Account Receivable, Financial Accounting
Overview:
A Cash or Sales discount is the reduction in the price of a product or service offered to a customer by the seller to pay the due amount within a specified time period.
This is one of the best ways most of the sellers could improve the cash flow for their operations.
The amount of sales discount is deducted from the gross sales to calculate the company’s net sales and recorded in a separate sales discount account.
The sales discount account is reported on the income statement as a contra revenue account which means that it is directly deducted from the gross sales and does not appear in the expense section.
It is also not shown in the face of financial statements as well as in the noted to sales or revenue of financial reports.
Sales discount in income statement may be presented as:
Value of Gross Sales xxx
Less: Value of Sales Discounts (xxx)
Net Sales xxx
Less: Expenses(xxx)
Profit / Loss xxx
Types of Sales Discounts:
In normal business generally, there are two types of discounts. Trade discounts and sales discounts or cash discounts.
Trade discount refers to the reduction in the price of a commodity or service sold to wholesalers at the time of bulk purchases.
Trade discounts are not recorded as sales discounts and deduct directly at the time recording sales.
Sales or Cash Discounts are properly recorded and shown in the financial statements. The common terms used for sales discounts are 10%, 2/15, n/30.
Let’s discuss the step by the step accounting treatment of sales discount.
Initial Recognition of Sales Transaction:
The best practice to record a sales entry is debiting the accounts receivable with full invoice and credit the revenue account with the same amount.
For example, XYZ a cement distributor firm issues an invoice worth $25,000 to a customer allowing 3% discount on invoice price if the customer pays within the 10 days. The XYZ should initially recognize the transaction in the following way:
Dr – Accounts Receivable $25,000
Cr – Sales Revenue $25,000
This entry will recognize the sale amount $25k as well as recognizing the account receivable amount $25K in the income statement. The recognition of the sales is at gross before cash discount since the customer does not make the payment yet.
The discount is applicable only if the customer making the payment and the payments are within the term and condition which is within the 10 days.
Subsequent entry:
In case the customer is making the payment for the goods that they purchase based on the term and condition and the company is using or maintaining the Sales discount account, then here is the entry to records the sales discount as well as the payments from the customer.
Dr – Cash/Bank $24,250
Dr – Sales Discount $750
Cr – Accounts Receivable $25,000
As you can see in this entry, $750 is the sales discount or cash discount which is recorded as expenses and the company received cash only $24,250.
The total account receivable of $25,000 is discharged from the account receivable balance during the time the customer makes payment.
In case the company uses or maintain the allowance for sales discount account, then the records will as the following:
Dr – Cash/Bank $24,250
Dr – Allowance for Sales Discounts $750
Cr – Accounts Receivable $25,000
Both cash or sales discount and allowance for sales discount is the same.
They are the expenses account which is reported in the income statement for the period that the allowance or discount occurs.
The above example is for the case that the customer makes the payment within 10 days and the discount is allowed.
What if the payment is after 10 days?
So if the customer is making the payment after 10 days, the discount is not applicable to them. Then the payment needs to be made in full.
Right?
Here is the entry in case sales discount is not applicable and customer making the payment for all of the invoices:
Dr – Cash/bank $25,000
Cr – Account receivables $25,000
As you can see, full amounts of cash are received and the full amount of account receivables are discharged from the company account.
Here is how the sales or cash discount is calculated.
Calculation of discount amount* = Gross * Discount Percentage
= $25,000*3%
= $750*.
The above are the entries and the calculation of the sales discount.
But, how do we present it in the income statement?
The sales discount will be shown in the company’s profit and loss statement for an accounting period below as the gross revenue of the company.
Suppose the XYZ company recorded only one invoice in their accounting period.
The other only expense for the period is office rent worth $5,000. The income statement of the XYZ Company will show the following figures.
Gross Sales $25,000
Sales Discount ($750)
Net Sales$24,250
Expenses:
Office Rent$5,000
Net Profit / Loss for the Period$19,250.
Account Receivable, Financial Accounting
Sales return is the return of products or commodities by customers to the seller, usually within some agreed time period. There may be countless reasons for sales return but some of the common reasons are:
▪ Goods are defective
▪ Goods are not according to the customer needs
▪ Goods are shipped too late to the customer
▪ Wrong Products sent to the buyer
▪ Products are not according to the specifications
One the buyer identifies these kinds of problems, the buyer will normally need to return the goods back and then asking for returning cash or reducing the credit balance.
These will reduce the sales revenues that are recorded in the income statement.
Accounting Entries for Sales Return:
Accounting for sales return is mainly concerned with the revising of revenue and cost of goods sold previously recorded.
