Financial Accounting Ch. 5

"n/30"

"net thirty" means that if the customer does not take the discount, full payment net of any returns or allowances is due within 30 days

uncollectible accounts

(bad debit) accounts receivable that cannot be collected

to understand how to apply the allowance method, we'll consider the following three stages in the process:

1. at the end of the initial year, establish an allowance by estimating future uncollectible accounts 2. during the subsequent year, write off actual bad debts as uncollectible. note that actual write-offs may differ from the previous year's estimate 3. at the end of the subsequent year, once again estimate future uncollectible accounts

three important points to understand when estimating contra revenues are:

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 returns, sales allowances, and sales discounts that occur during the year 3. total revenues are further reduced by an adjusting entry at the end of the year for the estimate of additional sales returns, sales allowances, and sales discounts expected to occur in the future but that relate to the current year

what is the equation for average collection period?

365 days/ receivables turnover ratio

direct write-off method

A method of accounting for bad debts that involves charging receivable balances to Bad Debt Expense at the time receivables from a particular company are determined to be uncollectible.

What is the receivables turnover ratio?

Net Credit Sales / Average Accounts Receivable

the year-end adjustment for future uncollectible accounts is affected by the current balance of Allowance for Uncollectible Accounts before adjustment.

The current balance before adjustment equals the balance of the allowance account at the beginning of the current year (or end of last year) less actual write-offs in the current year

Net accounts receivable

The difference between total accounts receivable and the allowance for uncollectible accounts

allowance method

a company reports its accounts receivable for the net amount expected to be collected; to do this, the company must estimate the amount of current accounts receivable that will prove uncollectible in the future and report this estimate as a contra asset to its accounts receivable

aging method

a more accurate method is to consider the various ages of individual accounts receivable, using a higher percentage of uncollectible for "old" accounts than for "new" accounts; also a balance sheet method

under the allowance method,

accounts receivable are reported for the net amount expected to be collected. At the end of the current year, estimated future uncollectible accounts are reported in a contra asset account, reducing net accounts receivable

contra revenue account

an account with a balance that is opposite or "contra" of that of its related revenue account

percentage-of-receivables method

an allowance for uncollectible accounts in 2021 by applying a single estimated percentage (30%) to total accounts receivable. Sometimes referred to as a balance sheet method, because we base the estimate of bad debts on a balance sheet account - accounts receivable

average collection period

another way to express the same efficiency measure. this ratio shows the approximate number of days the average accounts receivable balance is outstanding. It is calculated as 365 days divided by the receivables turnover ratio

nontrade receivables

are 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

as total revenues less any amounts for returns, allowances, and discounts

upside to extending credit to customers

boosts sales by allowing customers the ability to purchase on account and pay cash later

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

allowance for uncollectible accounts

contra asset account representing the amount of accounts receivable that we do not expect to collect; a way to reduce accounts receivable indirectly, rather than decreasing the accounts receivable balance itself

we reduce revenue for sales returns using a

contra revenue account - sales returns

sales return

customer returns good previously purchased

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

notes receivable are similar to accounts receivable except that notes receivable are

formal credit arrangements with a written debt instrument, or note

sales allowance

if the customer doesn't return goods but the seller instead reduced the customer's balance owed for goods or services provided

benefit of extending credit

is that the seller makes it more convenient for the buyer to purchase goods and services. In the long term, credit sales should benefit the seller by increasing profitability of the company

the cost of extending credit

is the delay in collecting cash from customers, and as already discussed, some customers may end up not paying at all

the legal right to receive cash

is valuable and represents an asset of the company. this asset is referred to as accounts receivable (sometimes called trade receivables)

it is important to emphasize that the direct write-off method is generally 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. The 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

a credit balance before adjustment indicates that the balance of the allowance account at the beginning of the year (or end of last year) may have been too high

it's possible that some of the estimated uncollectible accounts have not proven bad yet

net revenues are also referred to as

net sales

downside to extending credit to customers

not all customers will pay fully on their accounts

we record interest earned on notes receivable but

not yet collected by the end of the year as interest receivable and interest revenue

sales allowances

occur when the seller reduces the customer's balance owed or provides at least a partial refund because of some deficiency in the company's good or service

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

collecting cash on an account previously written off also has no effect

on total assets and no effect on net income

"2/10"

pronounced "two ten" indicates the customer will receive 2% discount if the amount owed is paid within 10 days

receivables turnover ratio

provides a measure of a company's ability to collect cash from customers. The ratio shows the number of times during a year that the average accounts receivable balance is collected.

trade discounts

represent a reduction in the listed price of a good or service; companies typically use trade discounts to provide incentives to larger customers or consumer groups to purchase from the company; can be a way to change prices without publishing a new price list or to disguise real prices from competitors

accounts recievable

represent the amount of cash owed to a company by its customers from the sale of goods or services on account

unlike a trade discount, a sales discount

represents a reduction, not in the selling price of a good or service, but in the amount to be received from a credit customer if collection occurs within a specified period of time; intended to provide incentive to the customer for quick payment

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

payment terms

require the customer to pay within 30 to 60 days after the dale; even though no cash is received at the time of the credit sale, the seller records revenue immediately once goods or services are provided to the customer and future collection from the customer is probable

the reason we use a contra revenue account is to keep a record of the total revenue recognized

separate from the reduction due to subsequent sales returns

note that the receivables not expected to be collected

should not be counted in assets of the company

invoice

source document that identifies the date of sale, the customer, the specific items sold, the dollar amount of the sale, and the payment terms

discount terms

such as 2/10, n/30, are a shorthand way to communicate the amount of the discount and the time period within which it's available

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

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

"Sales Revenue" account refers to

the sales of goods (inventory)

"Service Revenue" account refers to

the sales of services

a debit balance before adjustment indicates that the balance of the allowance account at the beginning of the year was too low

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

compared to the allowance method, the direct write-off method causes assets to be overstated and operating expenses to be understated

this is why the direct write-off method of accounting for uncollectible accounts is generally not permitted for financial reporting purposes except in limited circumstances

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.

overall, the write off of the account receivable has no effect on

total amounts reported in the balance sheet or in the income statement. there is no decrease in total assets and no decrease in net income with the write off. We have already recorded the negative effects of the bad news. the net effects is that there is no change in the net receivable (accounts receivable less the allowance) or in total assets

What does the "net" in net credit sales refer to?

total credit sales net of discounts, returns, and allowances (similar to net revenues calculated earlier in the chapter)

credit sales

transfer good or services to a customer today while bearing the risk of collecting payment from that customer in the future; also known as sales on account or services on account

bad debts expense is sometimes referred to as

uncollectible accounts expense or provision for doubtful accounts

sales returns, sales allowances, and sales discounts are contra revenue accounts;

we subtract the balances in these accounts from revenues when calculating net revenues

notes receivable

when receivables are accompanied by formal credit arrangements made with written debt instruments (or notes)

contra revenues represent reductions of revenues,

whereas expenses represent the separate costs of generating revenues