This article discusses a widely used method to valuing accounts receivable.
Sometimes customers fail to make good on what they owe. This failure to pay may be willful, but often it is not. Usually, customers intend to pay for the goods and services they acquire, but due to unforeseen economic setbacks or failure to adequately control spending, they find themselves unable to make payments. This very ordinary circumstance creates a valuation problem.
Let’s say a firm has $15,000 of receivables at the end of an accounting period. Can the firm determine if these receivables are fully collectable? If the accounts receivable are not fully collectable, assets and revenue are overstated. Arriving at a reasonable valuation of accounts receivable usually is not that difficult, but getting a precise dollar amount of collectable accounts is not usually possible. Welcome to the world of accounting estimates!
A figure for accounts receivable on a balance sheet of a company with a large number of individual accounts reflects an estimate of what the company believes is collectable. You hope that the estimate is made in good faith and is reasonable. However, sometimes managers do not act in good faith, and they inflate the amount of receivables they deem to be collectable. This results in an overstatement of both assets and revenues.
The most common method of estimating the collectability of receivables is to use an aging schedule. In an aging schedule, accounts receivable are classified in terms of how long they have been outstanding. A typical schedule divides receivables into categories of less than 30 days, 31-60 days, 61-90 days, and over 90 days. Based on general credit experience, the longer a receivable is outstanding, the less chance of full collection.
Example. Let’s say that Joint Ventures accounts receivables total $75,000 at the end of the most recent year. Based on past credit, experience Morrisin estimates that 90% of receivables under 30 days will be paid, 70% of those between 31-60 days will be paid, 60% of those between 61-90 days, will be paid and only 50% of those over 90 days will be paid. If the distribution of the $75,000 receivables is broken down in an aging schedule, Joint Ventures would estimate the collectable receivables as follows:
Sometimes the valuation question may go beyond simply making a good faith estimate of collectability. In some situations management may be tempted to commit outright fraud. Because no cash is collected when sales are made “on account”, a corrupt management can record fraudulent additional sales by simply creating fictitious customers and recording fictitious sales.
Another time honored-means of inflating Accounts Receivable and Sales Revenue involves what as known as “keeping the books open” at the end of the accounting period. In this case the customers and sales are real but January sales are recorded as December sales so the end of year financial statements include inflated assets and revenue.
Part of the audit function is to test the existence and collectability of accounts receivable and this can serve as a brake on such fraudulent practices. In the audit of large companies with millions of dollars of receivables and hundreds of thousands of individual accounts, the audit process relies on statistical sampling, which usually provides a reasonable, but not exact, estimate of collectable accounts.