6.3.1: Accounts Receivable

Recognition and Measurement of Accounts Receivable

Accounts receivable result from credit sales in the normal course of business (called trade receivables) that are expected to be collected within one year. For this reason, they are classified as current receivables on the balance sheet and initially measured at the time of the credit sale at their net realizable value (NRV). Net realizable value (NRV) is the amount expected to be received from the customer. IFRS and ASPE standards both allow NRV to approximate the fair value, since the interest component is immaterial when determining the present value of cash flows for short-term accounts receivable. In subsequent accounting periods, accounts receivable are to be measured at their amortized cost which is the same as cost, since there is no present value interest component to recognize. For long-term notes and loans receivable that have an interest component, the asset's carrying amount is measured at amortized cost which will be described later in this chapter.

The valuation of the account receivable is also affected by:

• Trade and sales discounts
• Sales returns and allowances

Trade Discounts

Manufacturers and wholesalers publish catalogues with inventory and sales prices to assist purchasers with their purchases. Catalogues are expensive to publish, so this is only done from time to time. Sellers often offer trade discounts to customers to adjust the sales prices of items listed in the catalogue. This can be an incentive to purchase larger quantities, as a benefit of being a preferred customer or because costs to produce the items for sale have changed.

Since the catalogue, or list, price is not intended to reflect the actual selling price, the seller records the net amount after the trade discount is applied. For example, if a plumbing manufacturer has a catalogue or list price of $1000 for a bathtub and sells it to a plumbing retailer for list price less a 20% trade discount, the sale and corresponding account receivable recorded by the manufacturer is $800 per bathtub.

Sales Discounts

Sales discounts can be part of the credit terms for customers and are offered to encourage faster payment of the account. The credit term 1.5/10, n/30 means there is a 1.5% discount if the invoice is paid within ten days with the total amount owed due in thirty days.

Companies purchasing goods and services that do not take advantage of the sales discounts are usually not using their cash as effectively as they could. For example, a purchaser who fails to take the 1.5% reduction offered for payment within ten days for an account due in thirty days is equivalent to missing a stated annual interest rate return on their cash for 27.38% (365 days \(\div 20\) days \(\times 1.5 \%\)). For this reason, companies usually pay within the discount period unless their available cash is insufficient to take advantage of the opportunity.

IFRS 15.53 – the term variable consideration, discussed in Chapter 5, Revenue, would also include sales discounts because it is uncertain how many customers will actually take the sales discount. For this reason, IFRS states that an estimate of "highly probable" sales discounts expected to be taken by customers, needs to be determined and included at the time of the sale. Given the high rate of return identified in the preceding paragraph, recording the estimate immediately upon sale is conceptually sound and is consistent with the net method described below. The standard suggests using either the expected value (a weighted average of probabilities), or the "most likely amount" to estimate sales discounts, perhaps based on past history.

To illustrate the net method, assume that Cramer Plumbing sells fifty bathtubs to a reseller for $800 each, for a total sale of $40,000, with credit terms of 1.5/10, n/30. Using the net method, Cramer expects that the sales discount will be taken by the purchaser; therefore, Cramer Plumbing will record the following entry:

General Journal
Date	Account/Explanation	PR	Debit	Credit
	Accounts receivable . . . . . . . . . . . . . . . . .		39,400
	Sales revenue . . . . . . . . . . . . .  . . .  . .			39,400
	\((\$ 800 \times 50\) units \(\times 98.5)\)

Note the reduction due to the sales discount is immediately recorded upon the sale. This results in the accounts receivable being valued at its net realizable value and based on Cramer's "more likely than not" estimate of sales discounts expected to be taken, which is consistent with IFRS 15.53.

