Walk me through an increase of $10 in Accounts Receivable?
Why do the explanations for this always disregard COGS? I am only talking about the change’s effect on the Income Statement in terms of accrual accounting. Tell me if I’m wrong:
A $10 increase in accounts receivable increases revenue by $10, and assuming a 20% effective tax rate, increases net income by $8.
But this disregards any expense that should be recognized for COGS (according to the matching principle). Why?
An increase in AR doesn't directly affect COGS. The COGS has already been recognized when the sale was made. The increase in accounts receivable just means that the cash has not been collected yet.
You’re not necessarily wrong - there’s just more to it, and your explanation is a little off.
There are one or two correct journal entries that could be made:
and (for a goods/products company)
One simple answer could be that not all firms would have COGS (i.e- services company) from an increase in AR, which would make this explanation for the income statement correct. For a products company, the second journal entry wouldn’t be disregarded and would decrease the marginal revenue by COGS before making to down to net income.
However, these questions are generally meant to pose a simple scenario for you to demonstrate your knowledge of how changes flow through the financial statements. A more appropriate answer that would be expected to this question is that the increase in AR does increase revenue->net income on the income statement, but also that it increases working capital (via the balance sheet), which would be a non-cash change in accruals that would decrease CFO on the statement of cash flows. Hope that helps.
Thank you so much for the detailed and straightforward explanation! In an interview, do we want to ask about the type of the company or assume it is services-based for simplicity purposes? Would you say the reason most guides don’t refer to COGS in this question is for simplicity and assuming not all companies have inventory?
No problem, we all start somewhere. I would say especially for internships and entry-level roles, most interviewers are not looking to trip you up on a technicality like whether or not a company has COGs. If there’s key information to lead you toward that sort of conclusion, 9/10x it will be given to you with the question. If there’s no special info given, you’re probably safe with simplicity.
Got it, thanks!
Might be wrong here, but it could also be due to deferred revenues*. ARs can rise w/o an increase in COGS if a company bills / invoices its customers for goods sold, but not yet delivered. Because of this, the company isn't required to record the revenue and the corresponding expense at that point in time.
Based on this, cash would be unchanged and the both sides of the balance sheet remain equal since the rise in AR is met with a corresponding rise in liabilities (via deferred revenues).
*Initially thought that accounts receivable was only to be recognized for earned revenues (and thus contingent on delivery), but I think you're allowed to recognize billed, unearned revenues so long as you have a contractual right to collect the cash. If anyone thinks I'm off base, feel free to correct since I'm still learning too.
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