ACCTG 230- Chapter 5

Common Mistake:

Students often mistakenly record bad debt expense when they write off an uncollectible account. The bad debt expense was recorded in a prior year at the time of estimating uncollectible accounts.

Common mistake:

Students sometimes misclassify contra revenue accounts—sales returns and sales allowances— as expenses. Like expenses, contra revenues have normal debit balances and reduce the reported amount of net income.

• F.Y.Eye offers terms of DISCOUNT 2/10, n/30 on $2,000 owed; Customer pays on March 10 (w/in 10 days) - DEBIT: - CREDIT:

- DEBIT: Cash $1,960 - DEBIT: Sales Discount $40 - CREDIT: Accounts Receivable $2,000 This means if cash is collected from the customer within 10 days, the amount due will be reduced by 2%. So if the customer pays within 10 days, she will receive a sale discount of $40 (=$2,000 x 2%)

Interest Calculation and Collection of Notes Receivable • After six months, Kimzey collects the full amount owed by Justin, INCLUDING INTEREST

- DEBIT: Cash $10,600 - CREDIT: Notes receivable $10,000 - CREDIT: Interest revenue $600

contra revenues represent _______ of revenues:

REDUCTIONS whereas expenses represent the separate costs of generating revenues.

Receivables Turnover Ratio= _______ / _______

Receivables Turnover Ratio= NET CREDIT SALES / AVERAGE ACCOUNTS RECEIVABLE

Net revenues:

After accounting for each of these reductions, a company will calculate this as total revenues less any amounts for returns, allowances, and discounts. - Also called NET SALES

The trade discount of $600 is record __________ by simply recording revenue equal to the discounted price.

indirectly

Underestimating Bad Debts--Example 1. What if actual bad debts in 2022 were $6 million, compared to an estimate of $5 million? 2. What adjustment is required at year-end?

- DEBIT: - CREDIT:

Example of Writing Off Accounts Receivable: • Kimzey receives notice that Bruce Easley has filed for bankruptcy and will not pay $4,000 • Kimzey writes off Bruce's account receivable

- DEBIT: Allowance for Uncollectible Accounts $4000 - CREDIT: Accounts Receivable $4000 • The write-off involves: ❑ Decreasing a contra asset (Allowance for Uncollectible Accounts) ❑ Decreasing an asset (Accounts Receivable) • The net effect on total assets is zero

Accrue Interest and Collect Interest: • On May 1, 2022, the maturity date, Kimzey collects the note of $10,000 and the interest of $600.

- DEBIT: Cash 10,600 - CREDIT: Notes Receivable 10,000 - CREDIT: Interest Receivable 200 - CREDIT: Interest Revenue 400

Accrue Interest and Collect Interest • On December 31, 2021, Kimzey accrues interest for a note receivable accepted on November 1, 2021.

- DEBIT: Interest Receivable 200 - CREDIT: Interest Revenue 200

Recording Notes Receivable: • Kimzey provided $10,000 of services to Justin Payne, who is not able to pay immediately • Justin Payne signs a promissory note, offering to pay $10,000 plus 12% interest in six months (August 1).

- DEBIT: Notes receivable $10,000 - CREDIT: Service revenue $10,000 • No interest is recorded on February 1

Other types of receivables:

- NON TRADE RECEIVABLE - NOTES RECEIVABLE

The four transactions that companies often offer that can reduce the amount of cash the company is ENTITLED TO RECEIVE from those customers:

1. Trade discounts 2. Sales returns 3. Sales allowance 4. Sales discount

• Sales Discounts:

= Contra revenue account ❑ Reported with total revenues in the income statement, but with a negative balance

Comparing the Allowance Method and the Direct Write-off Method for Recording Uncollectible Accounts:

Allowance account is credited for the estimate and debited for the actual write-off (balance cancels) • Over both years, debit Bad Debt Expense and credit Accounts Receivable ❑ Difference between the methods is TIMING

Average Collection Period= _______ / ________

Average Collection Period= 365 DAYS / RECEIVABLE TURNOVER RATIO

Common Mistake:

Because Allowance for Uncollectible Accounts has a normal credit balance, students sometimes misclassify this account as a liability, which also has a normal credit balance. Instead, this contra asset represents a reduction in a related asset account.

