Accounts Receivable Recognition and Valuation

Accounts Receivable Recognition and Valuation

Accounts receivable are unpaid customer invoices representing money owed to a company. It is an asset on the balance sheet until payment is received.

What is Accounts Receivable?

A Receivable arising from goods sold on account. In most Receivable transactions, the amount to be recognized is the exchange price between two parties. The exchange is the amount due from the debtor and is generally evidenced by some types of business documents.

In most receivables transactions, the amount to be recognized is the exchange price between the two parties. The exchange price is the amount due from the debtor (a customer or a borrower). Some types of business documents, often an invoice, serves as evidence of the exchange price.

Two factors that may complicate the measurement of the exchange price are;

  1. Trade and Cash Discounts: The availability of discounts, and
  2. Interest Element: the length of time between the sale and the due date of payments.

Trade Discounts

Prices may be subject to a trade or quantity discount.

Companies use such trade discounts to avoid frequent changes in catalogs, to alter prices for different quantities purchased, or to hide the true invoice price from competitors.

Trade discounts are commonly quoted in percentages.

For example, say your textbook has a list price of $90, and the publisher sells it to college bookstores for a 30 percent trade discount listless.

The publisher then records the receivable at $63 per textbook. Per normal practice, the publisher simply deducts the trade discount from the list price and bills the customer net.

Cash Discounts (Sales Discounts)

Companies offer cash discounts (sales discounts) to induce prompt payment. Cash discounts are generally presented in terms such as 2/10, n/30 (2 percent if paid within 10 days, gross amount due in 30 days), or 2/10, O.M., net 30, E.O.M. (2 percent if paid any time before the tenth day of the following month, with full payment received by the thirtieth of the following month).

Companies usually take sales discounts unless their cash is severely limited. Why?

A company that receives a 1 percent reduction in the sales price for payment within 10 days, with total payment due within 30 days, effectively earns 18.25 percent (.01-e-[20/365J), or at least avoids that rate of the interest cost.

Companies usually record sales and related sales discount transactions by entering the receivable and sale at the gross amount.

Under this method, companies recognize sales discounts only when they receive a payment within the discount period. The income statement shows sales discounts as a deduction from sales to arrive at net sales.

Some contend that sales discounts not taken reflect penalties added to an established price to encourage prompt payment.

That is, the seller offers sales on account at a slightly higher price than if selling for cash. The cash discount offered offsets the increase.

Thus, customers who pay within the discount period purchase at the cash price. Those who pay after the expiration of the discount period pay a penalty for the delay—an amount over the cash price.

Per this reasoning, companies record sales and receivables net.

They subsequently debit any discounts not taken to Accounts Receivable and credit to Sales Discounts Forfeited.

The difference between the gross and net methods is shown below.

Certainly! I’ll provide an example calculation for both the gross method and net method and add it to the table. Let’s assume a company sells goods worth $1,000 with credit terms of 2/10, net 30 (2% discount if paid within 10 days, otherwise, the full amount is due within 30 days).

Here’s the updated table:

#Gross MethodNet Method
RevenueFull invoice amount recorded as revenue initially.Revenue recorded at the discounted amount initially.
DiscountRecognized as a contra revenue account.Not recognized as revenue; recorded as a reduction in A/R.
PaymentIf customer pays within the discount period:
– Debit discount account and credit accounts receivable.
If customer does not pay within the discount period:
– No additional entries.
If customer pays within the discount period:
– Debit accounts receivable and credit discount account.
If customer does not pay within the discount period:
– No additional entries.
FinancialRevenue initially overstated; adjusted if discount taken.Revenue initially understated; adjusted if discount not taken.

Example Calculation:

Assuming the customer pays within the discount period (10 days) using the gross method:

Gross Method:
Debit: Accounts Receivable $1,000
Credit: Sales Revenue $1,000
Credit: Sales Discount $20 (2% of $1,000)

The net amount received from the customer would be $980 ($1,000 – $20 discount).

Now let’s calculate the net method:

Net Method:
Debit: Accounts Receivable $980 ($1,000 – $20 discount)
Debit: Sales Discount $20 (2% of $1,000)
Credit: Sales Revenue $1,000

In this case, the net amount received from the customer remains the same at $980.

I have updated the table with the example calculation.

If using the gross method, a company reports sales discounts as a deduction from sales in the income statement.

Proper expense recognition dictates that the company also reasonably estimates the expected discounts to be taken and charges that amount against sales.

If using the net method, a company considers Sales Discounts Forfeited as an “Other revenue” item. Theoretically, the recognition of Sales Discounts Forfeited is correct.

The receivable is stated closer to its realizable value, and the net sales figure measures the revenue earned from the sale.

As a practical matter, however, companies seldom use the net method because it requires additional analysis and bookkeeping.

For example, the net method requires adjusting entries to record sales discounts forfeited on accounts receivable that have passed the discount period.

Non-recognition of Interest Element

Ideally, a company should measure receivables in terms of their present value, that is, the discounted value of the cash to be received in the future. When expected cash receipts require a waiting period, the receivable face amount is not worth the amount that the company ultimately.

