Accounts Receivable
and Bad Debts Expense

A company's accounts receivable are considered to be a type of asset, and as such can be pledged as collateral for a loan. Asset-based lenders will often lend a company an amount equal to 80% of the value of its accounts receivable.

Some companies sell their accounts receivable to a factor. A factor buys the accounts receivables at a discount and then goes about the business of collecting and keeping the money owed through the receivables. Sometimes the factor will purchase the accounts receivables with recourse. This means the company that sold the receivables remains financially responsible if a customer does not remit the full amount to the factor. When the factor purchases the receivables without recourse, the company selling the receivables is not responsible for unpaid amounts.

There are two commonly used financial ratios that address the relationship between the amount of a company's accounts receivable as reported on the balance sheet and the amount of credit sales as reported on the income statement. These ratios are:

1. Accounts receivable turnover ratio, and
2. Days sales in accounts receivable.

Use the following link to learn how to calculate these ratios: Financial Ratios.

Generally accepted accounting principles (GAAP) require that companies use the allowance method when preparing financial statements. The use of the allowance method is not permitted, however, for purposes of reporting income taxes in the United States because the Internal Revenue Service (IRS) does not allow companies to anticipate these credit losses. As a result, companies must use the direct write-off method for income tax reporting.

In the direct write-off method, a company will not use an allowance account to reduce its Accounts Receivable. Accounts Receivable is only reduced if and when a company knows with certainty that a specific amount will not be collected from a specific customer.

For example, let's assume that on October 21, Gem Merchandise Co. is convinced that a specific customer's account receivable originating on June 5 in the amount of $1,238 is definitely uncollectible. Using the direct write-off method, the following entry is made:

Usually many months will pass between the time of the sale on credit and the time that the seller knows with certainty that a customer is not going to pay. It is difficult to adhere to the matching principle and the concept of conservatism when a significant amount of time elapses between the time of the sales revenues and the time that the bad debts expense is reported. This is why, for purposes of financial reporting (not tax reporting), companies should use the allowance method rather than the direct write-off method.

Because the material covered here is considered an introduction to this topic, many complexities have been omitted. You should always consult with an accounting professional for assistance with your own specific circumstances.

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