Finance Tips

The Flaw of Accounts Receivable in Financial Accounting to Non-accountants

In my previous publication, The Unresolved Flaws in Financial Accounting I addressed some of the complex flaws in financial accounting that add to the confusion and frustration non-accountants face in trying to decipher financial reports. This time, I look at accounts receivable.

Accounts receivable is an asset account in a balance sheet. It allows a company to hold revenues and expenses within the period they occur which is a generally accepted accounting principle. This recognizes transactions irrespective of when actual payments take place. What this means is that when a firm sells on account, it considers future payments for its goods and/or services as assets thus increasing revenue.

To a non-accountant investor or stockholder, this recording appears easy to understand on a newly released balance sheet. The truth is that there are other entries that derive from the accounts receivable recording. The net realizable value of this account is the actually amount that the firm expects it will actually receive in payments. Off the back, that means that the amount recorded in accounts receivable though making assets look good will not be actualized. This amount is however an estimate based on previous experiences, trends, and ratios.

The net realizable value creates another account, the allowance for bad debt expense. This account holds the difference between what that actual accounts receivable and the net realizable value. Most firms use an aging method, usually in 30-day blocks to make adjustments to the value of their assets on the balance sheet. These uncollectible payments are described as “contra assets” because they reduce the vale of previously declared assets.

Most non-accountants do not understand the forward and backward entries and adjustments to pages and pages of detail reporting regardless of how many pages of accompanying notes there are. The question becomes, why not subtract the estimated bad debt from the account receivable entry? The problem is that though the firm knows or rightfully estimates that some payments will not be received, it cannot write-off an account unless it specifically knows which accounts will be in default.

The danger with this estimated is that if the allowance for bad debt is under estimates, then accounts receivable and net income will be overstated and returns on investments and equity (ROI and ROE) will be inaccurate. This usually is the case when an entity wants to appear conservative in its estimates of uncollectible debts. Continue reading ‘The Flaw of Accounts Receivable in Financial Accounting to Non-accountants’ »

What is an account receivable? What is the significance of this accounting transaction and what can affect the amount of the receivable recorded? To start, accounts receivable is one of a series of accounting transactions that deals with billing customers when money is owes to a company or organization for a service that was provided in the past to a customer. Typically the business will generate an invoice for the customer who must pay on that debt within a pre-determined time period. This established time period is called either a credit or the payment terms. So far the idea of accounts receivable appears to be simple. A good or service is provided with a credit to a customer who is then billed for those services rendered in the form of an invoice which is in turn paid within a payment term. The credit is matched to the expenses of the company or organization in order to balance out the entities financial statements; accounting for all of the funds passed in the transaction. But, there are factors that would cause the amount recorded in the accounts receivable to differ from the original net realizable value. To clarify the net realizable value is the amount that originally was expected to be paid by the customers in order to settle their obligation. One such factor that would change this recorded amount would be the bad debt expense.

A bad debt expense, also referred to as an uncollectible accounts expense, represent the accounts receivable that are not expected to be collected. This estimated expense is recognized in the fiscal period of the sale by the company whenever it permits the customer to purchase a good or service with credit. Companies and organizations understand that when a good or service is purchased with credit there is a probability that the customer will not pay on that good or service in the future as agreed upon in the payment terms. Some bad debt losses are inevitable. Individual companies or organizations face the idea of bad debt losses in completely different ways. One entity when making a credit sale will place internal control policies and procedures to make sure that the loss is as minimal as possible. Doing so guarantees that every effort to collect the lost debt is made to collect the amount owed. On the opposite side of the spectrum a different entity would openly accept high risk customers knowing ahead of time that there is a chance they will experience a lot of debt loss. This may seem hazardous to the company or the organization in the long run. But, to maximize the return of investment, the entity will have the customer place a down payment on the service or good that is almost equal to the cost of that item. The company may choose to take on this extra risk in the second example to ensure a higher sales volume. The credit standards are not as tough which opens up a larger customer base. This is what a company considers when deciding how it wants to approach the possibility of bad debt loss. But how is a bad debt expense recorded within accounts receivable? Continue reading ‘Receivables, Bad Debts and Reserves. Oh my!’ »