If $10,000 of the account receivable is collected from the reseller within the ten-day discount period (for a cash amount of $9,850), the entry would be:

General Journal
Date	Account/Explanation	PR	Debit	Credit
	Cash . . . . . . . . . . . . . . . . . . . . . . . . . . .		9,850
	Accounts receivable . . . . . . . .  . . .  . .			9,850
	\((\$ 10,000 \times 1.5 \%)\)

The entry for collection of the remaining amount owing for $30,000 after the discount period is:

General Journal
Date	Account/Explanation	PR	Debit	Credit
	Cash . . . . . . . . . . . . . . . . . . . . . . . . . . .		30,000
	Sales discounts forfeited . . . . . .  . . .  . .			450
	Accounts receivable . . . . . . . . . . . . . . .			29,550
	For Sales discount forfeited \((\$ 30,000 \times 1.5 \%)\)

As can be seen above, the net method records and values the accounts receivable at its lowest, or net realizable value of $39,400, or gross sales for $40,000 less the 1.5% discount.

The gross method is much easier and ASPE can choose either method. For the gross method, sales are recorded at the gross amount with no discount taken. If the customer pays within the discount period, the applicable discount taken is recorded to a sales discounts account. Any payments made after the discount period are simply the cash amount collected and no calculation for the sales discounts forfeited is required.

Using the same example, assume that Cramer Plumbing sells fifty bathtubs for $800 each, with credit terms of 1.5/10, n/30. Using the gross method, the entry for the sale is:

General Journal
Date	Account/Explanation	PR	Debit	Credit
	Accounts receivable . . . . . . . . . . . . . . . . .		40,000
	Sales revenue . . . . . . . . . . . . .  . . .  . .			40,000
	( \(\$ 800 \times 50\) units \()\)

The entry on collection of $10,000 within the ten-day discount period is:

General Journal
Date	Account/Explanation	PR	Debit	Credit
	Cash . . . . . . . . . . . . . . . . . . . . . . . . . . .		9,850
	Sales discounts  . . . . . .  . . .  . .		150
	Accounts receivable . . . . . . . . . . . . . . .			10,000
	For Sales discounts (a contra sales revenue account):\((\$10,000 \times 1.5\%\)

The entry on collection of the remaining $30,000 after the discount period is:

General Journal
Date	Account/Explanation	PR	Debit	Credit
	Cash. . . . . . . . . . . . . . . . .		30,000
	Accounts receivable . . . . . . . . . . . . .  . .  . .			30,000

 

Note how the accounts receivable would not be reported at its net realizable value with this method. If discounts are significant, this would overstate accounts receivable and sales in the financial statements. For this reason, if the gross method is used and it is expected that significant cash discounts are likely to be taken by customers in the fiscal year, an asset valuation account and an adjusting entry is required to ensure that accounts receivable, net of the valuation account, will reflect its net realizable value.

At year-end, assume that $6 million of Cramer's accounts receivable all have terms of 1.5/10, n/30, and management expects that 60% of these accounts will be collected within the discount period, which it deems to be significant. The unadjusted balance in the allowance for sales discounts account (a contra account to accounts receivable) is $3,000 credit balance. The year-end adjusting entry to update the accounts receivable allowance account with the estimated sales discounts would be:

General Journal
Date	Account/Explanation	PR	Debit	Credit
	Sales discounts . . . . . . . . . . . . . . . . .		51,000
	Sales revenue . . . . . . . . . . . . .  . . .  .			51,000
	\(((\$ 6,000,000 \times 1.5 \% \times 60 \%)-\$ 3,000)\). Allowance for dales discounts is a contra accounts receivable account)

 

Throughout the following year, the allowance account can be directly debited each time customers take the discounts and is adjusted up or down at the end of each reporting period.

Sales Returns and Allowances

Many ASPE companies have policies that allow for the return of goods under certain circumstances and will refund all or a partial amount of the returned item's cost.

Assuming that returns for this company are insignificant, the entry for a $1,000 sales return on account (with a cost $800) returned to inventory, for a company using a perpetual inventory system, would be:

Sales allowances are reductions in the selling price for goods sold to customers, perhaps due to damaged goods that the customer is willing to keep if the sales price is reduced sufficiently.

For example, if a sales allowance of $2,000 is granted due to damaged goods that the customer chose to keep, the entry, assuming sales allowances for this company are insignificant, would be:

As was done with sales discounts, sales returns and allowances should be recognized in the period of the sale to avoid overstating accounts receivable and sales. Sales returns and allowances are therefore estimated and adjusted at the end of each reporting period. If the amount of returns and allowances is not material a year-end adjusting entry is not required and the entries shown above would be sufficient, provided that it is handled consistently from year to year. If returns and allowances are significant, an allowance for sales returns and allowances account, which is an asset valuation account contra to accounts receivable, is used to record the estimates.

