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The credit is to the allowance for bad debts account, which is a reserve account that appears in the balance sheet. The debit is to the bad debt expense account, which causes an expense to appear in the income statement. The best way to do so is to estimate the amount of bad debt that will eventually arise, and accrue an expense for it at the end of each reporting period. If a company sells on credit, customers will occasionally be unable to pay, in which case the seller should charge the account receivable to expense as a bad debt. Recording the transaction upon arrival at the customer requires substantially more work to verify. If the sale is made under FOB destination terms, then the seller is supposed to record these transactions when the shipment arrives at the customer this is because the delivery is still the responsibility of the seller until it reaches the customer's location.įrom a practical perspective, many companies record their sale transactions as though the delivery terms were FOB shipping point, because it is easy to verify. From that point onward, the delivery is technically the responsibility of either a third-party shipper or the buyer.
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If the sale is made under FOB shipping point terms, the seller is supposed to record both the sale transaction and related charge to cost of goods sold at the time when the shipment leaves its shipping dock. There is an issue with the timing of the preceding sale transaction. The latter method is preferred, because the seller is matching revenues with bad debt expenses in the same period (known as the matching principle). If so, the seller can either charge these losses to expense when they occur (known as the direct write-off method) or it can anticipate the amount of such losses and charge an estimated amount to expense (known as the allowance method). In addition, there is a risk that the customer will not pay. This is the system under which an account receivable is recorded. If the seller is operating under the more widely-used accrual basis of accounting, it records transactions irrespective of any changes in cash. Only when the customer pays does the seller record a sale. Since issuing an invoice does not involve any change in cash, there is no record of accounts receivable in the accounting records. If the seller is operating under the cash basis of accounting, it only record transactions in its accounting records (which are then compiled into the financial statements) when cash is either paid or received. New Controller Guidebook Receivables Under the Accrual and Cash Basis of Accounting The invoice describes the goods or services that have been sold to the customer, the amount it owes the seller (including sales taxes and freight charges), and when it is supposed to pay. This is considered a short-term asset, since the seller is normally paid in less than one year.Īn account receivable is documented through an invoice, which the seller is responsible for issuing to the customer through a billing procedure. Conversely, this creates an asset for the seller, which is called accounts receivable. When goods or services are sold to a customer, and the customer is allowed to pay at a later date, this is known as selling on credit, and creates a liability for the customer to pay the seller.