Accounts Receivable Definition
Accounts receivable is a current asset because it represents a claim to cash that a company expects to receive within one year.
Accounts Receivable Description
An extension of credit is offered from one company to another. For example, if one of Sunny’s customers purchases sunglasses by cash or credit card, Sunny reports the earnings as a cash sale since the store did not extend credit directly to the customer.
When the store issues credit to the customer directly, on the other hand, usually to another company, the sale is recorded in accounts receivable as opposed to cash.
Most companies do not charge interest on accounts receivable unless the account becomes past due. An extension of credit is then essentially an interest free loan to customers, and not collecting payments on time creates opportunity costs for the company. For example, the company could use the cash from sales to invest the money and earn interest, pay down debt from which the company is incurring interest expenses, or finance growth opportunities instead of having money tied up in accounts receivable in lieu of cash sales.
So why sell products on credit in the first place?
Firms expect that by selling on credit, they can achieve better sales and profits than they would if their sales were on a cash basis only. Even though a firm runs the risk of not being able to collect on some receivables, it expects that these uncollectible accounts and associated costs of credit sales will be sufficiently offset by an increase in sales and, in turn, an increase in net income.
To encourage prompt payment, companies may offer sales discounts. For example, a company may offer “2%/10, net 30.” This means if a customer purchases products and pays within 10 days, they can take 2% off the total price.
Accounts Receivable & Advantage of Payment Terms
|It is always in the company’s best interest to take advantage of purchase discounts. When a company offers payment terms of “2%/10, net 30,” for example, this means if the customer purchases products and pays within 10 days, they can take 2% off the total price!
Otherwise, full payment is due within 30 days.The loss of the 2% discount in exchange for an additional 20 days to pay is equivalent to paying an annual interest rate of 36%!
360/additional days to make payment * discount rate, 360/20 * 2% = 36%!
Nonetheless, it is a business reality that a certain percentage of customers will not pay balances due at all.
The reasons may vary, from economic downturns, company cash flow problems, or product or payment term disputes. Therefore, GAAP requires that companies properly estimate and report the bad debt expense from sales on credit.