Accounting 201 Ch 5 SDSU

Estimating Uncollectible Accounts

- to use the allowance method, a company first estimates at the end of the current year how much in uncollectible accounts will occur in the following year -the receivables not expected to be collected should not be counted as assets

Note

-Even though the seller does not receive cash at the time of the credit sale, the firm records revenue immediately once goods or services are provided to the customer and future collection from the customer is probable -along with recognized revenue, at the time of sale the seller also obtains a legal right to receive cash from the buyer. The legal right to receive cash is valuable and represents an asset of the company -this asset is referred to as accounts receivable (aka trade receivables) and the firm records it at the time of a credit sale.

Discount Terms

-Ex: 2/10, n/30 are a shorthand way to communicate the amount of the discount and the time period within which it's available -the term "2/10" pronounced "two ten" for example indicates that the customer with receive a 2% discount if the amount owed is paid within 10 days. -the term "n/30" is pronounced "net thirty" and it means that if the customer does NOT take the discount, fully payment net of any returns or allowances is due within 30 days.

Allowance Method

-GAAP require that we account for uncollectible accounts using the allowance method. -this method involves allowing for the possibility that some accounts will be uncollectible at some point in the future -using this we account for events (customers' bad debts) that have NOT YET occurred but that are likely to occur -under the allowance method, companies are required to estimate FUTURE uncollectible accounts and record those estimates in the CURRENT year. -estimated uncollectible accounts reduce assets and increase expenses -disadvantage rises from the fact that reported amounts under the allowance method represent management estimates, which they can use to report manipulated earnings

Estimating Uncollectible accounts in the following year

-a credit balance before adjustment indicates that the estimate of uncollectible accounts at the beginning of the year (or end of last year) may have been too high. however, it is possible that some of the estimated uncollectible accounts have not proven bad yet. - a debit balance before adjustment indicates that the estimate at the beginning of the year was too low

Sales Discount

-represents a reduction, not in the selling price of a product or service, but in the amount to be paid by a credit customer if payment is made within a specified period of time. -intended to provide incentive for a quick payment -we record sales discount in a contra revenue account, so we can keep up with the total revenue separate from the reduction in that revenue due to quick payment.

Aging method

-a more accurate method than assuming a single percentage uncollectible for all accounts is to consider the various AGES of all individual accounts receivable, using a higher percentage for "old" accounts than for "new" accounts. -for instance, accounts that are 120 days past due are older than accounts that are 60 days past due -the older the account, the less likely it is to be collected -to determine the age of accounts receivable, companies must keep track of their individual customers -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

Direct Write-off Method

-alternative method used for tax reporting that is commonly referred to as the direct write off method -under this, we 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 -it is important to emphasize that the direct write off method is not allowed for financial reporting under GAAP, it is only used in financial reporting if uncollectible accounts are not anticipated or are expected to be very small -direct write-off method is primarily used for tax reporting -companies do not report a tax deduction for bad debts until those bad debts are actually uncollectible

Average Collection period

-another way to express the same efficiency measure -ratio that shows the approx number of days the average accounts receivable balance is outstanding. it is calculated as 365 days divided by the receivables turnover ratio -as follows: Average Collection Period= (365 days)/(Receivables turnover ratio)

Uncollectible Accounts

-bad debts -customers accounts that we no longer consider collectible -the allowance for uncollectible accounts is sometimes referred to as the "allowance for doubtful accounts"

Contra revenue account

-both sales returns and sales allowances are classified as contra revenues -it is an account with a balance that is opposite, or "contra", to that of its related revenue account -use this to keep a record of the total revenue earned separate from the reduction due to subsequent sales returns or sales allowances. -sometimes companies combine their sales returns and sales allowances into a single sales returns and allowances account

End of Period Adjustment for Contra Revenues

-companies must adjust these amounts at the end of the year using adjusting entries -Revenue Recognition Standard requires a company to report revenues equal to the amount of cash the company "expects to be entitled to receive" -to reduce revenues we debit sales discounts, sales returns, and sales allowances -in addition, at the end of the year the company must estimate any additional discounts, returns, and allowances that will occur in the next year as a result of sales transactions in the previous year. -important points to understand: 1. revenues are reported for the amount of cash a company expects to be entitled to receive from customers for providing goods and services 2. total revenues are reduced by sales discounts, sales returns, and sales allowances that occur during the year 3. total revenues are further reduced by an adjusting entry at the end of the year for the estimate additional sales discounts, sales returns, and sales allowances expected to occur in the future but that relate to the current year.

Subsidiary Ledgers

-contains a group of individual accounts associated with a particular general ledger control account. -Ex: subsidiary ledger for accounts receivable keeps track of all increases and decreases to individual customers' accounts. the balances of all individual accounts then sum to the balance of total accounts receivable in the general ledger and reported in the balance sheet -also used for accounts payable, property and equipment, investments, and other accounts

Sales Return

-customers may not be satisfied with a product or service purchased, and if the customer returns a product, we call that a sales return -after the sales return we reduce the customer's account balance if the sale was on account, or we issue a cash refund if the sale was for cash.

