Overview of Accounts Receivable
When goods or services are sold to a customer, and the customer is allowed to pay at a later date, this is known as selling on credit, and creates a liability for the customer to pay the seller. Conversely, this creates an asset for the seller, which is called accounts receivable. This is considered a short-term asset, since the seller is normally paid in less than one year.
An account receivable is documented through an invoice, which the seller is responsible for issuing to the customer through a billing procedure. The invoice describes the goods or services that have been sold to the customer, the amount it owes the seller (including sales taxes and freight charges), and when it is supposed to pay.
We will illustrate these concepts below.
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Receivables Under the Accrual and Cash Basis of Accounting
If the seller is operating under the cash basis of accounting, it only record transactions in its accounting records (which are then compiled into the financial statements) when cash is either paid or received. Since issuing an invoice does not involve any change in cash, there is no record of accounts receivable in the accounting records. Only when the customer pays does the seller record a sale.
If the seller is operating under the more widely-used accrual basis of accounting, it records transactions irrespective of any changes in cash. This is the system under which an account receivable is recorded. In addition, there is a risk that the customer will not pay. If so, the seller can either charge these losses to expense when they occur (known as the direct write-off method) or it can anticipate the amount of such losses and charge an estimated amount to expense (known as the allowance method). The latter method is preferred, because the seller is matching revenues with bad debt expenses in the same period (known as the matching principle).
There is an issue with the timing of the preceding sale transaction. If the sale is made under FOB shipping point terms, the seller is supposed to record both the sale transaction and related charge to cost of goods sold at the time when the shipment leaves its shipping dock. From that point onward, the delivery is technically the responsibility of either a third-party shipper or the buyer.
If the sale is made under FOB destination terms, then the seller is supposed to record these transactions when the shipment arrives at the customer; this is because the delivery is still the responsibility of the seller until it reaches the customer's location.
From a practical perspective, many companies record their sale transactions as though the delivery terms were FOB shipping point, because it is easy to verify. Recording the transaction upon arrival at the customer requires substantially more work to verify.
Accounting for Bad Debt
If a company sells on credit, customers will occasionally be unable to pay, in which case the seller should charge the account receivable to expense as a bad debt. The best way to do so is to estimate the amount of bad debt that will eventually arise, and accrue an expense for it at the end of each reporting period. The debit is to the bad debt expense account, which causes an expense to appear in the income statement. The credit is to the allowance for bad debts account, which is a reserve account that appears in the balance sheet. Later, when a specific invoice is clearly identifiable as a bad debt, the accountant can eliminate the account receivable with a credit, and reduce the reserve with a debit.
For example, ABC International invoices $1 million of invoices to various customers in January and estimates that $40,000 of this amount will not be paid. Accordingly, it records the following entry to create a bad debt reserve:
If the customer were to later pay the invoice, ABC would simply reverse the entry, so that the allowance account is increased back to its former level.
An alternative method is the direct write-off method, where the seller only recognizes a bad debt expense when it can identify a specific invoice that will not be paid. Under this approach, the accountant debits the bad debt expense and credits accounts receivable (thereby avoiding the use of an allowance account). It is not the preferred method for recording bad debts, because it introduces a delay between the recognition of a sale and the recognition of any related bad debt expense (which violates the matching principle).
Accounting for Early Payment Discounts
If a company offers customers a discount if they pay early and they take advantage of the offer, then they will pay an amount less than the invoice total. The accountant needs to eliminate this residual balance by charging it to the sales discounts account, which will appear in the income statement as a profit reduction.
For example, ABC International offers a $100 discount to a customer if it pays a $2,000 invoice within 10 days of the invoice date. The customer does so. ABC uses the following entry to record the transaction:
