7.1 Accounts Receivable and Net Realizable Value
At the end of this section, students should be able to meet the following objectives:
- Understand that accounts receivable are reported at net realizable value.
- Know that net realizable value is an estimation of the amount of cash to be collected from a particular asset.
- Appreciate the challenge that uncertainty poses in the reporting of accounts receivable.
- List the factors to be considered by officials when estimating the net realizable value of of a company’s accounts receivable.
Reporting Accounts Receivable
Question: The goal of financial accounting is to paint a fairly presented portrait that enables decision makers to make a reasonable assessment of an organization’s financial health and future prospects. This likeness should be communicated based on a set of generally accepted accounting principles (either U.S. GAAP or IFRS) with no material misstatements included. The success of the conveyance is dependent on the ability of the accountants to prepare financial statements that meet this rigorous standard.
Equally as important, every party analyzing the resulting statements must possess the knowledge necessary to understand the multitude of reported figures and explanations. If appropriate decisions are to result based on this information, both the preparer and the reader need an in-depth knowledge of the reporting standards.
For example, the asset section of the balance sheet produced by Dell Inc. as of January 28, 2011, indicates that the company held “accounts receivable, net” amounting to $6.493 billion. What does this figure reflect? What information is communicated to decision makers about a company and its accounts receivable when a single number such as $6.493 billion is reported?
Answer: One of the most satisfying results of mastering the terminology, rules, and principles of financial accounting is the ability to understand the meaning of amounts and disclosures reported about an organization. Such information is presented and analyzed daily in magazines, newspapers, radio, television, and the Internet. As with any language, failure to comprehend elements of the discussion leaves the listener lost and feeling vulnerable. However, with a reasonable amount of study, the informational content begins to make sense and quickly becomes useful in arriving at logical decisions.
In previous chapters, the asset accounts receivableAn asset that reports the amounts generated by credit sales that are still owed to an organization by its customers. was introduced to report monetary amounts owed to a reporting entity by its customers. Individual balances are generated by sales made on credit. Businesses sell on credit, rather than demanding cash, as a way to increase the number of customers and the related revenue. According to U.S. GAAP, the figure presented on a balance sheet for accounts receivable is its net realizable valueThe amount of cash that is expected to be generated by an asset after costs necessary to obtain the cash are removed; as related to accounts receivable, it is the amount an organization estimates will ultimately be collected from customers.—the amount of cash the company estimates will be collected over time from these accounts.
Consequently, officials for Dell Inc. analyzed its accounts receivable as of January 28, 2011, and determined that $6.493 billion was the best guess as to the cash that would be collected. The actual total of receivables was higher than that figure but an estimated amount of doubtful accounts had been subtracted in recognition that a portion of these debts could never be collected. For this reason, the asset is identified on the balance sheet as “accounts receivable, net” or, sometimes, “accounts receivable, net of allowance for doubtful accounts” to explain that future losses have already been anticipated and removed.
Hawthorne Corporation operates a local hardware store in Townsville, Louisiana. The company’s accountant recently prepared a set of financial statements to help justify a loan that is being sought from a bank. The balance sheet reports net accounts receivable of $27,342. What does that figure reflect?
- Sales made to customers on account.
- An estimation of the amount that will be collected from the debts now owed by customers.
- The historical cost of the goods that were sold to customers who have not yet made payment.
- The total amount owed by customers as of the balance sheet date.
The correct answer is choice b: An estimation of the amount that will be collected from the debts now owed by customers.
According to U.S. GAAP, accounts receivable should be reported at net realizable value, the amount expected to be collected. This approach requires an estimation to be made of the amount of the present balances that will prove to be uncollectible so that the net receivable balance can be established for reporting purposes.
Lack of Exactness in Reporting Receivables
Question: As discussed in previous chapters, many of the figures reported in financial accounting cannot be absolutely correct. Although $6.493 billion is the asset balance shown by Dell, the cash eventually collected will likely be somewhat higher or lower. Should the lack of exactness in reporting receivables cause concern for decision makers?
Answer: No one will ever be able to predict the precise amount of cash to be received from nearly $6.5 billion in accounts receivable. In fact, Note One to Dell’s financial statements specifically states, “The preparation of financial statements in accordance with GAAP requires the use of management’s estimates. These estimates are subjective in nature and involve judgments that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at fiscal year-end, and the reported amounts of revenues and expenses during the fiscal year. Actual results could differ from those estimates.”
