Accounts receivable are considered an asset in the business’s accounting ledger because they can be converted to cash in the near term.
Most businesses have accounts receivable. These are sales for which payment has not yet been received. The customer has not paid for the good or service received at the time of the transaction. I
Instead, the business has extended credit to the customer and expects to receive payment for the transaction at some point in the future.
Accounts receivable represent convertible assets owed to the company. That is, they describe a financial resource that can be converted to cash in the near future, once the customer has paid. An asset is any resource that provides monetary value to a business. It can help the business produce economic value and can be converted to cash.
Assets are usually classified into one of two categories—current and non-current. Current assets refer to those that are liquid, meaning they can be easily converted to cash in less than a year.
Accounts receivable are typically collected in two months or less. For this reason, they are considered a current asset or a “short-term asset.”
Accounts receivable assets will be recorded in the balance sheet for the business along with other assets.
The balance sheet is a document that summarizes the business’s overall financial status. It is a static document that provides this information at a specific point in time.
By providing detailed information at a fixed point in time, the balance sheet can be said to provide a “snapshot” of the business and its key financial indicators.
Information in the balance sheet represents the three fundamental accounting measures: assets, liabilities, and equity. Accounts receivable will be recorded in the balance sheet along with other short-term or current assets, such as cash, cash equivalents, stock inventory, marketable securities, and prepaid expenses.
Typically, assets are listed first on the balance sheet, followed by liabilities and equity. Sometimes assets are listed in the left column, and liabilities and equity are listed on the right. In either case, the balance sheet is organized around the fundamental accounting equation, which is represented as: Assets = Liabilities + Equity. All data in the balance sheet is arranged according to these three categories.
Accounts receivable record purchases and transactions that have not yet been paid for by the customer. In a perfect world, all accounts receivable will be collected in the standard timeframe of one year or less.
In reality, this does not happen. Some accounts receivable will never be collected—this is considered bad debt.
Bad debt offsets accounts receivable assets by subtracting the value of the asset in the income statement. Because businesses do not know if or when an accounts receivable will become a bad debt, they estimate instead.
The business can estimate bad debt in one of two ways.
Direct write-off method—with this method, accounts are written off as a loss once they are determined to be uncollectible. Because this method does not adhere to the matching principal, it is the less acceptable accounting method.
Allowance method—this method allows the business to remain consistent with the matching principal. According to this method, the business will set aside a reserve for expected bad debts, also called doubtful accounts. This reserve, or allowance, is referred to as a contra asset account because it “nets” or balances against the accounts receivable assets listed in the balance sheet.
The allowance is calculated based on an estimate of how many accounts receivable might not be collectible. The estimate is calculated as a percentage of sales multiplied by a historical average of accounts receivable that have gone uncollected.
Although it is based on an estimate, this method allows a business to align bad debt to the reporting period in which the sale occurs. This is in accordance with the matching principal, and therefore, it is considered a more accurate form of accounting bad debt expenses.
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