Chapter 8
The receivables turnover ratio indicates how many times, on average, this process of selling and collecting is repeated during the period.
The higher the ratio, the faster the collection of receivables.
The aging method gets its name because it is based on the"age" of each amount in Accounts Receivable at the end of the period.
The older and more overdue an account receivable becomes, the less likely it is to be collectible.
On January 1, Portillo, Incorporated lends a corporate customer $80,000 at 6% interest. The amount of interest revenue that should be recorded for the quarter ending March 31 equals:
1,200 explanation: Interest = Principal × Interest Rate × Time = $80,000 × 0.06 × 3/12 (January through March) = $1,200
The allowance method follows a two-step process, described below:
1. Make an end-of-period adjustment to record the estimated bad debts in the period credit sales occur. 2. Remove ("write off") specific customer balances when they are known to be uncollectible.
There are two acceptable methods of estimating the bad debts in a given period.
1. Percentage of Credit Sales Method. (simpler to apply) 2. Aging of Accounts Receivable. (more accurate)
disadvantages of extending credit
1. increase wage costs 2. bad debt costs 3. delays receipt of cash
Morrow Incorporated uses the percentage of credit sales method of estimating doubtful accounts. The Allowance for Doubtful Accounts has an unadjusted credit balance of $5,500 and the company had $280,000 of net credit sales during the period. Morrow has experienced bad debt losses of 5% of credit sales in prior periods. After making the adjusting entry for estimated bad debts, what is the ending balance in the Allowance for Doubtful Accounts account?
19,500 explanation: The percentage of credit sales method estimates Bad Debt Expense by multiplying the historical percentage of bad debt losses by the current period's credit sales. Bad Debt Expense = Net credit sales × Bad debt loss rate = $280,000 × 0.05 = $14,000 Ending balance in Allowance for Doubtful Accounts = Unadjusted credit balance in Allowance for Doubtful Accounts + Bad Debt Expense = $5,500 + $14,000 = $19,500
A note receivable was created on November 1, 2021. Its maturity date is October 31, 2022. What is the time fraction needed to compute the interest revenue for the year ended December 31, 2021?
2/12 explanation: Recall that: Interest = Principal × Interest Rate × Time. For the computation of interest earned through December 31, the time component of this equation will be 2/12 (or the two months from November 1 through December 31 divided by the twelve months covered by the interest rate).
Credit Card Sales
Another way to avoid lengthy collection periods is to allow customers to pay for goods using PayPal or national credit cards. This not only speeds up the seller's cash collection but also reduces losses from customers writing bad checks. PayPal and Credit card companies charge a fee for their services.
Revising Estimates
Bad debt estimates usually differ from the amounts that are later written off. If the differences are material, companies are required to revise their bad debt estimates for the current period
when companies sell on account, they specify the length of credit period (and any cash discounts for prompt payment).
By comparing the number of days to collect to the length of the credit period, you can gain a sense of whether customers are complying with the stated policy.
account recoveries
Collection of a previously written-off account is called recovery and is accounted for in two parts. First, put the receivable back on the books by recording the opposite of the write-off. Second, record the collection of the account
record sales on account
Dr. Accounts Receivable Cr. Sales Revenue
Aging of Accounts Receivable - Step 2
Estimate bad debt loss percentages for each category.
Which of the following statements about the trade-offs of extending credit is not correct?
Even if there are no bad debts from credit sales, the delayed receipt of cash will always increase additional costs beyond the increased revenue from credit sales. Explanation: The disadvantages of selling on credit are increased wage costs, bad debt costs, and delayed receipt of cash. The advantage of extending credit is that it helps business customers buy products and services, thereby increasing the seller's revenues. (If the additional costs are expected to exceed the increased revenue, the company would not choose to extend credit to customers.)
When interest is calculated for periods shorter than a year, the formula to calculate interest is:
I = P × R × T, where I = interest calculated, P = principal, R = annual interest rate, and T = (number of months ÷ 12). explanation: Because interest rates are always stated as an annual percentage even if the note is for less than a year, the time period is the portion of a year for which interest is calculated. Ask yourself how many months out of 12 or how many days out of 365 the interest period covers. As such, in the interest equation, T equals the number of months ÷ 12.
advantage of extending credit
Increases the seller's revenues
calculating interest
Interest (I)= Principal (P) x Interest Rate(R) x Time(T)
Receivable Turnover Ratio
Net Sales Revenue/Average Net Receivables Average Net Receivables= beg. (net receivables+ end net receivables) /2
Factoring Receivables
One way to speed up collections is to sell outstanding accounts receivable to another company (called a factor).Your company receives cash for the receivables it sells to the factor (minus a factoring fee)
accruing interest earned
PxIRxT dr, interest receivable cr, interest revenue
Inglewood Industries has net sales of $936,600 and average net receivables of $223,000 for the year. Which of the following statements is correct? (Round all calculations to one decimal place.)
