Hi, Else here.
And today, we'll start our discussion
about accounts receivable.
What are accounts receivable?
To understand that, let's step back for a minute
and look at previous videos.
When we sell goods or services, we sometimes
sell them in exchange for cash.
This is a transaction.
And in order to analyze any transaction,
we have to ask ourselves the critical questions.
Those are, what did we get and what did we give away?
If there's still confusion, we can ask ourselves
the enhancing questions that help us clarify our thinking,
what did we earn, what do we use or consume, and what do we owe?
For this transaction, we have to ask ourselves what did we get?
We got cash.
That's an asset because it has future economic benefit.
What did we give away?
We gave away a good or service and that
means we earned revenue.
What would the impact of this entry look
like on the accounting equation?
There would be an increase in assets, cash, and an increase
in equity through revenues.
This is an external transaction because it's
an exchange between two parties, one of whom
is outside of the company.
But what happens if we sell to a customer on account
or for credit?
Both of these things mean that we have allowed the customer
to receive a good or service now and to pay us later.
When we sell to a customer on account,
we'll give them the good or service with a bill or invoice.
We still have to record revenue because we provided the service
or delivered the good, so equity will be increased.
We also have to record an asset because we
have the future right to collect cash from our customers.
And that's an asset called accounts receivable.
Where is accounts receivable on the financial statements?
Let's quickly look at the balance sheet.
You can see that accounts receivable are current assets
because we generally collect the cash
within one year or operating cycle, whichever is longer.
Remember that assets are listed in order of liquidity,
how fast they'll be converted into cash,
or used or consumed to help generate revenue.
Accounts receivable is listed under cash
and short-term investments because they're
less liquid, taking longer to convert into cash.
Accounts receivable is listed above inventory, pre-paids
and supplies.
That's because they don't take as long to convert into cash.
Before we work on some examples, let's
explore why a company would want to sell an account
or for credit.
Well, I'll give you an example that applies to me.
Down the street from my office, there's
a little fast food place that makes excellent vegetarian
food.
There's not that many places that serve good vegetarian
lunches, so I like to go there.
But I never carry cash.
And this place only accepts cash.
Because of that, I almost never go there.
Instead, I go to a competitor of theirs right near them
that does accept cash or credit.
That's exactly why companies sell on account.
They know that if they don't, one of their competitors will.
And they'll lose customers.
In order to remain competitive with their competitors,
they have to sell on account.
Now, why do companies want to buy on credit?
Well, that's because they can get the product or service
without paying any cash today.
Yes, they still owe cash in the future.
A company who buys on credit records an accounts payable,
a liability that they have to pay in cash in the future.
But they benefit because they get the product or the service
now, maybe 30 or 45 days before they have to pay the cash.
They get a double benefit.
They can delay their cash payments
while still getting the product or service now.
That's a pretty sweet deal.
Looks like selling for credit benefits the customer
because they can delay payment but get the product or service
now.
Not so much the seller.
Yes, the seller remains competitive.
But they don't get their cash right away, which
has a cost attached to it.
We'll get a better understanding of the full cost
of selling on credit by the end of this video.
Let's do a few examples to see how accounts receivable, called
AR for short, are recorded.
On August 28, 2014, ABC Company sells $1,200 of services
to a customer on account, providing them with 30 days
to pay the invoice.
On October 2nd, ABC Company calls the customer
to advise them that they have not as yet paid their invoice
and it's past due.
On October 18th, the company pays.
What is the entry on October 28th?
What did we give away?
We gave away a service so we record an increase to revenues.
What did we get?
We got a promise from the customer
to pay in the future, which is an asset account called
accounts receivable.
The entry on August 28th is an increase in assets of $1,200
and an increase in equity of $1,200,
which is a transactional entry.
What is the entry on October 2nd when we call the customer?
Nothing because there's been no exchanges yet.
We didn't get anything, and we didn't give anything away,
so no entry.
What is the entry on October 18th when the customer pays?
Again, analyze using the critical questions.
What did we get, and what did we give away?
We got cash, so asset, the account cash, increases.
What did we give away?
We gave back the customer's IOU, so we
have to reduce the accounts receivable
account by the amount the customer paid.
The end result, accounts receivable for that customer
will be 0 because they don't owe us anything anymore.
What if we sold a product instead of a service?
How would that change our entries?
Say this time, ABC Company, who uses the perpetual inventory
system, sold $2,500 of goods on credit
for the selling price of $6,000.
They did this on November 1st, 2014.
On credit or for credit means the same thing as on account.
And we can use either term.
For this sale, our terms are net 15,
which means the customer has to pay the whole amount within 15
days.
