6.3 Accounts receivable

Definition of Accounts Receivable

Accounts receivable represents money owed to a company by customers who purchased goods or services on credit. It's classified as a current asset on the balance sheet because the amounts are expected to be collected within one year or the company's operating cycle, whichever is longer.

Accounts receivable arise whenever a company extends credit terms to customers rather than requiring immediate payment. Understanding how to value, estimate, and report these receivables is central to assessing a company's liquidity and credit risk.

Accounting for Accounts Receivable

Initial Recognition of Receivables

A receivable is recognized when the company has delivered goods or rendered services and has earned the right to collect payment. The receivable is recorded at the invoice amount.

The journal entry at the point of sale:

• Debit Accounts Receivable
• Credit Sales Revenue

for the invoice amount.

Measurement of Accounts Receivable

Accounts receivable are initially measured at the fair value of the consideration receivable, which is typically the invoice amount. If the receivable is due within one year, no discounting for the time value of money is required. For receivables extending beyond one year, you'd need to consider present value, but that situation is uncommon for trade receivables.

Valuation of Accounts Receivable

Accounts receivable are reported at their net realizable value (NRV), which is the amount the company actually expects to collect. You calculate NRV as:

$\text{Net Realizable Value} = \text{Gross Accounts Receivable} - \text{Allowance for Doubtful Accounts}$

The allowance for doubtful accounts is a contra-asset that estimates the uncollectible portion of receivables. It's based on factors like historical loss experience, individual customer creditworthiness, and current economic conditions.

Presentation in Financial Statements

On the balance sheet, accounts receivable appear as a current asset, typically listed right after cash and cash equivalents. Companies report:

• Gross accounts receivable
• Less: Allowance for doubtful accounts (contra-asset)
• Equals: Net accounts receivable

The net figure is what analysts use in financial ratios and liquidity assessments.

Estimating Uncollectible Accounts

Allowance Method vs. Direct Write-Off Method

Two approaches exist for handling bad debts, but they're not equally acceptable under GAAP:

• Allowance method: Estimates uncollectible accounts in advance and records an allowance before specific accounts go bad. This is the method required under GAAP because it satisfies the matching principle, recognizing the bad debt expense in the same period as the related revenue.
• Direct write-off method: Recognizes bad debt expense only when a specific account is actually identified as uncollectible. This method violates the matching principle because the expense often hits a different period than the revenue. It's only acceptable when bad debts are immaterial.

Aging of Accounts Receivable

The aging method is a balance sheet approach that estimates the allowance based on how long invoices have been outstanding. Older receivables are more likely to be uncollectible.

Steps for the aging method:

1. Sort all outstanding receivables into age categories (e.g., current, 1–30 days past due, 31–60 days past due, 61–90 days past due, over 90 days).
2. Assign an estimated uncollectible percentage to each category based on historical experience. For example, current receivables might have a 1% rate, while receivables over 90 days might have a 40% rate.
3. Multiply each category's balance by its estimated uncollectible percentage.
4. Sum the results to get the required ending balance in the allowance account.
5. Record an adjusting entry for the difference between the required balance and the existing balance in the allowance account.

This method directly targets the allowance balance, so any existing balance in the allowance account must be considered when recording the adjusting entry.

Percentage of Sales Method

The percentage of sales method is an income statement approach that estimates bad debt expense as a percentage of credit sales for the period.

1. Determine the historical bad debt percentage (e.g., 2% of credit sales).
2. Multiply the period's net credit sales by that percentage.
3. Record the result directly as bad debt expense, regardless of the existing allowance balance.

Journal entry:

• Debit Bad Debt Expense
• Credit Allowance for Doubtful Accounts

The key difference from the aging method: the percentage of sales method focuses on calculating the expense for the period, while the aging method focuses on calculating the correct allowance balance. This distinction matters on exams.

Percentage of Receivables Method

The percentage of receivables method is similar to the aging method in that it's a balance sheet approach, but simpler. Instead of breaking receivables into age categories, you apply a single estimated uncollectible percentage to the total ending accounts receivable balance.

1. Multiply the gross accounts receivable balance by the estimated uncollectible percentage.
2. The result is the required ending balance in the allowance account.
3. Record an adjusting entry for the difference between the required balance and the current balance in the allowance account.

Journal entry:

• Debit Bad Debt Expense (for the difference)
• Credit Allowance for Doubtful Accounts

Accounting for Notes Receivable

Characteristics of Notes Receivable

Notes receivable are formal written promises (promissory notes) in which the maker agrees to pay a specific amount on a specific date. They differ from accounts receivable in several ways:

• They're documented by a formal legal instrument, not just an invoice.
• They typically carry a stated interest rate.
• They have a specific maturity date.
• They can be short-term (due within one year) or long-term (due beyond one year).

Notes receivable commonly arise from sales transactions, lending arrangements, or the conversion of overdue accounts receivable into a more formal agreement.

