The Financial Accounting Standards Board (FASB) is the organization responsible for creating Generally Accepted Accounting Principles. Under these guidelines, companies must follow certain procedures for calculating their gross and net accounts receivable. The difference between the two lies in the method a company chooses to estimate its bad debts.
The gross accounts receivable account represents an asset to the company on the balance sheet. The balance in the account is the amount of money that the company has a legal right to collect, but has yet to receive cash for. For example, credit-card companies are in the business of extending credit to consumers. When a consumer uses the card to make a purchase, they are legally liable to repay the credit-card company. At this moment, the credit-card company increases its gross accounts receivable for the amount the consumer owes. However, some debtors will not pay their balances, which is why companies also report a net accounts receivable.
The difference between gross accounts receivable and net accounts receivable is the amount that a company anticipates it will be unable to collect. In a perfect world, a company would always collect 100 percent of the money it is owed. However, this is not the case, and both investors and lenders prefer to see a more realistic balance of what the company will collect. A significant factor in evaluating the health of a company is the amount of cash it has on hand and the cash it realistically expects to collect in the near future. As a result, using a net number provides a better insight into a company’s cash-flow position.
In order to get from gross to net accounts receivable, company accountants put great effort into estimating the percentage of the gross receivable balance that will be uncollectible, and therefore, written off on the company’s books. Company accountants estimate the bad-debt charge as either a percentage of annual sales or percentage of annual credit sales. This estimate reduces the profit a company reports on the income statement. However, the bad-debt expense also increases the balance in the allowance for doubtful accounts on the balance sheet.
The balance in allowance for doubtful accounts is subtracted from the gross accounts receivable balance to arrive at net accounts receivable. The balance initially increases for the bad-debt expense the company estimates and fluctuates during the year as the company determines which specific invoices will never be collected. For example, if the company anticipates that $1 million of its $100 million gross accounts receivable balance is uncollectible, the allowance account increases by $1 million. As a result, the net accounts receivable balance is $99 million. However, once the company makes a final determination that a specific invoice is worthless; the company reduces the allowance account as well as the gross receivables account. The key issue here is that the net accounts receivable is just a temporary estimate until the company obtains better information.