For example, management estimates the total sales returns and allowances to be $51,500, which it deems to be significant. If the company follows ASPE, and the unadjusted balance in the allowance for sales returns and allowances account is $5,000 credit balance, the year-end adjusting entry would be:

Note how another contra account, the sales returns and allowances account, is used to record the debit entry for the previous two journal entries above. Its purpose is to track returns and allowances transactions separately, as opposed to directly recording them as a debit to sales. If amounts in this contra account become too high, it could indicate to management the possibility of future sales lost due to unsatisfied customers.

During the reporting period, the allowance for sales returns and allowances asset valuation account can be directly debited each time customers are granted returns or allowances. This asset valuation account will subsequently be adjusted up or down at the end of each reporting period.

Sales with right of return under IFRS has been discussed in Section 5.3, Sales With Right of Return, where a detailed example is presented.

Estimating Allowance for Uncollectible Accounts

When accounts receivables exist, some amounts of uncollectible receivables are inevitable due to credit risk. This risk is the likelihood of loss due to customers not paying their amounts owing. If the uncollectible amounts are both likely and can be estimated, an amount for uncollectible accounts must be estimated and recognized in the accounts to ensure that accounts receivable and net income are not overstated over the lifetime of the accounts receivable (IFRS 9; lifetime expected credit losses). The allowance account, called the allowance for doubtful accounts (AFDA), is an asset valuation account (contra account to accounts receivable), which is used the same way as the Allowance for Sales Discounts discussed earlier.

Many companies set their credit policies to allow for a certain percentage of uncollectible accounts. This is to ensure that the credit policy is not too restrictive or liberal, as explained in the opening paragraph of the Receivables Management section of this chapter.

Measuring uncollectible amounts at the end of each reporting period involves estimates that can be calculated using several methods:

• Percentage of accounts receivable method
• Accounts receivable aging method
• Credit sales method
• Mix of methods

The first three methods were covered in the introductory accounting course. Below is a review of these methods. The mix of methods is perhaps a more realistic view of how companies estimate bad debt expense over a reporting period.

For each method above, management estimates a percentage that will represent the likelihood of collectability. The estimated total amount of uncollectible accounts is calculated and usually recorded to the AFDA allowance account, with the offsetting entry to bad debt expense. The net amount for accounts receivable and its contra account, the AFDA, reflects the net realizable value of the accounts receivable at the reporting date.

Percentage of Accounts Receivable Method

For this method, the accounts receivable closing balance is multiplied by the percentage that management estimates is uncollectible. This method is based on the premise that some portion of accounts receivable will be uncollectible, and management uses reasonably available and supportable information (IFRS 9) regarding past experiences, current economic conditions, and expected future conditions as a guide to the percentage used. For this reason, the estimated amount of uncollectible accounts is to be equal to the adjusted ending balance of the AFDA. The adjusting entry amount must therefore be the amount required that results in that ending balance of the AFDA.

For example, assume that accounts receivable and the AFDA ending balances were $200,000 debit and $2,500 credit balances respectively at December 31, and the uncollectible accounts is estimated to be 4% of accounts receivable. This means that the AFDA adjusted ending balance is estimated to be the amount equal to 4% of $200,000, or $8,000. The adjusting entry to achieve the correct AFDA adjusted ending balance of $8,000 would be:

The AFDA ending balance after the adjusting entry would correctly be $8,000 ((\$2,500 unadjusted balance + \$5,500 adjusting entry).).

Sometimes the AFDA ending balance can be in a temporary debit balance due to a write-off of an uncollectible account during the period. If this is the case, care must be taken to make the correct calculations for the adjusting entry. For the example above, if the unadjusted AFDA balance was a $300 debit balance, then the adjusting entry for uncollectible accounts would be:

The AFDA ending balance after the adjusting entry would correctly be $8,000 ().

Notice that the AFDA ending balance of $8,000 is the same for both examples when applying the percentage of accounts receivable method. This is because the calculation is intended to be an estimate of the AFDA ending balance, so the adjustment amount is whatever is required to result in that ending balance.

