Accounts Receivable (AR) DiscountedDefined along with Examples

Written By:
Adiste Mae

What are Accounts Receivable (AR) Discounted?

Accounts Receivable Discounted refers to the process of generating cash by selling unpaid invoices (Accounts Receivable) to a bank or another financial institution that offers to buy outstanding receivables.

When unpaid invoices are discounted, they are generally bought by a Factor (the financial institution that buys unpaid invoices) at less than the face value. 

Understanding Accounts Receivable Discounted

When companies sell their products or services on credit, it is reported in the Balance Sheet under current assets.

Depending on the AR practices of the company, the period it takes for customers to pay their debts will determine whether their policies are effective.

However, an urgent requirement to raise capital or a need to improve the cash flow will push companies to sell the AR to a Factor at a discounted rate – less than the face value.

When the AR is sold to the Factor, the company receives cash immediately. 

However, when Factors purchase the Accounts Receivable at less than the face value, it is usually done without recourse.

This means the Factor takes the full risk of the invoice not being paid.

It is for this reason that invoices are sold at a discount because the Factor assumes all the risk of the invoice defaulting, and at the same time, be compensated for the delay in receiving the funds.

When customers make payment, it is made directly to the Factor. 

Before, only large firms are able to sell Accounts Receivable to Factors because it is only them that are able to meet the minimum requirements set by the financial institutions.

Today, most firms, including small and medium enterprises, across different industries are now able to sell Accounts Receivable at a discount to obtain immediate cash directly from factoring firms or through intermediaries. 

Allowance for Doubtful Accounts

When companies sell goods or services on credit, there is a probability that some of the outstanding invoices will not get paid.

According to the Generally Accepted Accounting Principles (GAAP), expenses must be recognized in the same period that revenues are.

This is why for the same period that revenue is recognized for credit sales, a corresponding expense account shall also be recorded.

The probability of a receivable not being collected is recorded under the allowance method as Allowance for Doubtful Accounts.

The estimate for uncollectible amounts will be recorded in the Income Statement as an expense, and in the Balance Sheet as a contra account to the Accounts Receivable.

Even if an allowance has already been recorded, the balance can accumulate across different accounting periods and the company will still have the right to collect the outstanding amount from their customers and adjust the allowance account accordingly.