(Trade) Accounts Receivable
Accounts Receivable is the amount owed by a customer for a sale made on credit. If the amount is owed within one year, it is a current asset. If the amount is owed more than one year after the books are closed, it is a non-current asset.
The journal entry that gives rise to an account receivable is:
Accounts Receivable (Gross)Debit
SalesCredit.
The accounting problem with accounts receivables is that not all receivables are going to be collected by the firm. Firms know this, but in the real world, it is often difficult to do business without extending credit to one’s customers. Therefore, firms need to adjust their assets (accounts receivables) and their income statement (revenues or expenses) to reflect the fact that not all receivables will be turned into cash.
The GAAP accounting way of doing this is by estimating the amount of the uncollectibles during the period in which the sales are made. This is called the allowance method, since the firm is estimating an allowing for uncollectible accounts. This method is a three-part process.
Step 1: Recognize the gross revenues over the period. The journal entry is:
Accounts Receivable (Gross)Debit
SalesCredit.
Step 2: Estimate the expected uncollectibles at the end of the period.
The amount to be recognized is recorded as an expense (a debit to bad debt expense) and a reduction to the accounts receivables (a credit to net accounts receivables).
Because we like to keep track of the uncollectibles, open up a contra account called Allowance for Uncollectible Accounts. It is contra to the gross accounts receivables account, and therefore acts as a reduction to that account. The journal entry is:
Bad Debt ExpenseDebit
Allowance for Uncollectible AccountsCredit.
This entry is called an adjusting entry because we make it only once -- when the books are closed. Remember, it is just an estimate of future write-offs.
Step 3: Next period, write off the actual accounts as it becomes apparent to us who will not pay. This is merely a “bookkeeping” entry, in that it identifies the estimated account from Step 2. The journal entry is:
Allowance for Uncollectible AccountsDebit
Accounts Receivables (Gross)Credit.
Step 4: Sometimes, a specific account that has previously been written off subsequently turns out to be collectible. To account for this, just reverse step 3. The journal entry is:
Accounts Receivables (Gross)Debit
Allowance for Uncollectible AccountsCredit
Note: Sometimes steps 3 and 4 are combined in the 10-K filing and is called “net write-offs.”
One important thing to remember is that Net Accounts Receivables (the amount that appears on the balance sheet) is equal to Accounts/Receivables (Gross) minus Allowance for Uncollectibles.
Using T-accounts:
Accounts/R (Gross) Allowance for Uncollectible Accounts (XA)
Beg. Bal. / . / Beg. Bal.+ / - / - / +
(1) Sales / (3) Write-off / (3) Write-off / (2) Bad Debt Expense
Cash Collected from Customer
(4) Reinstatement / (4) Reinstatement
End. Bal / . / End. Bal.
Cash Collected from Customers
We can solve for cash collected from customers if we know the other information in the accounts receivables (gross) account. Specifically, we need to know the beginning and ending balances of the gross accounts receivables account, the total sales of the firm for the period, and the net write-offs taken for the period. The beginning and ending balances come from the balance sheet (or perhaps the footnote on accounts receivables). The sales are in the income statement. We can ascertain the write-offs through two possible ways: (1) it may be disclosed in the footnotes of the financial statements or (2) if we solve for it through the contra account.
Some (Trade) Accounts Receivable Facts
A.Some companies expect more uncollectible accounts when the economy is weak.
B.Some companies extend credit to relatively poor credit risks expecting more uncollectible accounts.
C.Companies with aggressive collection policies are likely to have high accounts receivable turnover ratios.
National credit cards allow companies to convert new receivables to cash immediately while the credit card issuers accept the credit risks. In turn, the companies accept discounts on the receivables (factoring) and may have less contact with their customers.