Chp. 8: Receivables, Bad Debt Expense, and Interest Revenue

Allowance Method

A method of accounting that reduces accounts receivable (as well as net income) for an estimate of uncollectible accounts (bad debts).

Estimated bad debts are recorded:

in the period the relevant credit sales occur.

All contra-asset accounts are ________ accounts.

permanent

Like all contra-asset accounts, such as Accumulated Depreciation, the Allowance for Doubtful Accounts is a permanent account, so its balance:

carries forward from one accounting period to the next.

Receivable Write-Off

The act of removing an uncollectible account receivable and its corresponding allowance from the accounting records.

How is the loss from an uncollectible account recorded if it is removed from Accounts Receivable and its contra-account, Allowances for Doubtful Accounts?

as a Bad Debt Expense; this income account is unaffected by receivable write-offs

Receivable write-offs _____ affect the net receivable balance because Accounts Receivable and Allowance for Doubtful Accounts decrease by the same amount.

do not

Estimated amounts of uncollectibles may be based on either:

a percentage of credit sales method or an aging of accounts receivable method.

Percentage of Credit Sales Method

Estimates bad debts based on the historical percentage of sales that lead to bad debt losses. Also called the income statement approach.

Aging of Accounts Receivable Method

Estimates uncollectible accounts based on the age of each account receivable. Also called the balance sheet approach.

The percentage of credit sales method is _______ to apply, but the aging method uses more detailed data and therefore is generally more accurate.

simpler

The percentage of credit sales method is simpler to apply, but the aging method:

uses more detailed data and therefore is generally more accurate.

How do you calculate the estimated amount of uncollectibles according to the percentage of credit sales method?

historical percentage of sales that lead to bad debt losses multiplied by the current period’s credit sales

How do you calculate the estimated amount of uncollectibles according to the aging of accounts receivable method?

list AR accounts in order received, apply a bad debt percentage to each chronological category and add all totals

How do companies ensure bad debts and the allowance for doubtful accounts do not become materially misstated over time as actual bad debt amounts differ from bad debt estimates?

by lowering estimates in the current period to correct overestimates of prior periods or raising estimates in the current period to correct underestimates of prior periods

Collection of a previously-written account is called a:

recovery.

Collection of a previously written-off account is called a recovery and is accounted for in two parts. First, ___________. Then, record the collection of the account (affected Cash and AR).

record the opposite of the write-off (affecting AR and Allowance for Doubtful Accounts)

Collection of a previously written-off account is called a recovery and is accounted for in two parts. First, record the opposite of the write-off (affecting AR and Allowance for Doubtful Accounts). Then:

record the collection of the account (affected Cash and AR).

The direct-write off method records Bad Debt Expense only when __________. Although this alternative method is easier to use, it overstates the value of AR and violates the expense recognition principle. It is not considered a generally accepted accounting method, but the IRS, which discourages use of accounting estimates, requires this method for tax purposes.

a company writes off specific accounts.

A company reports Notes Receivable if it uses a promissory note to document its right to collect money from another party and intends to retain that right until a specified future date (called the _____ date).

maturity

One reason why a company might report a Notes Receivable is if the company _________ to employees or businesses.

loans money

One reason why a company might report a Note Receivable is if the company sells:

expensive items for which customers require an extended payment period.

One reason why a company might report a Note Receivable is if the company converts:

existing accounts receivable to notes receivable to allow an extended payment period.

Accounts receivable are interest-free until:

they become overdue.

Unlike accounts receivable, which are interest-free until they become overdue, notes receivable charge interest:

from the day they are created to their maturity date.

To calculate interest, you need to consider three variables:

principal, the annual interest rate, and the time period.

Regarding interest, the principal is the:

amount of the notes receivable.

Interest rates are always stated as a(n) ______ percentage.

annual

interest formula

interest (I) = Principal (P) x Interest Rate (R) x Time (T)

Receivables Turnover

The process of selling and collected on account. The receivables turnover ratio determines the average number of times this process occurs during the period.

The higher the receivables turnover ratio, the:

faster the collection of receivables.

The higher the receivables turnover ratio, the faster the collection of receivables, and the faster the collection of receivables, the:

shorter your company’s operating cycle, which means more cash available for running the business.

A low receivables turnover ratio can be a warning sign, suggesting the company:

is allowing too much time for customers to pay.

Days to Collect

A measure of the average number of days from the time a sale is made on account to the time it is collected.

Factoring

An arrangement where receivables are sold to another company (called a factor) for immediate cash (minus a factoring fee).

Receivables Turnover formula

Net Credit Sales / Avg. Net AR