Accounts Receivable Beyond Converting Credit SalesThinking of accounts receivable: credit sales converted into accounts receivable (A/R), and then wash them when the corresponding cash is collected. That is what I learnt when I was an accounting student. I stepped out and got my first job as a bookkeeper for a medium enterprise where I found much more complex accounts receivable cases—sales return, early payment discounts, credit card transactions, receivables factoring, long-term receivables, and bad debts—not as simple as converting credit sales into A/R and washing them. So, what is the accounting treatment for such A/R cases?



What Are inside and Should Be Outside Of Accounts Receivable?

An account receivable is a claim that is payable in cash, and that is in exchange for the services or goods provided by the company. As a rule of thumb, the accounts receivable should only contain transactions for which there is a clear, short-term expectation of cash receipt from a customer. This definition excludes:

  • Note payable, which is essentially a return of loaned funds—it should be itemized in the financial statements under a separate account.
  • Employee advances or employee loans of any type that may be payable over a longer term. These items may more appropriately be stored in an ‘Other Accounts Receivable’ or ‘Accounts Receivable from Employees’ account.

In addition, you should not create an accrued account receivable to offset an accrued sale transaction.


How Does Accounts Receivable Transaction Flow?

The typical flow into and out of accounts receivable is quite simple: If there is a sale on credit terms, then the accountant credits the sales account and debits accounts receivable. When cash is received in payment from a customer, the cash account is debited and accounts receivable are credited.

There is usually some type of sales tax involved in the transaction, in which case the account receivable is debited for the additional amount of the sales tax and a sales tax liability account is credited for the same amount.

There may be several sales tax liability accounts involved, since the typical sales tax can be broken down into liabilities to city, county, and state governments. These liability accounts are later emptied when sales taxes are remitted to the various government tax collection agencies.

It sounds simple, right? But not really—they can be complicated by a variety of additional transactions, many of which occur frequently. Read on…


Accounting Treatment For Sales Returns

When a customer returns goods to your company, you should set up an offsetting sales contra account, rather than backing out the original sale transaction. The resulting transaction would be a credit to the account receivable account and a debit to the contra account. There are two reasons for using this approach:

  • First, a direct reduction of the original sale would impact the financial reporting in a prior period, if the sale originated in a prior period.
  • Second, a large number of sales returns charged directly against the sales account would essentially be invisible on the financial statements, with management only seeing a reduced sales volume.

Only by using (and reporting) an offsetting contra account can management gain some knowledge of the extent of any sales returns.


How To Account Early Payment Discounts

Unless a company offers an exceedingly large early payment discount, it is unlikely that the total amount of this discount taken will have a material impact on the financial statements. Consequently, some variation in the allowable treatment of this transaction can be used. Here they are:

  • First approach, and the most theoretically accurate approach is to initially record the account receivable at its discounted value, which assumes that all customers will take the early payment discount. Any cash discounts that are not taken will then be recorded as additional revenue. It results in a properly conservative view of the amount of funds that you can expect to receive from the accounts receivable.
  • Second approach, as an alternative that results in a slightly higher initial revenue figure is to record the full, undiscounted amount of each sale in the accounts receivable, and then record any discounts taken in a sales contra account. One objection to this second approach is that the discount taken will only be recognized in an accounting period that is later than the one in which the sale was initially recorded (given the time delay usually associated with accounts receivable payments), which is an inappropriate revenue recognition technique.
  • Third approach, as an additional alternative approach that avoids this problem is to set up a reserve for cash discounts taken in the period in which the sales occur, and offset actual discounts against it as they occur.

Given the relatively small size of early payment discounts, you may be more concerned with finding the most cost-effective approach for handling them, rather than the most technically correct one that will yield slightly greater accuracy at a cost of increased accounting labor.


Credit Card Accounts Receivable

When recording an account receivable that is based on a credit card payment, the accountant may record the receipt of cash at the same time as the credit card transaction. However, the receipt of cash from the credit card provider will actually be several days later, so this results in an inaccurate representation of cash receipts.

This is a particular problem if the credit card transaction is recorded at month-end, since the bank reconciliation will show the cash receipt as an unreconciled item that has not really appeared at the bank yet.

