Accounts Receivable
Accounts receivable is a current asset that reports the amount a company's customers owe the company for goods or services provided on credit. Under accrual accounting, a company credits a revenue account and debits Accounts Receivable when billing customers. When an account receivable is collected, the accountant debits Cash and credits Accounts Receivable.
A company that extends credit to a customer faces the risk of not collecting the account receivable. If a loss does occur from extending credit, it is reported as an operating expense, such as bad debt expense.
There are two ways of reporting losses from credit sales. One is the direct write-off method. Under this approach, the company does not anticipate any loss. The asset Accounts Receivable is reported at its full amount and no expense is reported until it is known with certainty that a customer will not pay the amount owed. This method is not encouraged by accountants, because it may be overstating assets and net income.
The preferred way to report losses from credit sales is to anticipate that some receivables will not be collected. This approach is the allowance method. It gets it name because of the contra account to Accounts Receivable entitled Allowance for Doubtful Accounts. The credit balance in the allowance account works to value the accounts receivable at their approximate net realizable amount. Under the allowance method, the bad debt expense and the credit to the allowance account is reported closer to the time of the sale---thus providing a better matching with revenues. Under the allowance method the accounts receivable are reported at a more realistic and conservative amount.
To assist in the managing of accounts receivables, an aging of the accounts receivable is prepared. An aging sorts the customers' balances by how long the customers have owed the open invoice amounts.
Sales on credit involve credit terms such as "net 10 days" or "net 30 days" or "2/10, net 30" and others. Net 30 days means there is no discount allowed from the amount on the sales invoice. If the credit term is "2/10, net 30" the customer can remit 2% less than the invoice amount if the customer pays within 10 days. Otherwise the full amount is due in 30 days.
If a customer pays for the same invoice twice, should the customer be informed?
I say yes. If youbecome aware of the double payment when posting the customer’s secondremittance, I woulddouble check your records to be certain you are not owedmoney from the customer and wouldtheninform the customer. If the check was sent in error, I would photocopy the check, document on the photocopy what had occurred, and then return it to the customer.
If you did not notice the double payment when processing the customer’s remittance, the customer’s accounts receivable record will show a negative amount due for the sales invoice and might even show a negative amount due from the customer. If your company mails statements to its customers, the customershould be able to seeits double payment when reviewing the statement.
What is the accounts receivable collection period?
The accounts receivable collection period is similar to the days sales outstanding or the days sales in accounts receivable.
To illustrate the accounts receivable collection period, let’s assume a corporation had net credit sales of $360,000 during the past year and its accounts receivable balance was on average $40,000. The average credit sales per day were approximately $1,000 per day ($360,000 of annual credit sales divided by 360 or 365 days per year). The average accounts receivable balance of $40,000 divided by $1,000 of credit sales per day equals 40 days.
An alternative calculation is to use the accounts receivable turnover ratio. In our example, the accounts receivable ratio is 9 times per year ($360,000 of net credit sales divided by $40,000—the average accounts receivable balance). 360 days per year divided by the accounts receivable turnover of 9 equals 40 days.
What is the days’ sales in accounts receivable ratio?
The days’ sales in accounts receivable ratio, also known as the number of days of receivables, tells you theaverage number of daysit takes to collect anaccount receivable. Since the days’ sales in accounts receivable is an average,you need to be careful when using it.
The calculation for determining the days’ sales in accounts receivable is the number of days in the year (usually 360 or 365 days is used) divided by theaccounts receivable turnover ratio for a specific year. If a company’s accounts receivable turnover ratio was 10, then the days’ sales in accounts receivable is 36 days (360 daysdivided by the turnover ratio of 10).
Since the accounts receivable turnover ratio used in the days’ sales in accounts receivable was based on 1)credit sales during a one-year time period, and 2) the average accounts receivable balances during that one-year period, the36 days calculated above is an average.It is possible that within the accounts receivable there are some accounts which are 120 days or morepast due. This information might behidden by the average, because the averageincludedsome accounts that paid early. Therefore, it is best to review an aging of accounts receivable by customer to understand the detailbehind the days’ sales in accounts receivable ratio.
what is the accounts receivable turnover ratio?
The financial ratio accounts receivable turnover is a company’s annual sales divided by the company’s average balance in its Accounts Receivable account during the same period of time.