For the seller, revenue can be revised by debiting the sales return account (A contra account by nature) and crediting cash/accounts receivable with the invoice amount.
Here is the entry:
Dr- Sales Return allowance / Revenue
Cr – Cash/Accounts Receivable
This entry will reduce both sales amount and cash or account receivables considering the customer/buyer does not make the payment on the goods that they purchase.
This is not finished yet.
Now we have to deal with inventory/goods that customers just returned.
These inventory/goods need to be stored and recorded in the warehouse.
So when the company’s warehouse physically receives the goods, the inventory account will be debited to increase the asset and the cost of goods sold will be credited.
Here is the entry to recognize inventory and derecognition of the cost of goods sold.
Dr – Inventory / Stock
Cr – Cost of Goods Sold
So one this entry is posted, inventory will be increased and the cost of goods sold will be derecognized.
Now let move to the example,
Example:
ABC cosmetics, A cosmetic distributor deals in two products, Product Y and Product Z.
On 2nd Feb 2020 the firm record credit sales of 10 pieces for product Y and 15 pieces for product Z to one of its old customers at a price of $50 and $25 each respectively.
On 5th Feb 2020, the customer sent back 5 pieces of product Y and 6 pieces of product Z to ABC cosmetics.
The ABC cosmetics purchase product Y at $40 per piece and product Z at $20.
Show the general entries to record sales and sales return in the books of ABC cosmetics.
Solution:
1. On Feb 2, the journal entry to record the sales account.
Dr Account Receivable (ABC cosmetics) $875
Cr Product Y sale (10*$50) $500
Cr Product Z sales (15*$25) $375
2. On Feb 2, the journal entry to adjust inventory and record cost of goods sold account.
Dr – Cost of Goods sold $700
Cr – Product Y (10*$40) $400
Cr – Product Z sales (15*$20) $300
3. On Feb 5, journal entry to record the sales return and adjustment of the buyer’s account.
Dr Sales Return Allowance / Revenue (5*50) $250
Dr Sales Return Allowance / Revenue (6*25) $150
Cr Account Receivable (ABC Cosmetics) $400
4. On Feb 5, journal entry to update the inventory account.
Dr Product Y (5*$40) $200
Cr Product Z sales (6*$20) $120
Cr Cost of Goods Sold $320
At the time of preparing an income statement, the amount in the sales return allowance is deducted from the total sales to calculate the actual sales/net sales of the company.
Sales returns and allowances:
Normally sales returns and allowances are two different kinds of transactions, but accounting treatment for both the transactions is the same and mostly the same account is used to record both types of transactions.
Sales returns occur when a customer returns goods to the seller due to some fault, while the term sales allowance used when the buyer agrees to keep the products, but for a lesser price.
Account Receivable
Introduction:
To know the accounting for bad debts recovered, it is necessary to know what bad debts are and how they arise.
When a company supplies goods to a customer or another business on credit, the company has to recognise the same amount of receivables in their books as to that of the value of sold items.
Let’s say after a certain period, our customer goes bankrupt and is not able to pay for our goods supplied to them.
We then recognise this as a loss which is called bad debts. Let’s assume that lately, our customer wants to pay either in full or in partial, we recognize the payment amount as our income. These are explained in detail below:
Receivables turn to
bad debts:
Initially, a company recognizes a receivable amount owed by a customer to the company as a loss called bad debts.
When a company takes all the actions to make sure receivables are received in full. For example, they may take legal actions against the customer business if they don’t pay after official processes. This makes the company believe that the receivables are no longer recoverable.
Let’s say the company has a receivable amount of $500 from ABC Company. After bankruptcy, the company will put the $500 receivable from ABC Company as bad debts.
This means that the company has recognized a loss against the receivables from ABC Company. The following accounting double entry will be passed in the books of the company:
Debit Bad debts $500 (P&L)
Credit Receivables account $500 (BS)
This entry will directly affect both income statement and balance sheet. Bad debt amount $500 will be recognised as expenses in income statement and account receivable will be reduced by $500.
Read the full article on how to write off the account receivable
Bad debts recovered:
Bad debt recovery is the payment received that was previously written off against a company’s receivables.
As the bad debt creates a loss for the company initially when recorded as bad debt, bad debt recovery generates income for the company when they are recovered.
This recovered amount may be a partial payment received against the total of the written-off amount or it may be a lower amount agreed with the company for the total written-off amount. In either case, the company will recognize it as income for the business.
The example:
In the above example, we assumed that our business had a receivable amount of $500 against ABC Company. This total amount was expensed out as bad debt and was recognized as a loss or expense in the income statement.
Let’s assume, after a specific long time, ABC Company has started its operations again with improved performance and is wealthy now. They offered our company a settlement of $300 against the total amount of $500.
