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Trade receivables arise when a business makes sales or provides a service on credit. For example, if Ben sells goods on credit to Candar, Candar will take delivery of the goods and receive an invoice from Ben. This will state how much must be paid for the goods and the deadline for payment, eg within 30 days. Ben now has a trade receivable – the amount payable to him by Candar.

The total value of trade receivables for a business at any one time represents the amount of sales which have not yet been paid for by customers. The trade receivables figure will depend on the following:

  1. The value of credit sales. The greater the value of credit sales then, other things being equal, the greater the total of trade receivables.
  2. The period of credit given. The longer the period of credit given to customers then, other things being equal, the greater the total of trade receivables.
  3. The efficiency with which the business administers its trade receivables. The more inefficient the business is in billing its customers and collecting overdue accounts then, other things being equal, the greater the total of trade receivables.

RECORDING THE CREDIT SALE

Let’s imagine that Ingrid makes a credit sale of $6,450 to Manfredi. The sale was made on 17 March 20X0 and the goods have been delivered to Manfredi along with an invoice for $6,450. The invoice states that the amount owing should be paid within 30 days from the date of the invoice.

The invoice will be processed through Ingrid’s accounting system. The original entry will be in Ingrid’s Sales Day Book which lists all credit sales chronologically. Total credit sales (including the $6,450) will be posted from the Sales Day Book to the debit of trade receivables account and the credit of sales account – both accounts being in the General Ledger. The $6,450 will also be posted to the debit of a personal account opened for Manfredi and kept in the Receivables Ledger.

In a computerised accounting system, all these accounting entries and the production of the invoice would take place simultaneously.

Manfredi’s account will look something like Table 1 below in the Receivables Ledger.


Table 1: Manfredi's account in the receivables ledger

f3-trade-rec-1

Manfredi’s account shows a debit balance. This is an asset because it ‘is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity’ (IASB Framework for the Preparation and Presentation of Financial Statements, paragraph 40).

Here the ‘entity’ is Ingrid’s business, the ‘past event’ is the sale, and the ‘future economic benefits’ are represented by the cash received from Manfredi when he settles the invoice.

The debit balance is also a current asset because it meets the criteria in paragraph 66 of IAS 1, Presentation of Financial Statements. This states that an entity should classify an asset as current when any one of the following applies:

  • (a) The entity expects to realise the asset, or intends to sell or consume it, in its normal operating cycle.
  • (b) The entity holds the asset primarily for the purpose of trading.
  • (c) The entity expects to realise the asset within 12 months after the reporting period.
  • (d) The asset is cash or a cash equivalent (as defined in IAS 7) unless the asset is restricted from being exchanged or used to settle a liability for at least 12 months after the reporting period.

In this example, the asset meets criterion (c) because the amount  is payable within 30 days, and also criterion (a) because Ingrid’s normal operating cycle is buying and selling on credit, collecting cash from customers, and paying suppliers.

The effect on the accounting equation is that inventory will decrease by the cost of the goods sold and receivables will increase by the selling price of the goods sold. So total assets increase by the profit made on the sale. This also increases capital/equity. There is no change in liabilities.

The profit on this transaction is therefore taken when the goods are sold even though no money has exchanged hands yet. This is because this transaction meets all of the recognition rules in paragraph 14 of IAS 18:

  • (a) The entity has transferred to the buyer the significant risks and rewards of ownership of the goods.
  • (b) The entity retains neither continuing managerial involvement to the degree usually associated with ownership, nor effective control over the goods sold.
  • (c) The amount of revenue can be measured reliably.
  • (d) It is probable that the economic benefits associated with the transaction will flow to the entity.
  • (e) The costs incurred, or to be incurred, in respect of the transaction can be measured reliably.


All these criteria are met here:

  • Manfredi now possesses and controls the goods (criterion (a)) and Ingrid doesn’t (criterion (b))
  • Manfredi has agreed the price (as per the invoice), meeting criterion (c)
  • Manfredi is likely to pay the invoice (Ingrid wouldn’t have sold to Manfredi otherwise, and can sue for payment if necessary) (criterion (d))
  • Ingrid’s costs of buying and selling the goods are measurable (criterion (e)).


What happens now?
If all goes well, Manfredi will keep to the terms of the agreement and Ingrid will receive payment within 30 days. If Manfredi pays on 16 April 20X0, Ingrid will debit this in her Cash Book (in the Bank column) and credit the trade receivables account (in the General Ledger). The payment will also be credited to Manfredi’s account in the Receivables Ledger, as shown in Table 2 below.


Table 2: Manfredi's account in the receivables ledger (post-payment)

f3-trade-rec-2

This now completes the transaction cycle. The asset trade receivables reduces by the amount of the payment, and cash at bank increases by the same amount.

