounts
Estimated bad debts expense (or uncollectible accounts expense) should be included in the operating expenses in the income statement, matching sales earned in the current period with the associated expense of uncollectible accounts. Estimates generally are based on past experience, current credit policies, and economic conditions. Companies may estimate uncollectible accounts by using a percentage of sales revenue or examine the age of year-end receivables based on the due date, paying close attention to past due accounts, knowing that the likelihood of collection diminishes the longer an account has been past due.
Example: In 2009, a company’s first year of operations, it made credit sales of $500,000, collected $450,000 on account, and has $50,000 in year-end receivables. It estimates that $5,000 of its year-end receivables will be uncollectible. The balance sheet at year end reports the amounts legally due from customers less an allowance for estimated uncollectible accounts, as shown below:
Accounts Receivable $50,000
Less: Allowance for Uncollectible Accounts (5,000)
Accounts Receivable (net) $45,000
Accounts receivable (net) of $45,000 represents the amount of cash the company expects to collect; this often is referred to as net realizable value. Alternatively, the company may report only the net amount of receivables, with the amount of the allowance shown parenthetically, as shown below:
Accounts Receivable (net of allowance for uncollectible accounts of $5,000) = $45,000
Although the company expects that it will collect only $45,000 of its current accounts receivable, let’s assume it still continues to pursue collection in the next year, 2010, but to no avail, and finally writes the $5,000 of accounts receivable off its books in 2010.
Should the $5,000 of bad debts expense appear in the 2009 or the 2010 income statement?
According to the matching principle, it is an expense of 2009, matched with the sales revenue earned in that period, not an expense of some future year when the decision is made to write the specific accounts off the books. The financial statement results for 2009 and 2010 would be as shown below:
Sales Revenue $500,000 $0
Bad Debts Expense $(5,000) $0
The example highlights the proper matching of the bad debts expense associated with sales revenue earned in 2009, and ignores any additional sales revenue the company earned in 2010.
Contrary to the accounting concept of matching, some companies may use the direct write-off method and report bad debts expense in the income statement in the year in which the specific accounts are written off. Although this method is used for income tax purposes, it is contrary to the matching principle and should be used in financial statements only if the amounts are immaterial (insignificant).
If the company’s estimate was accurate, the net amount of receivables both before and after the write-off is $45,000, which is the amount the company expected to collect from its year-end receivables, as shown below:
Writing Off a Specific Customer Receivable
Accounts Receivable $50,000 $45,000
Less: Allowance for Uncollectible Accounts (5,000) 0
Accounts Receivable (net) $45,000 $45,000
Is it easy to estimate uncollectible accounts accurately? Even companies which have been in business for years and have used consistent credit policies may be affected by unexpected events. For example: Hurricane Katrina probably had an impact on the likelihood of collecting receivables from customers in New Orleans. Easy credit, declining real estate values, and rising homeowner defaults on mortgage loans in recent years have had far-reaching effects on lenders, investors and the economy. At the time of this writing, many financial institutions have failed, credit has dried up, and the United States is in the midst of an unprecedented financial and economic crisis.
Allowances for Cash Discounts, Sales Returns, and Collection Expenses
Many companies offer cash discounts to credit customers as an incentive for early payment. For example: If the credit terms are 2/10 net/30 on a $10,000 account balance, the customer is offered a 2 percent cash discount of $200 if the account balance is paid within 10 days (2/10), but the customer must pay the full amount due of $10,000 in 30 days (net/30). Although the company would receive less than it billed, if receivables are collected soon, it may be able to take advantage of cash discounts on amounts it owes to its own suppliers.
Customers often are permitted to return items purchased on credit or may be granted a price allowance on damaged goods they otherwise might return. A company may engage the services of another company to process its receivables or pursue past-due accounts. As with cash discounts, sales returns and allowances and collection expenses reduce the amount of cash the company expects to generate from its receivables. Depending on the nature and significance of these amounts, the company may review its year-end receivables and establish additional allowances, somewhat like the allowance for uncollectible accounts. In that case, it will report a more conservative value for its receivables, reflecting the amount of cash it expects to generate, and the estimated discounts, returns, and collection expenses will be matched with the revenue earned in the year of the sales, not in a later time period when they are taken.
A company may offer relatively informal credit terms to its customers, but if credit is extended for a longer time or if a customer’s account is past due, the company may require the customer to sign a formal promissory note specifying the maturity date, the repayment terms, and any assets pledged as collateral for the loan. Although a business may make a cash loan to an individual or another company, this would not be a common practice unless lending activities are a significant part of ongoing and routine business operations.
Formal promissory notes offer two advantages over the somewhat informal credit terms associated with accounts receivable. First, the note is a legal document which offers the company better protection in the event of default; second, the note typically specifies that it be repaid with interest.
Let’s assume a company sold merchandise to a customer and accepted a $2,000 promissory note on December 1, 2009. The stated annual interest rate on the note is 12 percent, and the $2,000 principal and interest owed on the note are due when the note matures in six months, on June 1, 2010. The total amount of interest that will be received when the note matures is calculated as follows:
Principal X Interest Rate X Time X Interest
$2,000 X 12% X 6/12 months X $120
Notes: The 12 percent interest rate on the note is an annual interest rate, but the note term is only six months, and so only $120 in interest will be received. How should these events be reported in the December 31, 2009, financial statements? The company has earned one month of interest even though it will not collect the note or the interest until 2010.
According to the revenue recognition principle, a portion of the total interest that will be received is to be reported in the income statement each year: one month in 2009 and the other five months in 2010. On the December 31, 2009, balance sheet, notes receivable of $2,000 is the principal amount of the note, and the $20 of interest earned but not yet collected is an accrued receivable, as shown below:
Notes Receivable and Interest
2009 2010 Total
Interest Earned $20 $100 $120
Balance Sheet, December 31, Year 1
Notes Receivable $2,000
Accrued Interest Receivable $20
In some industries, companies borrow against or sell their notes and accounts receivable to generate cash more quickly. In secured borrowing arrangements, the company pledges its receivables as collateral for the loan and then describes the arrangements in the footnotes to the financial statements.
In other cases, it may sell its receivables either with recourse or on a without recourse basis. If a customer defaults and does not pay the balance when due, if the receivable was sold without recourse, the party purchasing the receivable bears the risk of loss and must estimate the bad debts expense, as was discussed above.
However, if a customer defaults on a receivable sold with recourse, the party selling the receivables must reimburse the purchaser for the loss. In this case, the seller must estimate the amount of uncollectible receivables it sold with recourse, and the recourse obligation, which is the estimated amount the seller may owe the buyer, will be reported as a liability on the seller’s balance sheet. Additional information about these arrangements must be provided in the footnote disclosures.
Accrued Receivables (Accrued Revenues)
According to the matching principle, the income statement should include revenues earned during the time period even though the cash may not be received until a future date. Accrued receivables (accrued revenues) represent amounts yet to be collected for revenues a company has earned, such as interest earned on investments and notes receivable, or revenues unrelated to routine business operations such as amounts billed for rent or other incidental services provided. An illustration of accrued interest was presented in the earlier section on notes receivable.
Related Party Receivables
Related party receivables may include amounts owed to the company by affiliated companies, such as advances or loans to subsidiaries. It also may include receivables from company executives or employees. As these receivables are very different from the trade receivables from company customers, they should be disclosed separately on the balance sheet, and additional information may be included in the financial statement’s footnotes. Recent business scandals have heightened the public’s awareness of such matters as unscrupulous executives have gained personally by taking advantage of their companie’s resources.