If you imagine purchasing a product, such as groceries, it’s easy to picture yourself stopping at the checkout, pay in cash or write a personal check, and possess the product. This is a simple transaction where you will exchange money for the products. No bad debts or accounts receivables in this case.
However, in the business world, most businesses are willing to offer their products to their clients on credit. This would be the same as the grocer giving you ownership right to the groceries, issue a sales invoice, and allow you to pay for the products at a later date.
Whenever you sell goods on credit two things happen; first, you will boost your potential to increase revenue. This is because most buyers enjoy the convenience and effectiveness of purchasing a product on credit. Secondly, you will open up your business to the potential losses if your clients fail to pay the amount indicated in the sale invoice when it’s due.
Under the accrual method of accounting, a sales credit will:
- Increase the revenue gained from sales which you should report them in the income statement
- Increase the amount due from clients, and you should report this amount in the accounts receivables. Note that accounts receivables are assets that you should report in your business balance sheet.
Sometimes, a client might fail to pay you what they owe your business. If this happens, your business suffers a bad debt, and this is an expense that is reported on the income statement. It also reduces accounts receivables (assets) on the business’s balance sheet.
Concerning financial statement, you, the business owner, should report the estimated bad debts as soon as possible using the impairment approach. Accounts receivables are recognized as assets in the balance sheet and are expected to turn in cash within one year. With that, a company’s balance sheet is likely to overstate its accounts receivables especially when part of the accounts receivables can’t be collected. To avoid this overstatement, you should specifically identify which are those accounts receivables cannot be collected, perhaps due to bankruptcy or know financial difficulties faced by the debtors. Impairment will be required for these irrecoverable debts.
Note that you should not record any increase in the allowance for doubtful debts in the business’s income statement as this method has been prohibited to avoid manipulation of accounts over different financial periods. Engage an accounting firm in Singapore today and let the experts show you the inside out.