6.3 Accounts receivable

Accounts receivable are a crucial aspect of a company's financial management. They represent money owed by customers for goods or services provided on credit, impacting cash flow and financial health. Understanding accounts receivable is essential for assessing a company's liquidity and credit risk.

This topic covers the accounting treatment, valuation, and reporting of accounts receivable. It explores methods for estimating uncollectible accounts, handling notes receivable, and factoring arrangements. The section also discusses important financial ratios and disclosure requirements related to accounts receivable.

Definition of accounts receivable

• Accounts receivable represents the amount of money owed to a company by its customers for goods or services provided on credit
• Arises when a company allows customers to purchase goods or services without immediate payment, extending credit terms
• Represents a current asset on the balance sheet as the amounts are expected to be collected within a year or the company's operating cycle

Accounting for accounts receivable

Initial recognition of receivables

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• Accounts receivable are recognized when a company has delivered goods or rendered services to a customer and has the right to collect payment
• Recorded at the invoice amount, which is the amount the company expects to receive from the customer
• Journal entry: debit Accounts Receivable and credit Sales Revenue for the invoice amount

Measurement of accounts receivable

• Initially measured at the fair value of the consideration receivable, which is usually the invoice amount
• Subsequent measurement depends on the time value of money and the collectability of the receivables
• If the receivable is due within one year, it is recorded at the original invoice amount without discounting

Valuation of accounts receivable

• Accounts receivable are reported at their net realizable value, which is the amount expected to be collected from customers
• The net realizable value is determined by subtracting the allowance for doubtful accounts from the gross accounts receivable balance
• The allowance for doubtful accounts is an estimate of the uncollectible portion of the receivables based on historical experience, customer creditworthiness, and current economic conditions

Presentation in financial statements

• Accounts receivable are presented as a current asset on the balance sheet, typically listed after cash and cash equivalents
• The gross accounts receivable balance is reported, along with the allowance for doubtful accounts as a contra-asset account
• The net accounts receivable balance (gross receivables minus allowance) is the amount expected to be collected and is used in financial analysis and ratio calculations

Estimating uncollectible accounts

Allowance method vs direct write-off method

• The allowance method estimates uncollectible accounts in advance and records an allowance for doubtful accounts, which is adjusted periodically
• The direct write-off method recognizes bad debt expense only when a specific account is identified as uncollectible and is written off against accounts receivable
• The allowance method is preferred under generally accepted accounting principles (GAAP) as it matches the expense to the period in which the revenue was earned

Aging of accounts receivable

• Aging of accounts receivable is a technique used to estimate the allowance for doubtful accounts based on the age of outstanding invoices
• Receivables are grouped into age categories (e.g., current, 1-30 days past due, 31-60 days past due) and a percentage of uncollectible accounts is assigned to each category based on historical experience
• The estimated uncollectible amounts for each age category are summed to determine the total allowance for doubtful accounts

Percentage of sales method

• The percentage of sales method estimates bad debt expense as a percentage of credit sales for the period
• The percentage is based on historical experience and is applied to the period's credit sales to determine the bad debt expense
• The journal entry is: debit Bad Debt Expense and credit Allowance for Doubtful Accounts for the estimated amount

Percentage of receivables method

• The percentage of receivables method estimates the allowance for doubtful accounts as a percentage of the ending accounts receivable balance
• The percentage is based on historical experience and is applied to the gross accounts receivable balance to determine the allowance
• The journal entry is: debit Bad Debt Expense and credit Allowance for Doubtful Accounts for the difference between the estimated allowance and the existing allowance balance

Accounting for notes receivable

Characteristics of notes receivable

• Notes receivable are written promises to pay a specific amount on a specific date, typically arising from sales, financing, or other transactions
• Notes receivable are more formal than accounts receivable and usually have a stated interest rate and a specific maturity date
• Notes can be short-term (due within one year or the operating cycle) or long-term (due beyond one year)

Calculating interest on notes receivable

• Interest on notes receivable is calculated using the stated interest rate and the principal amount of the note
• The formula for calculating interest is: Interest = Principal × Interest Rate × Time (in years)
• Interest income is recognized over the life of the note using the effective interest method, which allocates interest income based on the carrying amount of the note

