Companies report their accounts receivable in the balance sheet based on accounting sales records. Companies might engage in credit sales to allow customers to buy on accounts and record revenue in the form of accounts receivable. Without proper evaluation of customers' reliability, companies could overstate accounts receivable. Overstated accounts receivable affect not only the balance sheet but also reported income and equity. However, overstating accounts receivable has no effect on a company's cash flow, another major element in financial reporting.
Companies overstate their accounts receivable when they choose not to exclude from total outstanding accounts receivable the amount of potentially uncollectible accounts of certain customers. Under generally accepted accounting principles, or GAAP, companies estimate the amount of uncollectible accounts receivable based on experience and current market conditions if it's probable that some customers mighty not honor their accounts. By doing so, companies avoid having overstated accounts receivable when they decide to write off those that are deemed, in fact, uncollectible.
Advertisement Article continues below this adOverstating accounts receivable directly inflates the size of a company's balance sheet. Following GAAP, companies report assets at their original cost but re-evaluate and make adjustments over time based on an asset's changing fair market value. Accounts receivable are reported as a current asset in the balance sheet, and overstating accounts receivable results in unadjusted and thus inflated carrying value of the initially reported accounts receivable. Under GAAP, the carrying value, or fair market value, of outstanding accounts receivable is the amount of originally recorded accounts receivable subtracted by the amount of uncollectible, or doubtful accounts.
Any uncollectible accounts receivable are unpaid debt by customers and constitute a bad debt expense for the company. As a result of not taking into account uncollectible customer accounts, overstating accounts receivable understates a company's bad debt expense. Such bad debt expenses would have been reported in a company's income statement as a deduction from revenue. Thus, overstating accounts receivable indirectly overstates a company's reported net income. When net income is closed to retained earnings at the end of an accounting period, retained earnings as an equity in the balance sheet is also overstated.
Advertisement Article continues below this adCompanies sometimes refer to accounts receivable for cash flow calculation. For example, when calculating cash flows based on net income, companies need to subtract any increase in accounts receivable from net income because accounts receivable as sales included in net income are not cash. It seems then that used as a subtraction from net income, overstated accounts receivable may further reduce cash flow. However, because the same overstated accounts receivable has been also included in the net income calculation, the net effect of overstating accounts receivable on cash flow is actually zero.