Initial recognition of accounts receivables

Initial recognition of accounts receivables

The initial recognition of an accounts receivable means how a company should account for an account receivable when a credit sale transaction has been made. For this purpose, it is important to know the definition of the transaction price.

The receivable and the related revenue are recognized when control of the goods or services transfers to the customer - typically at shipment or delivery, depending on the shipping terms.

It should be noted that because of certain features of a sale, the amount recorded can differ from the list or invoice price. Trade discounts are always netted out before anything is recorded. Cash (prompt-payment) discounts are a form of variable consideration under ASC 606, which may reduce the transaction price - but in practice, companies record them using either the gross method (receivable at the full invoice amount, with the discount recognized only if the customer takes it) or the net method (receivable at the discounted amount). The gross method remains the more common, exam-tested approach despite not reflecting the net amount at initial recognition.

On the balance sheet, however, GAAP requires accounts receivable to be reported at the net amount expected to be received from the customer, not simply the face value of the transaction price.

Trade discounts

Trade discounts are offered by the seller as a reduction of the list price of goods or services typically provided for large orders, special offerings, or to business partners.

$$\text{Trade discount}=\text{List price}\times \text{Trade discount \%}$$

$$\text{Sales}=\text{List price}-\text{Trade discount}$$

The accounting for trade discounts is simple because they are not recorded in the books. The journal entry to record a sales transaction where a trade discount was provided records the accounts receivable and the revenue at net of the trade discount.

Example: Trade discount

On April 1, Company XYZ sold 25,000 units of inventory for $10 per unit to Wholesale Company, a strategic business partner who is a wholesaler of the inventory that Company XYZ produces. The company provides a 20% trade discount for wholesale orders above 20,000 units. How is the accounts receivable recorded at initial recognition?

• Total sales at list price: 25,000 × $10 = $250,000
• Trade discount (20% of list price): $(50,000)
• Net sales (and accounts receivable): $200,000

Answer: Dr accounts receivable $200,000 / Cr sales $200,000, to record the sale to Wholesale Company on April 1, net of the 20% trade discount.

Cash discounts

Cash discounts can also be called prompt payment discounts because their nature is to incentivize the customer for paying the accounts receivable earlier than the due date. This is typically included in the invoice that is provided to the customer with the following format:

$$\text{Cash discount terms: 2/15, n/30}$$

The discount terms above can be interpreted as follows:

• the first portion (“2/15”) of the above terms relates to the cash discount
• the second section (“n/30”) relates to the due date of the invoice

The above terms mean that if the payment is made within 15 days, a 2% discount is provided on the transaction price and that the whole amount is due 30 days from the invoice date.

As a consequence, if the payment is made beyond 15 days but still within the 30 days of full term, the full transaction price is due. In contrast, if the 30 days of term has elapsed and the customer has failed to make a payment, the accounts receivable is considered as past due. The term past due will be relevant in the discussion about the allowance for credit losses.

In practice, the cash discounts can be in different combinations of percentages, discount periods, and due dates depending on the policy of the companies providing them. There are two ways of accounting for cash or prompt payment discounts:

1. the gross method
2. the net method

For example, on a $10,000 sale with 2/15, n/30 terms, the 2% discount is $200: the net amount is $9,800 if the customer pays within the discount period, compared with the $10,000 gross amount recorded initially under the gross method.

Initial recognition of cash discount: gross method

The gross method, the more common approach in practice, initially records the accounts receivable at the gross amount, without accounting for the discount the customer might take. This keeps the accounting simple when the customer doesn’t take the discount, since the amount initially recorded as a receivable equals the amount collected. Sample journal entries illustrating the gross method follow:

Journal entry upon sale

At initial recognition, the discount is ignored when using the gross method

Journal entry upon payment beyond the discount period

The journal entry below shows an alternate journal entry if the customer decided to take advantage of the discount.

Journal entry upon payment within the discount period

Initial recognition of cash discount: net method

The net method records both the accounts receivable and sales at the net amount, and is used when customers typically take the discount. The initial accounting is the same as how trade discounts are recorded.

Journal entry upon sale

At initial recognition, the discount is already considered when using the net method

Journal entry upon payment beyond the discount period

The journal entry below shows an alternate journal entry if the customer decided to take advantage of the discount.

Journal entry upon payment within the discount period