Accounts Receivable

Accounts Receivable is the accounting system that is designed to keep track of who owes your company money and why. It also needs to post deposits, issue credit memos, prepare statements, and send dunning letters, etc. Whether computerized or not, these are the basic functions the Accounts Receivable system must provide. This chapter will discuss the terminology and functions of the system.

Goods and Services

Whether a company provides goods or services or some combination of both, they are going to charge for them. The selling process brings customers to the business who want to pay for the items. Accounts Receivable kicks in once the sale is made, and handles various actions including recording the amount owed and, eventually, getting the money paid and into the checking account.

The work flow consists of:

• Purchase Order: A request to buy goods or services (not always needed).
• Sale Made/Shipped: Goods or services performed or delivered.
• Invoice Sent to Customer: Paper or electronic notice sent to customer.
• Payment Received: Money received from customer.

It is possible a sale could be made without a prior purchase order and it is also possible that the customer pays in cash at the time of the sale. In that example, only a single journal entry is needed:

More likely, the sale will be made on credit, with payment to be made within a specified time frame (such as 30 days). The journal entries to record the credit sale are shown below:

This is the basic journal entry record for sales made on credit to the customer.

Customers

Customers are the people for whom you will produce a product or perform a service, and you expect to get paid by them for that product or service in return. Whether or not you call them customers or clients is largely a matter of professional preference. Most lawyers and other service-oriented firms tend to refer to them as clients while most product-oriented firms tend to use the customer terminology. No matter what you call them, they are the same thing: people from whom we hope to receive money!

Accounting systems generally keep track of customer demographic information, including possibly multiple ship-to addresses, payment terms, and notes about the customer, etc. While the customer data is needed to record sales transactions, it is also a source of selling/marketing that allows for repeat sales, etc.

Payment Terms

Customers, particular large or repeat customers, will have payment terms with the company. A common payment term such as “net-30” means that payment is due in 30 days. This payment term might be standard for the company; however, some customers may negotiate different payment terms. Often, government entities take longer to pay.

Companies might be able to charge late fees or interest if payment is not made by the due date. Such a charge would be considered miscellaneous income when reported on the income statement.

Tax-exempt Certificate

Many types of sales are subject to sales tax; it is the company’s responsibility to collect the sales tax from the customer and to pay it to the taxing agency in a timely manner. Some customers might be exempt from sales tax and will have a certificate to confirm it. Typically, this information is kept in the customer’s file and is used to prevent the system from charging sales tax at the time the sale is made to the customer.

Detailed Sales Example

Let’s look at an example of a sale, with sales tax and late payment, to see how the journal entries might look.

1. Received a purchase order for $10,000 worth of soccer equipment.
2. Delivered the equipment, charging a $150 delivery charge.
3. Invoiced customer for $10,750 (Equipment-$10,000, Sales Tax $600, delivery $150).
4. After 30 days, payment was not received.
5. Charged a late fee of $100.
6. After 45 days, partial payment of $9,000 was made.
7. After 60 days, a check for the remaining balance of $1,850 was received.

Recording the sale consists of a sales increase and a shipping income increase. You could combine shipping into Sales if you don’t need to track it separately for any reason. The final part is the $600 sales tax liability; that is payable to the taxing agency. The total invoice amount is added to Accounts Receivable, which represents an asset on our balance sheet.

After 30 days, when payment is not received, we add a late charge and send a notice to the customer:

After 45 days, a partial payment was received so we record that by reducing the amount owed and increasing the cash account:

Finally, after 60 days, the remaining balance was paid off so we create another entry to record the money into the cash account and reduce the customer’s balance to zero:

You can see the transactions flowing in and out of the Accounts Receivable account to reflect the sale and subsequent payments. You can also look at a snapshot during the period to see how much money is owed and how much is likely to be received within a month or two (depending upon your credit terms).

Early Pay Discounts

Some companies offer discounts for early payment by using terms such as 2/10, Net 30, which means you take a two-percent discount if you pay within ten days, or you pay the full amount if you pay within 30 days. This discount represents an expense to the company. If, like in the example above, the customer choses to pay within 10 days and takes the discount, the journal entry would be the following:

The Sales Discount account is a contra-revenue account used to reduce the sales revenue. It is an expense of the business (i.e., a cost of receiving payment early). Some companies may choose to report it as an expense although the contra-revenue account is more commonly used.

The example above uses the Gross method to record sales discounts (i.e., the sale is recorded at the full amount) and the amount is reduced only if the discount is taken. Another approach is called the Net method which assumes the customer will take the discount so it records the sale at the discounted amount and adds back the potential discount only if the cost does not take it. The journal entries from the above would appear as follows using the Net method:

When the payment is received, if paid on time, the following is a standard journal entry to reduce Accounts Receivable and increase cash:

However, if the payment is not made in time, then the discount no longer applies, so the following journal entry would be recorded:

Note: An accountant will often suggest discount terms, and the percent will vary based on prevailing interest rates. The discount only makes sense if you can make more money in interest in 20 days than the discount amount you are offered. Of course, if your customers are notoriously slow in paying (such as the government), the discount might make sense. In the U.S., some government agencies are required by law to take the discount if one is offered.

Returns

Occasionally, a customer may decide to return the product they purchased, subject to your policies and a possible restocking fee. Let’s assume we accept returns but do not refund shipping, and we charge a five-percent restocking fee on any returns.

