6 - Accounts Receivable - Sales, Collections, Discounts, Agings, & Write-Offs

Welcome to Accounting 101, Episode 6, Accounts Receivable, Sales, Collections, Discounts, Aging and Write-Offs. Today we are going to discuss Accounts Receivable and the journal entries that are made related to Accounts Receivable. Accounts Receivable is the money that is owed to a company from its customers for sales that the company made to its customers. Accounts Receivable is an asset account, so it is shown on the balance sheet, and as we discussed in the episode on Contra Accounts, gross accounts receivable may be reduced by an allowance for doubtful accounts to yield net accounts receivable, if the allowance method is being used. If the direct method is being used, there will be no allowance counter account. The way to increase accounts receivable is to debit accounts receivable because accounts receivable is an asset account with a normal debit balance. The corresponding credit will be to a revenue account because accounts receivable is recording money that we are owed for sales to our customers. So to recap, when we make a sale on account to a customer, we debit accounts receivable and credit revenue, and that will increase both of those accounts. Side note, accounts receivable just like accounts payable is used under the accrual method of accounting, which requires a company to recognize revenue when earned and to recognize expenses when incurred. There's more to it than that, but we will cover accounting methods in another episode. Just keep in mind that the accrual method is the more proper method to use, rather than the cash method because the accrual method keeps better track of the actual activity, whereas the cash method of accounting recognizes revenue and expenses only when cash is changing hands. So back to our accounts receivable. The way to decrease accounts receivable, of course, is to credit accounts receivable because it is an asset. The corresponding debits when accounts receivable is reduced with a credit can be a debit to cash, which means we are collecting a payment, a sales discount, which is a contour revenue account, or a write-off, which can be done either using bad debt expense under the direct method or allowance for doubtful accounts, which is a Contra asset account under the allowance method. Another side note, when I discuss debiting and crediting accounts receivable, when you actually make the entry in your accounting software, you are going to be increasing or decreasing accounts receivable for a particular customer, and you will list the invoice number that is being affected. But I am just going to be saying accounts receivable, but what I really mean is the specific sub-account for that customer. All of the sub-accounts for all of your customers will add up to your gross accounts receivable balance. Let's go through an accounts receivable sales example. Let's pretend that our company provides computer consulting services to our customers. So when we want to build one of our customers, we will send them in invoice, and that invoice will have an invoice number and amount, and when the amount is due. And we might offer them a discount if they pay within a certain time period. Let's forget any discounts right now, and let's say that we are sending our customer invoice number 101 for $10,000. When we generate that invoice in our accounting system, we are going to debit accounts receivable for $10,000 to increase the amount we are owed from this customer, and we are going to credit sales for $10,000 to recognize our revenue. When our client receives the invoice we send them, they are going to debit computer consulting expense for $10,000, which will increase that expense, and they are going to credit accounts payable for $10,000, and that will increase accounts payable because it is a liability account with a normal credit balance. Another side note, accounts payable is the inverse of accounts receivable. When we are recognizing an accounts receivable, that means one of our customers is recognizing accounts payable. We will go further into accounts payable in the next episode though. So let's say that in 60 days this customer of ours decides to pay invoice number 101 for $10,000. So our customer will debit accounts payable for $10,000, which will reduce accounts payable, and they will credit cash for $10,000 because they are reducing their cash by $10,000 to make a payment to us. Now when we receive the payment, we are going to debit cash for $10,000 because we need to increase cash for the amount of payment we received, and we are going to credit accounts receivable for $10,000, which will reduce the amount we are owed from that customer by $10,000. That's how the sales process for accounts receivable works in a nutshell. Keep in mind that in an accounting class, the textbook will say on account or on credit when they want you to use accounts receivable or accounts payable, and they will say paid when they want you to use cash. Let's move on to journal entries for sales discounts related to accounts receivable. We went over sales discounts in the Contra accounts episode, but let's do another example here. If we had offered a 3% discount in our example with invoice number 101, if our customer had paid within 10 days, and they did so, we would give them a $300 discount off of the $10,000. We still record a debit to accounts receivable for $10,000 and a credit to revenue for $10,000 when we initially send the invoice, but now if the customer pays within 10 days to record that entry, we know we are going to have to get rid of the entire receivable because we can't show on our books that the customer owes us anything for invoice number 101. So we know we are going to credit the entire receivable balance for $10,000. Our debit to cash can only be $9,700 because that is the amount of payment we received, and we know that our debits and credits must equal, so we are going to have another debit for $300, and that is going to be 2 sales discounts. Sales discounts is a Contra revenue account with a normal debit balance, so it will reduce our revenue. This means that our net revenue from this transaction would be $9,700, which is our gross revenue of $10,000, less our sales discount of $300. Okay, let's move on to accounts receivable agents. You may have heard the term accounts receivable agent, and that simply means you are generating a schedule of how long your receivables have been