Week 9 Bad Debts and Doubtful Debts

These flashcards cover key vocabulary and concepts related to bad debts and doubtful debts in financial accounting, focused on accounting conventions, principles, and treatment in financial statements.

Bad Debts

Amount of trade receivables for a particular period that, with reasonable certainty, will never be paid by the customer.

Doubtful Debts

Amount of trade receivables for a particular period that appear doubtful of being paid by the customer in the future.

Prudence Convention

Avoid overstating assets/income and recognize expected losses promptly without anticipating gains.

Business Entity Convention

The assumption that a business's financials are separate from its owners, treating the business as a distinct entity for accounting purposes.

Matching Principle

The principle that assesses revenues and related expenses in the same accounting period.

Net Realisable Value (NRV)

The estimated selling price of a trade receivable less any costs expected to be incurred in realizing that value.

Allowance for Doubtful Debts

A contra-asset account that deducts from trade receivables to reflect the estimated losses from debts that may not be paid.

Double-Entry Bookkeeping

An accounting method where every transaction affects at least two accounts, keeping the accounting equation balanced.

Trade Receivables

Amounts owed to the business by customers for goods or services sold on credit.

Income Statement

A financial statement that shows the company’s revenues and expenses during a specific period, resulting in profit or loss.

Statement of Financial Position

A financial statement that provides a snapshot of a company's assets, liabilities, and equity at a specific point in time.

Direct Write-Off Method

A method of accounting for bad debts where specific uncollectible accounts are written off as expenses when they are deemed worthless.

Allowance Method for Bad Debts

A method of accounting for bad debts that estimates uncollectible accounts at the end of each period using a contra-asset account, matching bad debt expense with related sales revenue.

Percentage of Sales Method

An income statement approach used to estimate bad debt expense as a percentage of credit sales for a given period.

Aging of Receivables Method

A statement of financial position approach used to estimate the allowance for doubtful accounts by categorizing accounts receivable by elapsed time and applying different uncollectibility percentages.

Journal Entry for Estimating Bad Debts (Allowance Method)

Debit Bad Debt Expense, Credit Allowance for Doubtful Debts.

Reliability Principle

Accounting information must be verifiable, neutral, and free from material error.

Materiality Principle

The significance of information in influencing the decisions of users; trivial matters can be ignored.

Going Concern Principle

The assumption that a business will continue to operate indefinitely in the foreseeable future.

Cost Principle

Assets are recorded at their historical (original) cost at the time of purchase.

Adjusting Entry

An accounting entry made at the end of an accounting period to record revenues and expenses that have not been recorded through daily transactions.

Journal Entry for Writing Off a Specific Bad Debt (Allowance Method)

Debit Allowance for Doubtful Debts, Credit Trade Receivables.

Accrual Basis Accounting

Revenues are recognized when earned and expenses when incurred, regardless of when cash is exchanged.

Cash Basis Accounting

Revenues are recognized when cash is received and expenses when cash is paid.

Contra Account

An account that reduces the balance of another account. (e.g., Allowance for Doubtful Debts reduces Trade Receivables).

Recovery of a Written-Off Bad Debt (Steps)

1. Reinstatement of receivable: Debit Trade Receivables, Credit Allowance for Doubtful Debts. 2. Collection of cash: Debit Cash, Credit Trade Receivables.

Revenue Recognition Principle

Revenues should be recognized when earned, regardless of when cash is received, provided they are measurable.

Expense Recognition Principle

Expenses should be recognized when incurred, regardless of when cash is paid, to match them with related revenues.

Accounts Payable

Amounts owed by the business to its suppliers for goods or services purchased on credit.

General Ledger

The main record-keeping system for a company's financial data, with debit and credit account records for every asset, liability, equity, revenue, and expense.

Trial Balance

A list of all ledger accounts and their balances at a specific point in time, used to verify the equality of total debits and credits.

Depreciation Expense

The portion of the cost of a tangible asset allocated as an expense over its useful life, reflecting its wear and tear or obsolescence.

Accumulated Depreciation

A contra-asset account representing the total amount of depreciation expense charged against an asset since its acquisition.

Book Value of an Asset

The cost of an asset minus its accumulated depreciation as shown on the statement of financial position.

Periodicity Assumption

The concept that the economic life of a business can be divided into distinct time periods (e.g., months, quarters, years) for financial reporting.

Capital Expenditure

Funds used by a company to acquire, upgrade, and maintain physical assets such as property, plants, industrial buildings, or equipment.

Net Realisable Value (NRV) Equation for Trade Receivables

NRV = \text{Estimated Collectible Amount} - \text{Estimated Collection Costs}

Distinction: Bad Debts vs. Doubtful Debts

Bad Debts are confirmed uncollectible amounts; Doubtful Debts are estimated uncollectible amounts.

Why Allowance Method is Preferred over Direct Write-Off

To adhere to the matching principle by recognizing expenses in the same period as the revenues they helped generate, improving financial reporting accuracy.

Journal Entry for Writing Off a Bad Debt (Direct Write-Off Method)

Debit Bad Debt Expense, Credit Trade Receivables.

Effect of Direct Write-Off Method on Trade Receivables

Trade receivables are only reduced when a specific account is deemed uncollectible, potentially leading to overstated receivables on the Statement of Financial Position before write-off.

Calculation of Accounts Receivable Turnover

\frac{\text{Net Credit Sales}}{\text{Average Net Trade Receivables}}

Calculation of Days Sales Outstanding (DSO)

\frac{365 \text{ Days}}{\text{Accounts Receivable Turnover Ratio}}

Benefits of Effective Accounts Receivable Management

Improved cash flow, reduced risk of bad debts, and better customer relationships due to clear payment terms.

Credit Risk

The possibility that a borrower or counterparty will fail to meet its obligations in accordance with agreed terms, particularly relevant for trade receivables.

Invoice

A commercial document issued by a seller to a buyer, indicating the products or services sold, quantities, and agreed prices for products or services the buyer has already received.