chapter 7
New Accounts in Chapter 7
Key Components:
Notes Receivable
Allowance for Doubtful Accounts (ADA or Allow for DA)
Uncollectible Accounts Expense
Interest Receivable
Interest Expense
Basic Accounting Equation:
Assets = Liabilities + Stockholder’s Equity
Contra Accounts
Definition: Accounts that do not follow the standard Debit/Credit properties within the basic accounting equation.
Function: They exhibit contrary characteristics to normal account functions.
Example: Allowance for Doubtful Accounts.
Activity:
Draw the T-account of ADA to demonstrate its role as a contra account
Accounts Receivable Clarifications
Definition of Receivables:
Smaller Receivables:
Short payment windows, commonly associated with “buy now, pay later” scenarios.
Will often have discount terms.
Larger Receivables:
Longer credit terms and larger amounts, typically referred to as being “issued”.
Will usually include interest percentages and structured payments that incorporate both interest and principal.
Recognition of Uncollectible Receivables
Methods to Recognize Uncollectible Receivables:
Allowance Method: This method creates an estimate of what is not expected to be collected from a customer based on:
A percentage of Revenue.
A percentage of Receivables.
Direct Write-off Method: Not covered in this course.
Allowance Method Details
Purpose: To create an estimate of uncollectible accounts.
Components:
The difference between receivables shown and the established “allowance” is denoted as Net Realizable Value (NRV).
NRV represents the expected cash to be received from customers.
Main Goal: Show receivables at their NRV on balance sheets.
Avoids misrepresenting receivables and future cash inflow expectations.
Relationship: NRV remains unchanged even when both A/R and ADA are impacted with equal amounts in opposite directions (one debit, one credit).
Methods for Allowance Method Calculation
Percent of Revenue Method:
Estimate uncollectible amount based on a percentage of sales, computed as:
ext{Estimated Uncollectible ext{Amount}} = ext{Percentage of Uncollectible} imes ext{Sales}Where to Expense: To Uncollectible Accounts Expense.
Important Note: Compute off the top rather than the balance at the end of the period.
Percent of Receivables Method:
Two approaches (a and b):
a. Flat Percentage of Ending A/R Balance:
ext{Estimated Uncollectible} = ext{Percentage Uncollectible} imes ext{Ending A/R Balance}Resulting balance is shown in the Allowance for Doubtful Accounts.
b. Aging of A/R Method:
Breaks down amounts due from customers into “buckets” by how long they have been outstanding (days overdue).
Each bucket assigned a percentage likelihood of collectability.
The goal is to determine the reported NRV of A/R and specifically the ending balance of Allowance for Doubtful Accounts.
Scenarios for Estimating Uncollectible Accounts
Scenario 1: Estimating using Percent of Sales Method
Given: $20,000 of Services on account.
Example Transaction:
Debit: Uncollectible Accounts Expense
Credit: Allowance for Doubtful Accounts
Amount Calculation:
ext{Sales on Account} imes ext{Percentage Uncollectible} = ext{Amount to Expense}
T-account to record transactions reflecting estimated uncollectible amounts.
Scenario 2: Estimating using Percent of Receivables Method
Given: Balance in Accounts Receivable estimated at specific unrecoverable percentages.
Example Transaction:
Adjustment entries to Allowance for Doubtful Accounts and Uncollectible Accounts Expense based on the estimated uncollectible amount from estimated A/R.
Debit: Uncollectible Accounts Expense
Credit: Allowance for Doubtful Accounts
Write-off of Specific Accounts
Recording the Write-off:
Reflects the acknowledgment of a specific account that is no longer collectible.
Entries for Write-off include:
Debit: Accounts Receivable
Credit: Allowance for Doubtful Accounts
Financial Statement Impact: Reflecting specific amounts that will not be collected.
Subsequent Recovery of Written-Off Accounts
What occurs if a previously written-off account is collected?
Recovery Entry:
Reverse the write-off:
Debit: Accounts Receivable
Credit: Allowance for Doubtful Accounts
Collection Entry:
Debit: Cash
Credit: Accounts Receivable
Note: The NRV of A/R does not change during recovery processes.
Exercises for Application
Exercise 7-4A: Percent of Revenue Allowance Method
Year 1 Events for Rosie Dry Cleaning:
Services on account: $45,000.
Cash collected from accounts receivable: $39,000.
Uncollectible account expense estimated at 1 percent of revenue on account.
Year 2 Events:
Write-off uncollectible account of $300.
Total services provided: $62,000.
Cash collected from accounts receivable: $61,000.
Adjusted for uncollectible accounts expense at 1 percent of services on account.
T-accounts must be utilized for the Year end calculations including:
Net Income calculations
Cash Flow from Operating Activities
Balance of Accounts Receivable/ Net Realizable Value
Additional Exercises
Exercise 7-7A: Percent of Receivables Allowance Method for Leach Inc.
Year 1 summary and journal entries for various transactions related to accounts and revenue, where Leach estimates 5% of A/R will be uncollectible.
Include T-account work and calculations.
Year 2 Summary and Journal Entries
Details of service provision, write-offs, collections, and uncollectible expense adjustments.
Balancing T-accounts and calculating final values for receivables and related accounts.
Specific Exercises on Notes Receivable Handling
Record of transactions related to loans and interest within accounting cycles, showcasing both the cash activities and impact on financial statements including NRV determinants.
Final Exercises and Practical Applications
Additional exercises related to credit card payments, collection methods, adjustment for revenue recognition based on credit card transactions.
Overall Analysis of Accounts Receivable
Accounts Receivable Turnover: Relevant calculations and definitions.
Average Number of Days to collect A/R:
Formula demonstrated with data from Market, Inc. and Supply, Inc.
Implications of the calculation for financial analysis.