Principles of Financial Accounting Ch.5~ Exam 2

Types of Receivables

-Accounts receivables -Nontrade receivables -Notes receivable

Bad Debt Expense

-Reported in the I/S

Nontrade receivables:

-receivables from sources other than customers --Examples: tax refund claims, interest receivable, loans by the company to other entities (including stockholders and employees)

When do companies records an asset (A/R) 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 A/R is reduced

Sales Return

-••Customer returns goods previously purchased (a) Seller issues a cash refund (if original sale was for cash) (b) Seller reduces balance of A/R (if original sale was on account)

Accounting for Uncollectible Accounts and Reporting of A/R on the B/S

After we estimate uncollectible accounts to be $6 million, we reduce the $20 million balance of accounts receivable and report them at their esmative than making no estimate at all. Earlier in the chapter, we discussed contra revenue accounts—sales discounts, returns, and allowances. Recall that these accounts provide a way to reduce revenue indirectly. In the same way, the allowance account provides a way to reduce accounts receivable indirectly, rather than decreasing the accounts receivable balance itself. We report the allowance for uncollectible accounts in the asset section of the balance sheet, but it represents a reduction in the balance of accounts receivable. The difference between total accounts receivable and the allowance for uncollectible accounts is referred to as net accounts receivable, which is net realizable value.

Estimating Uncollectible Accounts

At the end of 2021, Bauman Industries is owed $20M from customers and estimates that 30% will not be collected. December 31st 2021--------------------Debit Credit Bad Debt Expense 6 Allowance for Uncollectible Accounts 6 (estimate for future bad debts) ($20 M x 30%= 6M)

Aging Method

Considers how long the receivables have been outstanding Why? Older accounts are more likely uncollectible More accurate than applying a single percentage to total A/R Note: The account titles in the journal entry are the same as when we applied a single percentage to the ending balance, but the amount will differ.

What type of revenue accounts are sales returns and sales allowances?

Contra revenue accounts, these accounts have normal debit balances and reduce the reported amount of NI, but they represent reductions of revenues not expenses

Allowance Method in a Subsequent Year

Debit Credit Bad Debt Expense ........................................... 5 Allowance for Uncollectible Accounts... 5 (Estimate future bad debts) Allowance for Uncollectible Accounts ($M) -Beg. balance for 2022 -Bal. before adjustment Year-end adjustment Ending balance for 2022 -Write-offs in 2022

Underestimating Bad Debts--Example

Debit Credit Bad Debt Expense ........................................... 8 Allowance for Uncollectible Accounts... 8 (Estimate future bad debts) A debit balance before adjustment indicates that the balance of the allowance account at the beginning of the year was too low. In the case of a debit balance, we've written off more bad debts in the current year than we had estimated. The year-end adjusting entry is affected by the extent to which the previous year's ending balance of Allowance for Uncollectible Accounts differs from the current year's actual amount of uncollectible accounts. In the example on this slide, the balance before adjustment was a debit of $1. Because we estimate the ending balance in the Allowance should be $7 credit, we need to add $8 to the account. The journal entry for this adjustment is shown in this slide.

Average Collection Period

Number of days the average A/R balance is outstanding Average collection period= 365 days/ receivables turnover ratio

Allowance Method in a Subsequent Year example

Recall: At the end of 2021, Bauman estimated bad debts at $6M (i.e., future write-offs of $6M). Actual bad debts (write-offs in 2022) were only $4M. Thus, the year-end 2021 amount was overestimated by $2M. Assume Bauman estimated bad debts at the end of 2022 to be $7M. How does Bauman record its $7M estimate of future bad debts at the end of 2022?

Income Statement for Bauman Industries reporting Estimated Bad Debt Expense

Revenue from credit sales $50 Expenses: Bad debt expense $6 Other operating expenses $34 40 Net income $10 Bad Debt Expense. The offsetting debit in the entry to establish the allowance account is bad debt expense. Bad debt expense represents the cost of estimated future bad debts that is reported as an expense in the current year's income statement, along with other expenses. Illustration 5-5 shows the income statement for Kimzey Medical Clinic after estimating bad debt expense. In the 2021 income statement, we reduce the $50 million of revenue from credit sales by total expenses of $40 million, of which $6 million is for estimated future bad debts.