A better treatment of credit card accounts receivable is to batch the credit card slips for each credit card provider for each day, and record a single credit to sales and debit to accounts receivable at the time of the credit card transaction for each batch of credit card slips.

If you’re aware of the credit card processing fee charged by the credit card provider, this should be recorded at once as an offsetting expense. If there is some uncertainty regarding the amount of the fee, then the accountant should expense an estimated amount to a reserve at the time the account receivable is set up, and adjust the reserve when the transaction is settled.


Accounting For Factored Accounts Receivable

If a company uses its accounts receivable as collateral for a loan, then no accounting entry is required. However, if it directly sells the receivables with no continuing involvement in their collection, and with no right to pay back the factor in case a customer defaults on payment of a receivable, then a sale transaction must be recorded.

Typically, this involves a credit to the accounts receivable account, a debit to the cash account for the amount of the buyer’s payment, and a gain or loss entry to reflect any gain or loss on the transaction.

The amount of cash received from the factor will also be reduced by an interest charge that is based on the amount of cash issued to the company for the period when the factor has not yet received cash from the factored accounts receivable; this results in a debit to the interest expense account and a credit to the accounts receivable account.

A variation on this transaction is if the company only draws down cash from the factor when needed, rather than at the time when the accounts receivable are sold to the factor. This arrangement results in a smaller interest charge by the factor for the period when it is awaiting payment on the accounts receivable. In this instance, a new receivable is created that can be labeled “Due from Factoring Arrangement.”

Another variation is when the factor holds back payment on some portion of the accounts receivable, on the grounds that there may be inventory returns from customers that can be charged back to the company. In this case, the proper entry is to offset the account receivable being transferred to the factor with a holdback receivable account.

Once all receipt transactions have been cleared by the factor, any amounts left in the holdback account are eliminated with a debit to cash (from the factor) and a credit to the holdback account.

If the company factors its accounts receivable, but the factor has recourse against the company for uncollectible amounts or if the company agrees to service the receivables subsequent to the factoring arrangement, then the company still can be construed as having retained control over the receivables. In this case, the factoring arrangement is considered to be a loan, rather than a sale of receivables, resulting in the retention of the accounts receivable on the company’s balance sheet, as well as the addition of a loan liability.


Accounting Treatment For Bad Debts

You must recognize a bad debt as soon as it is reasonably certain that a loss is likely to occur, and the amount in question can be estimated with some degree of accuracy.

For financial reporting purposes, the only allowable method for recognizing bad debts is to set up a bad debt reserve as a contra account to the accounts receivable account. Under this approach, you estimate a long-term average amount of bad debt. And you can make the journal entry as follows:

  • Debits the bad debt expense (which is most commonly kept in the operating expenses section of the income statement) for this percentage of the period-end accounts receivable balance; and
  • Credits the bad debt reserve contra account
  • When an actual bad debt is recognized, you credit the accounts receivable account and debit the reserve. No offset is made to the sales account. If there is an unusually large bad debt to be recognized that will more than offset the existing bad debt reserve, then the reserve should be sufficiently increased to ensure that the remaining balance in the reserve is not negative.

There are several ways to determine the long-term estimated amount of bad debt for the preceding treatment: 

  • Way-1. Determine the historical average bad debt as a proportion of the total credit sales for the past 12 months.
  • Way-2. Calculate a different historical bad debt percentage based on the relative age of the accounts receivable at the end of the reporting period. It results in a more accurate estimate compare to Way-1.

For example: Accounts aged greater than 90 days may have a historical bad debt experience of 50%, whereas those over 25% have a percentage of 20%, and those below 30 days are at only 4%.

This type of experience percentage is more difficult to calculate, but can result in a considerable degree of precision in the size of the bad debt allowance. It is also possible to estimate the bad debt level based on the type of customer.


Accounting Treatment For Long-Term Accounts Receivable

If an account receivable is not due to be collected for more than one year, then it should be discounted at an interest rate that fairly reflects the rate that would have been charged to the debtor under a normal lending situation.

An alternative is to use any interest rate that may be noted in the sale agreement. Under no circumstances should the interest rate be one that is less than the prevailing market rate at the time when the receivable was originated. The result of this calculation will be a smaller receivable than is indicated by its face amount. The difference should be gradually accrued as interest income over the life of the receivable.