Basic Accounting Procedures in Handling Accounts Receivable
A company that extends credit to its customers as a general practice records the sales by creating a subsidiary ledger for every customer’s account. The related accounting entries in the general ledger books represent periodic totals of sales made on credit.
1. Basically, there is no cash received; hence the item Accounts Receivable will be debited and the corresponding credit will be Sales on Credit. This is to readily distinguish the total amount of sales on credit against the COD sales.
2. It is important for companies to have sound credit policies before granting sales on credit to customers. Otherwise, recognizing revenues without actually adding cash to the company’s coffers spells disaster in the long run.
3. However, even with sound credit policies, there are instances when customers fail to honor their commitments and risk tarnishing their credit reputations by defaulting on payments. As a general rule, a matter of 180 days after the account has become past due is reasonable time in which defaulted accounts are considered as bad debts.
4. There are two reasons why it is considered to be proper accounting procedure to recognize as bad debts the defaulted accounts of more than 180 days. At this point, however, it should be clear to the reader that in recognizing a defaulted account as Bad Debt, collection efforts will still continue and that all possible means of collection should still be applied.
Under IRS Tax rules - All sales revenues recognized as income for the year shall be taxed in the same year they are recognized whether actually earned or unearned. Interests earned from these Accounts Receivable-Sales are accrued and recognized as additional income for the year.
Under SEC rules - All income reported in the SEC financial report should reflect only the income that was actually earned at the time of reporting. Sales on credits and accruals therefore do not qualify as actual revenues.
5. Thus, the defaulted accounts are technically written-off as receivables accounts, by setting-up an Accounts Receivable contra asset called Allowance for Doubtful Accounts (ADA) and by debiting the Bad Debts expense account. Readers may read a separate article on how to set up these Allowances for Doubtful Accounts through the article entitled, Allowance for Doubtful Accounts: Examples and Explanations.
While under the ADA, the defaulted accounts are not yet treated as outright deduction of the Accounts Receivable balance but are merely provided as valuation estimates in order to present the real net worth of a company.
6. Balance Sheet Presentation of Accounts Receivable:
Accounts Receivable – Sales or Trade ----------xyz
Less: Allowance for Doubtful Accounts ------- xyz
Net Book Value –Accounts Receivable Sales or Trade --- xyz
7. In recognizing the default as Bad Debts expense, this entry will have an offsetting effect against the amount included as Sales on Credit. In addition, all accrual of interest will cease and could be reversed since the entries are mere accrual or adjusting entries.