Our initial journal entry for the sale was recorded as shown below:

When the customer decides to return the item, we need to reduce Accounts Receivable and reduce our Sales Tax liability. If we will not receive money from the customer at all, the journal entry would be an exact reversal of the above entry:

However, if the customer accepts our return policy and agrees to pay for shipping and the restocking fee, the journal entry will reflect this as shown below:

After this transaction is posted, the original Accounts Receivable balance is now $650, which reflects payment for the shipping charge of $150 and the $500 restocking fee.

If returns are common in your business or industry, you might want to create a special account to record sales returns. This would be called a contra-revenue account (which means that the balance of this account offsets the corresponding revenue account). This account would then be debited rather than directly debiting the Sales account.

Bad or Uncollectable Debt

Unfortunately, not all payments will be made by the customer for a variety of reasons (e.g., fraud, bankruptcy, etc.). There are a variety of methods for accounting for bad debt.

Direct Write-off

The direct write-off method is simple. Once you realize that the debt will not be collected, you create a journal entry to reduce accounts receivable by the amount of the bad debt:

However, this method is generally not used since it does not match revenues and expenses. If the sale occurs in one year, with the anticipation that payment will be received in the following year, then the actual write-off will not occur in the year the sales was recorded. This violates the matching principle of GAAP.

Bad Debt Allowance

Using the Bad Debt Allowance method assumes that some portion of your sales (or receivables) will not get paid. You can create a special allowance account in anticipation of this. This allowance account reduces the balance expected in the Accounts Receivable account and is treated as an expense on the income statement.

Your balance sheet will now look like the following when reporting Accounts Receivable:

• 1100 Accounts Receivable
• 1101 Allowance for Bad Debt
• Net Receivables

This provides a better picture of what the account value actually is. You will also have an expense on the income statement called Bad Debts Expense.

There are two methods used to compute the balance of the allowance account.

Percentage of Sales

If you offer credit sales, you should keep them in a separate account than the cash sales. So, when you compute the percent, you only compute it on sales that could potentially become bad debt. Unless the cash is counterfeit (which is a different entry), cash sales do not become bad debt. The formula is simple:

• Bad Debts Expenses = (Estimated percent) * Credit Sales

This amount is computed and recorded as an expense, and added to the Allowance contra account by the following journal entry:

Note that the balance sheet account (Allowance for Bad Debt) can continue to grow. If the account balance is increasing each year (meaning, less bad debt than estimated), you will probably adjust your estimation percentage in subsequent years. The allowance account balance should be pretty close to zero balance each year but probably never exactly since it is based on a guess of a future event.

Percentage of Receivables

The Percentage of Receivables approach handles the computation a bit differently. Rather than estimate what the yearly expense is, it attempts to estimate what the balance in the allowance account should be. Then, a journal entry is made to bring the account balance to that amount.

At the period’s end, a company looks at total Accounts Receivable and makes an estimate as to how much is (in dollar terms) likely to remain uncollectable. Typically, the older a receivable is, the less likely it is to be collected. (An aging report is helpful in this computation).

Once this estimate is computed, the balance in the Allowance account is considered. The entry consists of the amount needed to bring the balance in line with the estimate. For example, imagine the contra account has a balance of $2,500. Based on aging schedules and experience, the company believes $9,000 of the Accounts Receivable will be uncollectable. The entry to add the difference ($6,500) to the account is shown below:

Writing Off Debt

Regardless of how you compute the Allowance for Bad Debt amount, the write-off entry for the actual determination that the debt is bad is the same:

Ideally, at the end of the year, the allowance account with be close to zero, indicating your estimation was pretty close. If the contra-account has a large balance, you should revisit how you calculate your estimate. If you are generally using up the entire balance, while it indicates your percentage is good, you might want to compare it to other, similar business to see if actions can be taken to improve your collection rate.

Reporting on Accounts Receivable

The transactions above will also be recorded into the Accounts Receivable asset account (which is hopefully short-term and converted to cash within the year). There are a couple of standard reports and ratios that are commonly computed as part the Accounts Receivable function.

Accounts Receivable Aging

The Accounts Receivable Aging report calculates the age of all of the outstanding invoices and categorizes them into buckets, typically 30, 60, 90 days—although the categories can be anything that makes sense for the business.

For example, if a business has $300,000 in Accounts Receivable, it might have an Aging report as shown below:

Accounts Receivable Aging

Current (<30 days): $125,000

Late (31-60 days):  $45,000

Past due (>60 days): $130,000

This report would indicate collection efforts might need to be stepped up since a good portion of the Accounts Receivable is past due (however, the definition of past due is variable based upon the industry, and payment terms, etc.). In some cases, the normal period might be 60 days so you might age your report to consider 120 days past due.

Accounts Receivable Turnover Ratio

The Accounts Receivable Turnover ratio measures how many times a business converts its Accounts Receivables to cash during a given period. You can use the ratio to get the average number of days it takes for invoices to get paid.

To calculate the ratio, you need to know the period sales on credit and you need to compute an average balance in the Accounts Receivable account. Let’s say we had credit sales of $475,000 for the year. At the beginning of the year, the Accounts Receivable account had a balance of $17,500, and at year’s end, it was $26,000:

•                     Beginning Accounts Receivable Balance:     $17,500
•                     Ending Balance:                                          $26,000
•                     Average Balance:                                       $21,750          ($17,500+$26,000)/2
•                     Turnover Ratio:                                           22 days          ($475,000/$21,750)

A turnover ratio of 22 days is generally pretty good, although you should compare it with similar industries to get a sense of whether or not it is a reasonable number.

Summary

Selling to and collecting payment from customers is a driving force behind revenue for the company. In an ideal environment, customers pay on time, never return anything, and the journal entries are simple. However, in the real world, the accounting system has to deal with those scenarios, plus late payments, early pay discounts, returns, bad debt, and more.