Our company has agreed to ABC Company and received a settled $300. As our company has recognised a loss recently, this will be turned back into income with the rest $200 still as a loss.
Our company will perform the following account double entry after the payment is received from ABC Company.
Debit Cash/bank $300 (BS)
Credit Income $300 (P&L)
The receivables account is not affected in the last entry because we have already credited the receivables account.
Even if the further $200 is recovered from ABC Company, it will not affect the receivables account because in either case the receivables account is credited by the whole amount.
Further $200 received will be treated the same as the $300 received from ABC Company.
Account Receivable
Introduction:
When a company has a policy of selling goods on credit, a lot of
times customers end up not paying the amount they owe to the company.
This expense is referred to as a bad debt expense and its treatment and reporting on the financial statements is a bit raveling.
The International Accounting Standards defines the procedure and
methods to record bad debt expense. The Accounting Standards prefer to create a
provision for bad debts expense on the basis of organizations past experience.
The estimated may be a percentage of total credit sales or total
trade receivables balance. The main logic behind the creation of this provision
is to accommodate the bad debts expense in the accounting period which they relate.
In the other methods matching concept is missing which is against
the rules of accounting.
Provision
for bad debt with example:
The doubt that some invoices are uncollectible is a forecasted
expense. For example, there are 2000 customers who owe you an amount of
$500,000. You estimate that out of these 2000 customers a few would fail to pay
back a total amount of $25,000.
In the present, you don’t know out of the 2000 specifically which
customer would fail to pay their dues but a probable expense of $25,000 has
been estimated.
This implies that you would be unable to credit the accounts
receivable unless you know the customers that are going to default.
In order to deal with this situation instead of waiting for the
customers to be identified, a contra asset account is created against the
accounts receivable which is also known as allowance for doubtful debt or
provision for doubtful debt account. The entry passed to record this procedure
is given below:
Bad debt expense DR xx
Provision for bad debt CR xx
The provision for doubtful debt account is created to reduce the
accounts receivable balance to its net realizable value without having to
credit it.
Since it is a contra asset account it has a credit balance as
compared to the debit balance of accounts receivable.
It is reported on the balance sheet along with the accounts
receivable. In our example given above,
the following entry would have been passed:
Bad debt expense DR 25,000
Provision for bad debt CR 25,000
Hence, on the balance sheet a net amount of $475,000 would be
shown which is the amount expected to be collected from the customers.
Importance
of Allowance for Doubtful Debts:
A debit to the bad debt expense account meant that the amount
would be reported as an operating expense on the income statement.
The allowance for doubtful debt account lets us report the bad
debt expense as soon as the estimate is calculated and help us in portraying a
true and fair view of the financial statements.
Let me explain how. The uncollectible invoices of the current year
will be reported as bad debt at a later point in the future.
If we report this expense on the income statement at the time defaulting customers are identified this would understate the profit and overstate the expense for that year since the bad debt expense is not related to its revenue.
The bad debt expense is related to the revenue generated in the current year.
Hence in order to achieve the goal of matching principle, bad debt expense or doubtful debts should be recognized as soon as they are expected.
In conclusion, to be able to prepare financial statements as per generally accepted accounting rules, allowance for doubtful debt account must be accordingly maintained.
Account Receivable
Revenue:
Revenue also referred to as sales or turnover is the total amount of income that a business has earned through the sale of goods or services to the public.
According to the matching principle and accrual system of
accounting, revenue is recognized or the sale is made when the revenue is
earned i.e. earlier of:
- Delivery of goods to the customer.
- Goods are made available to the
customer.
Hence there are two types of sales: cash sales and credit sales.
As the name suggests, cash sales are when payment is collected at the time of
sale. On the contrary, credit sales are when revenue is accrued.
The sale is made but the payment is collected at a later time in the future. Hence, a background check should be made for every customer making bulk purchases on credit in order to avoid losses. The entry for credit sales is:
Dr_Accounts Receivable
Cr_Sales
Prudence Concept:
As per the prudence concept, revenue shall only be realized when it is certain whereas expenses shall be recognized when they are probable.
This concept exists to avoid overstating the profit or understating the expense. Hence a true and fair view of the financial position of an entity is shown.
Prudence concept applied to sales:
Now when we talk about credit sales, we recognize it when we are certain of collecting the amount i.e. the accrued revenue. However, the chances of fraud still exist.
Hence, at the yearend, an estimate is calculated as a percentage of accounts receivable or sales for the year. This estimate is reported as an operating expense reducing the net income.
It is treated as per the prudence concept and the matching
principle. The probable loss of income related to the sales made this year is reported
as an expense reducing the uncertain revenue recorded as sales.
