What is Accounts Receivable?

what-is-accounts-receivableAccounts receivable is an asset which is the result of accrual accounting. The firm has delivered products or rendered services (hence, revenue has been recognized), but no cash has been received, as the firm is allowing the customer to pay at a later point in time.

Accounts Receivable Example

The firm sells products with a cost of 100 for 120 to a customer on account. The firm uses the perpetual inventory system.

The journal entry of this transaction is:

T-account Debit Credit
Accounts receivable 120
Sales 120
Cost of goods sold 100
Inventory 100

The nominal value of accounts receivable is the legal claim that the firm has on the customers. If all customers pay in full, this is the amount that the firm will collect. However, it is common that some customers end up not paying. The net value of accounts receivable is the nominal amount minus an allowance for uncollectibility. Thus, net accounts receivables is the amount that the firm expects to collect.

Receivables Example

In their annual report over 2008, Google presents their accounts receivable after deducting the allowance for uncollectible accounts receivable (annual report).
The net value of accounts receivable is $2,163 million and $2,642 million for 2007 and 2008, respectively. The allowance for 2007 is $33 million, and for $80 for 2008. The percentage that Google expects to be uncollectible is 1.5% (=33/(33+2163)) for 2007 and 2.9% (=80/(80+2642)) for 2008.

The benefit of allowing customers credit consist of the gain on the additional sales that allowing the credit generates. The cost is the risk that accounts will end up uncollectible. To mitigate this risk, it is common practice to perform a credit check before a firm sells products/services to a customer on account. Nevertheless, it is likely that some customers will not be able to pay, as eliminating the risk on nonpayment could very well adversely affect sales. In this section I will focus on how firms account for uncollectible accounts.

Accounts Receivable Explained

Key points:

– nominal accounts receivable refers to the legal claim of the firm on its customers

– the allowance for uncollectible accounts is the amount that the firm expects not to collect

– net accounts receivable is the amount that the firm will be able to collect, which equals nominal accounts receivable minus the allowance for uncollectible accounts

How to Write Off Bad Debt and Worthless Receivables

There are three different methods to write off bad receivables:

Management Discretion

The percentage of sales method to account for uncollectible accounts is not allowed under IFRS. The IASB (standard setting body) believes that management has too much discretion to estimate the percentage that is used to calculate the expense. The concern is that if earnings is a little low (or too high), management will use this discretion to use a lower (or higher) percentage in order to ‘smooth’ earnings. Also, even an unmanaged percentage can turn out to be too low or too high. After several years the allowance it could an unrealistic number, totally unrelated with the true risk in accounts receivable.

The ageing of accounts method is allowed under IFRS. Even though there is discretion with this method as well, the allowance is directly related to the risk assessment of end of the period’s accounts receivable. It is possible to use both methods, by applying the percentage of sales during the year and at year’s end use the ageing of accounts method so that the allowance reflects the risk in accounts receivable. This approach combines the advantage of matching of the percentage of sales method and the risk assessment of the ageing of accounts method. This approach is allowed under IFRS.

Key points:
– IFRS does not allow the percentage of sales method, because the end of year value of the allowance is not directly related with the risk assessment in end of year accounts receivables (instead, it is directly related to the sales in the past)

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