Financial Accounting Chapter 7

Ace Company has $1 million in accounts receivable but believes that $40,000 of those accounts will not be collected. Several of the customers will leave town, die, go bankrupt, or simply decide that they do not owe the amount for some reason. On Ace's balance sheet, what amount is reported for these receivables within the asset section?

Accounts receivable are reported at net realizable value. That is the amount of cash that is expected to be collected from those accounts. Ace Company will report its "net accounts receivable" on the balance sheet as $960,000. That is the estimated amount of cash that will eventually be collected from these receivables. This balance is reported within the company's assets.

Ace Company has $1 million in accounts receivable but feels that $40,000 of those accounts will not be collected. The company reports its "net accounts receivable" as $960,000 on its balance sheet. How is that amount actually presented?

Because no accounts have yet been written off, the accounts receivable total is $1 million and is reported at that balance. Of that amount, $40,000 is not expected to be collected so the net realizable value is $960,000. The $1 million is recorded as a debit balance in accounts receivable. The $40,000 is separately recorded as a credit in the allowance for doubtful accounts. On the balance sheet, the two are netted together to arrive at the $960,000 net realizable value. Figure 7.3 in this chapter provides an example.

The allowance for doubtful accounts is referred to as a contra account. What does that term mean?

A contra account is one that is always shown with another account but as a decrease. It reduces the other balance to the net amount that is to be reported. The allowance for doubtful accounts decreases the accounts receivable total to bring it down to net realizable value—the amount that is expected to be collected.

The Cicero Corporation makes a sale to Ms. A on account for $3,000. The correct journal entry is made for this transaction and both the debit and credit are entered into the proper general ledger T-accounts (accounts receivable and sales revenue). At the same time, an entry is made into the accounts receivable subsidiary ledger. What is the purpose of a subsidiary ledger?

A subsidiary ledger maintains a record of all the individual balances that make up a general ledger account total. In one such subsidiary ledger, Cicero keeps a record of each separate receivable balance included within its accounts receivable total. Thousands of individual accounts might make up the total. Thus, a separate balance is established for Ms. A and, when she makes this purchase, the amount she owes is increased in the accounts receivable subsidiary ledger by $3,000.

Where are accounts receivable presented on a set of financial statements?

Accounts receivable arise from sales transactions with customers and are normally collected within the following year. The account is reported on the balance sheet as a current asset. If a formal note is signed for the amount, the balance is labeled as a note receivable. Notes receivable are reported as either current assets or noncurrent assets depending on the length of time until the cash will be collected.

At the end of the current year, a company has a $1,000 credit balance in its allowance for doubtful accounts. The company will now debit bad debt expense and credit the allowance for doubtful accounts. Assume that the company has accounts receivable of $600,000 and estimates that 6 percent of all accounts receivable are uncollectible. What amount is recognized in this adjusting entry?

Accounts receivable total $600,000. If 6 percent of these receivables are estimated as bad, the allowance for doubtful accounts needs to be raised to $36,000. The adjustment increases the $1,000 credit to a $36,000 credit so the expense is $35,000. With the percentage of receivables method, the balance in the allowance account influences the amount recognized in this entry.

At the end of the current year, a company has a $1,000 debit balance in its allowance for doubtful accounts. The company will now debit bad debt expense and credit the allowance for doubtful accounts. Assume that the company has accounts receivable of $600,000 and estimates that 6 percent of all accounts receivable are uncollectible. What amount is recognized in this adjusting entry?

Accounts receivable total $600,000. If 6 percent of these receivables are estimated as bad, the allowance for doubtful accounts needs to be raised to $36,000. The adjustment increases the $1,000 debit to a $36,000 credit so the expense is $37,000. It takes a $37,000 entry to move the $1,000 debit balance to a $36,000 credit balance.

Ace Company makes $500,000 in sales on account in Year One. The company estimates that $3,000 of this amount will not be collected. The actual identify of those customers will not be known until Year Two. The company debits bad debt expense for $3,000 and credits the allowance for doubtful accounts by $3,000. When is this adjusting entry made?

