Accounting: The Language of Business - Vol. 2 (Intermediate: Part 138)

To attract investors, corporations began to publish their financials (in the 1800s) in the form of a balance sheet, income statement, and cash flow statement. These documents were proof of a company’s profit-making abilities. Although investment capital stimulated operations and profits for most corporations, it also increased the pressure on management to please their new bosses: the shareholders. For their part, the shareholders did not completely trust management, which exposed the need for independent financial reviews of a company’s operations.

(Investopdia)

Short-Term Operating Assets: Cash and Receivables (Part C)

by

Charles Lamson

Accounting for Accounts Receivable: Initial Measurement

Accounts receivable (also referred to as trade accounts) are amounts due to an entity from its customers or clients that originated from the sale of goods or services. Accounts receivable do not involve signed contracts, and there is generally no interest charged due to their short-term nature.

Companies generally record accounts receivable at the amount of sale. (Both U.S. GAAP and IFRS allow companies to choose to value most financial assets at fair value. This fair value option will be discussed in more detail in a later post.) The terms of sale—particularly discounts such as trade discounts, routing discounts, and sales discounts—affect the initial measurement of accounts receivable. (Sales returns also may impact the initial measurement of accounts receivable. Companies selling products often give the buyer the right to return the product. Returned merchandise is referred to as sales return. We discuss sales return in greater depth in Part 130.)

Trade Discounts and Volume Discounts

Trade discounts are reductions of the catalog or list price when a company sells to a reseller in the same industry. A volume discount reduces the list price for customers purchasing a large quantity of merchandise. Therefore, both trade and volume discounts lower the amount of the sales revenue and impact the amount initially recorded in accounts receivable. Example 9.1 illustrates accounting for volume discounts. Accounting for trade discounts is similar.

Sales Discounts

Sales discounts (also called cash discounts) are reductions granted to customers for early cash payments as an incentive to encourage quick invoice payment. Although the seller will collect less total cash, it will have cash earlier for use in current operations. The benefits of improved cash flow and liquidity are greater than the cost of the discount.

Companies usually include sales discounts on customer invoices. A typical sales discount is written as 2/10, n/30, which means the just customer will receive a 2% discount if she pays within 10 days of the invoice date: otherwise, the full balance is due within 30 days. Kellogg Company, the multinational food company, disclosed in its 2015 financial statements that it generally requires payment for goods sold at 11 or 16-days subsequent to the date of invoice as 2/10, n/11, 1/15, or n/16 in the United States, but terms can vary around the world and by business type (Kellogg Company's 2015 10K filing, page 2). There are two acceptable approaches to recording sales discounts: the most-likely-amount method or the expected-volume method.

Most-Likely-Amount-Method. Under the most-likely-amount method, a company initially records accounts receivable at the most likely amount of cash that it will collect from its customer. If the company anticipates that its customer will not take the discount, then it will record the receivable at the full (growth) sales amount (the gross method). 

1. If the customer pays after the discount period, it pays the full amount. The amount of cash received is the gross amount of the receivable on the books. No further adjustments are needed to reflect the fact that the customer did not take the discount.

2. If the customer pays within the discount period, the journal entry must reflect the discount because the company receives less cash than the gross account receivable on the books. The net amount of cash received is the difference between the gross receivable amount and the discount. The sales discount equals the gross amount of the receivable or invoice times the sales discount percentage. The sales discount is recorded in a contra-revenue account, reducing the amount of revenue recorded on the income statement.

If the company anticipates that the customer will take the sales discount, then it initially records sales and accounts receivable at the net amount (the net method).

1. If the customer pays within the discount period, then the journal entry measures the amount of cash received as the net amount of the receivable on the books. No additional adjustments are required to reflect the discount taken.

2. If the customer pays after the discount period, the company receives more cash than the net carrying value of the receivable. In this case, the credit to accounts receivable is less than the debit to cash. The seller credits the difference to the sales discounts forfeited account, a revenue account. The sales discounts forfeited can be interpreted as interest revenue on extending credit to the customer.

For most companies, recording accounts receivable at the net amount is more appropriate than recording the receivable at the gross amount because their customers usually take the discount. Thus, recording the receivable at the net amount is considered a more reliable measurement of the current asset. Example 9.2 illustrates accounting for sales discounts using the most-likely-amount method.

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 446-448*

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