Key Point:

Companies record an asset (accounts receivable) and revenue when they sell goods or services to their customers on account, expecting collection in the future. Once the receivable is collected, the balance of accounts receivable is reduced.

Sales Returns: example (2/2)

Customer decides she doesn't want the sunglasses and returns the pair. - DEBIT: Sales Return $200 - CREDIT: Accounts Receivable $200

When were negative effect of bad debts recorded?

In an adjusting entry at the end of the previous year.

Interest calculation:

Interest = Face value x Annual interest rate x Fraction of the year

Does the write-off have any effect on total assets (balance sheet) or total expense (income statement)?

NO because we already recorded the negative effects of the bad news.

Key Point LO5-6:

The direct write-off method waits to reduce accounts receivable and record bad debt expense until accounts receivable prove uncollectible in the future. This leads to accounts receivable being overstated in the current year. The direct write-off method generally is not acceptable for financial reporting.

KEY POINT:

The receivables turnover ratio and average collection period can provide an indication of management's ability to collect cash from customers in a timely manner.

Why do we use a contra revenue account?

To keep a record of the total revenue recognized separate from the reduction due to subsequent sales returns.

Key Point:

Using the aging method to estimate uncollectible accounts is more accurate than applying a single percentage to all accounts receivable. The aging method recognizes that the longer accounts are past due, the less likely they are to be collected.

Key Point:

Writing off a customer's account as uncollectible reduces the balance of accounts receivable but also reduces the contra asset—allowance for uncollectible accounts. The net effect is that there is no change in the net receivable (accounts receivable less the allowance) or in total assets.

An invoice:

a source document that identifies the date of sale, the customer, the specific item sold, the dollar mount of sale, and the payment terms.

Percentage-of-receivables method:

aka balance sheet method. estimating uncollectible accounts based on the percentage of accounts receivable expected not to be collected

Common Mistake: Some students erroneously think firms should reduce total assets and record bad debt expense at the time the bad debt actually occurs. However, companies ___________ future bad debts and establish an allowance for those estimates.

anticipate

Sales allowance is a _______ _______ account.

contra revenue account

Sales return is a _______ _______ account.

contra revenue account

Notes Receivables:

formal credit arrangements evidenced by written debt instruments (or "notes")

n/30:

net thirty: If the customer does NOT take the discount, full payment net of any returns or allowances is due within 30 days.

Notes receivable are similar to accounts receivable except that notes receivable are formal credit arrangements made with a written debt instrument, or ______.

note

Uncollectible accounts:

or bad debts - customers accounts that we no longer consider collectible

Nontrade Receivables:

receivables that originate from sources other than customers ❑ Tax refund claims, interest receivable, and loans by the company to other entities, including stockholders and employees

Estimating Uncollectible Accounts:

• At the end of 2021, Kimzey is owed $20 million from customers and estimates that 30% will not be collected. - DEBIT: Bad Debt Expense $6 - CREDIT: Allowance for Uncollectible Accounts $6 • Bad Debt Expense: ❑ Expense reported in the income statement • Allowance for uncollectible accounts: ❑ Contra asset reported in the balance sheet ❑ Reduces the balance of accounts receivable

Establishing an Allowance for Uncollectible Accounts:

• Bases the estimate of bad debts on a balance sheet amount—accounts receivable • Also called the "balance sheet method"

Accounts Receivable:

• Cash owed to the company by its customers from sales or services on account • Recorded at the time of the sale or service • Also called TRADE RECEIVABLES

Aging Method:

• Considers the AGES of receivables ❑ Older accounts are more likely uncollectible • More accurate than using a single percentage • The journal entry is the same as when we applied one percentage to the ending balance, but the amount will be different.

