Essay Sample on Bad Debts and Accounts Receivable: Relationship to Business Assets and Liabilities

Introduction

Ideally, business should be about meeting a seller, writing out a personal check and taking possession of goods. It should be such a simple transaction whereby the buyer and the seller exchange money for goods. However, in the real world of business many businesses, companies, financial institutions or banks must be willing to offer their services or sell their goods on credit. This would be equivalent to a seller transferring ownership of goods to a buyer, issuing a sales invoice, and expecting payment form the buyer at a later date. In such a scenario where the seller offers services or goods on credit, two things are bound to occur. In the first case, the seller potentially boosts sales and increase revenues because many buyers will appreciate the efficiency and convenience of making purchases credit. In the second case, unfortunately, the seller opens itself up to potential losses in the event that buyers do not pay the sales invoice amount as it is due. In the second scenario, accounts receivables are entered, but a question lingers: will it be a bad debt? And if so how does it relate to business assets or liabilities? Accounts receivable are business assets that turn out to be liabilities where the debtor defaults.

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Accounts Receivable

When seller transfers ownership of goods to the buyer without a payment being made, and instead issuing a sales invoice, the sales invoice leads to the creation of accounts receivable. Accounts receivables are the balance of money due to a seller for goods or services offered but not yet paid for. Accounts receivable are amounts of money for goods or services offered on credit. Accounts receivable are created from the entries in the sales invoices which represent a line of credit extended by a seller to a buyer and normally due within a relatively short time period ranging from a few days to a year (Umbach, 2018).

Bad Debts

In certain circumstances, the seller cannot recover its outstanding balances in respect of certain accounts receivable on a due date. Such a situation arises because of many reasons such as improper follow up by the seller, trade dispute or fraud, a customer going bankrupt, clients not willing to pay, and weak financial position of the buyer among many others (Jenarius, 2013). When a seller is unable to collect or receive payments or payment invoices from clients or customers until a specified time or due date expires, accounts receivables become debts. The buyer becomes a debtor. There are two categories of debts: doubtful and bad debts. A doubtful debt is an account receivable which circumstances have rendered its ultimate recovery uncertain (Jenarius, 2013). Accounting requires that a doubtful debt is entered as a business expense in the profit and loss account, and be credited to a provision to set off against ultimate default in case it happens so (Jenarius, 2013).

In the case of customer default, a bad debt arises. A bad debt is an account receivable that is not collectible, thus it is worthless to the creditor. A bad debt arises when all the efforts have been made to collect the debt but unsuccessful or where further efforts will incur an additional cost that is more than the amount that the creditor will eventually collect from the debtor (Jenarius, 2013). In case of bad debts, a business is expected to write off accounts receivables as an expense.

There are two ways in which a business can account for uncollected accounts receivable: the allowance for doubtful accounts, and the direct write-off. In the allowance for doubtful method, an uncollected account receivable or debt is estimated and recognized in the period in which that revenue was expected. In every period, estimated doubtful accounts are expensed out by debiting bad debts expense account, and crediting allowance for doubtful accounts account (Jenarius, 2013). When it is confirmed that a debt is no longer receivable, it is sliced out by debiting the allowance for doubtful debts account and crediting accounts receivable (Jenarius, 2013). The rationale behind allowance for doubtful debts is the concept of prudence in accounting that requires an allowance be created to recognize the potential loss that will arise from the possibility of an occurrence of bad debts (Jenarius, 2013). In the direct write-off method, doubtful debts are not estimated. Instead, bad debts are recognized when the account actually turns out to be uncollectible.

How Do Bad Debts Relate to Business Assets and Liabilities?

Defining a Business Asset

A business asset is a piece of property or equipment purchased primarily or exclusively for business use. Business assets fall in broad categories including current and non-current, tangible and intangible, operating and capitalized, and short- and long-term (Davies & Crawford, 2005). In the business world of accounting, assets are divided into the current (short-term) and non-current (long-term). Current are business assets that can easily be turned into cash within a short period of time up to one year. Examples are marketplace securities, cash, accounts receivable and inventory. Non-current assets are those that are expected to yield value for more than a year to the business. They are assets that the business does not intend to convert them into liquid cash within a year. Non-current assets are capitalized and expensed over the life in the process of depreciation. Non-current assets include buildings, equipment, vehicles, and others (Davies & Crawford, 2005). Assets are debited in a balance sheet or recorded on the left side.

Defining a Business Liability

A business liability is defined as legal financial debts or obligations arising in the course of a business operation. A liability is money owed to another party (Davies & Crawford, 2005). In business, a liability can be in form of money borrowed on a short- or long-term basis. Short-term liabilities are the borrowed money which is to be paid back within a year. Long-term liabilities are the loans expected to be repaid in a longer period of time such as 5, 10n or 15 years. Liabilities are entered on the right-hand side of the balance sheet or simply credited.

The Interaction between Bad Debts, Assets, and Liabilities

As earlier discussed, a receivable account undergoes a process to be considered a bad debt. The process is an accounting one. It begins with an invoice being entered as a receivable account. Going by the guidelines outlined by Generally Accepted Accounting Principles (GAAP) where the need for conservatism and following the concept of matching revenues with expenses is clearly stated, businesses have a basis to create a provision for doubtful and bad debts through the creation of additional journal entries (Wood & Sangster, 2008). As such, accounts receivable are earlier on considered as business assets. A business asset was defined as a property that can be turned into liquid cash in a short time. Accounts receivable are expected to be collected from the buyers within a specified time in less than a year, hence converting it into liquid cash for the business. As such, accounts receivable are considered a business current asset.

When a due debt expires for a receivable account and the debtor cannot meet his or her obligation, the debt becomes doubtful until it reaches a point where it is considered a bad debt. As seen earlier, when it is confirmed that a debt is no longer receivable, it is sliced out by debiting the allowance for doubtful debts account and crediting accounts receivable. During such a time, a bad debt becomes a business expense or liability. As recommended by Jenarius (2013), any provision made for doubtful debts is directly debited to the income statement and such provisions should also appear on the balance sheet as liabilities under the category of current liabilities. This occurs when the seller still expects to collect the debt. However, once the debt cannot be collected, the bad debt or receivable accounts are treated as business expenses credited on the balance sheet rendering it a business liability that is to be written off.

Conclusion

Whereas business accounts receivable are business assets in the short run, they turn out to be liabilities in the long-run. Accounts receivable are supposed to be collected in the short term (0 to 12 months). However, in the event that the debtor is unable to settle the debt, accounts receivables become doubtful debts which are entered in relevant journals to provide an allowance for a business expense while still hoping that the customer will pay. During this time, accounts receivable are debited. If the customer fails to pay, it becomes a bad debt that is now credited in the balance sheet as the debt is written off.

References

Davies, T., & Crawford, I. P. (2005). Business accounting and finance. Berkshire: McGraw-Hill Education.

Jenarius, T. (2013). Evaluating the efficiency of accounting recording for doubtful and bad debts: Case study: Unity Cooperative Society (UNICS) Cameroon compared to NORDEA bank Finland. Centria University of Applied Sciences (thesis).

Umbach, W. S. (2018). The Fundamentals of Accounting: A Series of Case Reports (Doctoral dissertation, The University of Mississippi).

Wood, F., & Sangster, A. (2008). Frank Wood's Business Accounting UK GAAP (Vol. 1). Pearson Education.