This site contains affiliate links to products and services. We may receive a commission for purchases made through these links.
Definition:
Amounts owed to the business by individuals or businesses. Receivables arise from credit sales of goods or services. To the company, these represent current assets; several companies have large amounts of accounts receivable.
Financial Statements Presentation:
Accounts receivable are current assets, reported on the balance sheet statement. Usually, they are classified as (1) accounts receivable, (2) notes receivable, and (3) other receivables. As you remember, current asset presentation in the balance sheet follows a liquidity order; normally, accounts receivable follow cash.
Description of Accounts Receivables:
- Accounts receivables are amounts customers owe on account; thus, they arise from credit sales to customers. The expected collection ranges between 30 and 90 days depending on the industry.
- Notes receivable – promises for receivable amounts—involve a document formally written, with interest calculated. The expected collection ranges between 90 and 180 days, depending on the industry.
- Other receivables – other transactions including receivables from employees, taxes, or others classified as no trade in nature.
Recognition:
Recognizing is very simple; once a business sells on account, it debits accounts receivable and credits sales revenues. In both cases, accounts receivable and sales revenues increased for the portion that was on credit.
Other transactions:
Selling on credit might bring instances of returns, allowances, and discounts. These transactions affect the accounts receivable balance. For example, any return or allowance should decrease the accounts receivable balance of the affected client. A typical transaction will debit Sales Returns and Allowances and credit Accounts Receivable (client affected).
When the company has discounts for early payment, and the client pays within the discount period, the following entry applies: debit—cash less discount, debit sales discounts, and credit accounts receivable.
Subsidiaries:
Each client has its own account; thus, you should be able to keep track of all your credit sales for future collection. A subsidiary is a list containing all your accounts receivable (credit sales) pending collection. The business’ subsidiary list of accounts receivable must total the amount presented on the accounts receivable general ledger balance.
Accounts receivable valuation:
The accounts receivable must be valued based on the probability of its recoverability; therefore, certain estimates or evaluations must be made to report the amounts. In those cases that credit sales losses arise, businesses record bad debt expense or uncollectible accounts expense in their accounting books.
There are two methods used in accounting for uncollectible accounts: (1) the direct write-off method and (2) the allowance method.
1. Direct Write-off Method for Uncollectible Accounts
As the name states, once a business determines that an account cannot be collected, then it charges the loss to bad debt expense. The journal entry is a debit to Bad Debt Expense and a credit to Accounts Receivable (client affected). This method only shows actual losses from uncollectibles.
Very important note: This method is NOT acceptable for financial reporting purposes, since it fails to match the expense with the sales revenue (matching principle). Moreover, it fails to show accounts receivable expected recoverability (net realizable value). Use this method when bad debts represent an immaterial amount for the business.
2. Allowance Method for Uncollectible Accounts
The allowance involves estimating an uncollectible amount over the credit sales balance at the end of the reporting period. The journal entry required debits, bad debt expense, and credits for allowance for doubtful accounts. The allowance account is a contra-account that is presented as a deduction of the accounts receivable balance in the financial statements. Therefore, this method allows proper matching of expenses with corresponding credit sales revenues. In addition, it allows proper presentation of the accounts receivable balance based on its net realizable value or collection probability.
When an account becomes uncollectible, the business will prepare the following journal entry to record the loss: debits, Allowance for Doubtful Accounts, and credits, Accounts Receivable (client affected). Therefore, actual losses do not impact bad debt expense; instead, they impact the allowance for doubtful accounts.
Any recovery of a previous uncollectible account has two-step journal entries: (1) debit, accounts receivable (client affected), and credit, allowance for doubtful accounts; then (2) debit, cash, and credit, accounts receivable (client affected).
In summary:
Accounts receivable correspond to the current asset side of the balance sheet statement. Two methods of recording bad debts exist: the direct write-off and the allowance for uncollectible accounts. For financial reporting purposes, the accounts receivable must present the net realizable value; thus, a reserve should be calculated and recorded as a contra account.