Sample An Essay on Accounts Receivable Assignment

An Essay on Accounts Receivable Assignment Sample

INTRODUCTION

"Accounting Issues: An Essay Series—Part I—Cash" [Laux, 2007] explains why this series is necessary. In that accounting assignment article, the relationship between the asset cash and the various accounting characteristics—again shown in the table on the following page—was explored. The analogy of climbing a mountain serves as the foundation for examining the difficulties in initially recording transactions, adjusting the accounts, and reporting the elements through financial statements. That is, during the daily accounting activities ("on the plains"—before the ascent up the mountain even begins), up the "foothills," and finally to the "peak," where we hope economic reality is reflected in such a way that investors and creditors find the information useful in making decisions. We continue in that same vein by discussing the ideas and problems that are most directly related to accounts receivable. You should review the aforementioned paper, paying close attention to the section under "The Conceptual Framework at a Glance," if you need a "refresher" on the hierarchy of accounting characteristics. The following part discusses the general accounting approach to receivables, while the two sections that follow focus on the conceptual relationships and measurement problems that are most obviously related to accounts receivable. The most intriguing headlines and associated articles are presented in the last section for additional research.

ACCOUNTING FOR RECEIVABLES IN BRIEF

Accounts receivable are created when clients buy goods or services with the promise to pay later, as stated in the principles of accounting course. Typically, the gross or retail amount of the initial transaction is added to Accounts Receivable and Revenues to record it. The accountant must estimate how many of those receivables will likely be collected in the future at the end of the accounting period during the adjusting process in order to provide to the statement readers a "net" (collectible) amount that actually reflects an asset (an economic resource expected to benefit future periods as the dollars are collected in cash). This "net realizable value" is the difference between the gross amount in the accounts payable account and the balance in the allowance for bad debts account (a contra-asset account), a balance established during the adjusting process typically through one of three estimation approaches—as a percentage of gross accounts payable, through an ageing of accounts receivable, or as a percentage of sales. While the basic course will cover the specifics of this adjustment process, suffice it to state that (1) it includes an estimate and (2) that estimate is often based on historical data. The theoretical effects of recording gross accounts receivable and identifying uncollectible accounts at year-end are covered in the section that follows.

THE CONCEPTUAL FRAMEWORK AND ACCOUNTS RECEIVABLE

As seen in the graphic on the page above, the existence of both relevance and dependability for a reported item is what determines how valuable a choice is. Therefore, the reported Accounts Receivable balance (and the related Allowance for Bad Debts account) must be significant to creditors and investors, able to affect how they evaluate past economic events and/or aid in the forecasting of future cash flows. Both of these conceptual connections will be discussed individually.

The closest thing to cash for the majority of businesses is accounts receivable from customers, aside from marketable securities (which, in compared to accounts receivable, typically make up a small percentage of overall assets). It weighs heavily in crucial metrics like the current ratio, the fast (or acid-test) ratio, and accounts receivable turnover and influences creditor decisions like granting short-term loans because it is such a significant asset and component of liquidity. The absolute amount of and changes in Accounts Receivable play a significant role in future cash flow projections, scoring well on the relevance metric.

Readers of financial statements rely on net realizable value (NRV), which is calculated as Accounts Receivable at historical cost less Allowance for Bad Debts (AFBD), to predict future cash flows; however, because NRV depends on an estimate (AFBD), its accuracy is limited. As a result, there is a trade-off between relevance and reliability. Companies can adjust estimated uncollectible accounts to influence revenue, and numerous cases of fraudulent and misleading reporting have recently been reported. Other corporate income smoothing approaches have involved fiddling with this estimate, underestimating bad debts in years where income is falling short of projections, and overestimating uncollectible accounts in years where income is generally exceeding projections. If one organization employs bad debt estimations as a manner of smoothing income while another resists the temptation, this can also affect comparability over time and between companies.

In estimating uncollectible accounts, businesses must provide complete disclosure (explain to statement readers how they arrive at AFBD) and must maintain their basic methodology from year to year, creating the impression of high consistency. However, a degree of flexibility is given in determining the percentages (of gross sales, accounts receivable, or even within the percentages used in the ageing of accounts procedure) that establish the net realizable value, allowing businesses to avoid true consistency from year to year and hindering the statement reader's ability to predict future cash flows from a given year's net amount. The conceptual linkages that are related to the measurement of accounts receivable are examined in more detail in the section that follows.

