Accounts receivable

Uncollectibility of accounts receivable

Accounts receivable is an asset which is the result of accrual accounting. The firm has delivered products or rendered services (hence, revenue has been recognized), but no cash has been received, as the firm is allowing the customer to pay at a later point in time.

Example


The firm sells products with a cost of 100 for 120 to a customer on account. The firm uses the perpetual inventory system.

The journal entry of this transaction is:

T-account Debit Credit  
Accounts receivable 120    
Sales   120  
Cost of goods sold 100    
Inventory   100  

The nominal value of accounts receivable is the legal claim that the firm has on the customers. If all customers pay in full, this is the amount that the firm will collect. However, it is common that some customers end up not paying. The net value of accounts receivable is the nominal amount minus an allowance for uncollectibility. Thus, net accounts receivables is the amount that the firm expects to collect.

Example


In their annual report over 2008, Google presents their accounts receivable after deducting the allowance for uncollectible accounts receivable (annual report).
The net value of accounts receivable is $2,163 million and $2,642 million for 2007 and 2008, respectively. The allowance for 2007 is $33 million, and for $80 for 2008. The percentage that Google expects to be uncollectible is 1.5% (=33/(33+2163)) for 2007 and 2.9% (=80/(80+2642)) for 2008.

The benefit of allowing customers credit consist of the gain on the additional sales that allowing the credit generates. The cost is the risk that accounts will end up uncollectible. To mitigate this risk, it is common practice to perform a credit check before a firm sells products/services to a customer on account. Nevertheless, it is likely that some customers will not be able to pay, as eliminating the risk on nonpayment could very well adversely affect sales. In this section I will focus on how firms account for uncollectible accounts.

Key points:
- nominal accounts receivable refers to the legal claim of the firm on its customers
- the allowance for uncollectible accounts is the amount that the firm expects not to collect
- net accounts receivable is the amount that the firm will be able to collect, which equals nominal accounts receivable minus the allowance for uncollectible accounts

Direct write-off method

Using the direct write-off method means that no allowance is made, and that the company writes down accounts receivable once they are uncollectible. When an account receivable is written off, it is expensed:
bad debt expense                    x
accounts receivable                           x

There are two drawbacks of this method. First, applying the matching principle implies that the cost of the uncollectible accounts need to be expensed in the period of the sale. Giving credit to customers helps to generate sales (if this were not the case, the firm would simply demand payment at time of delivery). Thus, not creating an allowance violates the matching principle. Second, accounts receivable are at the nominal value, whereas the ‘true’ value (the amount that is expected to be collectible) is probably lower. The next two methods overcome these drawbacks.

Key points:
- application of the matching principle implies that the expenses related to uncollectible accounts need to be booked in the period where the sales were made
- with the direct write-off method the expense is booked in the period when the account is uncollectible, which is not in accordance with the matching principle

Percentage of sales method

With the percentages of sales method an allowance is created, as the name suggest, with a percentage of every sale. From past experience the firm learns which percentage of sales eventually turns out to be uncollectible. Each time the firm sells on account, this percentage of the sales is booked as an expense and added to the allowance. When at a later point in time an uncollectible invoice needs to be written off, the allowance is used as a buffer.

Expenses are incurred to increase or form an allowance at the period of the sale, thus satisfying the matching principle. Subsequently, the allowance can be used to write off worthless receivables without the need to book an expense. At the end of the period, the allowance is subtracted from the nominal value of accounts receivable, resulting in net accounts receivable.

Example


From past experience, the firm knows that 2% of sales on account in uncollectible. Sales for the period amount to 400,000. The period’s beginning credit balance of the allowance for uncollectible accounts is 5,000.

The journal entry to book the bad debt expense is:

T-account Debit Credit  
Bad debt expense 8,000    
Allowance for uncollectible accounts   8,000  

During the period, invoices for an amount of 9,000 are written off.

The corresponding journal entry is:

T-account Debit Credit  
Allowance for uncollectible accounts 9,000    
Accounts receivable   9,000  

Suppose end of period accounts receivable (after the above journal entry) amounts to 500,000.

The presentation of accounts receivable on the balance sheet will be:

Accounts receivable, nominal  500,000  
Allowance for uncollectible accounts   -4,000  
  _______  
Accounts receivable, net 496,000  

Key points:
- with the percentage of sales method the firm books expenses at the time of the sale into an allowance, which is used when invoices turn out to be uncollectible

Ageing of accounts method

With the ageing of accounts method also an allowance created. Unlike the percentage of sales method, the expense is not booked at time of sales, but at the period’s end instead. In addition, the amount of the expense is not related to the sales, but it is reverse-engineered from a targeted balance of the allowance. The ageing of accounts procedure results in an expected uncollectible amount for the accounts receivable at the period’s end. It attributes a probability of uncollectibility depending on the age of the invoice. The older the invoice, the more likely it is it will be uncollectible. These percentages are again based on past experience. The uncollectible amount for total accounts receivable is the sum of the uncollectible amounts for each individual invoice. The expected uncollectible amount is the target balance of the allowance. The bad debt expense for the period is the difference between the targeted balance of the allowance and the current balance.

Example


End of year accounts receivable is 250,000. The allowance for uncollectible accounts has a debit balance of 5,000. The ageing of accounts procedure indicates that 7,000 is expected to be uncollectible.

The target balance of the allowance is 7,000 credit. The current balance is 5,000 debit, this means bad debt expense is 12,000.

T-account Debit Credit  
Bad debt expense 12,000    
allowance for uncollectible accounts   12,000  

Key points:
- the ageing of accounts method creates the allowance at year’s end; the expense in this method is the amount that is needed to get the allowance to the amount that is expected to be uncollectible

Management discretion

The percentage of sales method to account for uncollectible accounts is not allowed under IFRS. The IASB (standard setting body) believes that management has too much discretion to estimate the percentage that is used to calculate the expense. The concern is that if earnings is a little low (or too high), management will use this discretion to use a lower (or higher) percentage in order to ‘smooth’ earnings. Also, even an unmanaged percentage can turn out to be too low or too high. After several years the allowance it could an unrealistic number, totally unrelated with the true risk in accounts receivable.

The ageing of accounts method is allowed under IFRS. Even though there is discretion with this method as well, the allowance is directly related to the risk assessment of end of the period’s accounts receivable. It is possible to use both methods, by applying the percentage of sales during the year and at year’s end use the ageing of accounts method so that the allowance reflects the risk in accounts receivable. This approach combines the advantage of matching of the percentage of sales method and the risk assessment of the ageing of accounts method. This approach is allowed under IFRS.

Key points:
- IFRS does not allow the percentage of sales method, because the end of year value of the allowance is not directly related with the risk assessment in end of year accounts receivables (instead, it is directly related to the sales in the past)

Continue with reading the next tutorial: Long term assets



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