Accounts receivable is a current asset that reports the amounts a company's customers owe the company for goods or services provided on credit. Under accrual accounting, a company credits a revenue account and debits Accounts Receivable when billing customers. When an account receivable is collected, the accountant debits Cash and credits Accounts Receivable.
A company that extends credit to a customer faces the risk of not collecting the account receivable. If a loss does occur from extending credit, it is reported as an operating expense, such as bad debts expense.
There are two ways of reporting losses from credit sales. One is the direct write-off method. With this approach, the company does not anticipate any loss. The asset Accounts Receivable is reported at its full amount and no expense is reported until it is known with certainty that a specific customer will not pay the amount owed. This method is not encouraged by accountants, because the company may be overstating its assets and net income.
The preferred way to report losses from credit sales is to anticipate that some receivables will not be collected. This approach is the allowance method. It gets it name because of the contra account to Accounts Receivable entitled Allowance for Doubtful Accounts. The credit balance in the allowance account works to value the accounts receivable at their approximate net realizable amount. With the allowance method, the debit to bad debts expense and the related credit to the allowance account is reported closer to the time of the sale—thus providing a better matching of the expense with revenues. The allowance method results in the accounts receivable being reported at a more realistic and conservative amount.
To assist in the managing of accounts receivables, an aging of accounts receivable is prepared. An aging sorts the customers' balances by how long the customers have owed the open (unpaid) invoice amounts.
Sales on credit often involve credit terms such as "net 10 days" or "net 30 days" or "2/10, net 30" and others. Net 30 days means there is no discount allowed from the amount on the sales invoice. If the credit term is "2/10, net 30" the customer can remit 2% less than the invoice amount if the customer pays within 10 days. Otherwise the full amount is due in 30 days. The discounts associated with credit terms such as "2/10, net 30" or "1/10, net 30" are referred to as early payment discounts.
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Harold Averkamp (CPA, MBA) has worked as a university accounting instructor, accountant, and consultant for more than 25 years. He is the sole author of all the materials on AccountingCoach.com. Read more about the author.