What Is Trade Accounting and How Does It Work?

Trade accounting is the system businesses use to record and manage transactions conducted on credit. This includes when a company sells goods or services without receiving immediate payment, or when it purchases items from suppliers on credit. This accounting method is used for tracking money owed to and by a company over a specific period.

Trade accounting provides a clear picture of a company’s short-term financial liquidity. By tracking credit-based exchanges, a business can better manage its cash flow, which is the net movement of cash into and out of its accounts. This oversight helps ensure a company has sufficient cash to meet its immediate liabilities, fund operations, and pursue growth opportunities.

Key Accounts in Trade Accounting

Trade accounting uses two primary accounts to reflect a company’s short-term financial position with its customers and suppliers. These accounts provide insight into the operational cash cycle and are key components of the balance sheet.

Trade Receivables, commonly known as Accounts Receivable, represents the total money owed to a company by its customers for goods or services delivered but not yet paid for. When a sale is made on credit, the amount is recorded in this account. Because these amounts are expected to be converted into cash, often within 30 to 90 days, Trade Receivables are classified as a current asset on the company’s balance sheet and are a component of working capital.

Trade Payables, often referred to as Accounts Payable, is the opposite of Trade Receivables. It represents the money a company owes its suppliers for goods or services purchased on credit, such as for raw materials or inventory. Since these debts are due for payment within a year, Trade Payables are classified as a current liability on the balance sheet, reflecting the company’s short-term obligations.

Journalizing Core Trade Transactions

Each credit transaction is captured through a journal entry that follows the principles of double-entry bookkeeping. This system requires that every entry has both a debit and a credit to keep the accounting equation in balance.

When a company sells goods on credit, it debits Accounts Receivable and credits Sales Revenue. For example, a $1,000 sale increases the amount owed by customers and the company’s reported sales by that amount. If physical goods are sold, a second entry is made to debit Cost of Goods Sold and credit Inventory.

Conversely, a purchase on credit creates a liability. If a company buys $500 worth of supplies, it would debit an asset account like Inventory and credit Accounts Payable for $500. This entry acknowledges the receipt of goods while recognizing the obligation to pay for them later.

Journal entries are also required for returns and discounts. A sales return is recorded with a debit to Sales Returns and Allowances and a credit to Accounts Receivable, reducing both accounts. To encourage prompt payment, sellers may offer discounts like “2/10, n/30,” meaning a 2% discount if paid in 10 days. If a customer pays a $1,000 invoice within the discount period, the seller debits Cash for $980, debits Sales Discounts for $20, and credits Accounts Receivable for $1,000.

Accounting for Uncollectible Accounts

Companies face the risk that some customers will not pay what they owe, and they must account for this to avoid overstating assets. The matching principle of accrual accounting requires that expenses be recognized in the same period as the revenues they help generate. Therefore, a company must estimate and record potential bad debts in the same period the credit sale was made.

The allowance method is required under Generally Accepted Accounting Principles (GAAP) for this purpose. It involves estimating uncollectible accounts at the end of a period and recording it in a contra-asset account called the Allowance for Doubtful Accounts. Common estimation techniques include the percentage-of-sales method or the aging-of-receivables method, which bases the estimate on how long accounts have been outstanding.

The adjusting journal entry to record the estimate is a debit to Bad Debt Expense and a credit to the Allowance for Doubtful Accounts. This entry increases the company’s operating expenses and establishes a reserve for future uncollectible accounts.

When a specific customer’s account is identified as uncollectible, it is written off. The journal entry for a write-off is a debit to the Allowance for Doubtful Accounts and a credit to Accounts Receivable. This action removes the uncollectible amount from the books but does not impact the Bad Debt Expense account, as the expense was already recognized when the estimate was made.

A simpler alternative is the direct write-off method, where a bad debt is recognized as an expense only when it is deemed uncollectible. This method is not compliant with GAAP for most companies because it violates the matching principle. It is sometimes used for federal income tax purposes or by small businesses with immaterial amounts of uncollectible accounts.

Reporting on Financial Statements

The results of trade accounting are presented on a company’s financial statements, primarily the balance sheet and income statement. This reporting provides a view of a company’s short-term liquidity and operational performance.

On the balance sheet, Trade Receivables are listed as a current asset but are presented at their net realizable value. This is calculated by subtracting the Allowance for Doubtful Accounts from the gross accounts receivable balance. For example, the balance sheet might show “Accounts receivable, net of allowance for doubtful accounts of $5,000.” Trade Payables are reported under the current liabilities section.

The income statement reflects revenue from credit sales and their associated expenses. Sales Revenue is reported at the top, with a deduction for Sales Returns and Allowances to arrive at net sales. The cost of the goods sold is then subtracted to determine gross profit. Bad Debt Expense is included as part of selling, general, and administrative (SG&A) expenses, reducing operating income.