ENCOURAGING PROMPT PAYMENT

Sometimes, the entity may give a discount if a customer pays an invoice early. This is to encourage prompt payment by the customer. The accounting entries depend upon whether or not the entity expects the customer to take advantage of the prompt payment/settlement discount:

  • Customer is expected to take advantage of discount
    For example, let’s suppose that Ingrid allows a 2% discount to Manfredi if the invoice is paid within 14 days – half the normal period of credit. If Ingrid expects that Manfredi will take advantage of the discount, the invoice is issued with the discount already deducted – ie $6,321 (98%). If, subsequently, Manfredi doesn’t pay within 14 days, an invoice for the additional amount (ie $129 representing the discount that was not taken advantage of) is issued on the 31 March.

  • Customer is not expected to take advantage of discount
    In this scenario, Ingrid does not expect Manfredi to pay within 14 days, and so the invoice is issued for the full amount. However, if after the full invoice has been issued, Manfredi then pays within the 14 days. Ingrid can issue a credit note for $129 for the prompt payment/settlement discount. 

CUSTOMER FAILS TO PAY

It may be that Manfredi does not pay by the due date. At this point Ingrid should implement her procedures to monitor and collect overdue accounts. These should be efficient, fair and legal. Ingrid may ultimately have to employ the services of a debt collector and/or resort to legal proceedings against Manfredi. These procedures are beyond the scope of this article, although some of the basics of good credit control will be covered later.

However, there may come a time when Ingrid has to accept that the amount due from Manfredi will not be collectible. This might be because, for example, Manfredi has been declared bankrupt or has disappeared and cannot be traced.

At this point, Ingrid is going to have to face the fact that her trade receivable of $6,450 is no longer the asset she thought it was because it is now no longer probable that the economic benefits associated with the transaction will flow to her (IAS 18, paragraph 14 (d) – see above). Suppose that on 28 December 20X0 Ingrid decides to write the amount off  as an irrecoverable debt. This will be recorded in Manfredi’s account in the Receivables Ledger as shown in Table 3 (below).
 

Table 3: Manfredi's account in the receivables ledger (irrecoverable debt)

f3-trade-rec-4

The original entry for the write off will be in the journal:

 $$ 
Dr Irrecoverable debts6,450  
   Cr Receivables control 6,450 


Invoice due from customer Manfredi written off as irrecoverable
The amounts will then be posted to the double entry system by debiting irrecoverable debts and crediting trade receivables – both accounts will be in the General Ledger.

The trade receivable now ceases to be an asset and becomes an expense. The adverse effect on profit can be significant. If Ingrid sells her goods  at a uniform gross margin of  30%, the effect of the non-collection of the amount due can be summarised as shown in Table 4.


Table 4: Ingrid sells her goods at a uniform gross margin of 30%

f3-trade-rec-fig

Ingrid will have to make additional sales of $15,050 just to break even (30% of $15,050 = $4,515).

MAKING AN ALLOWANCE FOR RECEIVABLES

Let us now assume that the financial year end for Ingrid is 31 December 20X0. The irrecoverable debt arising from the sale to Manfredi has been recognised in the same year in which the sale was made. Ingrid may feel that it would be prudent to make an additional charge for irrecoverable debts based on the total of trade receivables as at the end of the year.

Ingrid expects that a fairly fixed percentage of trade receivables will prove to be uncollectible each year.

Suppose that Ingrid estimates that on average 3% of trade receivables will prove to be uncollectible. This means that if Ingrid’s trade receivables as at 31 December 20X0 totalled $541,800 then she can expect to write off about $16,254 of this in 20X1. It would be appropriate to charge this amount as an expense in the year in which the related sales took place (the matching principle) even though Ingrid will not find out which specific receivables are uncollectible until 20X1.

Suppose now that the total trade receivables written off as irrecoverable during 20X0 was $196,201 (this will include Manfredi’s debt). The total amount charged in the income statement for 20X0 will now be:

 $ 
Irrecoverable debts196,201 
Add end of year allowance for receivables16,254 
Receivables expense for 20X0212,455 


And the amount included in current assets in the statement of financial position as at the end of 20X0 will be:

 $ 
Trade receivables541,800 
Less Allowance for receivables16,254 
 525,546 


This will all be recorded in the ledger accounts as shown in Table 5.


Table 5: Ingrid's ledger account

f3-trade-rec-6

OUT WITH THE OLD AND IN WITH THE NEW

We’re not quite finished yet. If 20X0 was not Ingrid’s first year of operation she would have made an allowance for trade receivables at the end of 2009. So, if Ingrid’s trade receivables totalled $400,932 as at 31 December 2009, she would have made an allowance for receivables of $12,028 (3% of $400,932). It is important that this allowance is reversed for 20X0 so that the irrecoverable debts of $12,028 anticipated and charged in 2009 are not charged again in the income statement for 20X0.

