The Flaw of Accounts
Receivable in Financial Accounting to Non-accountants
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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