Accounts receivable is a payment claim held by a company against a customer for either goods or services supplied. Many purchases today are made on credit, where actual payment comes at a later date. Payment information is delivered to the customer by way of invoice, which specifies the date limit by which the payment should be made. Offering goods or services on credit can be advantageous to the seller, as customers who do not have the immediate cash to pay for goods or services may be more willing to make a purchase when payments occur at a later date. However, the seller is also at a risk, as some customers may not make their payments when due.
Many businesses use what is called net 30, meaning that thirty days is the norm for receiving payments for items on credit after an invoice has been sent. After thirty days have passed, payments typically begin to accrue interest. Often, to increase payments, businesses may offer discounts if amounts are paid early.
Accounts receivable utilizes the accrual method of accounting. When a transaction occurs, a receivable account is debited and a revenue account is credited. When the transaction amount is paid, cash is debited and receivable is credited. However, if a customer does not pay its debt, the amount is marked as a credit loss or bad debts expense on an income statement and the accounts receivable is reduced on the balance sheet.
The net value of accounts receivable can be measured in two ways: the allowance method and the direct write-off method. The allowance method creates a contra-asset account, reducing balances of accounts receivable and provisioning for bad debt. This is accomplished by either analyzing each debt to determine if it will be unpaid, or by creating a static percentage based on the number of debtors. Provisions for bad debt are contained in the bad debt expense account on an income statement. The direct write-off method, on the other hand, deals with concrete financial information. If it is apparent that customers will not pay off their debts, only then is accounts receivable reduced.
Bad debts expense accounts are temporary accounts listed on an income statement which close at the end of an accounting year. At the start of a new accounting year, balances in this account are distributed into retained earnings. This account covers debts which cannot be collected from the buyer because the buyer has gone out of business or simply not paid its debts.
In addition to bad debts expense accounts is an allowance for doubtful accounts, which estimates the amount of uncollectible income from accounts receivable. Note that while bad debts expense accounts are temporary accounts, allowance for doubtful accounts is a permanent account which carries into the next accounting period. Whenever it becomes clear that a customer cannot pay an amount, allowance for doubtful accounts is debited while accounts receivable is credited.
Aging of accounts receivable is a report of unpaid customer invoices by date taken from the accounts receivable subsidiary ledger. It details how much a customer owes and how long the amount has been owed. Amounts are typically broken up into 30-day increments, with categories detailing payments past due less than thirty days ago, between thirty and sixty days ago, and more than sixty days ago. The aging of accounts receivable is also helpful in determining if customers are frequently late in making payments and if the amount could turn into a credit loss. This can be helpful in determining the allowance for doubtful accounts, creating a probability that payments will not be collected based on customer histories.
Use of the allowance method and the direct write-off method depends on how financial information is prepared. For example, while it is generally acceptable to use the allowance method when creating financial statements, it cannot be used when reporting income taxes, as noted by the IRS, as it will not allow businesses to anticipate losses in credit. The direct write-off method is the standard for reporting income tax. For financial statements, the two methods are sometimes able to be used together.