3. Sales Allowance:

• Customer does NOT return a product (a) Seller issues a cash refund if the original sale was for cash (b) Seller reduces the balance of accounts receivable if the original sale was on account

Sales Allowance: example

• Customer receives a reduced price on eye surgery because she is not satisfied with the results. F.Y.Eye reduces price by $400. • Sales Allowances is a contra revenue account. - Sales allowance: DEBIT - Accounts receivable: CREDIT • This transaction reduces revenue and current assets.

Sales Returns: example (1/2)

• Customer returns eyeglasses purchased for $200 on March 2 and receives full credit from F.Y.Eye. • Sales Returns is a contra revenue account. - DEBIT: Accounts Receivable $200 - CREDIT: Sales Revenue $200 • This transaction reduces revenue and current assets.

2. Sales Return:

• Customer returns goods previously purchased (a) Seller issues a cash refund if the original sale was for cash (b) Seller reduces the balance of accounts receivable if the original sale was on account

Sales Returns and Allowances:

• Customers are sometimes dissatisfied with a product or service

Percentage-of-Credit-Sales Method:

• Estimates uncollectible accounts based on the percentage of credit sales ❑ Also called the income statement method • Adjusts the allowance for uncollectible accounts for the current year's credit sales that we don't expect to collect

Average Collection Period:

• Number of days the average accounts receivable balance is outstanding

Receivables Turnover Ratio:

• Number of times during a year the average accounts receivable balance is collected

4. Sales Discounts:

• Offer a customer a reduction if payment is made within a specified period of time

Recording of Credit Sales:

• On March 1, a company provides services to a customer for $500. The customer doesn't pay cash at the time of service, but instead promises to pay the $500 by March 31. The company records the following at the time of the service. - DEBIT: Accounts Receivable $500 - CREDIT: Service Revenue $500

1. Trade Discounts:

• Reduction in list price of a product or service ❑ Used to provide incentives to larger customers or certain consumer groups (senior citizens, military) ❑ Recognized by recording revenue for lower amount • Example: typical price for eye surgery is $3,000. Eye doctor runs a "special" for $2,400 by offering trade discount of $600. - DEBIT: Accounts Receivable $2400 - CREDIT: Service Revenue $2400

Note Receivable:

• Similar to accounts receivable but include a written debt agreement, or note ❑ Normal debit balance • Classified as either current or noncurrent asset depending on time until due date

Allowance method (GAAP):

• Some accounts receivable will not be collected • Companies are required to: ❑ Estimate future uncollectible accounts ❑ Record estimates in the current year • Estimated Uncollectible accounts: ❑ Reduce assets (accounts receivable) ❑ Increase expenses (bad debt expense)

END-OF-PERIOD ADJUSTMENT FOR CONTRA REVENUES:

• The discussion above deals with how companies record contra revenues—sales returns, sales allowances, and sales discounts—during the year. However, companies also must adjust for these amounts at the end of the year using adjusting entries. • The revenue recognition standard requires a company to report revenues equal to the amount of cash the company "expects to be entitled to receive." • Those expectations could change as new information becomes available. Therefore, at the end of each year the company must estimate any additional returns, allowances, and discounts that will occur in the following year as a result of sales transactions in the current year.

Credit sales:

• Transfer products and services to a customer today and expect to collect cash in the future • Also known as SALES ON ACCOUNT or SERVICES ON ACCOUNT • Common for many business transactions

Writing Off Accounts Receivable:

• When it becomes clear a customer will not pay, the company writes off the customer's account balance as uncollectible

Direct Write-Off Method (Not GAAP):

• Write off bad debts only at the time they actually become uncollectible ❑ Unlike the allowance method, which requires estimation of uncollectible accounts before they even occur • Used: ❑ When uncollectible accounts are not anticipated or are immaterial ❑ Primarily used for tax reporting

• The write-off:

❑ Reduces the balance of Accounts Receivable ❑ Reduces the balance of the Allowance for Uncollectible Accounts