Adjusting entries are made when a company is ready to prepare financial statements. Thus, big companies usually make adjusting entries at the end of each month or quarter. Smaller companies wait until the end of the year. Either way, the bad debt expense must be recognized in Year One when the sale was made. In the textbook, Figure 7.1 records the sale and Figure 7.2 records the estimated bad accounts.

Ace Company makes $500,000 in sales on account in Year One. The company estimates that $3,000 of this amount will not be collected. At the end of Year One, the company debits bad debt expense $3,000 and credits allowance for doubtful accounts $3,000. Early in Year Two, the company learns that one customer has gone bankrupt. As a result, an $800 balance will never be collected. What journal entry is recorded at that time?

As shown in Figure 7.4, when an account receivable is judged to be bad, only one entry is ever recorded. The balance is moved from the allowance for doubtful accounts to become a reduction in accounts receivable. That entry is:

A company estimated its bad debts in Year One and then wrote off individual receivables during Year Two as they became uncollectible. At the end of the Year Two before new adjusting entries are made, the allowance for doubtful accounts retains a credit balance. What does that indicate? If the ending allowance for doubtful accounts were a debit balance instead, what would that mean?

At the end of any year, the allowance account might well have a credit balance remaining. That indicates the previous year's estimate of bad accounts was too high. In making the current year adjusting entry for uncollectible accounts, a smaller estimate might be warranted. If the allowance ends the year with a debit balance, the prior year estimate was too low. Thus, a larger expense might be appropriate for the new year.

Ace Company makes $500,000 in sales on account in Year One. The company debits accounts receivable and credits sales revenue because the performance obligation has been satisfied. When preparing financial statements at year end, Ace estimates that $3,000 of this amount will never be collected. How did company officials arrive at this $3,000 figure?

Bad debts, as well as many of the other estimations that a company makes for reporting purposes, are normally calculated by studying historical trends and then applying necessary adjustments for any changes in the company or in its environment. For example, if 3 percent of sales have proven to be uncollectible in the past but the current economy is in recession, a higher percentage is likely to be more appropriate.

Officials for the Webb Company want to collect cash from receivables more quickly so that the money can be reinvested. How can a company reduce the number of days it takes to collect its accounts receivable?

Companies often employ a number of techniques to reduce the length of time it takes to collect money from accounts receivables. Invoices can be sent to customers faster and follow up notices mailed on a more timely basis. Credit granting policies and collection procedures can be strengthened. Discounts for quick payment can be offered. Interest can be charged on delinquent balances. Unfortunately, these steps all have a cost so company officials must determine whether the potential benefit outweighs this cost.

Why do company officials usually monitor the age of accounts receivable so closely? Why is the age considered to be important?

Company officials prefer to collect cash from accounts receivable as quickly as possible so the money can be used to generate more profits. Unless interest is charged on a receivable, no revenue is generated while the company waits for payment. The quicker the money is collected, the quicker it can be used to buy more inventory or some other property to generate future revenues. In addition, older accounts are more likely to become uncollectible so that no money is ever collected. Quick collection is always preferred.

During Year One, the Acme Company had a number of transactions in countries located outside the U.S. As a result, each of the following accounts had a balance denominated in a foreign currency such as the Euro. At the end of Year One, which of these accounts are reported at the historic exchange rate and which are adjusted to the current currency exchange rate: (1) Land, (2) Rent Expense, (3) Sales Revenue, (4) Accounts Receivable, (5) Notes Payable, (6) Inventory.

For accounts denominated in a foreign currency, all monetary assets and monetary liabilities are adjusted to the current rate whenever a new exchange rate is established (and a gain or loss is created). All other accounts continue to be reported at the historic exchange rate when originally recorded. (1) Land - Historic Rate, (2) Rent Expense - Historic Rate, (3) Sales Revenue - Historic Rate, (4) Accounts Receivable - Current Rate, (5) Notes Payable - Current Rate, (6) Inventory - Historic Rate.

The percentage of sales method of estimating bad debts is referred to as an income statement approach. What is being estimated? The percentage of receivables method of estimating bad debts is referred to as a balance sheet approach. What is being estimated?

In the percentage of sales method, bad debt expense (a figure reported on the income statement) is estimated. In the percentage of receivables method, the allowance for doubtful accounts (a figure reported on the balance sheet as a contra account) is estimated.

