Accounts Receivable

Accounts receivable represent the contractual right to receive money on demand or on a fixed or determinable date; they arise from the sale of goods and services to customers and clients in the normal course of business; they are usually collected within 30-60 days; and are based on a customer's oral promise to repay. Accounts receivable and notes receivable are two types of trade receivable; that is, receivables that arise in the ordinary course of business. Because accounts receivable are a short-term extension of credit, they are classified as a current asset and listed under short-term assets on the balance sheet. 

The Difference Between Accounts Receivable and Notes Receivable

Notes receivable differ from accounts receivable in that they typically include a formal written instrument of credit as evidence of the debt (a promissory note), require the debtor to pay interest, and are collected in a time period greater than 30 days. All accounts receivable are trade receivables. Because notes receivable can arise from activities other that the ordinary course of business, a notes receivable can be either a trade receivable or a nontrade receivable. 

Recognition and Measurement of Accounts Receivable

Accounts receivable are recognized when the entity becomes a party to the contractual right to receive money either on demand or on a fixed and determinable date. For example, while an entity might have a commitment to sell a good or service to a customer or client, it doesn't have a contractual right to receive cash until they've performed under the contract. 

Receivables are initially recognized at fair value. In some instances measuring the fair value of the transaction is not the same as measuring the exchange price, or the amount due from the customer because of trade and cash discounts and interest rate factors. 

Receivables are typically subsequently measured on an amortized-cost-basis, the amount at which an investment is acquired, adjusted for accretion, amortization, collection of cash, previous other-than-temporary impairments recognized in earnings and foreign exchange (FASB Glossary). Some receivables are elligible to be subsequently valued using the fair value option as well.¹ 

Trade Discounts

List prices often have trade or quantity discounts. For example, the list price of a university-level accounting textbook might be $100, but the university bookstore might purchase these at a 30% discount, or $70 a piece. The normal practice is simply to deduct the discount from the list price and record the net amount as the receivable and revenue. 

Sales Discounts

Sales discounts are discounts to customers provided when payment is received within a specified number of days. For example, credit terms of 2/10 n/30 ("two-ten, net 30") mean that a business will receive a two percent discount on the selling price if it pays its account within ten days. There are two ways to account for sales discounts. The receivable and revenue can be calculated at its net value (that is, less any discounts offered), and if a customer pays after the discount period, the loss of a discount is accounted for as a penalty, and reported seperately in an account Sales Discounts Forfeighted. However, most company's simply record the total value of the sale and receivable assuming no discount will be taken. Under this method, when a payment is received in time, the amount of the discount taken is recorded in a contra revenue account Sales Discounts. Under this method, an Allowance for Sales Discounts is often used as a contra account to accounts receivable. 

Interest

Theoretically, accounts receivable should be recognized at their present value based on an effective interest rate. For example, if an account receivable is expected to be collected in 30 days, and the cost of borrowing for the firm is 12% annually, a $1000 receivable would be recognized today as a sale and receivable of $990 ($1000/1.01), and the additional amount received in 30 days would be recognized as interest revenue. However, because the interest discount is not normally material for most company's, accountants typically simply ignore this when accounting for accounts receivable. 

Accounts Receivable Valuation

Accounts receivable are presented on the balance sheet at their net realizable value. This means that they must be adjusted for uncollectible receivables and any returns, allowances or cash discounts that may be granted. Uncollectible accounts and their related bad debt expense can be accounted for under two methods: the allowance method or the direct right-off method. 


Reference:

1. FASB ASC 825-10-15