Sometimes customers fail to make good on what they owe. This failure to pay may be willful, but often it is not. Usually, customers intend to pay for the goods and services they acquire, but due to unforeseen economic setbacks or failure to adequately control spending, they find themselves unable to make payments. This very ordinary circumstance creates a valuation problem.
Let’s say a firm has $15,000 of receivables at the end of an accounting period. Can the firm determine if these receivables are fully collectable? If the accounts receivable are not fully collectable, assets and revenue are overstated. Arriving at a reasonable valuation of accounts receivable usually is not that difficult, but getting a precise dollar amount of collectable accounts is not usually possible. Welcome to the world of accounting estimates!
A figure for accounts receivable on a balance sheet of a company with a large number of individual accounts reflects an estimate of what the company believes is collectable. You hope that the estimate is made in good faith and is reasonable. However, sometimes managers do not act in good faith, and they inflate the amount of receivables they deem to be collectable. This results in an overstatement of both assets and revenues.
The most common method of estimating the collectability of receivables is to use an aging schedule. In an aging schedule, accounts receivable are classified in terms of how long they have been outstanding. A typical schedule divides receivables into categories of less than 30 days, 31-60 days, 61-90 days, and over 90 days. Based on general credit experience, the longer a receivable is outstanding, the less chance of full collection.
Example. Let’s say that Joint Ventures accounts receivables total $75,000 at the end of the most recent year. Based on past credit, experience Morrisin estimates that 90% of receivables under 30 days will be paid, 70% of those between 31-60 days will be paid, 60% of those between 61-90 days, will be paid and only 50% of those over 90 days will be paid. If the distribution of the $75,000 receivables is broken down in an aging schedule, Joint Ventures would estimate the collectable receivables as follows:
Part of the audit function is to test the existence and collectability of accounts receivable and this can serve as a brake on such fraudulent practices. In the audit of large companies with millions of dollars of receivables and hundreds of thousands of individual accounts, the audit process relies on statistical sampling, which usually provides a reasonable, but not exact, estimate of collectable accounts.