Trade Accounts Receivable and its Valuation

Trade receivable 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, 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.
  5. 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, 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 non collectible is very low, it is a necessary consideration with respect to valuation accuracy. non collectible 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 non collectible 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 non collectible 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. Noncollectable may also be recognized on a direct write-off basis. Finally, the possibility does exist that some accounts deemed noncollectable
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 noncollectable 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 noncollectable 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
  2.  Estimate based on accounts receivable. This method of estimating non 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 non collect-able 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 Noncollectable 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 non collectible. 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 noncollectable, 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 and Trades Receivable

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.

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