The receivables turnover ratio is 4.2 and the days-to-collect is 86.9. explanation: Receivables turnover ratio = Net sales revenue ÷ Average net receivables = $936,600 ÷ $223,000 = 4.2 times Days to collect = 365 ÷ Receivables turnover ratio = 365 ÷ 4.2 = 86.9 days
Aging of Accounts Receivable - Step 1
VFC applies the aging of accounts receivable method to its AccountsReceivable balances on February 28, after taking into account Februarysales and cash collections. The method includes three steps: (1) Preparean aged list of accounts receivable, (2) Estimate bad debt loss percentagesfor each category, and (3) Compute the total estimated bad debts.
aging of accounts receivable
While the percentage of credit sales method focuses on estimating Bad Debt Expenses (income statement approach) for the period, the aging of accounts receivable method focuses on estimating the ending balance in the Allowance for DoubtfulAccounts (balance sheet approach).
Company A lends $100,000 to Company B. The interest on the loan is reported as:
a revenue to Company A and an expense to Company B. explanation: Company A, the lender, earns the interest (Interest Revenue) and Company B, the borrower, incurs the cost (Interest Expense).
The Allowance for Doubtful Accounts account is a contra-account that offsets:
accounts receivable explanation: The Allowance for Doubtful Accounts is a contra-account that is subtracted from Accounts Receivable on the balance sheet.
dr, accounts receivable
balance sheet cash accounts receivable inventory
The adjusting entry used to record the estimated bad debts in the period credit sales occur decreases:
both net income and net accounts receivable explanation: The entry to record the estimated bad debts in the period credit sales occur includes a debit to Bad Debt Expense and a credit to the Allowance for Doubtful Accounts. The debit increases an expense account and decreases net income. Since the credit is to a contra-asset account, the entry decreases net Accounts Receivable and total assets.
The percentage of credit sales method estimates bad debt expense
by multiplying the historical percentage of bad debt losses by the current period's credit sales.
Unlike accounts receivable, which are generally interest free, notes receivable
charge interest from the day they are created to the day they are due (their maturity date).
aging of accounts receivable- step 3
compute the total estimated bad debts
A company reports Notes Receivable if it uses a promissory note to
document its right to collect money from another party.
recording interest received
dr, cash cr, interest receivable cr, interest revenue
recording principal received
dr, cash cr, note received
issuing a loan
dr, notes receivable cr, cash
The adjusting entry to record the estimated bad debts in the period credit sales occur includes a debit to an:
expense account and a credit to a contra-asset account explanation: The entry to record the estimated bad debts in the period credit sales occur includes a debit to Bad Debt Expense, an expense account, and a credit to the Allowance for Doubtful Accounts, a contra-asset account.
The accounting principle that governs the recording of bad debt expense in the same period as sales revenue is called the:
expense recognition principle (matching) explanation: The expense recognition principle, or "matching" principle governs the recording of expenses and the related revenues so they both are reported in the same period on the income statement. This principle will lead to less distorted views of net income in the period of the sale as well as the period of the bad debt expense.
cr, sales revenue
income statement sales revenue COGS gross profit
The receivables turnover ratio:
measures how many times, on average, the process of selling and collecting is repeated during the period. explanation: The receivables turnover ratio indicates how many times, on average, the process of selling and collecting is repeated during the period. It is calculated by dividing net sales revenue by average net receivables.
IBM signs an agreement to lend $200,000 to one of its customers to be repaid in one year at 5% interest. IBM would record this loan as:
notes receivable explanation: A note receivable is a promise that requires another party to pay the business according to a written agreement.
The days-to-collect measures the:
number of days it takes to collect accounts receivable.
Rather than evaluate the number of times accounts receivable turn over, some people find it easier to think in terms of the
number of days to collect receivables(called days to collect).
true or false: The aging of the accounts receivable method is based upon the principle that the longer an account is overdue, the higher the risk of non-payment.
true Explanation: The aging method gets its name because it is based on the "age" of each amount in Accounts Receivable. The older and more overdue an accounts receivable becomes, the less likely it is to be collectible.
true or false: The allowance method for uncollectible accounts conforms to the expense recognition principle.
true Explanation: The allowance method for uncollectible accounts conforms to the expense recognition principle. The allowance method records the Bad Debt Expense in the same period as the credit sale.
true or false: When a company routinely sells on credit, it is inevitable that some of its customers will not pay the amount owed.
true explanation: Some customers will not pay because they dispute the price or quality of the products or services or the customers are having financial difficulties.