MEASUREMENT ISSUES AND THEIR CONCEPTUAL CONNECTIONS

Two key measuring concerns are involved in accounts receivable analysis:

• Does the level of gross receivables reflect actual economic activities or events?

• Does the Allowance for Bad Debts reflect the amount of money that won't be recouped?

The first is about recognizing revenue, while the second is about recognizing and matching expenses. The crucial phase of revenue recognition is thoroughly covered in the majority of introductory accounting courses, making it abundantly clear that both the buyer and the seller must meet certain requirements before businesses should formally measure and record revenues (and the associated account receivable) in the accounting books. However, many "beyond-GAAP" blunders have happened at this point. (The following part will provide a presentation of some of the headliners.) Here, on the plains of routine accounting, accountants may choose to do so or may feel under pressure to do so, resulting in the early, exaggerated, or even fraudulent valuation of linked revenues and receivables. Recognition indicates non-GAAP accounting, and the resulting Accounts Receivable are exaggerated, if the company has not performed its duties (fulfilling a service contract or delivering a product with a restricted right of return) and/or if a client has not made a credible promise to pay the firm. The company's financial situation has not improved, it has not acquired any new assets, and there is no guarantee of future cash flows. Accountants must reflect this economic reality because that is the current state of affairs.

Similar to this, accountants must appropriately record an amount of AFBD that reflects the dollars of receivables that will not be collected, an expense to be recognised as Bad Debts Expense. Since this is based on an estimate, there is more room for error (accountants are not expected to be 100% correct), but viewers of financial statements should be able to trust that every attempt has been made in good faith. In other words, accountants shouldn't try to slant the estimate in any direction; instead, they should use their best judgement based on the data that is already available and other facts or prognostications (such as a generally acknowledged economic rebound or recession). This idea, known as "neutrality," improves the fundamental quality of dependability. The allowance method of recording bad debts also represents an effort to follow the matching principle by recording the expense related to uncollectible accounts in the same accounting period as (and hence "matched" with") the related revenues.

A few restrictions also apply to accounts receivable accounting. If a corporation has a history of very few uncollectible accounts, it can choose not to use the recommended strategy as mentioned (estimating uncollectible amounts and creating a contra-asset account) (low bad debt expense). This is the idea of materiality, which says that if the difference in income (and/or assets, in this example) is not significant, GAAP-based procedures can be abandoned. The expense of using the allowance technique may be seen as outweighing the advantage of the increased accuracy because it necessitates more work in predicting uncollectible accounts and leads to more complex accounting. Therefore, the cost-benefit limitation is relevant. Finally, the idea of conservatism encourages accountants to report the net amount (net realisable value—NRV) at the lower end of the acceptable range when faced with a range of defendable (logical) values for assets like accounts receivable. The reported NRV should be closer to $48,000 than $49,000, for instance, if an accountant thinks that between $1,000 and $2,000 of the $50,000 in gross receivables may be uncollectible. Be aware that conservatism DOES NOT advocate underestimating the amount of receivables that should be collected. It only advises that one should move to the lower end for assets within a reasonable range. Keep in mind that the objective is to reflect economic reality, not to deceive creditors and investors into thinking the company is in worse shape than it actually is!

Naturally, the headlines all too frequently imply that companies have actually attempted the exact opposite—overstating Accounts Receivables (and/or understating AFBD) in an effort to boost the stock price, obtain necessary funding, or to meet specific ratio criteria. A few of the incidents are listed in the section that follows.

ACCOUNTS RECEIVABLE IN THE NEWS AND LITERATURE

While not every sensational headline focuses on companies that have fabricated receivables, many do feature a preferred strategy for reporting fictitiously high income—overstating revenues, which is frequently coupled with too optimistic or even phantom accounts receivable. The ZZZZ Best case was among the most notable of the false accounts receivable/revenue scandal headlines. Young businessman Barry Minkow, once known as the "Wonder Boy of Wall Street," inflated the worth of his carpet cleaning company through phoney sales and receivables, valuing it at almost $350 million but ultimately selling it for less than $60,000. 1 Even though the Enron tale highlights the misuse of Special Purpose Entities and the corresponding beyond-GAAP reporting, it was also guilty of improper financial reporting in relation to both sales and receivables. It misestimated future contract values using internal models in an effort to increase compensation and the company's stock price. For example, it reported the gross amount of the energy contracts it brokered for buyers and sellers rather than the more reasonable fees earned by Enron. In Wells [2004], a Canadian company is featured, and European companies have also joined the fray, lest you think that these kinds of false comments are only made by American businesses.

