Accounts receivable represents the outstanding amount owed to a business from selling products or services on credit. Accounts receivables are itemized in the balance sheet as current assets.
Analyzing the quality of accounts receivables for an entity is essential in assessing its financial stability. Companies accept accounts receivables as it may persuade more sales when customers are willing to buy the product or service but do not have cash on hand.
Accounts receivables are important items in a company’s working capital. Companies cannot expect 100% of accounts receivables to be collected, so an allowance for doubtful debts should be estimated. Companies with poor quality of accounts receivables will face the problem of liquidity and solvency in the future.
Examples of Accounts Receivables
Accounts receivables can be from a sale to a customer on credit, a subscription or installment payment that is due, etc.
For example, Jack wants to buy a $10,000 car but doesn’t have the money at the sale. The car company would invoice him and allow him a 30 day time period to pay off the debt. During that time, the company would record $10,000 in their accounts receivables.
When Jack pays it off, the money will go back to the sales amounts. If Jack doesn’t pay the bill within 30 days, the company would be out of money. For the unpaid accounts receivable, the next step should be to contact the customer.
Accounts Receivable Process
The accounts receivable process starts when a company sells goods or services to customers, including payment terms, discounts, and credit terms in an invoice. Companies need to have strict rules for issuing credit and collecting debt in a good timely manner.
To maintain the proper accounts receivable process, payments should also be applied to the correct customers. Companies should have clerked for accounts receivable whose duties are to track accounts receivable to maintain accurate records and bookkeeping. The company’s collection department should use an aging report to track and list unpaid invoices.
Measurement of Accounts Receivable Under IFRS
Under International Financial Reporting Standards (IFRS), the measurement of accounts receivable is determined by the amount that is due from customers for goods or services that have been sold but not yet collected.
IFRS requires that accounts receivable be recognized when a business has performed a service or sold goods, and the customer has a legally binding obligation to pay for those goods or services.
The measurement of accounts receivable should reflect the expected future cash inflows, taking into account any losses resulting from uncollectible amounts.
The carrying amount of accounts receivable should be reduced by any provisions for doubtful debts which the company does not expect to collect in full.
The calculation of doubtful debts should be based on the best available estimate, taking into account all relevant information, such as the age of the receivable, the customer’s financial condition, and the company’s historical experience with collecting similar amounts.
In general, accounts receivable should be recorded at the amount due from customers, net of any allowances for doubtful debts, and should not be discounted.
However, in certain circumstances, a company may choose to discount its accounts receivable to reflect the time value of money.
In these cases, the discount should be recorded as interest revenue and should be recognized over the period until the discounted amount is due.
Accounts Receivable to Sales Ratio
One simple method of measuring the accounts receivable is with the accounts receivable to sales ratio calculated as accounts receivable for a given period of time divided by its sales over that period of time.
This ratio indicates a company’s unpaid sales percentage. A high account receivable to sales ratio indicates that a company’s position is risky with low quality of accounts receivable.
Accounts Receivable Turnover Ratio
Another method of measuring accounts receivables is with the accounts receivable turnover ratio. It is calculated as sales over a period of time divided by the average accounts receivables balance for that period of time.
The ratio measures how quickly a company can turn its accounts receivable into cash. A high accounts receivable turnover ratio means a company is turning receivables to cash faster.
Days Sales Outstanding
The last method of measuring the quality of accounts receivables with the day’s sales outstanding ratio. The ratio is calculated as average accounts receivable divided by sales and multiplied by 365. The ratio explains the average number of days it takes a company to convert its receivables into cash.
A shorter day’s sales outstanding ratio means a company can receive cash from its accounts receivables more quickly. While the ratio is high, that means longer than 90 days indicates poor quality of corporate earnings.
Classification of Accounts Receivables
Account receivables are classified as trade and other receivables in the balance sheet, including accounts receivables, notes, and other receivables. They are described below:
Accounts receivables are amounts that customers owe the entity for normal credit purchases. When accounts receivables are collected within two months of the sale, they are considered as current assets. Accounts receivables appear on the balance sheets below short-term investments and above inventory.
Notes receivables are those customers who have signed formal promissory notes to acknowledge their debts to the company. Promissory notes strengthen a company’s legal claim against those customers who fail to pay on due time as they promised.
Promissory notes that are due in one year or less are current assets, whereas those that are due in more than one year should be classified as long-term assets.