Discounting of notes receivable

• When a company receives a note receivable, it may choose to sell or discount the note to a financial institution to obtain immediate cash
• Discounting a note receivable involves selling the note at a price lower than its face value, with the difference representing the discount or interest income for the financial institution
• The journal entry for discounting a note receivable is: debit Cash and Discount on Notes Receivable, and credit Notes Receivable for the face value of the note

Derecognition of notes receivable

• Notes receivable are derecognized when the note is collected, sold, or written off as uncollectible
• When a note is collected, the journal entry is: debit Cash and credit Notes Receivable for the face value of the note, and debit Interest Receivable and credit Interest Income for any accrued interest
• When a note is written off as uncollectible, the journal entry is: debit Allowance for Doubtful Accounts and credit Notes Receivable for the face value of the note

Factoring of accounts receivable

Types of factoring arrangements

• Factoring is the sale of accounts receivable to a third party (the factor) at a discount in exchange for immediate cash
• Recourse factoring: the company is responsible for any uncollectible accounts, and the factor has the right to collect from the company for any unpaid invoices
• Non-recourse factoring: the factor assumes the risk of uncollectible accounts and has no recourse against the company for unpaid invoices

Risks and benefits of factoring

• Benefits of factoring include improved cash flow, reduced collection costs, and the transfer of credit risk to the factor (in non-recourse arrangements)
• Risks of factoring include the cost of factoring (the discount on the receivables), potential loss of customer relationships, and the loss of control over the collection process

Accounting for factoring transactions

• In a factoring arrangement, the company derecognizes the accounts receivable and recognizes the cash received and any factoring fee or discount
• The journal entry for factoring with recourse is: debit Cash and Factor's Commission Expense, credit Accounts Receivable, and credit Due to Factor for any unpaid balance
• The journal entry for factoring without recourse is: debit Cash and Factor's Commission Expense, and credit Accounts Receivable for the full amount of the receivables sold

Disclosure requirements

Disclosure of credit policies

• Companies should disclose their credit policies, including the terms of sale, the length of the credit period, and any incentives for early payment
• The disclosure should also include information about the company's process for evaluating customer creditworthiness and monitoring credit risk

Disclosure of allowance for doubtful accounts

• Companies should disclose the method used to estimate the allowance for doubtful accounts (e.g., aging analysis, percentage of sales, or percentage of receivables)
• The disclosure should include a rollforward of the allowance account, showing the beginning balance, additions (bad debt expense), deductions (write-offs), and ending balance

Disclosure of factoring arrangements

• Companies should disclose the existence of factoring arrangements, including the amount of receivables sold, the terms of the arrangement, and whether the factoring is with or without recourse
• The disclosure should also include the impact of factoring on the company's financial statements, such as the reduction in accounts receivable and the recognition of any factoring fees or discounts

Ratio analysis

Accounts receivable turnover ratio

• The accounts receivable turnover ratio measures how efficiently a company collects its receivables and is calculated as: Net Credit Sales ÷ Average Accounts Receivable
• A higher ratio indicates that the company is collecting its receivables more quickly, which is generally favorable
• The ratio can be used to compare the company's performance to industry benchmarks or to its own historical performance

Days sales outstanding (DSO)

• Days sales outstanding (DSO) represents the average number of days it takes a company to collect its accounts receivable and is calculated as: (Average Accounts Receivable ÷ Net Credit Sales) × 365
• A lower DSO indicates that the company is collecting its receivables more quickly, which is generally favorable
• DSO can be used to assess the effectiveness of the company's credit and collection policies and to compare its performance to industry benchmarks

Evaluating credit policies using ratios

• The accounts receivable turnover ratio and DSO can be used to evaluate the effectiveness of a company's credit policies
• If the turnover ratio is low or the DSO is high compared to industry benchmarks, it may indicate that the company's credit policies are too lenient, leading to slow collections and increased credit risk
• Conversely, if the turnover ratio is high or the DSO is low, it may suggest that the company's credit policies are too strict, potentially limiting sales growth
• Management can use these ratios to adjust credit policies, such as tightening credit standards for high-risk customers or offering incentives for early payment to improve collections and reduce credit risk