For example, if a company’s sales for the year 2007 were $6,000,000 and its average balance in Accounts Receivable for the sametwelve months of 2007 was $600,000, its accounts receivable turnover ratio is 10. This indicates thaton average the company’s accounts receivables turned over 10 times during the year 2007—or approximately every 36 days (360 or 365 days per year divided by the turnover of 10).
Whether theaccounts receivableturnover ratio of 10 is good or bad depends on the company’s past ratios,the average for other companies in the same industry, and by the specific credit terms given to this company’s customers.
It is important to note that theaccounts receivable turnover ratio is an average, andaverages can hideimportant details. For example, somepast due receivables could be “hidden”or offset byreceivables that have paid faster than the average. If you have access to the company’s details, you should review a detailed aging of accounts receivable to detect slow paying accounts
June 11, 2008
What is the difference between reserve and allowance?
Perhaps 50 years ago, accountants in the U.S. used Reserve for Bad Debts as the title of the contra account associated with Accounts Receivable or Loans Receivable. They also used Reserve for Depreciation as the title of the contra account associated with plant assets. The use of the word reserve led some readers of the financial statements to conclude that money was set aside for replacing plant assets orthe uncollectible accounts or loans. To avoid this misunderstanding, the accounting profession recommended that the word reserve have a very limited use. Accountants now use Allowance for Doubtful Accounts or Allowance for Bad Debts instead of Reserve for Bad Debts. In the case of plant assets, Accumulated Depreciation is used in place of Reserve for Depreciation
Why isn’t the direct write off method of uncollectible accounts receivable the preferred method?
Under the direct write off method, a company does not anticipate bad debt expense. Rather, it waitsuntil an account is actually written off as uncollectible before recording bad debt expense. This means its accounts receivable will be reported on the balance sheet at their full amounts—implying that all of the accounts receivable will be turning to cash. If there is some doubt concerning the collectibility of some of the receivables, the assets are potentially overstated and the company’s profit is potentially overstated. Since there is usually a significant amount of time between a credit sale and thewrite off of a bad account, the bad debt expense will occur in a much later period than the revenue from the sale. This is a problem under the matching principle.
The accounting profession prefers the allowance method over the direct write off method because theaccounts receivable will be presented on the balancesheet with a reductioncalled theallowance for doubtful accounts. This means the net amount of the accounts receivable willbe lower and closer to the amount that will actually be collected. Bad debt expense is reported at the time that the allowance for doubtful accountsis created and adjusted. Hence, the bad debt expense is reported closer to the time of the credit sale.
It should be noted that the Internal Revenue Service requires the direct write off method. They prefer to seethe tax deduction for bad debt expense only when an account receivable is actually written off—as opposed to allowing a deduction for an anticipated potential loss.
In the allowance methods of accounting for noncollectible accounts what adjustment must be made to the financial statements when a specific bad debt is written off?
/ [Edit]Answer
DR Allowance for Doubtful Accounts
CR Accounts Receivable
What is the difference between bad debt and doubtful debt?
ome people will use these terms or account titles interchangeably: Bad Debt Expense, Doubtful Account Expense, Uncollectible Account Expense. The same for these terms or account titles: Allowance for Bad Debts, Allowance for Doubtful Accounts, Allowance for Uncollectible Accounts.
The “Allowance for …” is a balance sheet account. However, it is a contra account to the asset Accounts Receivable. (Generally, the Allowance account will have a credit balance—whereas Accounts Receivable and other asset accounts normally have debit balances.) The Allowance account communicates to the reader of the balance sheet the amount of Accounts Receivable that will likely not be collected.
The three Expense account titles listed above are income statement accounts and will have the usual debit balance. These expense accounts report how much bad debt expense was incurred during the period shown in the heading of the income statement.
How do you estimate the amount of uncollectible accounts receivable?
One way to estimate the amount of uncollectible accounts receivable is to prepare an aging. An aging of accounts receivable lists every customer’s balance and then sorts each customer’s balance according to the amount of time since the date of the sale. For example, assume that all sales are made with terms of 30 days. Let’s also assume that Customer A has an accounts receivable balance of $12,000—consisting of $8,000 that was sold 15 days ago and $4,000 that was sold 40 days ago. The $8,000 will be entered into the column with the heading “Current” and $4,000 will be entered into the column with the heading “1-30 days past due.” After the sorting/entering is done for each and every customer, the columns are summed. The “Current” column is likely to be collectible. However, the amounts in the column headed “1-30 days past due” might not be 100% collected. The amounts in the column with the heading “31-60 days past due” will have a higher probability of being uncollectible. The column “61-90 days past due” indicates a still greater likelihood of not being collected. And the amounts in the column “More than 90 days past due” will be even less likely to be collected in their entirety.