Percentage-of-receivables Method

-estimating uncollectible accounts based on the percentage of accounts receivable expected not to be collected -aka balance sheet method, because we base the estimate of bad debts on a balance sheet amount---accounts receivable

Sales Allowance

-in other cases, the other customer does not return the product or service, but the seller reduces the customer's balance owed to provide at least a partial adjustment of the amount the customer owes. This adjustment is called the sales allowance.

Interest Calculation

-one issue that usually applies to notes receivable but not to accounts receivable is interest -we calculate interest as the face value of the note multiplied by the stated annual interest rate multiplied by the appropriate fraction of the year that the note is outstanding -we record interest earned on notes receivable but not yet collected by the end of the year as interest receivable and interest revenue

Nontrade Receivables

-receivables that originate from sources other than customers -they include tax refund claims, interest receivable, and loans by the company to other entities, including stockholders and employees

Net Revenues

-refer to a company's total revenues less any amounts for discounts ,returns, and allowances. -Ex: companies offer discounts to quickly sell inventory, attract new customers, reward long term customers, and encourage customers to pay quickly on their accounts. Beneficial to the company's long term success, but they can reduce amount of revenue earned in current period. Company revenue also reduced when customers return unsatisfactory products or demand allowances for inferior services or competitive pricing. This makes it important for company's to consider both total and net revenues (net sales).

Trade Discounts

-represent a reduction in the listen price of a product or service. -companies usually do this to provide incentives to larger customers/consumer groups to purchase from the company -can also be a way to change prices without publishing a new price list or to disguise real prices from competitors -when recording a discount, companies don't recognize trade discounts directly, but indirectly by recording the sale at the discounted price.

Bad Debt Expense

-represents the cost of the estimated future bad debts -we include bad debt expense in the income statement of the same period with which these bad debts are associated and by doing so we match expenses (bad debts) with the revenues (credit sales) they help generate -students often record a bad debt expense when they write off an uncollectible account. the bad debt expense was recorded in a year prior at the time of estimating uncollectible accounts

Receivables Turnover Ratio

-shows the number of times during a year that the average accounts receivable balance is collected (or "turns over") -we calculate it as follows: Receivables turnover ratio=(net credit sales)/(average accounts receivable)

Note

-students sometimes misclassify contra revenue accounts--sales returns and sales allowances-- as expenses when they are reductions in revenue. -expenses represent the separate costs of generating revenues -if sales returns and allowances are routinely high relative to total sales, this might indicate that customers are not satisfied with the company's products or services.

Net Accounts Receivable

-the difference between total accounts receivable and the allowance for uncollectible accounts -aka net realizable value

Allowance Method (notes)

-the upside to extending credit to customers is that it boosts sales by allowing customers the ability to purchase on account and pay cash later -many customers don't always have cash on them so credit works out for them -the downside to extending credit to customers is that not all customers will fully pay on their accounts due to financial difficulties

Net Realizable Value

-to be useful to decision makers, accounts receivable should be reported at the amount of cash the firm expects to collect, an amount known as the net realizable value

Credit Sales

-transfer products and services to a customer today while bearing the risk of collecting payment from that customer in the future -credit sales transactions are also known as *services on account* -makes it more convenient for the buyer to purchase goods and services and in the long term they should benefit the seller by increasing profitability of the company -downside is that there is a delay in collecting cash from customers, and some may not end up paying at all -these disadvantages reduce the operating efficiency of the company and lead to lower profitability.

Allowance for uncollectible accounts

-we adjust for future bad debts by making an allowance for uncollectible accounts -the contra asset account Allowance for Uncollectible Accounts represents the amount of accounts receivable we do not expect to collect -this provides a way to reduce revenue indirectly, rather than decreasing the accounts receivable balance itself. -we report the allowance or uncollectible accounts int he asset section of the balance sheet, but it represents a reduction in the balance of accounts receivable. -because allowance for uncollectible accounts has a normal credit balance, students sometimes misclassify this account as a liabiltiy, which also has a normal credit balance. Instead, a contra asset represents a reduction in a related asset

Notes Receivable

-when receivables are accompanied by formal credit arrangements made with written debt instruments (or notes) we refer to them as notes receivable

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. we recorded the decrease to assets as a result of the bad debt when established the allowance for uncollectible accounts in a prior year.

Key Point

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

Keypoint

the direct write off method reduces accounts receivable and records bad debt expense at the time the account receivable proves uncollectible. If the credit sale occurs in a prior reporting period , bad debt expense is not properly matched with revenues (credit sales). Also, accounts receivable will be overstated in the prior period. The direct write-off method typically 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

Key Point

the year end adjustment for future uncollectible accounts is affected by the current balance of allowance for future uncollectible accounts before adjustment. the current balance before adjustment equals the estimate of uncollectible accounts at the beginning of the year (or end of last year) less actual write-offs in the current year.

Key Point

when applying the percentage-of-credit-sales method, we adjust the allowance for uncollectible accounts for the current year's credit sales that we don't expect to collect (rather than adjusting at the end of the year for the percentage of accounts receivable we don't expect to collect