Recognition of Accounts Receivable

In most transactions involving receivables, the recognized amount is based on the agreed price between the seller and the buyer.

The agreed price represents what the debtor, often a customer or borrower, is expected to pay. An invoice or similar document generally supports this amount. However, determining the agreed price can become complex due to two factors: (1) the possibility of discounts (such as trade or cash discounts) and (2) the time gap between the sale and the payment date, which may include an implied interest component.

Trade Discounts

To manage prices effectively, companies may apply trade or quantity discounts, allowing them to adjust prices without frequent catalog updates. Trade discounts are commonly used to encourage larger orders, offer different rates for specific customer groups, or mask the actual price from competitors. These discounts are usually expressed as a percentage.

For instance, if a tablet has a list price of $150, but the manufacturer offers a 20% trade discount, the retailer pays $120 for each unit. The manufacturer records the receivable at the discounted price, not the original list price. Similarly, a popular cereal brand might sell a 12-ounce box with a $4.50 list price but apply a 15% trade discount when invoicing bulk buyers. The discounted price, not the list price, is recorded as the receivable and revenue.

Cash Discounts (Sales Discounts)

Cash discounts, also known as early payment discounts, are incentives for customers to pay their invoices promptly. For example, terms such as 1/10, n/30 mean that the customer receives a 1% discount if they pay within 10 days, with the full payment due in 30 days. Another common term, 2/10, E.O.M., net 60, offers a 2% discount if the payment is made by the tenth day of the following month, with the total due by the end of the next month. Such discounts benefit companies by improving cash flow and reducing outstanding receivables.

Companies use either the gross method or the net method to record sales and discounts:

Gross Method: Records the receivable and sale at the full amount. If the customer pays within the discount period, the discount is recognized separately, and net sales are calculated after deducting the discount.
Net Method: Assumes the customer will take the discount, recording sales at the reduced amount. If the customer does not pay within the discount period, the difference between the full and discounted amounts is credited to Sales Discounts Forfeited as “Other revenue.”

For example, using the gross method, if a company records sales of $8,000 with terms 2/10, n/30, and a customer pays $3,000 within the discount period, the company records:

Cash $2,940
Sales Discounts $60
Accounts Receivable $3,000

If the remaining $5,000 is paid after the discount period:

Cash $5,000
Accounts Receivable $5,000

The net method provides a more accurate expectation of revenue but requires tracking when customers forfeit their discounts.

Nonrecognition of Interest Element

Ideally, receivables should be valued based on their present worth, considering the time it takes to collect. However, for short-term receivables, this adjustment is often unnecessary because the impact is minor. In contrast, long-term receivables may need discounting to reflect their actual worth today.

For instance, if a sporting goods retailer sells items on account for $2,500, with payment due in five months, and the annual interest rate is 8%, the present value of the receivable would be around $2,411. This adjustment reflects the waiting period for cash collection. However, for most trade receivables due within a year, this adjustment is typically ignored, aligning with common accounting practices.