Fundamental Accounts Receivable Formulas

"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."

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.

Below are some fundamental accounts receivable formulas that can help Lenny Hoe Leghorn manage her receivables:

Cash discounts

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.

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