Finance Tips

Accounts receivable represent amounts due from customers who have purchased merchandise on credit and who have agreed to pay within a specified period or when billed by a company. Since all accounts receivable represent a portion of purchased merchandise on credit it is a given that some of the income represented within the account will not actually be received by the company. Due to this business phenomenon it becomes necessary for any company to account for this loss on the balance sheet. Commonly named bad debts expense this has become a major focal point in recent financial history because of the credit crisis in the subprime mortgage industry. For companies that issued subprime mortgages there is an internal assumption that a large portion of the accounts receivable or credit debt will not be repaid. The reason a company can handle such a large amount of risk is due to overall sales volume. By having a large clientele base revenues can be increased enough to cover the overall loss, but as recent history shows one shift in the current economic climate can have drastic consequences to not just one industry but to the global economy depending on how leveraged the world economy is to any one economic environment. In the case of the US mortgage market we found that it was not only the mortgage companies but all of the subsidiary investors which took on a portion of the risk by chasing large rewards, these risks created an overly leveraged market. As investors continued to build housing in the hope of riding increases in housing prices they created an excess in housing inventory, which in turn devalued the houses on the market as well as those being built. When localized household wealth declined mortgage lenders lost capital and the ability to fund refinancing and the necessity for an increase in the adjustable rates on existing home loans. Since there was already too much risk inherent in the market those borrowers who were questionable to begin with defaulted at an ever increasing rate until the market collapsed around them. These defaulted borrowers have to be accounted for on the books, and this is what we will take a closer look at.

When a purchaser buys merchandise on credit certain entries must be made to the accounting ledger. Let’s say NEC Inc. sells some coffee cups on credit. If we assume the cups were already produced and in inventory then Cost of Goods Sold (COGS) is debited for the manufacturing cost and Inventory is credited for the same amount, say 7,000 dollars. This takes care of the internal cost of producing those cups. Next Accounts Receivable is debited $10,000 and the Sales account is credited $10,000. Now NEC Inc. has transferred the COGS to the customer but instead of increasing cash flow it has only increased the money owed in the form of accounts receivable. Like your average consumer credit card when goods or services are sold from one company to another some form of payment timeline is agreed to, but for ease of use we will assume the retailer who purchase the cups agreed to pay the total amount in full that the end of the month. However, just few days later a natural disaster strikes and not only is the retailer completely destroyed but all possible liable parties are affected to the point where they cannot pay their debts. Now NEC Inc. has 10,000 dollars the on the books that should have become cash flow but instead will never be recouped. Continue reading ‘Matching Receivables: How to Account for Bad Debt’ »

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’ »

Do you have a lot of debt? Too many unpaid bills? Have you lately faced a major financial set back, such as a bankruptcy? Have you simply not had credit long enough to set up, good credit? Have you defaulted on a loan, missed a tax payment, or recently been reported to a collection agency? The problems that cause your credit problems should confirm how you decide to better your credit score. As you read through this article and others I have published, highlight or make a note of those tips that apply to you and from them make a checklist of things you can do that would help your credit status, improve. When you look for, professional credit counseling or credit advise, counselors will generally work with you to help you develop a personalized method that specially addresses your credit problems and financial history. Now, with this article and others I have published, you can develop a similar method on your own – in your own time and at your own cost.

When developing your action plan, know where most of your credit score is coming from:

1) Your credit history (accounts for more than a third of your credit score in some cases). Whether or not you have been a good credit risk in the past, is considered the best measure of how you will respond to debt in the future. For this reason, late payment, loan defaults, unpaid taxes, bankruptcies, and other unmet debt obligations will count against you the most. You can’t do much about your financial past now, but beginning to pay your bills on time – starting today – can help boost your credit score in the future. Continue reading ‘A method for dealing with your credit score’ »

If you don’t understand how your credit score works, you will also be at the mercy of any firm that tries to tell you how you can improve your score – on their conditions and at their price. In general, your credit score is a number that lets lenders know how much of a credit liability you are. The credit score is a number, commonly between 300 and 850, that lets lenders know how well you are paying off your debts and how much of a credit risk you are.

In general, the greater your credit score, the better credit risk you make and the more probable you are to be given credit at excellent rates. Scores in the low 600s and below will often give you probelms in finding credit, while scores of 720 and above will normally give you the best interest rates out there. Nevertheless, credit scores are a lot similar to GPAs or SAT scores from college days – while they give others a quick image of how you are doing, they are explained by people in different ways.

Some lenders put greater significance on credit scores than others. Some lenders will work with you if you have credit scores in the 600s, while others give their best rates only to those creditors with very high scores indeed.Some lenders will look at your complete credit report while others will accept or reject your loan application based purely on your credit score.

The credit score is derived on your credit report, which consist’s of a history of your past debts and repayments. Credit agencies use computers and mathematical calculations to arrive at a credit score from the information enclosed in your credit report. Each credit agency uses separate solutions to do this (which is why you will have different scores with different companies) but most credit bureaus use the FICO system. FICO is an acronym for the credit score calculating software offered by Fair Isaac Corporation company. This is by far the most used software since the Fair Isaac Corporation made the credit score model used by many in the financial industry and is still acknowledged, one of the leaders in the field. In fact, credit scores are frequently called FICO scores or FICO ratings, although it is important to realize that your score may be tabulated using other software.

One other thing you may want to understand about the software and mathematics that goes into your credit score is the fact that the math used by the software is based on research and approximate mathematics. This is an important and easy concept that can help you understand how to improve your credit score. In understandable terms, what this means is that your credit score is in a way calculated on the same principles as your insurance premiums. Your insurance company likely asks you questions about your health, your lifestyle habits (such as whether you are a smoker) because these bits of information can let the insurance company know, how much of a risk you are and how likely you are to make substantial claims, later on. This is based on research. Continue reading ‘Where do credit scores come from ?’ »

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!’ »