Accounts Receivables
The term Accounts receivable generally denotes all claims involving a future inflow
of cash. These receivables result from business transactions involving sales of
goods and services, loans and miscellaneous claims. The accounting procedures surrounding
the creation of receivables as well as the controls over the credit granting function
and the collection process are, therefore, of considerable importance.
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Trade Receivables
Trade receivables represent the sale of goods and services in the normal course
of business operations and account for the major portion of a firm's revenue-producing
activities. The open account, or trade account, created by a transaction between
business concerns is generally unsecured (an informal arrangement rather than a
legal agreement) and noninterest-bearing. This can be contrasted to retail trade
receivables, which typically involve the addition of an interest or service charge
to revolving charge accounts and installment agreements.
Trade receivables sometimes take the form of commercial credit instruments such
as promissory notes or time drafts. Since these are signed agreements, a measure
of legal commitment is provided and the holder may borrow against them (see Notes
Receivable).
Other Receivables
 Revenue is sometimes generated from sources other than trade receivables. Among
these are short-term advances to customers or subcontractors, insurance claims,
claims for rebates on taxes or other overpayments, sale of plant and equipment and
accruals of interest, rent, royalties, etc. Such receivables are properly classified
as current assets when collection is expected within one year and as other assets
or miscellaneous assets if a longer collection period is anticipated.
Valuation of Trade Receivables
Trade receivables are generally recognized at the time goods are sold and title
passes, or when the service provided is actually performed. The valuation placed
on the receivables depends on the amount due, the time of collection, and the probability
of collection.
Determining the amount due: The amount actually paid by the customer often includes
a variety of charges and discounts which the seller may impose on the quoted price.
(1) Trade discounts represent the difference between the gross or recommended list
price and the net price to the buyer before other discounts and charges. The receivable
and resulting revenue are both recorded at the net price.
(2) Cash discounts are offered as an incentive for prompt payment. They represent
the difference between the cash price and the amount realized.
(3) Credit card fees enable the seller of retail goods to extend credit to some
customers-the credit card holders. Credit card companies generally assume .the collection
function and charge the seller a fee for this purpose, usually basing it upon a
percentage of the sales price. Since the fees are automatic charges, they should
be accrued by the seller when the sale is recognized. Sales revenues are recorded
at full value while receivables due-from the credit card company are recorded at
the net amount expected. The difference, representing the fees charged by the credit
card company, is recorded as an expense of the period.
(4) Sales returns and allowances recognize the probability that some merchandise
will be returned or that an adjustment will be made on the sales price. Since returns
and allowances represent a reduction in receivables and anticipated cash, immaterial
amounts should be debited to an expense account when made, with the balance offset
against sales revenue in the income statement: Material amounts which can be objectively
estimated may be recorded by an adjusting entry at the end of the current period,
(5) Freight allowances may arise when the customer pays for the transportation of
goods even though the seller is obligated to do so. In such cases, both the receivable
and the revenue should be valued net of the transportation expense. When goods are
sold 'f.o.b. shipping point' and the customer is billed for the freight charge,
the revenue accounts should reflect only the invoice price of the goods sold. The
freight charge in the invoice should be credited to an expense account, such as
Transportation-out.
(6) Sales and excise taxes itemized separately On invoices should be credited to
appropriate liability accounts, such as Sales Taxes Payable. When taxes are included
iI1 the selling price of an item, the)' are in essence costs of production and should
be deducted from revenue generated as an expense,
(7) Container deposits received from customers create a liability for the seller
since it is understood that deposits will be refunded when containers are returned.
The container charge should be segregated from the sale amount on the invoice and
in the receivables; a separate liability account Should be established to avoid
overstatement of receivables.
The liability for container refunds is offset by a receivable from the Customer
for unreturned containers. When containers are not returned, the difference between
the amount charged to the customer and the cost of the container to the company
is taken as income.
Time of collection, It is generally acknowledged that a given amount of money is
worth less today than a year from now. Therefore, when it is known that a receivable
will not be collected for a long period of time and no interest is being charged,
it is customary to assign a present value to that account based on an appropriate
rate of interest.
Probability of collection: While the probability of any receivable being ultimately
uncollectible is very low, it is a necessary consideration with respect to valuation
accuracy. Uncollectible are estimated to prevent an overstatement of assets and
revenues; the estimate serves to reduce gross receivables to an approximation of
the net realizable value of short-term funds due from customers.
The valuation account carries a credit balance and is variously titled Allowance
for Doubtful Accounts or Allowance for Uncollectible Accounts. On the income statement,
the estimated allowance may be shown as a contra asset reducing gross sales, but
is more often included as an operating expense or other expense representing a failure
of management.
The two principal methods for estimating uncollectable are an estimate based on
a percentage of sales and an estimate based on an analysis of receivables at the
end of the accounting period. Uncollectable may also be recognized on a direct write-off
basis. Finally, the possibility does exist that some accounts deemed uncollectible
and written off may eventually be collected.
(1) Estimate based on sales. When the percentage of sales method is used,
the seller examines the relationship between credit sales and uncollectable in past
periods to derive a percentage applicable to credit sales in the current period.
This method attempts to match costs and revenues in each period. It assumes a fairly
stable relationship between credit sales and uncollectable and provides a basis
for estimation which is in essence an average reflecting past experience. Since
this method relies heavily on past experience, it is important to test the adequacy
of the established percentage on a periodic basis to allow for any changes in business
conditions.
