Accounts receivable is the dollar amount a business is owed by customers who do not pay immediately for products and services. Firms that allow customers to purchase “on account” generate accounts receivable balances, and this account balance has an impact on cash flow management.
Balance Sheet Location
To understand accounts receivable, it’s important to know where the account balance is posted in the financial statements.
Accounts receivable is an asset that is posted to the balance sheet, and this financial statement is created based on the balance sheet formula:
Assets – liabilities = equity
Accounts receivable is an asset, because the balance is converted into cash when a customer pays an outstanding invoice.
Current vs. Non-Current
Assets and liabilities are either current or non-current. A current asset represents cash, or an asset that will be converted into cash within 12 months.
Accounts receivable balances and inventory are current assets. Fixed assets, such as machinery and equipment used in a business, are non-current assets, because they will be used for years.
Using the current asset definition means that all accounts receivable balances must be collected within a year. In most industries, invoices are paid no later than 90 or 120 days after the sale, and accounts receivable balances that are “older” than 120 days may not be collectible, and should be written off as a bad debt expense.
Accrual Basis Method
The accrual basis method of accounting requires a business to post revenue when it is earned, and expenses when they are incurred. This method applies the matching principle, which matches revenue earned with the expenses that are incurred to produce the revenue.
The accrual basis presents a more accurate picture of net income, and this method ignores the timing of cash inflows and outflows.
Accounts receivable balances allow a business to record revenue from a sale before cash is paid, and this transaction complies with the accrual basis method of accounting.
Assume, for example, that you manage a tree service company, and you bill customer Smith $500 for removing a tree on March 25th, and the customer does not pay immediately. Here is the related journal entry to record the sale:
Debit accounts receivable $500 (debit)
Credit revenue- tree removal $500 (credit)
(To record tree removal revenue and to increase accounts receivable)
Both accounts receivable and revenue are increased.
When Smith pays the invoice April 6th, your tree service company posts this journal entry:
Debit cash $500 (debit)
Credit accounts receivable $500 (credit)
(To remove the accounts receivable balance and to record the cash payment)
The cash is received in April, but the revenue is correctly recorded in March.
Handling Bad Debt Expense
As mentioned above, accounts receivable balances that will not be collected should be reclassified to bad debt expense.
Knowing when an individual receivable balance will not be paid can be difficult to determine, so many companies use the allowance method to estimate the dollar amount of bad debt expense that is recorded.
Using the allowance method, a company estimates the dollar amount of bad debt as a percentage of accounts receivable, or a percentage of sales. The percentage is based on historical trends in the business.
Assume, for example, that your tree service company has a $100,000 accounts receivable balance, and that bad debt expense has typically been 2% of accounts receivable. You use the allowance method to post bad debt expense of ($100,000 X 2%), or $2,000 on April 30th:
Debit bad debt expense $2,000 (debit)
Credit allowance for doubtful accounts $2,000 (credit)
(To recognize bad debt expense using the allowance method)
Both bad debt expense and allowance for doubtful accounts are increased. In order to clearly understand the activity in the allowance account, here’s the $2,000 posted to a T-account:
|Allowance for Doubtful Accounts|
Note that a T-account lists the account name at the top, and places a debit column on the left, and a credit column on the right. Dollar amounts are listed below the column descriptions. The T-account will help you understand a second entry that is posted to the allowance for doubtful accounts below.
Bad debt expense is posted, even though the business owner cannot identify each bad debt item. This approach complies with the accounting principle of conservatism.
When an estimate can be made, an accountant should make a judgment that posts expenses sooner, rather than later. This principle gives the financial statement reader a more conservative-looking set of financial statements.
When the owner knows that an invoice will not be paid, the specific receivable amount should be written off.
Assume that you determine that a $400 accounts receivable balance for Jones will not be paid as of May 10th, because the customer declares bankruptcy. Your original entry for the Jones accounts receivable was a debit of $400:
Here is the journal entry to write off the balance:
Debit allowance for doubtful accounts $400 (debit)
Credit accounts receivable $400 (credit)
(To write off the $400 Jones accounts receivable balance)
Both the debit and credit entries are explained in T-accounts below:
|Allowance for Doubtful Accounts|
As you see in the T-account above, the allowance for doubtful accounts balance is reduced with a debit, because the invoice payment is not longer part of an estimate of bad debt expense. Once you know that the invoice will not be paid, you post a debit to remove a portion of the allowance for doubtful account balance.
In the T-account above, The Jones accounts receivable is reduced with a credit entry, because the balance is not longer an invoice that will be paid in cash- no longer an asset. The debits and credits zero out the Jones account receivable balance.
Note, finally, that the May 10th entry does not impact bad debt expense. The expense has already been recorded.
There are a variety of financial ratios that can help a business owner manage accounts receivable, and the impact on cash flow. One useful tool is accounts receivable turnover, which is defined as (net credit sales) / (average accounts receivable).
Net credit sales refers to sales that are not immediately paid in cash, and average accounts receivable is the (beginning balance for a period + ending balance for a period) /2.
Assume, for example, that the tree service company computes accounts receivable turnover for June and August:
June: ($100,000 net credit sales) / ($20,000 average accounts receivable) = 5
August: ($100,000 net credit sales) / ($50,000 average accounts receivable) = 2
The tree service company’s sales are the same in both months, but the average accounts receivable balance has increased dramatically. The increase means that the firm has, on average, $30,000 less cash to work with in August, as compared with June.
This changes may require the company to borrow money, in order to operate in August, and borrowing will require the firm to pay interest expense on the loan balance.
If the average accounts receivable balance increases at a much faster rate than sales, you may have a cash crisis on your hands. Keep a close eye on accounts receivable, so that you generate enough cash to operate your business.