Contra Accounts and Accounts Receivable as Assets
When accounts, especially assets, are reported on the balance sheet, they are recorded in their historical cost. For example, fixed assets like machinery or land are recorded as the purchase cost in order to preserve historical information. However, these assets lose value over time (usually based on use, write-downs or some other tax-induced formula determined by your accountant) and therefore affect the balance sheet.
The accounts used to offset a primary account are known as contra accounts. They are usually reported right after the primary account with a light indent on the balance sheet or within parenthesis.
Contra Accounts can also be used in the income statement, with the most common consisting of “Returns and Allowances,” which offsets the Sales account and represents returns by customers as well as discounts offered due to back-orders, bulk orders and promotions.
Of course it's important to keep an eye on all accounts, but contra accounts are especially important to analyze when a business is in a growth or expansion stage. Often, when the proportion of a contra account (its size relative to the primary account) is growing rapidly, then it's an early sign that the business needs to allocate more resources to a specific department or evaluate its business practices.
For example, if a business is growing and the proportion of “Bad Debt” to Account Receivable is steadily growing, it can be a sign that the Accounts Receivable or accounting department does not have enough resources to keep up with the increased business and is therefore having a harder time collecting debts. Or it can be that the business needs to evaluate its credit policy because it granting too much credit to risk customers. If a manager sees that the account is steadily decreasing, he or she may want to investigate to see which customers are driving the process. They may have similar characteristics and may help the business focus on an extra profitable customer group.
Another example is the “Spoilage” account. If it is steadily growing in proportion, what is the reason for it? Is it because inventory is getting misplaced and therefore forgotten? Are the storage facilities inadequate and need investment? Are the demand forecasts used to justify purchases inaccurate? Is the entire inventory management process inefficient? Additionally, if a manager sees that the account is steadily decreasing, he may want to investigate the reason behind the cost savings so he can replicate it in other parts of the business.
Account Receivables as Assets
Accounts receivable can be considered an investment made by a business. You are exchanging goods or services for payment in the future. The resulting accounts receivable balance counts as an asset and generates a return like goodwill with a customer or increased income if interest is charged on the balance.
When accounts receivable are seen as assets, there are management decisions that can be made in order to increase the value of those assets by influencing:
Accounts Receivable Total – The total dollar amount invested in accounts receivable. Basically, it's the proportion of sales made on credit and is highly dependent on sales and marketing strategy.
Credit Terms – The length of time a credit customer has to pay and related terms, which is a trade-off between the loss of cash flow and the return made on accounts receivable.
Credit Standards – The profile of the customers that credit is extended to, which is a trade-off between quality and quantity; a few customers steadily paying on time versus many customers with some not paying on time. Too lenient a policy will increase uncollectible sales while standards that are too strict will increase missed sales.
Over-investment in accounts receivable can be expensive in a number of ways. Since it delays the inflow of cash from sales, operating expenses often have to be financed with short-term financing, representing a direct cost to investment in accounts receivable. In extreme cases, if operating expenses exceed short-term financing capability, you may run out of available cash on hand.
Accounts receivable management also has important strategic implications. If credit policy, such as terms of payment and discounts offered for early payment, are not competitive compared to industry rivals, you may lose market share.
Additionally, if credit policy is misaligned with product profitability, such as a long credit period with a product that has small margins, profitability and reinvestment can decrease quickly.