Since the provision is a contra asset account, in the balance sheet of the entity, accounts receivables are reduced by provision for doubtful debts for the year.
The net amount of accounts receivable is then the amount the company expects to receive only.
Provision/allowance for doubtful debt:
What is the provision?
A provision is a liability of an uncertain amount of time. A provision for doubtful debt is an upcoming loss that would be incurred in the future at an uncertain time.
Even the amount of such expense would be uncertain since it is an
estimate. A provision is to be recorded as an expense if all the following
criteria are met:
- A present obligation (loss of
income) has arisen as a result of a past event (credit sales),
- payment is probable (more likely
than not),
- the amount can be reliably
estimated (percentage of sales or accounts receivable).
The provision for doubtful debt is used in the allowance method of dealing with the bad debt expense.
In conclusion, provision or allowance for doubtful debt is an estimated amount of invoices that would be uncollectible.
Another point to note here is that since these are estimates, we
are unsure of which invoice would default exactly.
Hence we can’t credit the accounts receivable account or the accounts receivable subsidiary ledger as a result of which a contra account is created known as the provision for doubtful debts account.
The entry passed at every year-end regarding the provision is as follows:
Dr_Bad debt expense
Cr_Provision for doubtful debts
In the future, when some accounts actually default and the doubtful debts become bad debts the following entry is booked:
Dr_Provision for doubtful debts
Cr _Accounts Receivable
The provision or reserve account is reduced with a debit entry whereas the accounts receivable accounts are finally credited since we know the exact invoices that have been defaulted.
Account Receivable
Bad debt expense:
Bad debt expense or doubtful debt expense is an operating expense related to the accounts receivable of the company.
It normally happens when the credit customers could not pay off the receivable, then the company already tries their best to recover, yet it could not get any positive results.
Then the company writes off those unrecoverable accounts receivable from its book.
To give you example, let we start from the recording receivable first.
When a company sells its goods or renders its services on credit, the following entry is passed:
Account Receivable Dr
Sales Cr
Account receivable and revenue will be recognized at the same time in the financial statements.
When these accounts receivable fail to pay the amount they owe, the loss incurred by the company is referred to as a bad debt expense. And the expenses are recorded in the current period immediately.
In simpler words, bad debt expense is the noncollectable invoices.
There are two methods of reporting the bad debt expense:
Allowance
method:
In the allowance method, an estimate is calculated every year that is debited to the bad debt expense account.
Hence, before occurrence of a bad debt a provision is created in
order to show a true and fair view of the company.
Direct
write-off method:
In this article, we will focus on the direct write-off method. Contrary to the treatment in the allowance method, we report the bad debt expense when it occurs in the direct write-off method.
The accounts receivable is written off in the year customer provides evidence for the invoice being uncollectible instead of reporting it as a provision in the year the sales to the particular customer was made.
Example:
Nina sold goods to Stephanie for $5,000 on credit in November
2018. This was booked as sales in Nina’s books and an account receivable
balance of $5,000 was reported for the year ended 2018.
In 2019, Stephanie failed to pay back the amount and a bad debt of
$5,000 was recognized.
Instead of creating a provision on 2018, Nina will write off the
bad debt in 2019 by debiting the bad debt expense account and crediting the
accounts receivable as shown below.
Bad debt expense DR $5,000
Accounts Receivable CR $5,000
This means that the bad debt expense for the year 2019 has been
overstated and the profit has been understated whereas bad debt expense for the
year 2018 has been understated and profit for the year has been overstated as
per the matching principle of accounting.
Hence, the company won’t be showing the true and fair view of its
financial statements if the direct write-off method was used since it violates
the basic principles of accounting.
This method delays the recognition of bad debt expense and goes against the prudence concept of accounting.
Any probable outflow of money or loss should be booked as an expense immediately.
Since sales are made on a credit basis there are chances of fraud and default payments which would result as an expense for the company at some point in the future.
An estimate shall be calculated each year and booked as an expense
in order to avoid the wrong treatment of bad debt expense.
The direct write-off method is often used for tax purposes only and can also be used if the bad debt expenses are immaterial. An immaterial amount is usually 5% of the net profit.
So for example, Ali (one of your customers) filed for bankruptcy
in 2019. He owed you an amount of $400 against purchases he made in 2017 that
he can’t pay anymore since his bank loans exceeded his net assets.
Can this bad debt expense be treated as per the direct write-off
method if the net profit for the year ended is $9,000?
The answer is yes since the bad debt expense is immaterial. It is
less than 5% of $9,000 i.e. $450.
It would still be better if the bad debt expenses are booked as
per the allowance method but wouldn’t really affect the reliability of
financial statements since the amount is immaterial.
