accounts receivable

Accounts Receivable

Christian Michele

Accounts receivable are relatively liquid assets, usually converting into cash within a period of 30 to 60 days. Therefore, accounts receivable from customers are customers are classified as current assets, appearing in the balance sheet immediately after cash and short-term investments in marketable securities. Sometimes companies sell merchandise on longer-term installment plans, requiring 12, 24, or even 48 month to collect the entire amount receivable from he customer. By definition, the normal period to collect accounts receivable is part of a company’s operating cycle. Therefore, accounts receivable arising from “normal” sales transactions usually are classified as current assets, even if the credit terms extend beyond one year.

Accounts receivable and cash flows.

In a statement of cash flows, the cash receipts from collecting receivables are included in the subtotal, net cash flow from operating activities. Collections of accounts receivable often represent a comp any’s largest and most consistent source of cash receipts. Thus, monitoring the collection receivables an important part of efficient cash management. A limited amount of uncollectible accounts is not only expected-it is evidence of a sound credit policy. If the credit department is overly cautious, the business may lose many sales opportunities by rejecting customers who should have been considered acceptable credit risks.

Estimating the amount of uncollectible accounts

Before financial statements are prepared at the end of the accounting period, an estimate of the expected amount of uncollectible accounts receivables should be made. This estimate is base upon past experience and modified in accordance with current business conditions. Losses from uncollectible receivables tend to be greater during periods of recession than in periods of growth and prosperity. Because the allowance for doubtful accounts is necessarily an estimate and not a precise calculation, professional judgment plays a considerable part in determining the size of this valuation account.

Writing off an uncollectible account receivable

Whenever an account receivable from a specific customer is determined to be uncollectible, it no longer qualifies as an asset and should be written off. To write off an account receivable is to accomplish this consists of a credit to the Accounts Receivable controlling account in the general ledger (and to the customer’s account in the subsidiary ledger), and an offsetting debit to the Allowance for Doubtful Accounts. The important thing to note in this entry is that the debit is made to the Allowance for Doubtful Accounts and not to the Uncollectible Accounts Expense account. The estimated expense of credit losses is charged to the Uncollectible Accounts Expense account at the end of each accounting period. When a particular account receivable is later

determined to be worthless and is written off, this action does not represent an additional expense but merely confirms our previous estimate of the expense. If the Uncollectible Accounts Expense account were first charged with estimated credit losses and then later charged with proven credit losses, we would be double-counting the actual uncollectible accounts expense. The procedures above describe the balance sheet approach to estimating and recording credit losses. This approach is based upon an aging schedule, and the Allowance for Doubtful Accounts is adjusted to a required balance. An alternative method, called the income statement approach, focuses upon estimating the uncollectible accounts expense for the period. Based upon past experience, the uncollectible accounts expense is estimated at some percentage of net credit sales. The adjusting entry is made in the full amount of the estimated expense, without regard for the current balance in the Allowance for Doubtful Accounts.

Some companies do not use any valuation allowance for accounts receivable. Instead of making end-of-period adjusting entries to record uncollectible accounts expense on the basis of estimates, these companies recognize no uncollectible accounts expense until specific receivables are determined to be worthless. This method makes no attempt to match revenue with the expense of uncollectible accounts. Uncollectible accounts expense is recorded in the period in which individual accounts receivable are determined to be worthless, rather than in the period in which the sales were made. In some situations, use of the direct write-off method is acceptable. If a company makes most of its sales for cash, the amount of its accounts receivable will be small in relation to other assets. The expense from uncollectible accounts should also be small. Consequently, the direct write-off method is acceptable because its use does not have a material effect on the reported net income. Another situation in which the direct write-off method words satisfactorily is in a company which sells all or most of its output to a few larger companies which are financially strong. In this setting there may be no basis for making advance estimates of any credit losses.

The internal control of accounts receivable

One of the most important of internal control is that employees who have custody of cash or other negotiable assets must not maintain accounting records. In a small business, one employee often is responsible for handling cash receipts, maintaining accounts receivable records, issuing credit memoranda, and writing off uncollectible accounts. Such a combination of duties is an invitation to fraud. The employee in this situation is able to remove the cash collected from a customer without making any record of the collection. The next step is to dispose of the balance in the customer’s accounts. This can be done by issuing a credit memo indicating that the customer has re turned merchandise, or by writing off the customer’s accounts as uncollectible. Thus, the

employee has the cash, the customer’s account shows a zero balance due, and the books are in balance.

Many retailing businesses minimize their investment in receivables by encouraging customers to use credit cards such as American Express, Visa, and MasterCard. A customer who makes a purchase using one of these cards signs a multiple-copy from, which includes a credit card draft. A credit card draft is similar to a check which is drawn upon the funds of the credit card company rather than upon the personal bank account of the customer. The credit card company promptly pays cash to the merchant to redeem these drafts. At the end of each month, the credit card company bills the credit card holder for all the drafts it has redeemed during the month. If the credit card holder fails to pay the amount owed, it is the credit card company which sustains the loss. Current income tax regulations require taxpayers to use the direct write-off method in determining the uncollectible accounts expense used in computing taxable income.

From the standpoint of accounting theory, the allowance method is better, because it enables expenses to be matched with the related revenue and thus provides a more logical measurement of net income. Therefore, most companies use the allowance method in their financial statements. Notice that conservatism in the valuation of assets also leads to a conservative measurement of net income in the current period. The large the valuation allowance, the large the current charge to uncollectible accounts expense. “Aging” accounts receivable means classifying each receivable according to its age. An aging schedule is useful to management in reviewing the status of individual accounts receivable and in evaluating the overall effectiveness of credit and collection policies. In addition, the schedule is used as the basis for estimating the amount of uncollectible accounts.