In old times, businesses used to trade in cash only. You pay for the thing you bought at the time of purchase! simple transactions. Even now, when you buy some clothes or do some grocery from a store, you get the goods, pay for them through your credit card or debit card at the time of checkout, and leave. Imagine that one of the grocery stores offers to sell the goods on credit allowing you to pay after two months of the purchase. What will happen? You and most of the customers will rush to the grocery store offering credit sales. Other grocery stores will also think of the same as not offering credit sales like one of their competitors will result in decrease in their sales revenue.
Now-a-days, businesses tend to sell their goods and services on credit as well. It means that they transfer the goods and services to the customers and allow the customers to pay for the goods and services later. This right to receive cash in exchange of the goods and services is recorded as a current asset known as accounts receivable.
Offering credit sales means that businesses are willing to assume some credit risk to increase their sales. We do not live in a perfect world and there will be some defaults. However, the companies still sell the goods or services on credit as they believe that the benefits of increased sales outweigh the credit risks involved.
Accounting of accounts receivable
As per accrual basis of accounting, sale of goods or services on credit is recorded in the following manner.
- Revenue or income is recorded.
- A current asset known as accounts receivable is recorded (Right to receive cash for the goods or services sold).
When the customer pays for the goods or services,
- Cash or bank balance is increased.
- Accounts receivable is decreased as it has been realized.
However, there can be situations where the customer defaults and does not pay for the goods or services bought. In such cases,
- Credit loss known as bad debt expense is recorded.
- Accounts receivable is decreased as it will not be realized now.
In the next chapters, we’ll build on the basic accounting concepts explained in this chapter. We’ll discuss the credit risks and credit risk management. Furthermore, we’ll learn the accounting of allowance for bad debts based on the prudence principle.