The nature of business and the level of development in the market that is partly catalyzed by the advent of financial engineering means that selling goods without collecting money has become normal way of doing business.
A lot of buy now and pay later scheme keep springing up everyday as organizations jostle to get the nod of buying customers. Many households will simply not be able to afford some luxuries that they enjoy if not for the availability of buy now pay later scheme.
In this article on what is accounts receivable, we will be providing simple non-technical definition of accounts receivable, explore some nitty gritty of accounts receivable and then show you the accounting treatment of accounts receivables. So, lets start by gaining understanding of what an account receivable really is.
What is receivable? Meaning of receivables
Receivables in simple language are those monies that organizations are yet to collect from customers who are yet to pay for goods and services that they have received from the business. This used to be called debtors in old accounting terminologies.
The Oxford Dictionary of Accounting, debtors are ‘those who owe money to an organization, for example for sales of goods. The dictionary also defines receivables as ‘claims held against customers and others for money, goods or services’
In summary, a receivable from a company perspective is any sum of money that is due to a company from any source for any legitimate reason.
Notice that our efforts so far has been towards gaining understanding of what a receivable is. Now lets quickly have a look at ‘accounts receivable’.
Different types of receivables
We have two types of receivables namely;
- Accounts receivable, and
- Notes receivables
Accounts receivables are short term privileges that companies offer their customers in the normal course of doing business with no interest charged. While notes receivables has to do with medium to longer term credits with an interest charged a typical example is the hire purchase scheme where an item that ordinarily would sell for say
N20,000.00 is sold to a customer for N25,000.00 for the fact that the customer would be allowed to spread the payment over one year.
What is account receivable? Meaning of account receivables
It has long been established that accrual method of accounting is best suited for most organizations. Under the accrual method of accounting, organizations path ways with their valuables when a customer acknowledges receipts and make promise to pay for the valuable in a future date.
That promise from a customer to pay for a valuable in a future date is what is referred to in accounting as ‘accounts receivables.’ Therefore, accounts receivables are promise backed amounts that customers owe a company for goods and services rendered on credit (or on account if really want to appear fanciful). It is not uncommon to see these types of credits been referred to as ‘trade receivables’ – its same as accounts receivable with the subtle difference coming from the fact that one is more closely aligned to physical exchange of goods.
A little beyond definitions of receivables
Much of the rapid growth we all experience in businesses recently are as a result of explosion in the credit system – the credit system acts as a growth catalyst. The credit system can be a double-edged sword when not properly managed, hence a key symptom of overtrading is rapid growth in credit sales.
Recall that we established that accounts receivables arose as a result of the fact that customers make promise to businesses that they would pay for the goods and services received at a later date.
Well, things don’t usually go as planned. Customers do sometimes default thereby giving room to doubt.
Accounting treatments of accounts receivables
We will look at the accounting treatment of accounts receivables from two angles; (1) when customers pay up promptly upon maturity of agreed credit term, and (2) what customers give a business reasons to doubt their ability to pay.
Accounting treatment of accounts receivables under normal circumstance
The accounting treatment of accounts receivable here is very straight forward. Debit the accounts receivable at the time of sale (or when service is rendered) and credit sales account.
When payment is eventually made, credit receivable accounts and debit cash or bank account depending on how the customer made the payment. This is all that there is with the ledger account postings under this normal scenario.
Accounting treatment of accounts receivables when there is doubt in the capability and willingness of the debtor to pay.
Companies use two methods for dealing with situations where there is evidence that debts would be uncollectable. First is the provision of allowance approach and the second is the outright write-off approach.
Under both approach, decision has to be made regarding what percentage of the receivables are doubtful. Deciding what this percentage should be is a management function – our job as accountants is to simply use the figure while making period end accounting adjustments.
Allowance method for recording receivables classed as uncollectable
The idea here is simple -make provision for uncollectable receivables (doubtful debt). Businesses take variety of measures to ensure that they only make credit sales to creditworthy customers but no one can ever be 100% accurate when dealing with complex entities like human beings, hence, provision is made to cater for those receivables that eventually not be collected.
This makes sense as it upholds the underlying accounting concept of ‘matching concept’ which accountants implement through the application of accrual method of accounting. The application of prudence concept is also displayed here.
Outright write-off method for recording receivables classed as uncollectable
Under this method, companies wait until they are 100 certain that a receivable has become bad before they simply write it off in that periods P&L.
The outright write off method is illegal within the confine of accounting standards and would therefore not be discussed further in this article. Tax authorities in some countries however do prefer this method.
Brief comment on the position of IFRS on accounts receivables
IFRS (International Financial Reporting Standard) defines financial instruments as any contract that gives rise to both a financial asset to one party and a financial liability or equity instrument to another party.
Receivables judging by the above definition are classic examples of financial instrument as defined by IFRS.
The presentation, measurement, recognition and derecognition rules as stipulated by the following accounting standards (IAS 32, IAS 39, IFRS 7 and IFRS 9) needs to be consistently applied to the treatments of accounts receivables as it meets the definition of financial instruments.
I will not go into details here but just keep that at the back of your mind that the IFRS rules do apply to accounts receivables when necessary. We are working on IFRS commentary series soon, so do keep a date with us.