Other receivables are nontrade receivables usually listed in separate categories on the balance sheet because every type of other receivables has different risk factors and liquidity characteristics.
Examples of other receivables are interest revenue from notes, wage advances, formal employee loans, and loans to other companies.
Are Higher or Lower Accounts Receivable Better?
Generally, having a lower account receivable is better because it means your customers are paying quickly. If your company is growing, you probably noted that your accounts receivables might grow over time and more sales to those customers.
Journal Entry for Accounts Receivables
Account receivable is almost the same as other assets account when it comes to journal entries. It is increasing debt and decreasing in credit.
When the credit sale is made, then the company has the right to collect those credit sales. At the time of sale is made on credit, the journal entries for account receivable and credit sales are as following:
This account receivable could be outstanding for one day up to one month, year, and more. At the time of collection, the company will have to derecognize the collected amount from that specific customer from the outstanding amount.
The journal entries for recording the collected account receivable or the derecognize the account receivable that it is collected are as following:
|Cash or Bank||X,XXX|
How to Improve your Accounts Receivable?
If you face difficulties collecting cash from your customers, you will want to improve your accounts receivable. The following steps may help you to collect the due amounts from your customers:
Offering a Discount
If you want your customers to pay faster, you may need to give them a discount. You may offer your customers to pay on time by offering them an early payment discount.
If your customers don’t pay on time, you may charge a penalty, usually a percentage of the total invoice. This type of penalty can help in chasing customer payments.
Considering Accounts Receivables Financing
Accounts receivable financing can be a good way to improve cash flow. After issuing an invoice, you can transfer the invoice to a factoring company.
They may pay you 80-90% of the invoice in cash and then pay you the remaining portion minus a service fee when the customer pays the factoring company.
Establishing a Business Line of Credit
An alternative to factoring is to establish a business line of credit. You’ll pay your bank interest for the money you have borrowed from your business line of credit and pay some additional fees to keep your credit line open.
Using a Collection Service
If you don’t have time to waste chasing customers for payment, you can outsource a collection service for accounts receivable.
The outsourced service reaches out to customers to remind them of overdue payments. They charge a fee for this service so that you may use the service for problematic customers.
Benefits of Accounts Receivable
It is an important aspect of a business’s fundamental analysis and crucial in managing its cash flow. When your sales are going better, but your customers are not paying on time, you will find yourself in a cash deficit situation, which is very challenging for small companies.
Accounts receivable is a current asset to measure a company’s liquidity to cover short-term obligations. Tracking accounts receivable is important to stay on top to make sure to collect the due amounts.
You should track not only the total accounts receivable number but also which customers are delaying their payments. With this information, you can contact those customers, chase payments, and keep your bank account full accordingly.
Valuating Accounts Receivable
Generally, companies use two methods to account for bad debts: the direct write-off method and the allowance method. GAAP requires companies to use the allowance method.
Direct Write-Off Method
Companies should use the direct write-off method under which bad debts are recognized after the company is certain that the customer will not pay its debt.
Before determining the uncollectible account balance, a company makes several attempts to collect the uncollectible amount from the customer.
The journal entry for bad debts increases bad debts expense accounts and a decrease in accounts receivable accounts. For example, Jack fails to pay a $500 balance.
The company records the write-off by debiting the bad debts expense account and crediting the accounts receivable account.
Under the allowance method at the end of each accounting period, an adjustment is made to estimate bad debts based on the business activity.
Established companies may reply on experience to estimate bad debts, but new companies must reply on published industry averages.
The adjustment entry doesn’t reduce accounts receivable directly. Accounts receivable is a control account that should have the same balance as the combined balance of every individual account receivable account.
What are accounts receivable that cannot be collected?
Accounts receivable that cannot be collected, also known as uncollectible accounts or bad debt, refer to money that a company is owed by its customers for goods or services that have been sold on credit but the customer is unable or unwilling to pay.
In other words, it is money that a company expects to receive from its customers but is unlikely to receive due to various reasons such as bankruptcy, default, or extended non-payment.
Uncollectible accounts are considered a loss for a company and are recorded as a reduction in the accounts receivable account and as an expense on the income statement.
This helps to accurately reflect the financial performance of the company and its ability to collect the money it is owed.
The allowance method is commonly used to estimate the amount of uncollectible accounts and to record the bad debt expense in the financial statements.
This method involves estimating the amount of accounts receivable that will likely become uncollectible and recording that amount as an expense in the income statement.