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Let's Start the Business Rolling at RidgeLeg
"Do you think this business will survive for years?" asks Donnie Leghorn, the husband of Lenny Hoe Leghorn, the owner. "We know a lot of trading companies that are easily toned down because of competition. They are left with millions in collectibles," he added.
"I am very positive about this," Lenny tells her husband. "I grew up with parents who were in this kind of business. All we have to do is to manage the accounts very well. It is good to transact in cash all the time but we see how competiton leads us to granting credit to clients. Anyway, I have created systems that will help us manage the receivables. This is trading, and since 60% will be on credit as planned, I will have to talk to my accountant regarding the use of simple formulas in handling receivables."
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How Do You Manage Accounts Receivable in a Trading Business?
If an enterprise is to sustain its operations, it has to compete. In today's economy where buying and selling goods and services are done through credit and borrowing agreements, a bulk of an enterprise's resources is tied up in receivables. So, as a strategy to fare well in the open market, Mrs. Leghorn allows 60% of her total sales to be on account. Her receivables, as a result of a trading concern, are called trade receivables.
For a start, management must establish strong credit policies and other necessary guidelines in granting accounts receivables. The personal supervision of the account manager is also important, and there are some simple formulas that the manager can use. The formulas presented below are also appropriate for RidgeLeg's plan for its customers' accounts.
RidgeLeg has opted to grant cash discounts and accept credit cards for purchases . Owner Lenny Leghorn also understands the need to provide allowances for bad debts, because she believes that in the normal course of business some clients might not be able to pay their accounts. Two methods are presented for managing uncollectible accounts.
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Formulas to Help Manage RidegeLeg's Accounts Receivables
Below are some fundamental accounts receivable formulas that can help Lenny Hoe Leghorn manage her receivables:
Cash discounts are reductions from the sales price as an inducement for prompt payment of an account. They are expressed in terms which read as 2/10, net/30. This cash discount, 2/10, net/30 means that if the customer is able to pay its debts within 10 days, (from the invoice date to the next 10 days) he will avail a discount of two percent based on the gross invoice amount. There are three methods in accounting for cash discounts but the most popular one, which is the allowance method, is discussed below:
In all illustrations, let us remember that assets like cash, accounts receivable, and sales discounts are normally placed at the left side or at their DEBIT sides; and allowances for sales discount and sales discounts forfeited are placed at their right sides or at their CREDIT sides.
Under the allowance method, the sales discount is recognized when it is offered to a customer using the account allowance for sales discounts. The accounts receivable is recorded at its gross sales price and the available cash discount is recorded as a credit in the valuation account, Allowance for Sales Discounts. Sales is recorded as net amount. Subsequently, if the discount is not taken, the allowance discount is debited and the Sales Discount Forfeited account is credited.
Going back to RidgeLeg, if there is a sale of $76,950 on July 16, 2005, $76,950 will be placed at the left side of the Accounts Receivable, while $75,411 will be posted at the right side of the Sales account. The difference of $1,539, which represents the sales discount, will be placed in a new account called Allowance for Sales Discount, at the right side of the account. As per agreement between the buyer and the seller, the sales discount will be granted if the account is settled within 10 days.
If collection is done on the 25th of July, which is within the discount period of 10 days, the Accounts Receivable account will be reduced by $76,950, placed at its right side, while Cash is increased by $75,411, placing the said amount at the left side of Cash. The Allowance for Sales Discount will be closed by placing the amount of $1,539 at its left side.
Please turn to Page 2 for more on Fundamental Accounts Receivable Formulas
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Accounts Receivable Formulas: In granting accounts to customers, some of the transactions that might occur are the following: the granting of cash discounts that induce customers to make prompt payment; credit card transactions, which most clients today are using for easy and safe transactions; and the conservative approach in handling accounts receivable, based on the assumption that not all accounts can be collected.
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Cash Discounts (continued)
If collection is made beyond the discount period, the records will reveal the following:
Cash will be increased by $76,950, placing the amount at the left side of Cash. The Allowance for Sales Discount, $1,539, will be closed by placing the amount at the left side of the account, bringing the account balance to zero. The Accounts Receivable of $76,950 will be closed, too, by placing the amount at the right side; and a new account called Sales Accounts Forfeited is created with an amount of $1,539, placing the said amount at its right side.