On November 28th, after two phone calls to our customer,
they pay us $4,000 on account.
The remaining $2,000 is paid on December 18th.
What entry must be made on November 1st?
What did we get, and what did we give away?
Well we gave away a good, so we have earned sales.
Sales increases, which increases income,
retained earnings, and equity.
What did we get?
We got the legal right to collect cash
from our customer in the future in accounts receivable.
What is our entry?
Assets increase accounts receivable,
and equity increases through sales, both by $6,000.
Have we've forgotten something?
We know from our videos on merchandising companies
that a sale of a product under the perpetual inventory system
requires two entries, a sales entry to the sales
account at the selling price and a cost entry
to the cost of goods sold at the cost of inventory.
Remember that cost of goods sold account is also
called cost of sales.
Our entry has to recognize that inventory
has been sent to the customer, so we
have to remove it from our inventory account
under the element assets.
In addition, the cost of earning that $6,000 of revenue
is $2,500, the cost of our inventory.
We used inventory to generate revenue.
And the word used tells us that we have to record an expense.
So our cost entry is a decrease to the inventory account
of $2,500 and a decrease to equity
through the cost of goods sold account, which
is one of the few expense accounts that does not
include the word expense.
So what is the entry on November 28th when the customer pays us
$4,000 on account?
When a customer pays on account, it
means that they did not pay the total amount of their invoice.
Instead, they made a partial payment.
We have to analyze the transaction using
our critical questions.
What did we get, and what did we give away?
We got cash.
So assets increase.
What did we give away?
We gave back only a portion of the customer's IOU,
$4,000 of the outstanding $6,000.
We have to reduce the accounts receivable
account by the amount the customer paid.
The end result, accounts receivable has gone down.
And only $2,000 is still due from the customer.
They owe us $2,000, so it remains as an asset
because we believe it has future economic benefit.
On December 18th, the customer pays us the remaining $2,000.
Now, what did we get at December 18th?
We got cash.
So assets increase.
What did we give away?
We gave back the remainder of the customer's IOU,
the $2,000 that was still outstanding.
We have to reduce accounts receivable
account by the amount the customer paid.
And the end result is that the customer's accounts receivable
account now stands at 0.
Although note, that it took us a bit of work
to get all that money from our customer.
Now, let's do one final example to show
exactly what the cost of selling on credit is.
Say that this time, also on November 1st, 2014,
ABC Company sells services for $18,000
to a customer on account, providing terms of 2/10,
net 45.
We know from our video on merchandising companies
that this means if the customer pays within 10 days,
they receive a 2% discount.
They only have to pay 98% of their bill.
The net 45 means that if the customer pays after 10 days
but before 45 days, they have to pay 100%
of the outstanding balance.
Say that on December 29th after repeat phone calls,
the customer has still not paid their account.
ABC Company is getting worried that this customer will never
pay.
What is the entry on November 1st?
What did we get, and what did we give away?
We gave away a service, so we record an increase
in revenues of $18,000.
We got a promise from the customer
to pay in the future, which is in accounts receivable.
Accounts receivable increased by $18,000.
What is the entry on December 29th after we've repeatedly
called the customer and we're getting worried
that the customer will never pay their outstanding balance?
Nothing, because there's been no exchanges yet.
Now, we're at our year-end, December 31st, 2014.
Our accounts receivable for this customer is $18,000.
Should we put that $18,000 on the balance sheet
as an asset with future economic benefit?
Does this accounts receivable balance
have a future economic benefit equal to $18,000?
That's questionable because this customer
seems to be having problems paying their bills.
Remember, earlier in the video when I pointed out that there's
a cost of selling on credit?
Well, now you know the cost.
The fact is, some of the customers who we sell to
on credit will never pay.
They're going to go bankrupt or they're just
going to disappear overnight.
The more customers you sell to on credit,
the bigger the issue of nonpayment of accounts
receivable becomes.
And that's the biggest cost of selling on credit.
Not only do you, the seller, have
to delay the period between when you provide the service
or deliver goods and when you actually get paid,
but you may never be paid at all.
So the question becomes, are the accounts receivable
of $18,000 at December 31st, 2014, collectible?
In fact, your future economic benefit from this customer
may be 0.
So the issue with accounts receivable
is how to value them at year end.
This is complicated by the fact that you may not
know who exactly won't pay.
Your customers may all look good at year-end.
But from your past history, you know
that some of those customers won't pay.
How do we value accounts receivable at period end
so that they represent their future economic benefit when
we don't even know the names of the customers who
will fail to pay in the future?
And that's the subject of our next video.
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