Examing the details of each of the past due accounts will help you estimate the amount that will likely be uncollectible.
Another way to estimate the amount of uncollectible accounts is to simply record a percentage of credit sales. For example, if your company and its industry has a long run experience of 0.2% of credit sales being uncollectible, you might enter 0.2% of each period’s credit sales as a debit to Bad Debt Expense and a credit to Allowance for Doubtful Accounts.
What is the purpose of the Allowance for Doubtful Accounts?
The Allowance for Doubtful Accounts is used when Bad Debt Expense is recorded prior to knowing the specific accounts receivable that will be uncollectible. For example, a company might have 500 customers purchasing on credit and they owe the company a total of $1,000,000. The $1,000,000 is reported on the company’s balance sheet as accounts receivable.
The company doesn’t know specifically which customer will not pay, but it estimates that a few customers out of the 500 will not be paying the full amount they owe. The company estimates that $10,000 will not be collected. Rather than waiting until those specific customers are identified, the company makes an accounting entry that debits Bad Debt Expense and credits Allowance for Doubtful Accounts.
The amount of the entry will be the amount necessary to get the ending balance in the Allowance account to be a credit of $10,000. When the balance sheet is prepared, it will show Accounts Receivable of $1,000,000 less the Allowance of $10,000 for a net realizable value of $990,000—the amount that will likely be turned into cash.
The entry also meant that the income statement will be reporting $10,000 of Bad Debt Expense sooner than if the company waited for the customers to admit they were not able to pay. This means that the expense is matched more closely with the revenues—the goal of accounting’s matching principle.
While this allowance method is good for financial reporting, it might not be allowed for income tax purposes. Be sure to check with a tax professional for the income tax rules.
What is a provision for discounts allowable?
The provision for discounts allowable is likely to be a balance sheet account that serves to reduce the asset account Accounts Receivable. The provision account’s counter part (remember double entry accounting) is an income statement account, such as Sales Discounts or Discounts for xxx.
Let me give you an example from the meat industry. We had 40,000 pounds of beef without a local customer, so we sold it to a company 1,000 miles away for the local price of say $1.50 per pound. Our accounting entry was to debit Accounts Receivable $60,000 and to credit Sales $60,000. We also knew that the beef would shrink approximately 800 pounds as it traveled in the refrigerated truck and that the customer would deduct $1,200 (800 pounds X $1.50) when the customer processed and paid our invoice. In order to more accurately report our Accounts Receivables, our Net Sales and our weekly profit, I immediately made an entry to debit Discount for Shrinkage (a contra account to Sales) and a credit to Provision for Discounts (a contra account to Accounts Receivable). By recording that entry, our balance sheet would report the true amount to be collected, $58,800 ($60,000 invoiced minus the anticipated deduction of $1,200). The income statement would report that Sales minus the discount were only $58,800.
The provision account allowed our Accounts Receivable to agree with our sales invoices, yet the balance sheet would report the net amount that we would realistically receive. It allowed us to “match” the discount to the week of the sale and not mismatch the discount to a later week when the customer remitted the reduced amount.
What is the Purpose of Control Accounts?
control account is a summary account in the general ledger. The details that support the balance in the summary account are contained in a subsidiary ledger–a ledger outside of the general ledger.
The purpose of the control account is to keep the general ledger free of details, yet have the correct balance for the financial statements. For example, the Accounts Receivable account in the general ledger could be a control account. If it were a control account, the company would merely update the account with a few amounts, such as total collections for the day, total sales on account for the day, total returns and allowances for the day, etc.
The details on each customer and each transaction would not be recorded in the Accounts Receivable control account in the general ledger. Rather, these details of the accounts receivable activity will be in the Accounts Receivable Subsidiary Ledger. This works well because the employees working with the general ledger probably do not need to see the details for every sale or every collection transaction. However, the sales manager and the credit manager will need to know detailed information on individual customers, including whether a customer recently reduced their account balance. The company can provide these individuals with access to the Accounts Receivable Subsidiary Ledger and can keep the general ledger free of a tremendous amount of detail.