The reported value of a monetary asset or monetary liability denominated in a foreign currency must be adjusted to the current rate whenever the currency exchange rate changes. The reported value of all other accounts simply remains at the original historic rate and never changes. What is a monetary asset? What is a monetary liability?

Monetary assets and monetary liabilities are cash and all other balances that establish a specific cash transfer in the future. Thus, cash, accounts receivable, and notes receivable are all monetary assets. Accounts payable, notes payable, salary payable, rent payable, and the like are all monetary liabilities. Inventory is not viewed as a monetary asset because the future cash amount is not specified.

At the end of the current year, a company has a $1,000 credit balance in its allowance for doubtful accounts. The company is now making an adjusting entry to debit bad debt expense and credit the allowance for doubtful accounts. Assume the company has sales for the year of $800,000 and estimates that 4 percent of all sales will prove uncollectible. What amounts are recorded in this adjusting entry?

Sales are $800,000. If the estimated amount of uncollectible accounts is 4 percent of those sales, then the expense is $32,000. In the percentage of sales method, the $1,000 credit balance in the allowance account does not directly influence the adjusting entry. The expense is $32,000 (as estimated) and the allowance goes from a $1,000 credit to a $33,000 credit.

A company estimates that $3,000 of its accounts receivable will never be collected. At the end of this year, the company debits bad debt expense for $3,000 and credits the allowance for doubtful accounts by $3,000. During Year Two, the company determines that a total of $3,200 of its accounts will not be collected. Should the company immediately record an additional expense of $200?

The $3,000 was an estimate and no one expected it to be exactly correct. No retroactive correction is made when actual bad debts turn out to be either higher or lower than the estimate. Instead, in recording bad debts at the end of Year Two, the amount of actual bad accounts will likely influence the new estimation. Here, the estimate made at the end of Year One proved too low. Thus, the company might choose to use a higher number at the end of Year Two.

At the end of the current year, Ace Company officials determine that the company is taking several days longer to collect its accounts receivable than in the previous year. How was this computation made?

The age of accounts receivable is determined in a two-step process. First, sales on account for the year are divided by 365 to determine the average amount of credit sales per day. Second, this credit sales per day figure is divided into the accounts receivable balance.

In all of the previous examples, the bad debt expense and the allowance for doubtful accounts had different balances after the adjusting entry was made. Why are those two balances different? Should they not be the same?

The allowance for doubtful account ends virtually every year with a residual balance. It might be a debit (the previous estimation was low) or a credit (the previous estimation was high). When the new estimation is made, bad debt expense is debited and the allowance for doubtful accounts is credited. The residual balance already in the allowance keeps the two accounts from having the same total. All bad debt figures are estimates so the difference does not cause a concern.

Ace Company makes $500,000 in sales on account in Year One. It debits accounts receivable and credits sales revenue because the performance obligation has been satisfied. The company estimates that $3,000 of this amount will never be collected. Bad debt expense is recognized for that amount and the allowance for doubtful accounts is also recorded? What purpose does the allowance for doubtful accounts serve?

The allowance for doubtful accounts temporarily holds the reduction in the accounts receivable until the actual identity of the uncollectible balances is uncovered. At that point, that amount is moved from the allowance to the accounts receivable T-account. Because the estimation is made before any account proves to be uncollectible, this contra account is needed to temporarily record the reduction.

In determining the net realizable value to report for accounts receivable, a company must estimate what portion of the various account balances will be collected. How does the company arrive at that figure?

The amount of cash a company expects to collect is normally estimated based on past experience. That amount should be adjusted for any changes in the economy (better economic times usually means more collections) and changes in the company (giving credit to a wider range of customers often leads to more bad accounts).

At the end of the current year, a company has a $1,000 credit balance in its allowance for doubtful accounts. In recognizing the expense for this new year, the company debits bad debt expense and credits the allowance for doubtful accounts. What are the two methods of determining the dollar amount to be recognized in this adjusting entry?

The amount to be recognized through a debit to bad debt expense and a credit to the allowance for doubtful accounts can be determined by (1) the percentage of sales method or (2) the percentage of receivables method (or a variation known as the aging method). The first method ignores any balance in the allowance account. The estimate is recorded as the expense. In the second method, the expense is the amount that is needed to get the allowance account up to the estimated balance.