Calculating Interest on Notes Receivable

Interest on notes receivable is calculated with this formula:

$\text{Interest} = \text{Principal} \times \text{Interest Rate} \times \text{Time}$

where Time is expressed as a fraction of a year. For example, a 90-day, 6% note with a $\$10{,}000$ principal would generate:

$\text{Interest} = \$10{,}000 \times 0.06 \times \frac{90}{365} = \$147.95$

Interest income is recognized over the life of the note. If a note spans two accounting periods, you'll need an adjusting entry at year-end to accrue the interest earned but not yet received.

Discounting of Notes Receivable

A company holding a note receivable can sell (discount) it to a financial institution to get cash before the maturity date. The bank pays less than the note's maturity value, and the difference is the discount (the bank's compensation for advancing the cash).

Steps to calculate proceeds from discounting:

1. Calculate the maturity value of the note (principal + total interest).
2. Determine the discount period (time from the discount date to the maturity date).
3. Calculate the bank discount: Maturity Value × Discount Rate × Discount Period.
4. Proceeds = Maturity Value − Bank Discount.

The journal entry debits Cash for the proceeds received, and credits Notes Receivable. Any difference between the carrying amount of the note and the cash received is recognized as interest income or interest expense.

Derecognition of Notes Receivable

A note receivable is removed from the books when it's collected, sold, or written off:

• Collection at maturity: Debit Cash for the face value plus interest; credit Notes Receivable and Interest Income (or Interest Receivable if previously accrued).
• Dishonored note (maker defaults): Debit Accounts Receivable (to reclassify the amount owed, including interest, as an open receivable); credit Notes Receivable and Interest Receivable.
• Write-off: If the note is deemed uncollectible, debit Allowance for Doubtful Accounts and credit Notes Receivable.

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. There are two main types:

• Recourse factoring: The selling company retains the risk of uncollectible accounts. If customers don't pay, the factor can demand payment from the seller. Because the seller retains credit risk, this arrangement may not qualify as a true sale under GAAP and could be treated as a secured borrowing instead.
• Non-recourse factoring: The factor assumes the credit risk. If customers don't pay, the factor absorbs the loss. This arrangement is more likely to qualify as a sale and result in derecognition of the receivables.

Risks and Benefits of Factoring

Benefits:

• Immediate cash flow improvement
• Reduced collection costs and administrative burden
• Transfer of credit risk to the factor (in non-recourse arrangements)

Risks:

• Factoring fees reduce the net amount received
• Potential loss of direct customer relationships
• Loss of control over the collection process

Accounting for Factoring Transactions

The accounting treatment depends on whether the arrangement qualifies as a sale or a secured borrowing. The key question is whether the transferor has surrendered control of the receivables.

For a sale without recourse:

• Debit Cash (amount received)
• Debit Loss on Sale of Receivables (the factoring fee/discount)
• Credit Accounts Receivable (full amount of receivables sold)

For a sale with recourse, the entry is similar, but the company may also need to record a recourse liability for the estimated obligation under the recourse provision.

For a secured borrowing (when sale criteria aren't met):

• Debit Cash
• Credit Liability (e.g., Borrowings Secured by Receivables)

The receivables stay on the balance sheet in a secured borrowing.

Disclosure Requirements

Disclosure of Credit Policies

Companies disclose their credit policies so that financial statement users can assess credit risk. Disclosures typically include:

• Terms of sale and length of the credit period
• Incentives for early payment (e.g., 2/10, n/30)
• The process for evaluating customer creditworthiness
• Concentrations of credit risk (e.g., heavy reliance on a few large customers)

Disclosure of Allowance for Doubtful Accounts

Companies disclose the estimation method used (aging analysis, percentage of sales, or percentage of receivables) and provide a rollforward of the allowance account:

This rollforward helps users understand how the allowance changed during the period and whether estimates appear reasonable.

Disclosure of Factoring Arrangements

When a company factors receivables, it discloses:

• The total amount of receivables sold or pledged
• Whether the arrangement is with or without recourse
• The terms of the arrangement, including fees
• The impact on the financial statements (reduction in receivables, recognition of any losses or liabilities)

Ratio Analysis

Accounts Receivable Turnover Ratio

The accounts receivable turnover ratio measures how efficiently a company collects its receivables:

$\text{A/R Turnover} = \frac{\text{Net Credit Sales}}{\text{Average Accounts Receivable}}$

A higher ratio means the company is converting receivables to cash more quickly. You can compare this ratio against industry benchmarks or the company's own prior periods to spot trends.

Days Sales Outstanding (DSO)

Days sales outstanding converts the turnover ratio into the average number of days it takes to collect receivables:

$\text{DSO} = \frac{\text{Average Accounts Receivable}}{\text{Net Credit Sales}} \times 365$

Alternatively: $\text{DSO} = \frac{365}{\text{A/R Turnover}}$

A lower DSO is generally favorable because it means cash is coming in faster.

Evaluating Credit Policies Using Ratios

These two ratios work together to evaluate whether a company's credit policies are appropriately calibrated:

• Low turnover / high DSO compared to industry peers may signal that credit terms are too lenient, leading to slow collections and higher credit risk.
• High turnover / low DSO compared to peers could mean credit terms are too restrictive, which might limit sales growth.

Management uses these ratios to fine-tune credit policies. For example, tightening credit standards for high-risk customers or offering early payment discounts (like 2/10, n/30) can improve collections without sacrificing too much revenue.