Accounts receivable – Definition
The function of the credit department is to establish and enforce credit policies. Credit policies should protect the firm against excessive bad debts but should not be so restrictive as to eliminate customers who, though they do not have a perfect credit rating, are likely to pay.
Explanation of accounts receivable
Accountants disclose receivables when the reporting company has the right to receive cash, some other asset, or services from another party. Generally, only existing legal rights are disclosed in the body of the balance sheet. Contingent (or potential) rights to collect may be disclosed in the footnotes if they are material and if sufficient information is provided to allow the reader to understand the contingency.
For example, if the management believes that it will win a lawsuit that it filed against another company, a receivable cannot be recorded until management has signed a settlement or the court has entered judgment in its favor. The primary sources of receivables are transactions with customers in which they are allowed to pay later. These items are collectively labeled as trade receivables. Receivables occasionally arise from lending cash to others, but these transactions are unusual for most businesses that are not financial institutions. Other types of transactions may create receivables, such as payments of advances and deposits, or filing for tax refunds.
Impact of accounts receivable on the firm
Compared to cash, there is more risk associated with receivables because of the possibility of not collecting the total amount due. This risk can be reduced by a collateral agreement with the debtor. The risk can be tolerated if it produces income through finance charges or through increased sales. Management tries to reduce the risk by controlling the procedures for granting credit. Controls are also created to assure that the balances of the receivables are correctly stated and that the debtors are correctly billed.
Types of Receivables
Receivables assume several types. Most of them, however, can be classified as either accounts or notes. Accounts receivable generally can be increased (up to a specified level) whenever the debtor wants, and are not necessarily paid in accordance with a rigid schedule. Charge accounts for customers are prime examples of accounts receivable. They are known as open accounts if the customer is free to add to them. They typically bear interest only after the passing of a set amount of time.
Notes receivable are evidenced by a signed document. The terms or amounts of the debt cannot be changed without substituting another document. A due date is usually established for notes, and they bear interest from the day on which they are signed. Both notes and accounts receivable are legally enforceable. Notes may be more easily converted into cash because quite often they are negotiable instruments. That is, they can be more easily sold or transferred to others.
Classification of Receivables
Trade accounts receivable that arise from ordinary sales are usually collected within a year or the operating cycle and thus are classified as current assets. Other receivables that arise from loans to outsiders, employees, or stockholders should be shown separately from trade receivables. If the receivable is due within a year or the operating cycle, it should be classified as current. If the receivable arises from a loan to a stockholder or employee and there is no definite due date, it should be considered noncurrent. It is included in either the long-term investment or other asset section of the balance sheet.
J. C. Penney’s annual report provides a good example of how receivables are presented in corporate financial statements. In the current asset section of its January 31, 2020 balance sheet, total receivables are listed net at $3,673 million. However, in the footnotes to the statements, this figure is disaggregated, as shown below:
When receivables are discounted with recourse, the issue arises as to whether the transfer should be treated as a sale or as collateral for a loan. The FASB has rules beyond the scope of this article that are related to this issue. In any event, any contingent liability arising from discounted notes treated as sales should be disclosed in the notes to the financial statements.
In order to help statement readers assess earning power, GAAP call for the reporting of interest income earned from receivables and the losses incurred through non-collection. In order to help the assessment of solvency, accountants categorize receivables by when they are due. Receivables expected to be collected within 12 months or the operating cycle are classified as current. All others are noncurrent. Additionally, accountants disclose the net amount of cash that is expected to be collected, as well as any collateral agreements.
In order to help users make other decisions, GAAP call for other disclosures regarding receivables. One of the most commonly used methods for providing this information involves distinguishing trade from nontrade receivables. Trade receivables arise from normal transactions with customers. Nontrade receivables, on the other hand, arise from transactions that are outside this normal line of activity. Users may be interested in knowing the origin of these receivables as well as the amounts and due dates.
This form of disclosure is helpful in dealing with related-party transactions between the firm and (1) another affiliated company, (2) a stockholder, (3) an employee, or (4) a family member of a stockholder or employee. The purpose of the disclosure is to reveal that the receivable arose from a transaction which may not have been executed at arm’s length. Consequently, receivables from these related parties are separately identified in order that users are aware of the underlying events.
Other categories of nontrade receivables are disclosed separately if there is significant information conveyed to the reader by doing so. In the event that separate classification is not helpful, they can be combined into a single other receivables item.