In my previous publication, The Unresolved Flaws in Financial Accounting I addressed some of the complex flaws in financial accounting that add to the confusion and frustration non-accountants face in trying to decipher financial reports. This time, I look at accounts receivable.
Accounts receivable is an asset account in a balance sheet. It allows a company to hold revenues and expenses within the period they occur which is a generally accepted accounting principle. This recognizes transactions irrespective of when actual payments take place. What this means is that when a firm sells on account, it considers future payments for its goods and/or services as assets thus increasing revenue.
To a non-accountant investor or stockholder, this recording appears easy to understand on a newly released balance sheet. The truth is that there are other entries that derive from the accounts receivable recording. The net realizable value of this account is the actually amount that the firm expects it will actually receive in payments. Off the back, that means that the amount recorded in accounts receivable though making assets look good will not be actualized. This amount is however an estimate based on previous experiences, trends, and ratios.
The net realizable value creates another account, the allowance for bad debt expense. This account holds the difference between what that actual accounts receivable and the net realizable value. Most firms use an aging method, usually in 30-day blocks to make adjustments to the value of their assets on the balance sheet. These uncollectible payments are described as "contra assets" because they reduce the vale of previously declared assets.
Most non-accountants do not understand the forward and backward entries and adjustments to pages and pages of detail reporting regardless of how many pages of accompanying notes there are. The question becomes, why not subtract the estimated bad debt from the account receivable entry? The problem is that though the firm knows or rightfully estimates that some payments will not be received, it cannot write-off an account unless it specifically knows which accounts will be in default.
The danger with this estimated is that if the allowance for bad debt is under estimates, then accounts receivable and net income will be overstated and returns on investments and equity (ROI and ROE) will be inaccurate. This usually is the case when an entity wants to appear conservative in its estimates of uncollectible debts.
It should be noted that sometimes, companies can sometimes turn accounts receivable into notes receivable. This is a document in which the buyer pledges to pay he outstanding balance based on a prearranged agreement.
Another account that adds to the mix for the non-accountant is the account for cash discounts. These are early payment incentives that companies offer buyers if the buyer makes payment by a certain early date, usually 2%, if paid within10 days of the purchase. Again this means that the accounts receivable will not be fully realized so an account for estimated cash discounts is added to the balance sheet.
As stated earlier, accounts receivable hold revenue and expenses together in the period in which they occurred. Expenses can by their very definition are out going. Accounts receivables are incoming, and net income is the realization of subtracting expenses from revenue. It stands to reason therefore that for a company to have a positive cash flow, be ability to recover on the accounts receivable in vital.
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