Accounting ch.8

What is a major advantage of extending credit to customers?

It helps business customers buy products and services, thereby increasing the seller's revenues.

What is one disadvantage of extending credit related to workforce?

Increased wage costs due to the need for hiring staff to evaluate creditworthiness, track debts, and collect receivables.

What are bad debts in the context of extending credit?

Bad debts occur when customers dispute what they owe or face financial difficulties, resulting in unpaid balances.

How long does a company typically wait to receive cash after extending credit?

30-60 days.

What financial action might a company need to take while waiting for cash from credit sales?

They may need to take out a short-term bank loan to cover other business activities.

What is a Note Receivable?

A promise requiring other parties to pay the business according to written agreements, typically charging interest.

How do Notes Receivable differ from Accounts Receivable?

Notes Receivable generally charge interest and are viewed as a stronger legal claim, but require new notes for each transaction.

When are Notes Receivable typically used?

When selling large dollar-value items, offering extended payment periods, or lending money.

What are Accounts Receivable?

Amounts owed to a business by its customers, some of which may never be collected.

What are the two main objectives when accounting for Accounts Receivable and bad debts?

1. Report Accounts Receivable at the expected collectible amount. 2. Match the cost of bad debts to the accounting period of related credit sales.

What principle is violated if sales and bad debts are recorded in different periods?

The expense recognition (matching) principle.

What is the Allowance Method in accounting for bad debts?

A method that reduces Accounts Receivable for estimated uncollectible accounts, involving a two-step process.

What is the first step in the Allowance Method?

Record estimated bad debts in the period credit sales occur using an end-of-period adjustment.

What is the second step in the Allowance Method?

Remove ('write off') specific customer balances when they are known to be uncollectible.

How do credit sales affect financial statements?

They increase both Accounts Receivable on the balance sheet and Sales Revenue on the income statement.

What happens to Net Income if bad debts are recorded in a different period than sales?

It leads to a distorted view of Net Income.

What is the impact of bad debts on the financial health of a business?

Not all Accounts Receivable will convert to cash, affecting profitability.

What is the relationship between extending credit and gross profit?

Most managers find that the additional revenue from selling on account exceeds the additional costs of extending credit.

What is the purpose of the Allowance for Doubtful Accounts?

To reduce Accounts Receivable and estimate bad debts.

What effect does estimating bad debts have on Net Income?

It reduces Net Income using an expense account called Bad Debt Expense.

What is the journal entry to record an estimated bad debt of $900?

Debit Bad Debt Expense $900, Credit Allowance for Doubtful Accounts $900.

What type of account is the Allowance for Doubtful Accounts?

A contra-asset account.

What happens to Bad Debt Expense at the end of the accounting period?

It is closed (zeroed out) as it is a temporary account.

What is the purpose of writing off a specific customer balance?

To remove uncollectible accounts from the accounting records.

What is the effect of writing off an $800 receivable on Accounts Receivable?

It decreases Accounts Receivable and Allowance for Doubtful Accounts by $800.

What are the two GAAP acceptable methods for estimating bad debts?

Percentage of Credit Sales Method and Aging of Accounts Receivable Method.

How does the Percentage of Credit Sales Method estimate bad debts?

By multiplying the historical percentage of bad debt losses by current period's credit sales.

What is the historical bad debt loss rate used in the example?

¾ of 1 percent.

What is the Aging of Accounts Receivable Method focused on?

Estimating uncollectible accounts based on the age of each account receivable.

What is the first step in the Aging of Accounts Receivable Method?

Prepare an aged listing of accounts receivable with totals for each age category.

What does the total estimate in the Aging of Accounts Receivable Method represent?

The balance to which the Allowance for Doubtful Accounts will need to be adjusted.

How do you compute the adjustment needed for the Allowance for Doubtful Accounts?

Subtract the existing unadjusted balance from the desired adjusted balance.

What does the write-off of a receivable not affect?

Income statement accounts.

What is the impact of writing off a receivable on the net accounts receivable balance?

The net accounts receivable balance remains unchanged after the write-off.

What is the role of the Bad Debt Expense account?

To record estimated bad debts for the accounting period.

What is a subsidiary account in the context of accounts receivable?

A separate accounts receivable account for each customer.

What happens to the balance of the Allowance for Doubtful Accounts from one period to the next?

Its balance carries forward as it is a permanent account.

What is the relationship between Accounts Receivable and Allowance for Doubtful Accounts?

The Allowance for Doubtful Accounts offsets Accounts Receivable to reflect expected uncollectibles.

What does the term 'write-off' mean in accounting?

The act of removing an uncollectible account receivable from the accounting records.

What is the significance of estimating bad debts based on current conditions?

It helps in accurately reflecting the financial position and performance of the company.

What is the effect of bad debt estimates on the accounting equation?

It reduces total assets (Accounts Receivable) and stockholders' equity (Net Income).

What is the accounting equation?

Assets = Liabilities + Stockholders' Equity

What does AFDA stand for?

Allowance for Doubtful Accounts

What happens when write-offs exceed estimates of uncollectible accounts?

The Allowance for Doubtful Accounts may have a debit balance.

How is the adjustment for Allowance for Doubtful Accounts calculated when it has a debit balance?

An amount equal to the desired balance plus the existing debit balance must be recorded.

What is a recovery in accounting?

The collection of a previously written-off account.

What are the two parts of accounting for a recovery?

1. Record the receivable back on the books. 2. Record the collection of the account.

What are Notes Receivable?

Promissory notes documenting a company's right to collect money from another party.

What are the three situations when a company reports Notes Receivable?

1. Loans to employees or businesses. 2. Sales requiring extended payment. 3. Converting accounts receivable to notes receivable.

What are the three variables needed to calculate interest on Notes Receivable?

1. Principal. 2. Annual Interest Rate. 3. Time Period.

What is the formula for calculating interest revenue?

Interest = Principal × Annual Interest Rate × Time Period.

What is the purpose of accruing interest earned?

To recognize interest revenue earned but not yet received at the end of an accounting period.

How is interest revenue recorded at the end of an accounting period?

Debit Interest Receivable and Credit Interest Revenue.

What happens when a company receives cash interest payment at maturity?

Cash is debited, Interest Receivable is credited, and Interest Revenue is recorded.

What is the Receivables Turnover Ratio?

A measure of how many times a company collects its average accounts receivable during a period.

What does a sudden decline in the Receivables Turnover Ratio indicate?

It may indicate issues such as increased returns or selling to less financially secure customers.

What is the impact of channel stuffing on Receivables Turnover?

It can lead to a decline in the Receivables Turnover Ratio due to customers being allowed more time to pay.

What is the journal entry for establishing Notes Receivable?

Debit Notes Receivable and Credit Cash.

What is the journal entry for recording interest earned?

Debit Interest Receivable and Credit Interest Revenue.

What is the journal entry for recording the collection of principal at maturity?

Debit Cash and Credit Notes Receivable.

What is the significance of maintaining accurate credit history for customers?

It ensures proper tracking of customer transactions and financial reliability.