Accounting for Receivables and Bad Debts
Receivables are amounts owed to a business by outsiders. Most receivables arise from credit sales to customers and are called “accounts receivable” or “trade receivables.” In this chapter we discuss the accounting for customer-based receivables under US GAAP and IFRS. Both regimes require that accounts receivable appear in the balance sheet at net realizable value. In theory, this value should reflect the amount owed to the company by its customers. But not all receivables are collected (customers go bankrupt) and some merchandise might be returned. The accounting for receivables must incorporate both of these factors. The appendix to this chapter discusses the banking-industry analog to uncollectible accounts – loan loss reserves.
Estimating bad debts
Some credit sales never get collected. Most companies establish credit policies that balance the expected cost of credit sales (e.g., billing costs, collection costs, and the risk of bad debts) with the benefit of increased sales. Companies choose what they believe will be the profit-maximizing policy.
The challenge from an accounting point of view is that accounts receivable should reflect how much cash the company expects to collect from its customers, not how much cash is owed to it. Therefore, estimates of bad debts, otherwise known as “uncollectible accounts,” must be made.
This estimate can be done in either of two ways:
- the sales revenue approach, or
- the gross ...