What Are Accounts Receivables and Bad Debts?

What Are Accounts Receivables and Bad Debts?

Imagine that you are buying something from a shop, for example, books. You can visualize that you are stopping at the counter, paying in cash or issuing a personal cheque, and you bring the books away, and you own them now. Such a situation is a simple transaction, the double entry accounting is straight forward where you will acquire something by exchanging it using money. In this scenario, there is no accounts receivables or bad debts.

Nevertheless, in the world of business, most firms will be willing to supply the products or services to their customers on credit. By using the situation above, this will mean that the owner of the bookshop gives you ownership to the books, issues a sales invoice then permits you to pay him later.

If you are selling something on credit, two things will occur. Firstly, the potential of you getting higher revenue (Also see Auditing a Revenue Cycle) will increase, since most of the customers will enjoy the benefit of buying an item on credit. At the same time, you may expose your firm to the potential loses in case your customers are unable to pay you the amount they own you when it is due (Also see Possible Ways For Receivables Management).   

Based on the matching concept of accounting, a sales credit is going to cause the revenue you generate to increase, and you should report it in your profit and loss statement. Besides, a sales credit will also cause the amount due from customers to gain, and you need to report that sum in the accounts receivables (Also see What are Trade Receivables and Non-trade Receivables?). Keep in mind that in the balance sheet of your business, you should report the accounts receivables as the assets of your business.

In some occasions, your customers may be unable to settle the amount that they owe to your company. When this occurs, your company faces a bad debt, and you need to report this as an expense on your incomes statement. Another impact is that your accounts receivable, which is one of your assets, will reduce on the balance sheet of your company.

About the financial statements, as you own the business, it is your responsibility to report the amount of predicted bad debts as early as you can by implementing the impairment method. You recognize accounts receivables as your assets in the company’s balance sheet, and you expect them to change into cash in a year. Especially when a company is unable to collect some of its accounts receivables, there is a high probability that the balance sheet of the company is going to overstate the accounts receivables it can obtain. To prevent this from happening, you need to determine the accounts receivable that you are unable to collect, whether it is because of bankruptcy or the financial problems that your debtor is facing. 

Keep in mind that if there is an increase in the allowance for doubtful debts (Also see The Proper Way of Recording the Provision for Bad Debts), you are not supposed to record it in the income statement of your business. This is because such a practice is banned to prevent manipulation of accounts from happening throughout different financial periods. If you want to gain more understanding about the accounts receivables and bad debts, do not hesitate to hire an accounting firm in Johor Bahru today.