Chapter 8 Accounting

What are the three components of the interest formula?

The three components of the interest formula are: (1) the principal, which is simply the amount of the receivable or payable, (2) the interest rate, which always is given in annual terms, and (3) the time period covered in the interest calculation.Because interest rates are stated in terms of a full year, the time factor is used to calculate interest for a period shorter than a year. It indicates how many months out of 12 the interest period covers (e.g. 6/12 month for semi-annual interest payments).

What is the effect of the write-off of uncollectible accounts (using the allowance method) on (a) net income and (b) net accounts receivable

The write-off of uncollectible accounts using the allowance method decreases the asset Accounts Receivable and decreases the contra-asset Allowance for Doubtful Accounts by the same amount. As a consequence, (a) net income is unaffected and (b) net accounts receivable is unaffected.

How does the use of calculated estimates differ between the aging of accounts receivable method and the percentage of credit sales method?

With the aging of accounts receivables method, the calculated amount is the desired balance to which the Allowance for Doubtful Accounts is to be adjusted. That is, the difference between this calculated amount and the existing balance in the Allowance for Doubtful Accounts is the amount recorded as an adjustment to Bad Debt Expense and the Allowance for Doubtful Accounts. In contrast, with the percentage of credit sales method, the calculated amount is the amount recorded as an adjustment to Bad Debt Expense and the Allowance for Doubtful Accounts.

Does an increase in the receivables turnover ratio generally indicate faster or slower collection of receivables?

An increase in the receivables turnover ratio generally indicates faster collection of receivables. Both the top number (net credit sales) and the bottom number (average receivables) in the ratio increase when credit sales occur. However, when collections occur, only the bottom number is affected. Thus, an increase in the ratio implies that collections (which reduce the bottom number in the ratio) have increased more than sales.

Which basic accounting principles does the allowance method of accounting for bad debts satisfy?

In conformity with the expense recognition ("matching") principle, the allowance method records Bad Debt Expense in the same period in which the credit was granted and the sale was made.Following the neutrality concept, accounting rules require accounts receivable be reported at the amount which the company actually expects to collect rather than the (optimistic) total that it would collect if the company received payments from all customers.

When customers experience economic difficulties, companies consider extending longer credit periods. What are the possible consequences of longer credit periods on Sales, Accounts Receivable, Allowance for Doubtful Accounts, Net Income, and the receivables turnover ratio?

Longer credit periods could entice customers to buy more on account than they might otherwise do with shorter credit periods. The consequences of greater credit sales are increased Sales Revenue and increased Accounts Receivable. All else equal, an increase in Accounts Receivable will require an increase in the Allowance for Doubtful Accounts. This allowance is likely to be increased by a greater proportion than the increase in receivables because the sales are being made to less creditworthy customers. On an overall basis, it is difficult to determine whether Sales Revenue will increase at a greater rate than the increase in Net Accounts Receivable. Consequently, it is difficult to determine how these two components of the receivables turnover ratio will affect the ratio. Likewise, the impact of longer credit periods on Net Income is not clear. If the gross profit from the increased sales exceeds the bad debts and other costs of allowing longer credit periods (e.g., increased wages for following-up on unpaid balances), Net Income will increase. If the increased sales are less than the related expenses, then Net Income will decrease.

What is the primary difference between accounts receivable and notes receivable?

The primary difference is that an account receivable is an amount owed to the business by a customer for merchandise or services sold on credit whereas a note receivable represents the company's right to collect from another party, as documented in a contract (called a promissory note). They also differ in that notes generally charge interest from the day they are signed to the day they are collected (whereas accounts receivable generally charge interest only when they become overdue) and notes receivable are viewed as a stronger legal claim.

What are the advantages of extending credit to customers?

The advantages of extending credit are that it allows a company to compete effectively with competitors who extend credit. The additional gross profit earned from selling on account is greater than the additional costs incurred.

Describe how (and when) the direct write-off method accounts for uncollectible accounts. What are the disadvantages of this method?

The direct write-off method accounts for uncollectible accounts in the period that the accounts are determined to be bad. It violates the concept of conservatism by reporting accounts receivable at the total amount owed by customers (an overly optimistic point of view) rather than what is estimated to actually be collectible (a more realistic viewpoint). Under the direct write-off method, an Allowance for Doubtful Accounts is not used. The direct write-off method breaks the matching principle by recording Bad Debt Expense in the period that customer accounts are determined to be bad rather than matching the expense to the revenues reported in the period when the credit sales are actually made.

What are the disadvantages to extending credit to customers?

The disadvantages of selling on credit include increased wage costs incurred in hiring personnel to monitor and track credit customers, bad debt costs from accounts that are collected late or not at all, and delayed receipt of cash.

What two approaches discussed in this chapter can managers take to speed up sluggish collections of receivables? List one advantage and disadvantage for each approach.

To speed up sluggish receivables collections, managers can: Hound customers for payment. Disadvantages of this method are: (1) it is time consuming and costly and (2) it can annoy customers and cause them to take their business elsewhere. An advantage of this method is that it prompts customers to pay their account balances. Sell outstanding accounts receivable to another company (called a factor). An advantage of this method is that you don't have to wait to collect cash for your receivables. You can receive payment for the accounts receivable with little effort on your part. The disadvantage of this method is that the company incurs the cost of having to pay the factor a fee that can be as much as 3% of the receivables sold. (Chapter 6 also suggests offering discount terms, such as 2/30, n/60.)