It is more customary for businesses to simply speed up revenues and receivables in an effort to boost earnings and match analyst projections. For instance, Sunbeam employed a "bill and hold" method (See Spiceland, p. 330), whereby they sold products to merchants at steep discounts prior to the "season" in which such sales typically occurred, and then stored the products in third-party warehouses to be delivered at a later time. As a result, the assets and revenues were transferred to a previous quarter, which improved the reported profitability and financial condition for that time. 3 In the early 1990s, IBM employed a set of deceptive practises that were considerably worse.

When machines were simply relocated to storage facilities prior to installation, receivables would result. This might be seen as a more egregious example of revenue recognition breach because IBM's "product" contained more than simply machines and installation; it also included client training and satisfaction. IBM also offered reimbursements if prices fell within a specific time period (a likely occurrence, making the ultimate receivable much less valuable).

Last but not least, in the variety of accounts receivable systems, this asset may be misstated due to a subpar calculation of the bad debts contra account, whether intentional or not. Giving accountants the freedom to forecast future collections might lead to either too high or too low net realisable values and bad debt expense. Overstating accounts receivable (and understating bad debt expenditure) served as a stepping stone to blatant false reporting in the cases of MCI and CFS, respectively. Finance manager Walter Pavlo initially turned to crime, embezzling millions of dollars, narrowly avoiding a nervous breakdown, pleading guilty to a number of offences, and receiving a sentence of 41 months and $5.9 million in restitution. This was after initially being found guilty of hiding bad debt to temporarily boost MCI's dwindling earnings. 5 Similar to this, Commercial Financial Services (CFS), a business that specialised in purchasing past-due credit card debt, was described by Zellner [1998] as being able to recover a staggering 30 cents on every dollar invested (in an industry in which the norm is 15 to 23 cents). The chief executive officer and the rest of his board of directors resigned as a result of the discovery of this inflated asset, endangering the stability of this emerging market. Other instances exist, but this one should serve as an excellent illustration of the potential consequences of poor accounting and/or accountants.

Less frequently, empirical investigations are conducted in the field of accounts receivable. Accounts receivable and the allowance for bad debts are both taken into consideration in one fundamental study [Lev and Thiagarajan, 1993] for using accounting data to assess the quality of earnings. According to the authors, disproportionate rises in accounts receivable (compared to sales) are associated with losses in future earnings, whereas the provision for bad debts has little or no impact on how to assess earnings persistence. The majority of empirical research cover the broader subject of manipulating and managing earnings. Rosner's 2003 paper, "Earnings Manipulation in Failing Firms," and Beneish [1999] are two of the greatest of these studies. The first looks on whether failing businesses are driven to fabricate financial data in order to hide their problems. When compared to control, non-distressed enterprises, the author finds that increases in accounts receivable are considerably bigger, which raises the possibility that financial difficulty is concealed by overstating receivables. In a similar vein, Beneish finds significant overstatement of accounts receivable in a study of profits manipulation in a group of enterprises from 1982 to 1988. According to a third empirical study by McNichols and Wilson [1988], businesses on the verge of failure use this adjustment much more frequently than businesses with more stable financial standing. This study specifically examines the use of the bad debts provision for masking true earnings patterns.

What then are the solutions to the manipulation conundrum? Receivables should be recorded at market value (rather than at the face or "gross" amount), according to a guest editorial by Robert Sterling in a 2003 issue of Abacus. However, estimation would still be necessary both when the receivable is added to the books and again when the financial statement date arrives. Wells (2004) provides a useful road map for identifying fraud, but he makes no suggestions for stopping it. Sarbanes-Oxley clearly tackles the issue in a more general approach by making executives more aware of their duty to verify the correctness of the reported receivables.

THIS SERIES CONTINUES

This article served as the second in a series of succinct pieces created to link the theoretical ideas of the conceptual framework to the different accounting components. The post highlighted a few approachable publications that addressed the measurement concerns related to receivables, looked at some headline stories, and provided insights into the asset known as Accounts Receivable. The series' next article will examine the main issues that accountants deal with when measuring and reporting inventories, another recent source of accounting crises.

REFERENCES