Accounts Receivable Aging Method

Typically, the older the uncollected account, the more likely it is to be uncollectible. Following this premise, the accounts receivable are grouped into categories based on the length of time they have been outstanding.

Just as was done for the percentage of accounts receivable method above, companies will use past experience to estimate the percentage of their outstanding receivables that will become uncollectible for each aged group, such as the four aging groups identified in the schedule below. The sum of all the estimated uncollectible amounts by group represents the total estimated uncollectible accounts. Just like the percentage of accounts receivable method previously discussed, the estimated amount of uncollectible accounts using this method is to be equal to the ending balance of the AFDA account. The adjusting entry amount must therefore be whatever amount is required to result in this ending balance.

Aging schedules are also a good indicator of which accounts may need additional attention by management, due to their higher credit risk group, such as the length of time the account has been outstanding or overdue.

Below is an example of an accounts receivable aging schedule:

Taylor and Company
Aging Schedule
As at December 31, 2020

Customer	Balance	Under	61–90	91–120	Over 120
	Dec 31, 2020	60 days	days	days	days
Abigail Holdings	$3,500	$1,500	$2,000
Beaver Industries Inc.	45,000	25,000	8,500	$6,500	$5,000
Cambridge Instruments Co.	18,000				18,000
Dereck Station Ltd.	25,000	25,000
Falling Gate Repair	6,840		6,840
Gladstone Walkways Corp.	26,000	26,000
Tremsol Cladding Inc.	15,000	10,000	4,000	1,000
Warbling Water Pond Installations	6,480	1,480			5,000
	$186,480	$124,050	$22,300	$22,130	$18,000
Percent estimated uncollectible		5%	10%	15%	35%
Total Allowance for uncollectible
accounts ending balance	$18,053	$6,203	$2,230	$3,320	$6,300

The analysis above indicates that Taylor and Company expects to receive $186,480 less $18,053, or $168,427 net cash receipts from the December 31 amounts owed. The $168,427 represents the company's estimated net realizable value of its accounts receivable and this amount would be reported as the net accounts receivable in the balance sheet as at December 31.

Assuming the data above for Taylor and Company and an unadjusted AFDA credit balance as at December 31 of $2,500, the adjusting entry for uncollectible accounts would be:

As was illustrated for the percentage of accounts receivable method above, the calculation of the adjusting entry amount must consider whether the unadjusted AFDA balance is a debit or credit amount.

Credit Sales Method

This is the easiest method to apply. The amount of credit sales (or total sales, if credit sales are not determinable) is multiplied by the percentage that management estimates is uncollectible. Factors to consider when determining the percentage amount to use will be trends resulting from amounts of uncollectible accounts in proportion to credit sales experienced in the past. The resulting amount is credited to the AFDA account and debited to bad debt expense.

Note that for this method, the previous balance in the AFDA account is not taken into consideration. This is because the credit sales method is intended to calculate the bad debt expense that will be reported in the income statement. This is a fast and simple way to estimate bad debt expense because the amount of sales (or preferably credit sales) is known and readily available. This method also illustrates proper matching of expenses with revenues earned over that reporting period.

For example, if credit sales were $325,000 at the end of the period and the uncollectible accounts was estimated to be 3% of credit sales, the entry would be:

Mix of Methods

Often companies will use the percentage of credit sales method to adjust the net accounts receivables for interim (monthly) financial reporting purposes because it is easy to apply. At the end of the year, either the percentage of accounts receivable or aging accounts receivable method is used for purposes of preparing the year-end financial statements so that the AFDA account is adjusted accordingly, and reported on the balance sheet.

Below is a partial balance sheet for Taylor and Company using the data from the Accounts Receivable Aging Method section above:

Taylor and Company
Balance Sheet 
December 31, 2020

Current assets:
Accounts receivable	$	186,480
Less: Allowance for doubtful accounts		18,053
	$	168,427

To summarize, the $186,480 represents the total amount of trade accounts receivables owing from all the credit customers at the reporting date of December 31, 2020. The $18,053 represents the estimated amount of uncollectible accounts calculated using the allowance method, the percentage of sales method, or a mix of methods. The $168,427 represents the net realizable value (NRV) of the receivable at the reporting date.

