More on sales and receivables

1 Introduction

This chapter looks in a little more detail at sales transactions and the receivables ledger

The accounting documents used are:

1. When sales are made, invoices will be issued to customers
   

2. Statements will be sent regularly to customers, setting out what is owed and what has been paid.
   

3. Remittance advices will be received from customers when they pay to explain which invoices are being settled.
   

2 Credit control

Credit control is the name given to the process of trying to ensure that cash is eventually received for all credit sales.

The process starts with a new customer applying for credit and this should initiate some investigation, such as:

• Asking for the applicant’s recent financial statements.
  

• Enquiries to a credit reference agency to see if the applicant has any history of poor payments.
  

Based on these investigations, the applicant will be accepted or rejected. A credit limit should be set for all customers.

Once credit sales have been made, each customer should be encouraged to pay according to the terms of the contract. There are three ways of proceeding:

• Send statements. These often act as a gentle reminder about what’s due.
  

• Settlement discounts. For example, pay 5% less if paid within 30 days.
  

• Prepare aged receivables analyses and act accordingly on the information contained there.
  

3 Settlement discounts

For example, an invoice is issued to DFH Ltd for $700 on 2^nd January 2013 with terms offering a settlement discount of 5% is settled within 30 days. The invoice was paid on 25^th January 2013. Therefore, because it was paid on time the amount due will be $700 x 95% = $665.

The discount of $35 is an expense of the business. The customer has been ‘let off’ $35 for prompt payment.

The entries in the DFH’s account would be:

The settlement discount is debited to the Discounts Allowed account in the general ledger. This is an expense account.

It is important to realise that the receivables total account should always reflect in total whatever happens the individual accounts. So, if a customer is given a settlement discount, this must also be credited to the total receivables account.

For example, consider a company with just three customers:

You will see that, the control account/total balance agrees with the sum of the individual balances in the receivables ledger ($1,300 = $700 + $400 + $200)

Each is entitled to a settlement discount of 5% if the amounts are paid within 30 days. ABC Ltd and DEF Ltd pay within this time limit; GHI does not and pays only $100 of what is owed.

After the receipts and the settlement discounts, those accounts are:

Note that the sum of the individual balances (now GHI Ltd only, $100) still equals the balance on the total receivables account.

Note that a settlement discount is entirely different to a bulk or trade discount. The bulk or trade discount is to all intents and purposes a straight reduction in the selling price and the only amounts ever invoiced or treated as a sale are after the discount has been removed.

With a settlement discount, the sales and the invoices are for the full amount (after the trade discount) and the discount is contingent upon prompt payment.

4 Sales returns and credit notes

A credit note is not an adjustment to the invoice; it is a transaction of its own and it is posted like one. Take DFH Ltd again. The $700 invoice of 2 January is followed on 12 January by a credit note for $120 net plus $24 sales tax, because some of the goods were faulty.

The credit note is listed in the sales returns day book, and the day book's totals are posted:

Debit Sales returns account $120

Debit Sales tax account $24

Credit Receivables control account $144

and the gross $144 is credited to DFH Ltd's own account in the receivables ledger:

The settlement discount is now 5% of the $556 actually owed, not of the original $700: 556 x 5% = $27.80, so the cash received is $528.20.

Note the three things a sales return always does: it reduces receivables, it reduces sales (through the sales returns account, so that gross sales and returns can both be seen), and it reverses the sales tax that was charged on the goods coming back.

4.1 Contra entries

Where the same business is both a customer and a supplier, the balance it owes you and the balance you owe it can be set against each other. That is a CONTRA ENTRY. If ABC Ltd owes you $1,400 and you owe ABC Ltd $1,600, the contra is put through by journal:

Debit Payables control account $1,400

Credit Receivables control account $1,400

and the same two entries are made in ABC Ltd's individual account in each memorandum ledger. $200 remains payable to ABC. The contra is always for the LOWER of the two balances — you cannot set off more than one side owes.

5 Aged receivables analysis

This looks at all the invoices still owed by customers and displays them in age categories.

Typically the age categories are something like:

≤ 30 days

30 to ≤ 60 days

60 to ≤ 90 days

90 to ≤ 180 days

> 180 days

Usually, the older an unpaid debt becomes, the less likely to be paid. Also, as debts become older more extreme action is likely to be taken to try to force payment. For example, final warnings, then taking customers to court.

The layout of an aged analysis is usually something along the lines of:

To be able to work out how old debts are, it is essential to know exactly which invoices have been paid. This is where remittance advices are important because they allow specific matching to be carried out.

For example, consider this customer’s account:

The customer sends a cheque for $3,800, and this is accompanied by a remittance advice as follows:

The payments set out on the remittance advice have to be matched as follows:

The matched items can be cleared out of the account to leave:

A valid aged analysis can be performed on the outstanding amounts.

6 Irrecoverable (bad) debts

Sometimes, despite all efforts to sell only to credit-worthy customers and to follow up old amounts carefully, it becomes clear that a debt is irrecoverable and no money will ever be received. Perhaps the customer has gone into liquidation (or simply disappeared!)

There is then no point in continuing to record the debt as a receivable (an asset) when it is worthless: the amount should be written off, ie reduced to zero. This is an expense to the business and will be recorded in an irrecoverable debts account (sometimes called a bad debts account).

As always, whatever adjustment you make to an individual receivable you must make to the receivables control/total account too. Writing off bad debts is one use of the journal.

Look at this example:

One of the receivables accounts in the receivables ledger is:

It has been decided that none of the $3,800 due from Badone Ltd will be recovered and that this amount should be written off.

The journal to do this is:

The accounts would then be:

One of the receivables accounts in the receivables ledger is:

7 Irrecoverable (bad) debts and sales tax

Debts are not usually written off until all reasonable hope of recovery is gone and this usually takes time. Sales tax will probably have been charged on the sales giving rise to the debt, and will have been paid over to the government. Now it is clear that the sales tax will never be collected from the defaulting customer.

In many sales tax regimes the seller can eventually recover the tax on a debt that has been written off, but the conditions differ from country to country and FA1 does not examine any particular country's rules. What FA1 does expect you to be able to do is separate the tax content of a written-off debt from the net amount, because only the net amount is the real cost of the write-off.

So, if the $3,800 above contained sales tax at 20%, the sales tax content of that debt would be $3,800/6 = $633.33 and the net amount of the sale would be 3,166.67 (check: 3,166.67 x 20% = $633.33).

Therefore, the cost of the irrecoverable debt is reduced by the sales tax amount as follows:

The debit to the sales tax account will reduce what has to be paid to the government in the future, so gives tax relief on the irrecoverable sales tax.

8 Allowances for irrecoverable debts

Once a write-off occurs the debt is, in effect, forgotten about and will not be pursued. However, before that stage is reached it will often begin to look unlikely that the debt will be recovered, but the company does not yet want to give up all hope and does not want to write off the debt. Nevertheless, to value the debt at its full amount would be over-optimistic.

In this case, an allowance can be made to reduce the value of the receivables. The allowance can be calculated using a combination of approaches:

• A specific debt is identified as ‘doubtful’. This will be a specific allowance for irrecoverable receivables.
  

• Our experience might show that, say 4%, of debts generally have to be written off, though we do not know now which ones these will be. This might sometimes be known as a general allowance for irrecoverable receivables.
  

9 FA1 exam focus — Chapter 5