Define Accounts Receivable
Accounts receivable are also known as receivables refers to short-term amounts due from buyers to a seller who have purchased goods or services from the seller on credit. Credit is usually granted in order to gain sales or to respond to the granting of credit by competitors. Accounts receivable is listed as a current asset on the seller’s balance sheet.
The total amount of accounts receivable allowed to an individual customer is typically limited by a credit limit, which is set by the seller’s credit department, based on the finances of the buyer and its past payment history with the seller. Credit limits may be reduced during difficult financial conditions when the seller cannot afford to incur excessive bad debt losses.
What is Accounts Receivable
Accounts receivable are commonly paired with the allowance for doubtful accounts (a contra account), in which is stored a reserve for bad debts. The combined balances in the accounts receivable and allowance accounts represent the net carrying value of accounts receivable.
The seller may use its accounts receivable as collateral for a loan, or sell them off to a factor in exchange for immediate cash.
Accounts receivable may be further subdivided into trade receivables and non trade receivables, where trade receivables are from a company’s normal business partners, and non trade receivables are all other receivables, such as amounts due from employees.
When sales are made on credit, accounts receivable are created which are recorded through the following journal entry:
| Accounts receivable | ABC | |
| Sales | ABC |
The accounts receivable balance is presented on balance sheet net of any allowance for doubtful accounts as follows.
| Accounts receivable | A |
| Less: allowance for doubtful accounts | B |
| Net accounts receivable | A – B |
When cash is collected from customer, the accounts receivable balance on balance sheet is reduced through the following journal entry:
| Cash | ABC | |
| Accounts receivable | ABC |
Many companies allow customers certain cash discount when they make payment quickly. The cash discount depends on the credit terms.
Notes receivable
Note receivable are receivables supported by a written statement by the debtor to pay a specified sum on a specified date. Like accounts receivable, notes receivable arise in the ordinary course of business; but unlike accounts receivable they are in written form. Notes receivable usually require the debtor to pay interest. They may be current and non-current.
When a company receives a note receivable it records it by the following journal entry:
| Notes receivable | G | |
| Sales/cash/accounts receivable | G |
Interest on accounts receivable is accrued as follows:
| Interest receivable (asset) | H | |
| Accrued interest (income) | H |
Non-trade receivables
None-trade receivables are receivables that arise from events that do not form the company’s main course of business. Examples include:
- Advances to employees
- Advance tax paid
- Deposits placed with other companies
Best Examples of Account Receivable
Scarlet Systems, Inc. (SS) developed an ERP software for Johnson Tools, LLC (JT) for $200,000 due within 30 days of successful testing of the system. Testing was completed on 30 April and the software became operational. JT paid an amount of $100,000 on 15 May.
JT had to settle another large liability in April which resulted in it not being able to pay the remaining invoice amount (i.e. $100,000) by 30 May. On 1 June, JT CFO convinced SS finance team to accept a note receivable due within 60 days carrying interest rate of 5% per annum for the remaining outstanding balance. JT paid the interest and principal of the note receivable at its maturity.
Required: Journalize the transactions.
Solution
The sale of software and related services is recorded through the following journal entry:
| Account receivable (JT) | 200,000 | |
| Sales | 200,000 |
Payment by JT on 15 May is journalized as follows:
| Cash | 100,000 | |
| Accounts receivable | 100,000 |
Conversion of accounts receivable to note receivable on 1 May is booked via the following journal entry:
| Note receivable | 100,000 | |
| Accounts receivable | 100,000 |
Following journal entry is made to account for receipt of note receivable principal amount and interest income:
| Cash | 100,833 | |
| Note receivable | 100,000 | |
| Interest income | 833 |
Where, interest income equals: $100,000 × 5% × 60/360
