Accounting: The Language of Business (Part 42)

I have to say accounting almost killed me.

Venus Williams

Receivables (Part A)

by

Charles Lamson

Assume that you have decided to sell your car to a neighbor for $7,500. Your neighbor agrees to pay you $1,500 immediately and the remaining $6,000 in a year. How much should you charge your neighbor for interest?

You should determine an appropriate interest rate by asking some financial institutions what they currently charge their customers. Using this information as a starting point, you could then negotiate with your neighbor and agree upon a rate. Assuming that the agreed-upon rate is 8%, you will receive interest totaling $480 for the one-year loan.

In the next few posts we will describe and illustrate how interest is computed. In addition, we will discuss the accounting for receivables, including uncollectible receivables. Most of these receivables result from a business providing services or selling merchandise on account.

Classification of Receivables

Many companies sell on credit in order to sell more services or products. The receivables that result from such sales are normally classified as accounts receivable or notes receivable. The term receivables includes all money claims against other entities, including people, business firms, and other organizations. These receivables are usually a significant portion of the total current assets.

Accounts Receivable

The most common transaction creating a receivable is selling merchandise or services on credit. The receivable is recorded as a debt to the accounts receivable account. Such accounts receivable are normally expected to be collected within a relatively short period, such as 30 or 60 days. They are classified on the balance sheet as a current asset.

Notes Receivable

Notes receivable are amounts that customers owe, for which a formal, written instrument of credit has been issued. As long as notes receivable are expected to be collected within a year, they are normally classified on the balance sheet as a current asset.

Notes are often used for credit periods of more than sixty days. For example, a dealer in automobiles or furniture may require a down payment at the time of sale and accept a note or a series of notes for the remainder. Such arrangements usually provide for monthly payments.

Notes may be used to settle a customer's account receivable. Notes and accounts receivable that result from sales transactions are sometimes called trade receivables. Unless we indicate otherwise, we will assume that all notes and accounts receivable in the next few posts are from sales transactions.

Other Receivables

Other receivables are normally listed separately on the balance sheet. If they are expected to be collected within one year, they are classified as current assets. If collection is expected beyond one year, they are classified as noncurrent assets and reported under the caption investments. Other receivables include interest receivable, taxes receivable, and receivables from officers or employees.

Internal Control of Receivables 

The principles of internal control that we discussed in prior posts can be used to establish controls to safeguard receivables. For example, the four functions of credit approval, sales, accounting, and collections should be separated, as shown in Exhibit 1.

EXHIBIT 1

The individuals responsible for sales should be separate from the individuals accounting for the receivables and approving credit. By doing so, the accounting and credit approval functions serve as independent checks on sales. The employee who handles the accounting for receivables should not be involved with collecting receivables. Separating these functions reduces the possibility of errors and misuse of funds.

To illustrate the need to separate functions, assume that the accounts receivable billing clerk has access to cash receipts from customer collections. The clerk can steal a customer's cash payment and then alter the customer's monthly statement to indicate that the payment was received. The customer would not complain and the theft could go undetected.

To further illustrate the need for internal control of receivables, assume that salespersons have authority to approve credit. If the salespersons are paid commissions, say 10% of sales, they can increase their commissions by approving poor credit risks. Thus, the credit approval function is normally assigned to individuals outside the sales area. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 318-319*

end