Assume that Best Buy makes a sale on account for $1,000, with payment due in four months. The applicable annual rate of interest is 12 percent, and payment is made at the end of four months.

The present value of that receivable is not $1,000 but $961.54 ($1,000 x0.96154). In other words, the $1,000 Best Buy receives four months from now is not the same as the $1,000 received today.

Theoretically, any revenue after the period of sale is interest revenue.

In practice, companies ignore interest revenue related to accounts receivable because the amount of the discount is not usually material to the net income for the period.

The profession specifically excludes from present value considerations “receivables arising from transactions with customers in the normal course of business which is due in customary trade terms not exceeding approximately one year.”

Valuation of Accounts Receivable

Generally, Receivable arising from goods sold or services. The valuation of receivables is slightly more complex. Short-term receivables are valued and reported at their net realized or expected cash value.

Accounts Receivables should be recorded net of any discounts expected to be taken and any anticipated sales returns or allowances, any unearned finance or interest changes included in their face amount, and any anticipated uncollectible items.

Reporting of receivables involves;

  1. Classification and
  2. Valuation on the balance sheet.

Classification involves determining the length of time each receivable will be outstanding. Companies classify receivables intended to be collected within a year or the operating cycle, whichever is longer, as current.

All other receivables are classified as long-term. Companies value and report short-term receivables at a net realizable value, the net amount they expect to receive in cash.

Determining net realizable value requires estimating both uncollectible receivables and any returns or allowances to be granted.

Uncollectible Accounts Receivable

Sales on any basis other than cash make uncertain the possibility of collecting the account.

An uncollectible account receivable is a loss of revenue that requires, through a proper entry in the accounts, a decrease in the asset accounts receivable and a related decrease in income and stockholders’ equity.

Companies recognize the loss in revenue and the decrease in income by recording bad debt expenses.

Methods of Recording Uncollectaible

Companies use two procedures to record uncollectible accounts:

  1. Direct Write-off Method.
  2. Allowance Method.

Direct Write-off Method

No entry is made until a specific account has definitely been established as uncollectible.

Then the loss is recorded by crediting Accounts Receivable and debiting Bad Debt Expenses. This method is not GAAP.

Allowance Method

An estimate is made of the expected uncollectible accounts from all sales made on account or from the total of outstanding receivables.

This estimate is entered as an expense and an indirect reduction in accounts receivable via an increase in the allowance account in the period in which the sale is recorded.

This method is GAAP.

A receivable is a prospective cash inflow. The probability of its collection must be considered in valuing cash flows.

These estimates normally are based either on the following;

  1. Percentage of Sales (Income Statement) Approach), or
  2. Outstanding Receivables (Balance Sheet) Approach.

Percentage of Sales (Income Statement Approach)

Suppose there is a fairly stable relationship between the previous year’s credit sales and bad debts. In that case, a company can convert that relationship into a percentage and use it to determine this year’s bad debt expense.

The percentage of Sales approach matches costs with revenues because it relates the charge to the period in which a company records the sale.

To illustrate, assume that Chad Shum Way Corp estimates from experience that about 2 percent of credit sales become uncollectible.

If Chad Shum Way has credit sales of $400,000 in 2010, it records bad debt expense using the percentage-of-sales method as follows:

DateAccounts TitleRefDebitCredit
Bad Debt Expense 8,000
Allowance for Doubtful Accounts8,000

The Allowance for Doubtful Accounts is a valuation account (a contra asset), subtracted from trade receivables on the balance sheet.

The amount of bad debt expense and the related credit to the allowance account are unaffected by any current balance in the account.

Because the bad debt expense estimate is related to a nominal account (Sales), any balance in the allowance is ignored.

Therefore, the percentage-of-sales method achieves a proper matching of cost and revenues. This method is frequently referred to as the income statement approach.

Outstanding Receivables (Balance Sheet) Approach

Using past experience, a company can estimate the percentage of its outstanding receivables that will become uncollectible without identifying specific accounts.

This procedure provides a reasonably accurate estimate of the receivables’ realizable value. But, it does not fit the concept of matching cost and revenues.

Rather, it simply reports receivables in the balance sheet at net realizable value. Hence it is referred to as the percentage-of-receivables (or balance sheet) approach.

Companies may apply this method using one composite rate that reflects an estimate of the uncollectible receivables.

Or, companies may set up an aging schedule of accounts receivable, which applies a different percentage based on past experience to the various age categories.

An aging schedule also identifies which accounts require special attention by indicating the extent to which certain accounts are past due.

Companies usually do not prepare an aging schedule to determine bad debt expenses.

Rather, they prepare it as a control device to determine the receivables composition and identify delinquent accounts.

Companies base the estimated loss percentage developed for each category on previous loss experience and the advice of credit department personnel.

Problems in the Valuation of Accounts Receivables

The basic problems that occur in the valuation of Accounts Receivables arc-

  • The determination of the face value of the Accounts Receivable because it is a function of the trade discount, cash discount, and certain allowance accounts such as the allowance for sales returns and
  • The probability of future collection of the accounts
  • The length of time between the sales and the due date of payments (the interest clement).