What is Accounts Receivable?
Accounts receivable is the amount that customers owe on their account. They are the outcome of selling goods and services. Companies generally expect to receive receivables within 30 to 60 days. Usually, they are the main kind of claims that a company holds.
What is the Reason for Increasing Accounts Receivable?
The reason for increasing accounts receivable is as follows:
- Credit Sales or Service
- Charge any Interest
- Dishonored Cheque
What is the Reason for Decreasing Accounts Receivable?
The reason for decreasing accounts receivable is as follows:
- Cash or Bank Collection
- Sales Return
- Bad Debts
- Provided Discount
- Bad debts Reserve
- Cheque Collection
How do Companies Recognize Accounts Receivable?
Recognizing accounts receivable is relatively simple. A service agency reports account receivable when conducting a service on the account. At the point of sale, a merchandiser reports the accounts receivable for the merchandise. When a merchandiser sells goods on account, it increases the accounts receivable account (Debit) and increases the sales revenues account (Credit).
The seller can provide early payment terms by giving a discount. Sales return also minimize accounts receivable. Any of the items may be inappropriate to the consumer and unused items may be returned.
How to Record Accounts Receivable in the Accounts Books?
Assume that Nancy Co. on July 1, 2020, sells merchandise on account to Fancy Company for $2,000, terms 2/10, and n/30.
On July 6, Fancy returns merchandise with a sales price of $200 to Nancy Co.
On July 11, Nancy receives payment from Fancy Company for the balance due.
The journal entries to record these transactions on the books of Nancy Co. are as follows.
|2020||Accounts Receivable—Fancy Company||$2000|
|(To record sales on account)|
|July-06||Sales Returns and Allowances||$200|
|Accounts Receivable—Fancy Company||$200|
|(To record merchandise returned)|
|July-11||Cash ($1800 – 36)||$1764|
|Sales Discounts ($1800*2%)||$36|
|Accounts Receivable—Fancy Company||$1800|
|(To record collection of accounts receivable)|
How do Companies Report Accounts Receivable in the Financial Statements?
On the balance sheet, companies report accounts receivable as an asset. But it’s sometimes difficult to determine the amount to report because some receivables will become uncollectible.
Before the credit sale is approved, each customer must satisfy the seller’s credit requirements. Inevitably, though, certain accounts receivable become uncollectible.
For instance, because of a decline in its sales revenue due to a downturn in the economy, a customer may not be able to pay. Similarly, people may be laid off or faced with unexpected hospital bills from their jobs.
Credit losses are reported by companies as Bad Debt Expense or Uncollectible Accounts Expense. Such losses are a normal and necessary risk on a credit basis for doing business.
Two methods are used to account for non-collectible accounts:
- The direct write-off method and
- The allowance method.
The following sections describe these methods.
The Direct Write-off Method:
When a company determines a specific account to be uncollectible, it charges the loss to the Bad Debt Expense under the direct write-off method.
Assume, for example, that Nathan Co. writes off as uncollectible Doren’s $4000 balance on December 23. Nathan Co.’s journal entry is as follows.
|Dec-12||Bad Debt Expense||$4,000|
|Accounts Receivable—M. E. Doren||$4,000|
|(To record write-off of Doren account)|
In this system, the bad debt expenditures just reflect real losses from the uncollectible. The company lists receivables on its gross amount. Although this method is easy, the use of this method will decrease both the income statement and the balance sheet.
Balance Sheet under the direct write off method:
Balance sheet (Partial)
|Less: Allowance for Doubtful Accounts||($4,000)||$296,000|
|Total Current Assets||$609,700|
Companies frequently report bad debt expenses in a period different from the period in which they report income, under the direct write-off method. The method would not try to balance bad debt expenses with sales revenue in the income statement. Nor does the direct write-off method illustrate the amount that the company currently plans to collect in the receivable balance sheet accounts. Consequently, for financial reporting purposes, the direct write-off method is not acceptable unless bad debt losses are negligible.
The Allowance Method:
The allowance method of accounting for bad debts involves the estimation of uncollectible accounts at the end of each year. This offers better matching on the income statement.
It also ensures that companies disclose receivables on the balance sheet at their cash (net) realizable value. Cash (net) achievable value is the net sum the company expects to receive in cash. This excludes amounts that the organization estimates that it will not collect. Thus, this method reduces receivables by the sum of the projected uncollectible receivables from the balance sheet.
Assume that Nathan Co. has credit sales of $1,800,000 in 2020. Of this amount, $300,000 remains uncollected on December 31. The credit manage predicts that $15,000 of these sales would be uncollectible.
