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Understanding and being able to calculate your accounting receivables is a vital skill for any small business.
In fact, it could affect the life and death of a business.
Account receivables that were never paid have destroyed innumerable businesses.
How do you keep that from happening to your business?
What are accounting receivables?
Accounts Receivable are the amount of money owed by the customers for goods or services purchased by them on credit. A receivable account can be created by someone who sells goods or services and extends a line of credit to its customers. They are also known as trade creditors or commonly abbreviated as “AR” & “O2C” (Order to Cash).
In layman terms, the total amount which is yet to be collected by debtors as per a firm’s sales book is termed as accounts receivables. Large firms using ERP packages replace traditional sales book with sales ledger control account.
The buyer can be a sole trader, a partnership firm or a full-fledged business. It is a short-term gain, hence an asset that is supposed to be received from the customers. Accounts receivables are shown on the asset side under the head current assets (right-hand side of a horizontal balance sheet).
Related Topic – What is Days Sales Outstanding (DSO)?
Let us assume that you sold goods worth 10,000 to one of your buyers who is supposed to pay you within 45 days of the day you bill him. Now, you send the customer an invoice for 10,000. In this case, the amount acts as dues to be received and will be booked in your records as accounts receivable.
It is similar to the situation where your mobile phone company generates an invoice on the 1st day of a month and gives you 30 days to pay the bill. It is an account receivable for the mobile phone company.
- Accounts receivable are created when you sell goods on credit.
- Accounts receivable should be collected from the customers within an agreed period of time.
- Accounts receivable are short-term gains, hence shown on the asset side under the head “current assets” of the balance sheet.
Journal Entries Related to Accounts Receivable
Below are the two main scenarios linked to accounts receivable cycle where, in the first case, credit sale is recorded and the customer is assumed to be billed, and, in the second case, cash proceeds from customers are recorded in the books of accounts.
At the time of recording a credit sale and billing the customer
|Accounts Receivable A/C||Debit|
|To Sales (on credit) A/C||Credit|
(This can also be recorded at a particular customer level subledger wise, in that case, the customer who is billed will be debited)
At the time of money received from customer
|Cash or Bank A/C||Debit|
|To Accounts Receivable A/C||Credit|
(This can also be recorded at a particular customer level subledger wise, in that case, the customer paying for the goods/services will be credited)
Accounts receivables can be considered as an investment made by the business that includes both risks and returns. Returns in the form of easily acquiring new customers and risk in the form of non-payments called bad debts.
- Accounts Receivables are asset accounts in the books of the seller because the customer owes him an amount of money to pay against the goods and services already delivered by the seller. Conversely, it creates a liability account in the books of customers called Accounts Payables.
- The Balance Sheet categorizes Account Receivables as a current asset because sales made on credit are expected to get paid soon as per the credit terms mentioned in the invoice issued by the seller.
- Generally, financial statements are prepared using the accrual accounting method that has been made mandatory by both GAAP & IFRS. Accrual accounting requires recording the revenues as for and when they are earned whether payments in cash is received or not.
Journal Entries for Accounting Receivable
E.g. The Indian Auto Parts (IAP) Ltd sold some truck parts to Mr. Unreal on credit. Since IAP has already incurred various expenses called the cost of goods sold (COGS) for the sales he has made but not been paid.
Now when Mr. Unreal Pays off his billing amount, the accounts-receivable account gets written off against payment received in cash. However, if payment is not received or is not expected to be received in the near future then considering it to be losses, the seller can charge it as expenses against bad debts.
Let’s elaborate above example of Indian Auto Parts (IAP) Ltd and journalize the related transactions step by step:
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- On Jan 1, 2019, IAP ltd sold some truck parts to Mr. Unreal on credit. The calculated amount of invoice including all expenses and taxes was $10000 to be paid on or before 31 Jan 2019. Mr. Unreal made full payment of $10000 on 28 Jan 2019.
- Recording credit sales if IAP provides credit terms to its customers. Consider credit terms as 2/10 net 30 i.e. if paid within 10 days, a discount of 2% is offered otherwise payment must be made within 30 days without any discount.
Mr. Unreal pays his billing amount on 8 Jan 2019 and avails the discount.
Accounting for Bad Debts
While making sales on credit, the company is well aware that not all of its debtors will pay in full and the company has to encounter some losses called bad debts. Bad debts expenses can be recorded using two methods viz. 1.) Direct write-off method and 2.) Allowance method.
#1 – Direct Write-Off Method
Bad debts are recorded as a direct loss from defaulters, writing off their accounts and transferred in full amount to P&L account, thus lowers your net profit.
E.g. Mr. Unreal passed away and will not be able to make any payment.
#2 – Allowance Method
Charge the reverse value of accounts receivables for doubtful customers to a contra account called allowance for doubtful account. This keeps the P&L account unaffected from bad debts and reporting of the direct loss against revenues can be avoided. However writing-off the account at a future date is possible. For example:-
a) Mr. Unreal incurred losses and is not able to make payment at due dates.
b) Mr. Unreal goes bankrupted and will not pay at all.
c) Mr. Unreal has recovered from initial losses and wants to pay all of its previous debts.