Credit Card Sales
The use of credit cards is popular and involves another type among the accounts receivable formulas. Because the company wants to maximize its sales, it allows customers to pay in cards. Credit card companies earn card fees, ranging from one to five percent of net credit card sales, thereby reducing the value of the company's accounts receivables. The account Credit Card Service Charge would be reported as an operating expense in the income statement.
Going back to RidgeLeg, if the owner accepts credit card transactions and signs a Memorandum of Agreement with Citibank Mastercard, the following transactions and the corresponding records will be made:
The company receives Citibank Mastercard drafts or receipts amounting to $1,200,000.
Accounts Receivable-Citibank Mastercard will be created with an amount corresponding to $1,200,000 and, at the same time, increasing Sales by placing the same amount of $1,200,000 at the right side of Sales.
RidgeLeg sends the receipts to Citibank, which will send back to RidgeLeg a check for $1,200,000 less its service fees. A 2% service charge that RidgeLeg would recognize as a selling expense will be created. This transaction effects the accounts as follows:
Cash is increased by $1,176,000; such amount is placed at the left side, increasing the amount of Cash by $1,176,000. An account called Credit Card Service Charge is created with a corresponding amount of $24,000 placed at the left side. The account Accounts Receivable - Citibank Mastercard will be closed by placing the total amount of $1,200,000 at its right side.
In granting credit to clients in trading activities, past due accounts cannot be avoided. Some of these accounts may not be collected, which is the reason why the company must regard a portion of these bulk amounts as uncollectible. Under IAS 39, Loans and Receivables are also stated to be measured on the balance sheet at its amortized cost using the effective interest method.
There are two methods of accounting for uncollectible accounts: direct write off and the allowance method.
The direct write off method recognizes bad debts expense by reducing directly the receivables account. In the case of RidgeLeg, if $40,000 proves to be uncollectible, the following accounts will be affected: An account called Bad Debts Expense amounting to $40,000 will be established, and there will be a reduction of the receivables with the amount of $40,000. The $40,000 Bad Debts Expense will be placed at its left side while $40,000 will be placed at the right side of the Receivables account to take into effect the reduction of the said account.
If, for example, the amount of $40,000 is recovered, the accountant will simply reinstate the account by placing again the amount of $40,000 at the left side of the Accounts Receivable and the corresponding effect is the creation of an account called Bad Debts Recovery with the amount of $40,000 placed at its right side. After doing this, the collection is recorded by placing an amount of cash at its left side with the amount of $40,000 and placing again the $40,000 at the right side of the Accounts Receivable.
Please turn to Page 3 for more on Fundamental Accounts Receivable Formulas
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In Part 3 of this article on accounts receivable formulas, there is not a guarantee, that a good management of receivables will be attained by relying only on the tools discussed in this article. There are other important areas to be managed, like the proper selection of clients to be granted credit, strong credit policies, and the monitoring of accounts receivable.
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Uncollectible Accounts (continued)
If RidgeLeg chooses to use the Allowance Method instead of the direct write off method, a reduction of the Accounts Receivable will be made. Tthe accountant will have to prepare another account called Allowance for Bad Debts and place the amount of $40,000 at its right side.
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Conclusion: How Do These Tools Help?
Cash discounts or sales discounts from the seller's point of view are a reduction from the sales price. They are created as an inducement for prompt payment of an account. There are three methods of cash discounts. Management will have to choose which one is appropriate for the company's situation. The decision dictates which accounts receivable formulas are utilized.
Credit card transactions are taken by the company to increase the volume of its sales. The company will only have to be careful what credit card company gives it the best option to increase revenue and which is safer to deal with. A cost benefit analysis which includes quantitative and qualitative factors must be used in determining the profitability of these credit card transactions.
Also, It cannot be avoided that some customer accounts will be uncollectible. The company should also select what method of accounting it is going to use for its uncollectible accounts.
The three tools discussed above are some of the tools that can be used by a company in the management of its accounts. These tools are particularly used in the granting of accounts receivable like those of RidgeLeg's transactions. But management must be aware that the handling of accounts receivable does not only rely on the tools discussed above. Critical areas like the selection of credit clients, credit policies, monitoring of accounts, sales work force, and the collection system should also be taken care of.
Book and Image Credits:
Intermediate Accounting Volume 1 by Robles and Empleo 2006