The total amount charged in the income statement for 20X0 will now be:

 $ 
Irrecoverable debts written off196,201 

Deduct start of year allowance for receivables

(12,028) 
Add end of year allowance for receivables16,254 
Receivables expense for 20X0200,427 


And the amount included in current assets in the statement of financial position as at the end of 20X0 will be unchanged:

 $ 
Trade receivables541,800 
Less Allowance for receivables16,254 
 525,546 


This will be recorded in the ledger accounts as shown in Table 6.


Table 6

f3-trade-rec-7

You will note that the allowance for the receivables account has just two entries for the year. At the end of each accounting period the old allowance is taken out and the new allowance is put in. In each case, the other entry is made in the irrecoverable debts account. This is an expense account which is closed off to the income statement each year.

The above method is relatively easy to understand if you are new to this, and it can always be relied on to get the correct figures. The charge in the income statement will always be: receivables written off – last year’s allowance for receivables + this year’s allowance for receivables.

The figure in the statement of financial position will always be: trade receivables – this year’s allowance for receivables.

THE INCREMENTAL APPROACH

This is an alternative way of updating the allowance for trade receivables at the end of each accounting period.

It reduces the number of entries in the ledger accounts, but is a bit more difficult to master. Using this method, the start of year allowance for receivables is just changed to give the end of year allowance. The problem is that the change in the allowance may result in an increase or a decrease.

Using the same data as before, the receivables expense charged in the income statement for 20X0 will be:

 $ 
Irrecoverable debts written off196,201 
Increase in allowance for receivables4,226 
Receivables expense200,427 


The amount included in current assets in the statement of financial position as at the end of 20X0 will be as before:

 $ 
Trade receivables541,800 
Less Allowance for receivables16,254 
 525,546 


The entries in the ledger accounts will be as shown in Table 7.


Table 7

f3-trade-rec-8a

If the allowance for receivables had been decreased, the allowance for receivables would have been debited with the decrease and the irrecoverable debts account would have been credited. Here’s an illustration. Suppose that in 20X1 receivables written off as irrecoverable totalled $166,400, and that the allowance for receivables is to be reduced to $15,000. The ledger accounts for 20X1 would be as shown in Table 8.


Table 8

f3-trade-rec-9

CREDIT CONTROL

Earlier we saw that irrecoverable debts can severely decrease profit (and cash flow). It is therefore important that a business does all it can to reduce the incidence of irrecoverable debts. Some think that good credit control is all about chasing up overdue accounts effectively. In fact, good credit control should start much earlier. The following considerations are the foundations of good credit control:

  • Who gets credit?
    The initial screening of potential credit customers is important. A credit sale is essentially a free gift to the customer until the invoice is paid. It is no use making a credit sale to a questionable customer just to achieve the sale. The profit is more than wiped out if the customer defaults. On the other hand, over enthusiastic vetting at this stage could result in lost sales to potentially good customers.

  • Terms of credit
    These should be set up and agreed in advance. They will include the credit limit (the maximum amount the customer can owe at any point in time), the credit period, whether discount can be claimed for quick payment, if interest is chargeable if the payment terms are not met, and so on. The terms of credit need not be the same for each customer.

  • Administration of billing and collection
    Efficiency here will be important. Invoices should be issued quickly and should be accurate. Customers generally will not pay unless, and until, they receive the invoice, so delays in invoicing will result in delays in payment. Errors in invoices also hold things up. The payment patterns of customers should be known, if possible, and invoices issued to take advantage of these. Businesses should also review their procedures for issuing statements and reminders.


Collection of overdue accounts
As mentioned earlier, procedures here need to be systematic, fair, reasonable and within the law. Avoiding the issue of non-payment, or just hopefully sending out computer generated reminders every few months, are unlikely to be effective.

On the other hand, threatening a customer might be effective but will most likely land the business in court.

FINALLY, SOME GOOD NEWS!

Having written off Manfredi’s debt in 20X0, Ingrid is surprised to receive a payment of $6,450 from Manfredi in 20X1 along with a letter apologising for the delay. There are two ways to record this.


Method A

 $ 
Dr Bank6,450 
Cr Irrecoverable debts6,450 


Method B

 $ 
Dr Bank6,450 
Cr Trade receivables (and Manfredi’s personal account)6,450 


And

 $ 
Dr Trade receivables (and Manfredi’s personal account)6,450 
Cr Irrecoverable debts6,450 


The difference between the two methods is that Method B reverses the irrecoverable debt write off.

Method A might be appropriate where a full or part payment is received at the end of bankruptcy proceedings or from a debt collection agency.

Method B might be more suitable when full payment is unexpectedly received from the customer. In this situation, the business should question whether it was a bit too hasty in writing the receivable off in the first place, and review its procedures generally.

Written by a member of the F3 examining team

Last updated: 1 Feb 2018