outstanding, and accounts receivable amounts are grouped together in two time periods. A typical accounts receivable agent will break the total accounts receivable into several columns. You can typically choose the number of periods you want to show as columns. But for example, you might see columns for receivables less than 30 days old, receivables between 31 and 60 days old, those between 61 and 90 days old, those between 91 and 120 days old, and those receivables that have been outstanding for over 120 days. The periods can vary, but that's the basic idea. There will also be a total column that adds up all of the columns for the periods, and this will equal your gross accounts receivable balance. An accounts receivable agent gives a company's management a good sense of the breakdown of what they are owed, and they can focus on attempting to collect the older receivables, or management can use the aging to make decisions regarding writing off specific receivables. You will usually see two types of accounts receivable aging reports, an accounts receivable aging summary, which is what I just described, and an accounts receivable aging detail, which can detail each period by customer and invoice. The main idea of either report is to summarize your accounts receivable by how long they have been outstanding. Inevitably for any company, some receivables will not be collected, so let's discuss the journal entries used to write off an uncollectable accounts receivable balance. Like everything else in accounting, there are multiple methods to deal with a write-off. U.S. generally accepted accounting principles, known as U.S. gap, allows two methods. The allowance method, which is the method that we discussed in the Contra account episode, but we will go over that method again here, and the direct write-off method. The allowance method is more annoying because there's an extra step to create the allowance for doubtful accounts, whereas the direct method is very straightforward. To recap the allowance method, the owner or management of the company creates an allowance for what they believe will be the uncollectable accounts receivable, most likely based on a percentage of revenue on credit and past history regarding collections. By revenue on credit, I mean the amount of revenue on account or the revenue that is going through accounts receivable, nothing to do with debits, credits, or credit cards. For example, let's say that we have a company and we believe that 1% of our sales on credit will be uncollectable, and we expect revenue on credit of $20 million. Side note, management of a company may also choose to use a percentage of accounts receivable based on the accounts receivable aging, but let's stick to percentage of revenue, 20 million times 1% equals 200,000. So under the allowance method, we will debit bad debt expense for $200,000, and this will increase our bad debt expense because it is an expense account with a normal debit balance, and we will credit allowance for doubtful accounts for $200,000, which will increase that account because it is a contra asset account with a normal credit balance. If we determine that a particular receivable for $50,000 is uncollectible. We will debit allowance for doubtful accounts for $50,000, and we will credit accounts receivable for $50,000. And this entry will reduce both of those accounts. Pause here and look at ALRI if you do not understand why both of those accounts are being reduced in that transaction. The other method for writing off accounts receivable is the direct write-off method. The direct write-off method is what is used for tax purposes in the United States. Basically, the government doesn't want business owners to be able to take a tax deduction in the current year for what they believe the uncollectible accounts receivable will be. But only for the amounts that are actually deemed to be uncollectible in that year. The journal entry for an uncollectible accounts receivable under the direct write-off method is to debit bad debt expense and credit accounts receivable. This entry increases our bad debt expense and decreases our accounts receivable. So, in that last example, we would have debited bad debt expense for $50,000 and credited accounts receivable for $50,000. It's as simple as that. Both methods identify and write-off specific accounts receivable with balances. The difference is that the allowance method creates the expense and allowance first and then depletes the allowance against identified uncollectible accounts. Whereas the direct method uses bad debt expense directly against any identified uncollectible accounts. And that's how you write-off an uncollectible accounts receivable. Another thing to consider about receivables is to make sure not to confuse accounts receivable with other things that have receivable in the name, like notes receivable and loans receivable, for example. Receivable itself just means something that is due to your company. But accounts receivable relates only to sales. You may see accounts receivable, abbreviate as AR or A/R, and sometimes you will see accounts receivable just referred to as receivables. But again, be careful not to mix receivables up with the other accounts that have receivable in the name, as I just mentioned. That's really all you need to know about accounts receivable right now. If you understand the debits and credits and the concepts that we went over today, you're in good shape. If you find yourself having trouble following the debits and credits, go back and listen to episode two, because as I keep stating, knowing whether to increase or decrease each account in a transaction and knowing how to increase or decrease each L-re type of account with debits and credits is the game. Learning the language of L-re must be primary. All of the other concepts that we're going over are to be built upon that fundamental knowledge. Otherwise, you're going to get through accounting one, and maybe accounting two, but you're going to get absolutely lost in intermediate and advanced accounting. If accounts receivable is still confusing to you after this episode, try re-listening to this episode and doing some research on the internet, and create index cards to remember the methods if you need to for your accounting class. Our next episode will focus on accounts payable, which as I stated earlier, is the opposite concept of accounts receivable. 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