The adjusting entry to record this transaction will be as follows.
|Dec-31||Bad Debt Expense||$15,000|
|Allowance for Doubtful Accounts||$15,000|
|(To record estimate of uncollectible accounts)|
Nathan Co. lists Bad Debt Expense as an operating expense in the income statement.
Allowance for Doubtful Accounts indicates the expected sum of consumer claims that the business expects in the future will become uncollectible.
Instead of direct credit to Accounts Receivable, businesses use a contra account because they do not know which clients would not pay. The credit balance in the allowance account will absorb the individual write-offs as they occur.
The company deducts the allowance account from the receivable accounts in the balance sheet portion of the current assets.
Balance sheet (Partial)
|Less: Allowance for Doubtful Accounts||($15,000)||$285,000|
|Total Current Assets||$698,700|
The $285,000 amount represents the expected realizable cash value of the accounts receivable at the date of the statement. Companies do not close the Doubtful Accounts Allowance at the end of the fiscal year.
Disposing of Accounts Receivable
Companies receive accounts receivables in cash and extract receivables from books during regular events. However, the “normal course of events” has changed as credit sales and receivables have grown insignificance. Companies now also sell receivables to another company, shortening the cash-to-cash operating period.
Businesses sell receivables for two main reasons.
First, it can be the only rational source of cash. Companies cannot borrow money when money is tight on the ordinary credit markets. Or the cost of borrowing may be prohibitive if money is available.
A second reason to sell accounts receivable is that billing and collection are always time-consuming and expensive. It is also cheaper for a retailer to sell the claims to another party who has experience in accounting and collecting. Credit card firms, such as MasterCard, Visa, and Discover, are experts in billing and obtaining accounts receivables.
Sale of Accounts Receivables
A common selling of receivables is selling to a factor. A factor is a financial institution or bank that purchases the receivables from businesses and receives payments directly from consumers. Factoring is a business worth billions of dollars.
Factoring agreements differ widely. Typically, the factor charges the company that sells the receivables a commission. This fee is 1-3% of the volume of receivables purchased.
To illustrate, assume that Tyra Computer factors $800,000 of receivables to the United Factors. United Factors assesses a 3% service fee on the volume of receivables sold.
The journal entry to record the sale by Tyra Computer on May 3, 2020, is as follows.
|Service Charge Expense (3% X $800,000)||$ 24,000|
|Accounts Receivable||$ 800,000|
|(To record the sale of accounts receivable)|
If Tyra Computer regularly sells its receivables, it reports its service charge as a sales expense. If the company sells receivables infrequently, this amount may be reported in the section “Other expenses and losses” of the income statement.
What’s the Turnover Ratio of Accounts Receivable?
The account receivables turnover ratio is an accounting method used to calculate a business ‘efficiency in obtaining its accounts receivables and customers’ money. The ratio reflects how efficiently a company uses and handles its credit to customers and how easily it receives or pays the short-term debt.
The Formula of the Accounts Receivable Turnover Ratio:
Accounts Receivable Turnover = Net Sales/Average Accounts Receivable
The Average Accounts Receivable Turnover in Days = 365 Days/Accounts Receivable Turnover
Net Sales= Total Sales- Sales Return
Average Accounts Receivable= (Accounts Receivable at the beginning of the period + Accounts Receivable at the end of the period)/2
Some Important Notes Regarding the Turnover of Accounts Receivable:
- A high turnover ratio of accounts receivable demonstrates the company’s success in collecting accounts receivable and a high percentage of high-quality customers who repay their debts quickly.
- A low turnover ratio of accounts receivables could be due to a business having a bad collection process, bad credit policies, or clients that are not economically feasible or creditworthy.
How to Calculate the Accounts Receivable Turnover Ratio?
Let’s Assume “Tyro International” had the following financial results for the year:
Total credit sales of $1,000,000.
Total sales Return of $200,000
January 1st (at the beginning of the year) accounts receivables $70,000
December 31 (at the end of the year) accounts receivables $80,000
In the following way, we can calculate the accounts receivable turnover ratio
Net Sales = Total Sales-Sales Return
Average Accounts Receivable = ($70,000+$80,000)
Accounts Receivable Turnover Ratio
= 10.67 times
What does it mean?
That year, on average, Tyro International collected its receivables 10.67 times. The company converted its accounts receivable into cash 10.67 times that year. The company could compare several years to decide whether 10.67 is an update or an indicator of a sluggish collection process.
Average Accounts Receivable Turnover in Days
= 34 days
What does it mean?
Customers take an average of 34 days to pay their accounts receivables for Tyro International. If the company has a payment policy of 30 days for its customers, the average turnover for accounts receivable shows that the customers are on average 4 days late.
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