Accounts receivable

Accounts receivable are part of a firm’s ASSETS; they repre-sent monies owed to the firm. (While receivables are assets, payables are liabilities to a firm. Payables are the firm’s debt—that is, monies owed by the firm.) An account receivable is created when a firm sells a good or service to a customer on credit (see DEBIT, CREDIT). Rather than receiving an asset in the form of cash, the firm records an asset called an account receivable. The sum of all the monies owed to the firm by its customers collectively is called accounts receivable.

Because accounts receivable are assets, debit entries will increase accounts receivable, and credit entries will decrease accounts receivable. Because of the dual nature of a transaction (an exchange of equal-valued resources between two parties), for every account receivable in a firm’s ledger, there is an equal-valued account payable in another firm’s ledger.

Every firm that sells on credit will have an INVESTMENT in accounts receivable. The presence of accounts receiv¬able, especially when sizable, creates a cash-flow problem for a firm. A sale was made; the merchandise was sold, but it was not liquidated (cash was not received). Thus, accounts receivable are in reality a pool of idle cash. To off¬set cash-flow problems, the accounts receivable need to be collected on a timely basis. Firms monitor their invest¬ment in accounts receivable by comparing their “days sales outstanding” (DSO) ratio with that of their industry.

A popular way firms attempt to offset cash-flow prob¬lems associated with receivables is to offer sales discounts on the invoices sent to their credit customers. Sales dis¬counts are percentages that can be deducted for the early payment of an invoice. A commonly used sales discount found on invoices is “2/10, net 30.” This means that 2 per¬cent may be deducted from the invoice if payment is made within 10 days of the invoice date; otherwise, the full amount of the invoice is due within 30 days of the invoice date. These sales discounts apply to short periods of time, usually 10 or 15 days, but when expressed as an annual percentage rate, these discounts are considerable and are powerful incentives for credit customers to pay early.

Because it is impossible to predict with accuracy which customers are good credit risks, it is natural and expected that some of the accounts receivable will ultimately prove to be uncollectible, at which time they will be written off as BAD DEBTS. Bad-debt expense can be minimized by a tightening of a firm’s credit policy. However, there is a trade-off: having a tight credit policy means that a firm will sacrifice sales to its marginal credit customers. Periodically a firm may review the status of its accounts receivable using an accounting method known as aging of accounts receivable (see BAD DEBTS, AGING OF ACCOUNTS), where the outstanding balance of each account and its DURATION are determined.