Knowledgeable decision makers understand that a degree of uncertainty exists in reporting all such balances. However, a very specific figure does appear on Dell’s balance sheet for accounts receivable. By communicating this one amount, company officials are asserting that they believe sufficient evidence is available to provide reasonable assurance that the amount collected will not be a materially different figure.The independent auditors will also analyze the same available evidence and must agree that it is sufficient to serve as the basis for rendering reasonable assurance that the financial statements are presented fairly before an unqualified opinion can be released.
This is the meaning of any accounts receivable balance presented according to U.S. GAAP. All parties involved should understand what the figure represents. Actual receipts are expected to be so close to $6.493 billion that an interested party can rely on this number in arriving at decisions about the reporting company’s financial health and future prospects. Officials believe that the discrepancy between this balance and the cash collected will be so small that the same decisions would have been made even if the exact outcome had been known. In other words, any difference between reported and actual figures will be inconsequential. Once again, though, absolute assurance is not given for the reported amount but merely reasonable assurance.
Clearly, the reporting of receivables moves the coverage of financial accounting into more complicated territory. In the transactions and events analyzed previously, uncertainty was rarely encountered. The financial impact of signing a bank loan or the payment of a salary can be described to the penny except in unusual situations. Here, the normal reporting of accounts receivable introduces the challenge of preparing statements where the ultimate outcome is literally unknown. The very nature of such uncertainty forces the accounting process to address such problems in some logical fashion.
Determining Net Realizable Value
Question: Inherent uncertainty is associated with the reporting of receivables. No one can know exactly how much cash will be collected. How do company officials obtain sufficient evidence to provide reasonable assurance that the balance is not materially misstated? How does any business ever anticipate the amount of cash that will be collected from what can be a massive number of accounts receivable?
Answer: In accounting, reported balances never represent random guesses. Considerable investigation and analysis goes into arriving at financial statement figures. To determine the net realizable value appropriate for accounts receivable, company officials consider the following relevant factors:
- Historical experience of the company in collecting its receivables
- Efficiency of the company’s credit verification policy
- Current economic conditions
- Industry averages and trends
- Percentage of overdue accounts at present
- Efficiency of company’s collection procedures
Dell Inc. explains this process within the notes to its financial statements by indicating that this estimation “is based on an analysis of historical bad debt experience, current receivables aging, and expected future write-offs, as well as an assessment of specific identifiable customer accounts considered at risk or uncollectible.”
Additional information disclosed by Dell indicates that the company actually held $6.589 billion in accounts receivable, but—at the date of the balance sheet—$96 million of these accounts were anticipated to be uncollectible. Thus, the amount of cash estimated from the receivables is the reported $6.493 billion net balance ($6.589 billion total less $96 million expected to be uncollectible). Quite obviously, decision makers studying the company will be interested in comparing such data to figures disclosed by Dell in previous years as well as the information disseminated by competing organizations such as Hewlett-Packard and Apple. Just determining whether $96 million in uncollectible accounts is a relatively high or low figure is quite significant in evaluating the efficiency of Dell’s current operations.
Gerwitz Corporation manufactures and sells shoes. At the end of the current year, the company holds $954,850 in accounts receivable and is presently assessing the amount of uncollectible accounts in that total. Which of the following is least likely to be relevant information in making this estimation?
- A current recession is taking place in the country.
- The company monitors its inventory levels very carefully.
- The company only sells to customers who have undergone an extensive credit check.
- Of the receivables held on the previous balance sheet date, 3 percent were never collected.
The correct answer is choice b: The company monitors its inventory levels very carefully.
Companies study as much relevant information as possible in estimating uncollectible accounts. Economic conditions are considered (such as a recession, which might reduce payments) and previous collection trends. In addition, the methods by which the company extends credit and pushes for payment can impact the amount to be received. Although monitoring inventory levels is important because it can reduce theft and breakage, no information is provided as to the collectability of receivables.
Because of various uncertainties, many of the figures reported in a set of financial statements represent estimations. Therefore, as discussed previously, such figures cannot be exactly accurate. No one can predict the future with such precision. The accountant only holds that reported balances contain no material misstatements. Accounts receivable is shown at its net realizable value, the amount of cash expected to be collected. Losses from bad accounts are anticipated and removed based on historical trends and other relevant information. Thus, the figure reported in the asset section of the balance sheet is lower than the total amount of receivables held by the company on that date.