(2) Estimate based on accounts receivable. This method of estimating un collectibles
depends on an analysis of receivables by age group and probability of collection.
It assumes that there is a strong relationship between the age of a receivable and
its eventual collection. It has the advantage of identifying specific accounts in
need of special attention. The procedure is to prepare an aged trial balance at
the end of the accounting period, classifying the outstanding amounts according
to whether the account is not due or past due, based on varying lengths of time.
It is important to note that actual write-offs of uncollectable rarely agree with
the balance in the allowance account. If the differences are nominal, it is not
necessary to change the balance. Major differences, however, require charges to
the current period's Uncollectible Accounts Expense or a similar account before
computing Extraordinary items. They should not be recorded as extraordinary items
or prior period adjustments.
(3) Direct write-off method. Under the direct write-off method, bad debts are recorded
only when specific accounts are determined to be definitely uncollectible. Losses
are recorded by crediting Accounts Receivable
and debiting Bad Debts Expense. Since this method overstates the net realizable
value of receivables at the end of the period and does not provide for proper matching
of collectibles and associated revenues, it is less desirable for income taxes than
the allowance method, although it is an acceptable alternative.
(4) Collection of receivables previously written off. When a firm uses the allowance
method for estimating uncollectable, the actual write-off of a receivable is a charge
to Allowance for Doubtful Accounts and a credit to Accounts Receivable. If the firm
uses the direct charge-off method, the charge is to Bad Debt Expense and a credit
to Accounts Receivable. When an account that has been written off is subsequently
collected and the firm uses the allowance method, the usual procedure is a reversing
entry crediting the recovery to the allowance account and debiting Accounts Receivable.
However, if there is a large amount involved and the credit to the allowance account
will create an excessive balance, the credit may go instead to a separate account
for Bad Debts Recovered. When . the direct charge-off method is used, the credit
may go either to Bad Debt Expense, if one has been created, or to Bad Debts Recovered.
Installment Sales
The installment contract is a widely used credit instrument which provides for payment
over an extended period of time. Selling goods and services on this basis requires
special considerations in terms of asset classification and valuation.
Installment receivables are usually carried on the books from 6 to 36 months; however,
according to ARB No. 43, they should be classified as current assets when this arrangement
represents the normal course of business operations. It is customary to record installment
sales at face value less unearned interest and finance Charges; interest and finance
charges are recognized as revenue only as earned.
Generating Cash from Accounts Receivable
Accounts receivable may be sold or used as collateral in order to generate immediate
cash for the business. These procedures are quite common in some industries while
in others they are used to raise funds in times of financial difficulty.
Factoring accounts receivable: When a receivable is sold or factored, the risk
of credit and all collection efforts are assumed by the buyer, or factor. The firm
selling the receivables receives its cash immediately, fora fee. Factoring arrangements
vary widely, and usually depend on such things as the amount of receivables purchased
and the credit standing of the firm's customers. The fees imposed by the factor
generally consist of an interest charge on the funds actually borrowed plus a commission
of from 1 to 3% of the net amount of receivables purchased.
The factoring of accounts receivable does not raise any particular accounting problems.
Cash is debited for receipts from the sale, Accounts Receivable is credited and
the factor's commission and interest charges are recorded as expenses. If the factor
holds back a percentage of the proceeds as protection against returns and allowances,
the seller records that amount as a receivable from the factor.
Assigning receivables: Under this method, the business (assignor) pledges
the receivables to the lender (assignee) as collateral for a loan. The assignor
retains aU credit risks and generally makes all collections since the customer is
rarely notified of the .assignment. The assignee generally advances less than 100%
of the receivables pledged, which means that the assignor has some equity in the
receivables.
For accounting purposes the following procedures should be used:
(1) Accounts that have been assigned should be transferred to a separate account
called Accounts Receivable Assigned.
(2) Funds received from the assignee should be credited to a Notes Payable, Assignee
account.
(3) Collections on those accounts turned over to the assignee would require a debit
to Notes Payable, Assignee and a credit to Accounts Receivable Assigned.
(4) Charges for interest, commissions, etc. should be handled as period expenses
and included in payments to the assignee.
In the balance sheet, the assignor's equity in pledged receivables is indicated
by deducting the balance due the assignee from the total receivables assigned.
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Notes Receivable
For accounting purposes, the term notes receivable refers to promissory notes, bills
of exchange or trade acceptances. Notes receivable are distinguished by the fact
that they are written contractual arrangements for the payment of a specific amount
'of money, generally plus interest, at a stated time. They are usually negotiable
or transferable instruments which enable the holder to use them for cash generation
in much the same way as is done with accounts receivable.
Valuation of notes receivable: A note
is generally recorded at its face value.
However, when no interest rate is specified, the face amount of a note is assumed
to include some provision for interest. Such nonbearing notes are recorded at face
value less an interest charge based on a percentage that is assumed to be reasonable.
The Discount on Notes Receivable is taken into income over the life of the note.
Discounting notes receivable: Notes receivable may be sold or discounted. When
a note is sold to a bank or finance company without recourse, the seller assumes
no future liability should the maker of the note default. Discounting, on the other
hand, is usually done on a recourse basis (i.e., money is borrowed using the note
as collateral and the borrower, who endorses the note, becomes contingently liable
should the maker default).
The proceeds or cash received when a note is discounted may be computed in one of
two ways:
(1) The interest or discount charged by the lender is deducted from the face value
of the note, or
(2) The discount rate may be applied to the maturity value of the note.
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