Unit 2: accounting for receivables introduction

1.3 Valuing Accounts Receivable
Once Receivables are recorded in the accounts, the next question is:

How these receivables should be reported on the balance sheet?

Determining the amount to report as an asset is important because some receivables will become uncollectible. To ensure that receivables are not overstated on the balance sheet, they are stated at their cash (net) realizable value.

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Cash (net) realizable value- is the net amount expected to be received in cash.



The cash realizable value excludes amounts that the company estimates it will not be able to collect. Receivables are therefore reduced by estimated uncollectible receivables on the balance sheet.
The income statement also is affected by the amount of uncollectible. An expense for estimated uncollectible is recorded to make certain that expenses are not understated and are matched with related sales revenue. This expense is reported as bad debts expense on the income statement.


1.4 Methods of Accounting for Bad Debts

How does accounts receivable become uncollectible?

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Although each customer must satisfy the credit requirements of the seller before the credit sale is approved, inevitably some accounts receivable become uncollectible. For example, a company may experience a decline in sales because of a downturn in the economy. Similarly, individuals may be laid off from their jobs or be faced with the unexpected hospital bills.

In accounting, credit losses are debited to Bad Debts Expense (or uncollectible Accounts Expense). Such losses are considered a normal and necessary risk of doing business on credit basis. In fact, from a management point of view, a reasonable amount of uncollectible accounts is evidence of a sound credit policy. When bad debts are abnormally law, the company may be losing profitable business by following a credit policy that is too strict. Of course, abnormally high bad debts indicate a credit policy is too lenient.

Two methods are used in accounting for uncollectible accounts:

(1) The allowance method and

(2) The direct write off method.

Each of these methods is explained in the following sections.