Note Receivable (N/R)

Similar to A/R, but include a written debt agreement (or "note") Classified as either current or noncurrent asset depending on time until due date Usually involves receipt of interest income: Interest= Face Value x Annual interest rate x Fraction of the year

Key Notes about Receivables turnover ratio

The receivables turnover ratio shows the number of times during a year that the average accounts receivable balance is collected (or "turns over"). The "net" in net credit sales refers to total credit sales net of discounts, returns, and allowances. The amount for net credit sales is obtained from the current period's income statement; average accounts receivable equals the average of accounts receivable reported in this period's and last period's balance sheets. The more frequently a business is able to "turn over" its average accounts receivable, the more effective a company is at granting credit to and collecting cash from its customers. The average collection period shows the approximate number of days the average accounts receivable balance is outstanding.

Notes receivable

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

Establishing an Allowance for Uncollectible Accounts

•Base the estimate of bad debts on the ending balance in A/R There are three stages in the process: •At the end of the initial year, establish an allowance by estimating future uncollectible accounts. •During the subsequent year, write off actual bad debts as uncollectible. Note that actual write-offs may differ from the previous year's estimate. •At the end of the subsequent year, once again estimate future uncollectible accounts. Consider the following example. In 2021, its first year of operations, Kimzey Medical Clinic bills customers $50 million for emergency care services provided. By the end of the year, $20 million remains due from customers. Those receivables are assets of the company. However, because Kimzey cannot always verify patients' ability to pay before administering care, it does not expect to receive the full $20 million. The receivables not expected to be collected should not be counted in assets of the company.

Accounts Receivable (A/R)

•Cash owed to the company by its customers from sales or services on account -Also called trade receivables •Recorded at the time of the sale or service ex: Debit Credit Accounts Receivable........................ 3,000 Service Revenue 3,000 (provide services on account)

End-of-Period Adjustment for Contra Revenues

•Companies must adjust for sales returns, allowances and discounts at the end of the year via adjusting entries. -Why? GAAP requires a company to report revenues equal to the amount of cash the company "expects to be entitled to receive." •At year-end, 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.

Receivables Turnover Ratio

•Number of times during a year the average A/R balance is collected Receivables turnover ratio= Net credit sales/average accounts receivable

Sales Discounts

•Offer a customer a reduction in amount owed if payment is made within a specified period of time --Why? Provides customer an incentive to pay quickly •Example: terms of 2/10, n/30 --Customer receives 2% discount if amount owed is paid within 10 days of invoice date --Otherwise, full payment (net of returns/allowances) is due with 30 days •Sales Discounts = contra revenue account --Reported with total revenues in the I/S, but with a debit (negative) balance

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

Allowance Method for Uncollectible A/R

•Some A/R will not be collected •Under GAAP, companies are required to: -Estimate future uncollectible accounts -Record those estimates in the current year •Estimated uncollectible accounts -Reduce assets (A/R) -Increase expenses (bad debt expense)

Credit Sales

•Transfer products/services to a customer today; expect to collect cash in the future •Also known as sales on account or services on account •Common for many business transactions

Collection of A/R Previously Written Off (Recovery)

•What if a customer later pays off part of amount owed? Debits Credits Accounts Receivable ....................................... xxxxx Allowance for Uncollectible Accounts... xxxxx (Reestablish portion of account previously written off) Debits Credits Cash ................................................................... xxxxx Accounts Receivable ................................. xxxxx (Collect cash on account) Note: collection has no effect on total assets or NI

Writing Off A/R

•When it becomes clear a customer will not pay, the company writes off the customer's account balance as uncollectible. •The write-off: -Reduces the balance of A/R -Reduces the balance of Allowance for Uncollectible Accounts •The write-off has no effect on total assets (B/S) or total expenses (I/S) -Why? Negative effects of bad debts were recorded in an adjusting entry at the end of the previous year.

Sales Allowance

••Customer does NOT return goods (gets price reduction) (a) Seller issues a cash refund (if original sale was for cash) (b) Seller reduces balance of A/R (if original sale was on account)