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Write-offs and Collections

Write-off of an Actual Uncollectible Account

Management may deem that a customer's account is uncollectible and may wish to remove the account balance from accounts receivable with the offsetting entry to the allowance for doubtful accounts. For example, using the data for Taylor and Company shown under the accounts receivable aging method, assume that management wishes to remove the account for Cambridge Instruments Co. of $18,000 because it remains unpaid despite efforts to collect the account. The entry to remove the account from the accounting records is:

Because the AFDA is a contra account to accounts receivable, and both have been reduced by identical amounts, there is no effect on the net accounts receivable (NRV) on the balance sheet. This treatment and entry makes sense because the estimate for uncollectible accounts adjusting entry (with a debit to bad debt expense) had already been done using one of the allowance methods discussed earlier. The purpose of the write-off entry is to simply remove the account from the accounting records.

Collection of a Previously Written-off Account

Even though management at Taylor and Company thinks that the collection of the $18,000 account has become unlikely, this does not mean that the company will make no further efforts to collect the amount outstanding from the purchaser. During the tough economic times in 2009 and onward, many companies were in such financial distress that they were simply unable to pay their amounts owing. Many of their accounts had to be written-off by suppliers during that time as companies struggled to survive the crisis. Some of these companies recovered through good management, and cash flows returned. It is important for these companies to rebuild their relationships with suppliers they had previously not paid. So, it is not uncommon for these companies, after recovery, to make efforts to pay bills that the supplier had previously written-off.

As a result, a supplier may be fortunate enough to receive some or all of a previously written-off account from a customer. When this happens, a two-step process accounts for the payment:

1. Reinstate the account receivable amount being paid by reversing the previous write-off entry for an amount equal to the payment now received.
2. Record the cash received as a collection of the accounts receivable amount reinstated in the first entry.

If Cambridge Instruments Co. pays $5,000 cash and indicates that this is all that the company can pay of the original $18,000, the entry would be:

Step 1: Reinstate the account receivable upon receipt of cash (reversing a portion of the write-off entry):

Step 2: Record the receipt of cash on account from Cambridge Instruments:

Summary of Transactions and Adjusting Entries

An understanding of the relationships between the accounts receivable and the AFDA accounts and the types of transactions that affect them are important for sound accounts analysis. Below is an overview of some of the types of transactions that affect these accounts:

Transaction or Adjusting Entry:		Accounts			Allowance for
		Receivable			Doubtful Accounts
		Debit	Credit		Debit	Credit
Opening balance, assuming accounts have
normal balances	1)	$$		1)		$$
Sale on account	2)	$$		2)
Cash receipts	3)		$$	3)
Customer account written-off	4)		$$	4)	$$
Reinstatement of account previously
written-off	5)	$$		5)		$$
Subtotal
End of period adjustment for uncollectible
accounts (debit to bad debt expense)	6)			6)		$$
Closing balance, end of period		$$				$$

Direct Write-off of Uncollectible Accounts

Some smaller companies may only have a few credit sales transactions and small accounts receivable balances. These companies usually use the simpler direct write-off method because the amount of uncollectible accounts is deemed to be immaterial. This means that when a specific customer account is determined to be uncollectible, the account receivable for that customer account is written-off with the debit entry recorded to bad debt expense as shown in the following entry:

If the uncollectible account written-off is subsequently collected at some later date, the entry would be:

If the uncollectible amounts were material, it would not be appropriate to use the direct write-off method, for many reasons:

• Without an estimate for uncollectible accounts, net account receivables would be reported at an amount higher than their net realizable value.
• The write-off of the uncollectible account will likely occur in a different year than the sale, which will create over- and under-statements of net income over the affected years resulting in non-compliance of the matching principle.
• Direct write-off creates an opportunity to manipulate asset amounts and net income. For example, management might delay a direct write-off to keep net income high artificially if this will favourably affect a bonus payment.

This section of the chapter is intended to be a summary overview of the methods and entries used to estimate and write-off uncollectible accounts originally covered in detail in the introductory accounting course. Students may wish to review those learning concepts from that course.