We previously have made reference to the accounting concept of conservatism. In accounting, conservatism means resolving uncertainty in a manner ~hat minimizes the. risk of overstating the company’s current financial position. With respect to the valuation of accounts receivable, conservatism suggests that the allowance for doubtful accounts should be at least adequate.
That is, it is better to err on the side of the allowance being a little too large, rather than a little too small. , Notice that conservatism in the valuation of asset-, also leads to a conservative measurement of net income in the current period. The larger the valuation allowance, the larger the current charge to uncollectible accounts expense.
Direct ‘Write-off Method
Some companies do not use any valuation allowance for accounts.receivable. Instead of making end-of-period adjusting entries to record uncollectible accounts expense on the basis of estimates, these companies recognize no uncollectible accounts expense until specific receivables. are determined to be worthless. This method makes no attempt to match revenue with the expense of uncollectible accounts.
Internal Controls for Receivables
One of the most important principles of internal control is that employees who have custody of cash or other negotiable assets must not maintain accounting records. In a small business, one employee’ often is responsible for handling cash receipts, maintaining accounts receivable records, issuing credit memoranda, and writing off uncollectible accounts. Such a combination of duties is an invitation to fraud. The employee in this situation is able to remove the cash collected from a customer without making any record of the collection. The next step is to dispose of the balance in the customer’s account. This can be ‘done by issuing a credit memo indicating that the customer ha~ returned merchandise, or by, writing off the customer’s account as uncollectible
Management of Accounts Receivable
Management has two conflicting objectives with respect to.the accounts receivable. On the one hand, management wants to generate as much sales revenue as possible. Offering customers lengthy credit terms, with little or no interest, has proven to be an effective means of generating sales revenue.
Every business, however, would rather sell for cash than on account. Unless receivables team interest, they are nonproductive assets that produce no revenue as they await collection. Therefore, another objective of cash management is to minimize the amount of money tied up in the form of accounts receivable. .
Several tools are available to a management that must offer credit terms to its customers yet wants to minimize the company’s investment in accounts receivable. We have already-discussed offering credit customers cash discounts (such as 2110, n/30) to encourage early payment. Other tools include factoring accounts receivable and selling to customers who use national credit cards .
Factoring Accounts Receivable
The term factoringdescribes transactions in which a business either sells its accounts receivable to a financial institution (often’ called afactor) or borrows money by pledging its accounts receivable as collateral (security) for a loan. In either case, the business obtains cash immediately instead of having to wait until the receivables can be collected.
Factoring accounts receivable is a practice limited primarily to small business organizations that de not have well-established credit. Large and solvent organizations usually are able to borrow money using unsecured lines of credit, so they need not factor their accounts receivable
Credit Card Sales
Many retailing businesses mmmuze their investment in receivables by encouraging .customers to use credit cards such as American Express, Visa,· and MasterCard. A customer who makes a purchase using one of these cards signs a multiple-copy form, which includes it credit card draft. A credit card draft . is similar to a check that is drawn on the funds of the credit card company rather than on the personal bank account of the customer. The credit card company promptly pays a discounted amount of cash to the merchant to redeem these drafts. At the end of each month, the credit card company bills the credit card holder for all the
drafts it has redeemed during the month. If the credit card holder fails to pay the amount owed, the credit card company sustains the loss.
By making sales through credit card companies, merchants receive cash more quickly from credit sales and avoid uncollectible accounts expense. Also, the merchant . avoids the expenses of investigating customers’ credit, maintaining an accounts receivable subsidiary ledger, and making collections from customers.
Other Credit Cards
When customers use non bank credit cards (such as American Express and Carte Blanche I. the rctuling business cannot deposit the credit card drafts directly in its bank account. Instead of debiting Cash. the merchant records-an account receivab Je fro~ the credit card company: Periodically, the credit card drafts are mailed (or transmitted electronically) ro the credit card company, which then sends a check to the. merchant. Credit card companies however, do not redeem the drafts. at the full sales price. The agreement between tile credit card company and the the credit card company to take a discount of between and 5% when redeeming the drafts.
To illustrate, assume that Bradshaw Camera Shop sells a camera for $200 to a customer who uses a Quiek Charge credit card. The entry would be
Evaluating the Quality of Accounts Receivable
Collecting accounts receivable Oil time is important; it spells the success or failure of a company’s credit and collection pelicies. A past-due receivable is a candidate for write-off as a credit loss. To help us judge how good a job a company is doing in granting credit and collecting its receivables. we compute the ratio of net sales to average receivables. This accounts receivable turnover rate tells us how many times the company’s average investment in receivables was converted into cash during the year. The ratio is computed by dividing annual net sales by average accounts receivable.
The data just described for computing the accounts receivable turnover rate and the average number of days to collect accounts receivable can be concisely stated as shown in the following equations:
In the annual audit of a company by a CPA firm. the independent auditors will verify receivables by communicating directly the people who owe the money. This confirmation process is designed to provide that the customers and other debtors actually exist and that they acknowledge their indebtedness. The CPA firm also may verify the credit rating” of major debtors