Welcome to the World of Credit!
In the world of business, cash does not always change hands immediately. When a business sells or purchases goods and services on credit, it records "promises to receive cash" and "promises to pay cash". In this chapter, we will learn how to record these transactions and manage credit balances. This is a fundamental part of the Recording transactions and events section of your ACCA Financial Accounting (FA) syllabus.
1. What are Receivables and Payables?
Before diving into the numbers, let us clarify the core terms. These represent two sides of credit transactions:
Receivables (Assets)
Receivables are amounts owed to your business by customers because you sold goods or services on credit. Since this represents a future economic benefit (cash inflow), it is classified as a Current Asset with a normal debit ( \( Dr \) ) balance.
Payables (Liabilities)
Payables are amounts that your business owes to suppliers because you bought goods or services on credit. Since this is an obligation to transfer cash in the future, it is classified as a Current Liability with a normal credit ( \( Cr \) ) balance.
Impact on the Statement of Financial Position
Receivables = Current Asset = Debit balance (\( Dr \))
Payables = Current Liability = Credit balance (\( Cr \))
2. Credit Management: Benefits, Costs, and Controls
Offering credit to customers has clear business trade-offs that every accountant must understand:
Benefits of offering credit:
- Attracts new customers and generates higher sales volumes.
- Helps maintain competitiveness and builds long-term customer loyalty.
Costs of offering credit:
- Risk of irrecoverable debts when customers default.
- Administrative and financing costs incurred while waiting for cash.
- Tied-up working capital requiring bank overdrafts or credit facilities.
Credit Limits and Aged Receivables Analysis
To control the risks of credit sales, businesses implement two key mechanisms:
1. Customer Credit Limits: A maximum balance that an individual customer is permitted to owe at any one time. New orders are placed on hold if the limit is exceeded.
2. Aged Receivables Analysis: A management report categorising customer balances by how long they have been outstanding (e.g., current, 30 days overdue, 60 days overdue, 90+ days overdue). It helps identify overdue debts, assess credit risk, and evaluate necessary debt allowances.
3. Recording Credit Sales, Purchases, and Discounts
Credit transactions are recorded in the general ledger accounts rather than the bank account at the date of invoice.
Recording a Credit Sale
When you sell goods to a customer on credit:
\( Dr \) Receivables
\( Cr \) Sales
Recording a Credit Purchase
When you buy goods from a supplier on credit:
\( Dr \) Purchases
\( Cr \) Payables
Discounts
Trade Discounts: A price reduction agreed before or at the time of sale (such as a bulk purchase discount). Trade discounts are deducted directly on the invoice and are never recorded in ledger accounts; entries are made at the net invoice amount.
Settlement Discounts: Offered to encourage early settlement (e.g., 2% discount if paid within 10 days). In accordance with IFRS 15, revenue and receivables are recorded at the amount expected to be received, taking anticipated settlement discounts into account.
4. Irrecoverable Debts and Recoveries
When it is certain that a customer cannot or will not pay an outstanding debt (for example, due to insolvency), the balance is written off as an irrecoverable debt.
Writing Off an Irrecoverable Debt
The receivable balance must be removed and recognised as an expense:
\( Dr \) Irrecoverable debts expense (Profit or loss)
\( Cr \) Receivables (Statement of financial position)
Debts Subsequently Recovered
If a customer pays a debt that was written off in an earlier period, the cash received is recorded and the irrecoverable debts expense is credited:
\( Dr \) Bank / Cash
\( Cr \) Irrecoverable debts expense (Profit or loss)
5. Allowance for Irrecoverable Debts
When debts are not definitively irrecoverable, but there is uncertainty regarding collection, prudence requires an allowance for irrecoverable debts.
Creating and Adjusting the Allowance
An allowance is calculated at the end of the reporting period on the remaining receivables balance (after writing off all irrecoverable debts). Only the movement (increase or decrease) is charged or credited to the statement of profit or loss:
To record an increase in allowance:
\( Dr \) Irrecoverable debts expense (Profit or loss)
\( Cr \) Allowance for irrecoverable debts (Statement of financial position)
To record a decrease in allowance:
\( Dr \) Allowance for irrecoverable debts (Statement of financial position)
\( Cr \) Irrecoverable debts expense (Profit or loss)
Presentation: On the statement of financial position, the closing balance of the allowance is deducted from receivables to report net receivables.
6. Contras Between Receivables and Payables
Sometimes a business buys from and sells to the same entity. Instead of both parties transferring cash back and forth, they may agree to offset their balances. This offset is known as a contra.
A contra is recorded at the lower of the receivable and payable balances outstanding:
\( Dr \) Payables
\( Cr \) Receivables
7. Supplier Statements and Reconciliations
Suppliers send periodic supplier statements detailing invoices issued, payments received, credit notes applied, and the balance owing. Reconciling the supplier statement to the business's own payables account is a vital internal control.
Common Causes of Differences:
- Invoices in transit: Invoices issued by the supplier but not yet received or recorded by the buyer.
- Payments in transit: Cheques or electronic transfers made by the buyer not yet credited on the supplier's statement.
- Disputed items or credit notes: Returns or discount allowances recorded by one party but not the other.
- Errors: Arithmetic errors or transposition figures made either in the buyer's payables ledger or on the supplier's statement.
Reconciling items that represent errors or omissions in the buyer's records require adjusting journal entries in the general ledger.
8. Summary and Key Takeaways
1. Receivables are current assets (\( Dr \)); Payables are current liabilities (\( Cr \)).
2. Aged receivables analysis and credit limits manage default risk and working capital.
3. Trade discounts are deducted on the invoice; settlement discounts follow expected receipt amounts.
4. Irrecoverable debts written off credit Receivables; debts subsequently recovered credit Irrecoverable debts expense.
5. Allowance movements pass through profit or loss; the closing allowance is deducted from receivables on the statement of financial position.
6. Contras offset mutually owed amounts (\( Dr \) Payables, \( Cr \) Receivables).
7. Supplier statements are reconciled to payables to identify timing differences and correct ledger errors.