If we imagine buying something, such as groceries, it's easy to picture ourselves standing at the checkout, writing out a personal check, and taking possession of the goods. It's a simple transaction—we exchange our money for the store's groceries.
In the world of business, however, many companies must be willing to sell their goods (or services) on credit. This would be equivalent to the grocer transferring ownership of the groceries to you, issuing a sales invoice, and allowing you to pay for the groceries at a later date.
Whenever a seller decides to offer its goods or services on credit, two things happen: (1) the seller boosts its potential to increase revenues since many buyers appreciate the convenience and efficiency of making purchases on credit, and (2) the seller opens itself up to potential losses if its customers do not pay the sales invoice amount when it becomes due.
Under the accrual basis of accounting (which we will be using throughout our discussion) a sale on credit will:
Increase sales or sales revenues, which are reported on the income statement, and
Increase the amount due from customers, which is reported as accounts receivable—an asset reported on the balance sheet.
If a buyer does not pay the amount it owes, the seller will report:
A credit loss or bad debts expense on its income statement, and
A reduction of accounts receivable on its balance sheet.
With respect to financial statements, the seller should report its estimated credit losses as soon as possible using the allowance method. For income tax purposes, however, losses are reported at a later date through the use of the direct write-off method.
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