A company makes $500,000 in sales on account in Year One and estimates that $3,000 will not be collected. In a Year One adjusting entry, the company debits bad debt expense for $3,000 and credits allowance for doubtful accounts by $3,000. In Year Two, the company learns that one customer has gone bankrupt. As a result, an $800 account will not be collected. To remove that account, the allowance for doubtful accounts is debited and accounts receivable is credited. Why is no expense recognized at that time?

The expense was recognized previously in Year One when it was incurred as a result of making sales on account. Even though the $3,000 total had to be estimated, it was recorded at that time. The Year One expense was reported last year. It should not be reported again in Year Two when an actual uncollectible account is identified.

At the end of the current year, a company has a $1,000 debit balance in its allowance for doubtful accounts. The company is now making an adjusting entry to debit bad debt expense and credit the allowance for doubtful accounts. Assume the company has sales for the year of $800,000 and estimates that 4 percent of all sales will prove uncollectible. What does the company report as its bad debt expense? What does the company report as its allowance for doubtful accounts?

The percentage of sales method is being used. Bad debt expense is 4 percent of $800,000 or $32,000. The allowance for doubtful accounts has a $1,000 debit in the T-account. The $32,000 amount recognized as the estimated bad debts is a credit to the allowance. The $1,000 debit is netted with the $32,000 credit so that the allowance account has a $31,000 credit balance.

At the end of the current year, a company has a $1,000 credit balance in its allowance for doubtful accounts. The company is now making an adjusting entry to debit bad debt expense and credit the allowance for doubtful accounts. Assume the company has sales for the year of $800,000 and estimates that 4 percent of all sales will prove uncollectible. What does the company report as its bad debt expense? What does the company report as its allowance for doubtful accounts?

The percentage of sales method is being used. Bad debt expense is 4 percent of $800,000 or $32,000. The allowance for doubtful accounts is the $1,000 credit in the T-account plus the $32,000 amount recognized as the bad debt amount for a total of $33,000. The $32,000 credit to the allowance is added to the $1,000 credit to arrive at the $33,000 reported total.

On Monday, a U. S. company buys inventory in Europe for 10,000 Euros on account. On Monday, one Euro is worth $1.20. On Thursday, the company prepares financial statements but one Euro is now worth $1.25. The liability has not been paid nor has the inventory been sold. Inventory stays at $12,000 but the account payable is adjusted from $12,000 to $12,500. What income effect, if any, is reported as a result of this adjustment?

The reported balance of the liability is increased by $500 when the value is adjusted from $12,000 to $12,500. Because the reported balance of a liability is being increased, a $500 loss must be reported on the company's income statement. The reported balance of inventory stayed at $12,000 so no income effect is created.

Ace Company has $1 million in accounts receivable but estimates that $40,000 of those accounts will never be collected. Why is this $40,000 recorded in a separate allowance for doubtful accounts account rather than as a direct reduction in the accounts receivable balance? In both cases, the net balance is reduced to $960,000.

Until specific accounts prove to be uncollectible, the total of accounts receivable is truly $1 million and the T-account should reflect that balance. A direct reduction is only made when actual accounts are deemed to be uncollectible. Until then, the reduction is recorded indirectly in the allowance account. The uncertainty of the $40,000 estimation is also easier to understand when isolated in the contra account. Clearer information is conveyed by using separate accounts to arrive at the net balance.

Ace Company is near the end of the year and is getting ready to prepare its financial statements. Just before making those statements, a $4,000 account receivable is judged to be bad and written off. How did that event change the total reported asset balance on the company's balance sheet? What is the impact of this discovery?

When an account is written off as uncollectible, the allowance for doubtful accounts is debited (reduced) and accounts receivable is credited (reduced). Both the asset and the contra asset are reduced by the same amount. Thus, the reductions offset each other. The net asset balance stays the same. If receivables are $500,000 and the allowance is $12,000, the net balance is $488,000. After a $4,000 write off, the receivables are $496,000 and the allowance is $8,000 for the same net $488,000 reported figure.