Chapter 8 COV

What three steps are there to the aging method?

1. Prepare an aged listing of accounts receivable 2. Estimate bad debt loss percetnages for each category 3. Compute the total estimate by multiplying the totals in step 1 by the percentages in step 2 and then summing across all categories

What are two objectives when accoutning for accounts receivable and bad debts?

1. Report accounts receivable at the amount the company expects to collect, referred to as net accounts receivable 2. Match the cost of bad debts to the accounting period in which the related credit sales are made

Which of the following describe a note receivable? Select all that apply A. More formal way of extending credit B. Specified interest rate C. Specified maturity date D. Stronger legal claim E. Used for small-dollar items

ABCD

What type of account is allowance for doubtful?

Allowance for doubtful accounts is a contra-asset account reported on the balance sheet and increased by a credit

While interest is earned each day, when are interest payments typically received?

Although interest is earned each day, interest payments are typically received only once or twice a year.

What happens as a result of this?

As a result, net income is overstated.

Are both methods acceptable under GAAP and IFRS?

Both methods are acceptable under GAAP and IFRS and both methods use the same journal entry: a debit to bad debt expense and a credit to allowance for doubtful accounts.

What is a company likely to attract by extending credit to customers?

By extending credit to customers, a company is likely to attract a greater number of customers willing to buy from it.

Madison Inc reported sales of 1,000,000, a debit balance in accounts receivable of 80,000 dollars and a credit balance of 5,000 dollars in the allowance for doubtful accounts. Management anticipates bad debt losses of 1 percent of credit sales Prepare the end-of-period adjusting entry to record bad debt expense:

Debit bad debt expense for 10,000 dollars and credit allowance for doubtful accounts for 10,000 dollars

What does anincrease in wage cost result in?

First, an increase in wage costs results in additional time required if the customer is credit worthy, tracking how much the customer owes, and the collection process

How do we first put receivable back on the books?

First, we put the receivable back on the books by recording the opposite of the write off with a debit to accounts receivable and a credit to allowance for doubtful accounts.

What happens for the sale of high dollar value items with an extended payment period?

For the sale of high-dollar value items with an extended payment period or when the business converts an existing account receivable to a note receivable to allow for an extended payment period.

What type of account is the allowance for doubtful account?

Like all contra-asset accounts, the Allowance for doubtful accounts is a permanent account, so its balance carries forward from one accounting period to the next.

How do we get to net realizable value on the balance sheet?

On the balance sheet, the allowance for doubtful accounts is subtracted from accounts receivable to arrive at the net realizable value or the amount expected to be collected.

What do we then record?

Second, we record the collection of the account with a debit to cash and a credit to accounts receivable

What is the interest rate?

The interest rate is the percentage of interest charged based on a 12 month period

What is the key in computing the correct amount of bad debt expense?

The key in computing the correct amount of bad debt expense is to consider any existing balance in the allowance account and subtract it from the desired ending balance computed in the schedule of aging accounts receivable

When may this bad debt not be discovered until?

This bad debt may not be discovered until the accounting period after the sale

What does extending credit also open up the door for?

While improved revenues are certainly an advantage, extending credit also opens the door for potential problems or addition costs.

What are some purchases made on?

credit

When does a note receivable charge interest?

A note receivable charges interest from the day it is created to the maturity

During period 2, the company discovers that a customer will not pay 1,000 dollars owed and the bad debt expense of 1,000 dollars that arose from sales occurring last period is recorded in period 2. What does this violate?

Again, this violates the expense recognition or matching principle, which requires the matching of bad debt expense and sales. As a result, net income is understated.

What type of account is bad debt expense considered to be?

Bad debt expense is an expense account reported on the income statement and increased by a debit

How will the balance in the allowance for doubtful accounts thus compare to the balance in the bad debt expense?

Consequently, the balance in the allowance for doubtful accounts will differ from the balance in bad debt expense, except during the first year that the allowance for doubtful accounts is used.

When does interest begin to accrue?

Generally, interest begins to accrue the day the note is issued and continues until the note is paid off.

Are both income statements distorted?

It is clear both income statements are distorted because the business failed to follow the matching principle where expenses are to be reported in the same period in which the revenues are earned

When are notes receivable commonly used?

Notes receivable are commonly used when a company loans money to its employees or another business.

What does payment before or at the time of purchase avoid?

Obviously, payment before or at the time of purchase avoids any risk of cash collection

What is the principal?

Principal is the total amount loaned

What happens since allowance for doubtful accounts is a permanent accoutn?

Since allowance for doubtful accounts is a permanent account on the balance sheet, the balance carries forward from year to year.

What is 17,240 dollars considered to be?

So, 17,240 dollars is the total amount estimated to be uncollectible and it also becomes the desired ending balance in the allowance for doubtful accounts to be reported in the balance sheet.

When does the allowance account increase?

So, the allowance account increases at the time bad debt expenses are recognized and decreases when accounts are written off. A customer might later pay an account balance that was previously written off

What is this approach known as?

The approach is known as the allowance method

What is the end of period adjusting entry?

The end of period adjusting entry would include a debit to bad debt expense for 2,000 dollars and a credit to the allowance for doubtful accounts for 2,000 dollars.

Let's assume a company that has been in business for quite a few years, was to estimate that 900 dollars of bad debts this period. What is the entry to record that estimate?

The entry to record that estimate would include a debit to bad debt expense and credit to allowance for doubtful accounts for 900 dollars.

What is estimated bad debt expense already recorded as part of?

The estimated bad debt expense relating to this uncollectible account was already recorded as part of the adjusting entry at the end of the period in which the sale is recorded.

What is the formula for computing interest?

The formula for computing interest is: interest (I) = Principal (P) * Interest rate( R) *Time (T)

What does the revenue recognition principle specify?

The revenue recognition principle specifies revenues are recognized when generated, regardless of when cash is received.

What is the solution for this?

The solution for this is to estimate the amount of bad debts based on past experience of total accounts receivable instead of guessing which customers will not pay.

What is time based on?

The time is based on the number of months interest accrues during that specific year divided by 12 months.

What are the effects of the write off in number 2?

The write-off (in number 2) has offsetting effects on accounts receivable and the allowance for doubtful accounts, ultimately yielding no net effect on net accounts receivable or net income

What are the disadvantages to selling goods on credit?

There are three main disadvantages to selling goods on credit: increased wage costs, bad debt costs, and delayed receipt of cash.

What is therefore not incurred?

Therefore, no additional expense is incurred when the account is finally written off.

What is this known as?

This is known as a receivable write off.

What does this mean?

This means a company that has a note receivable has to accrue interest revenue and interest receivable.

What steps does this method involve?

This method involves the following steps: 1. Estimate and record uncollectibles with an end-of-period adjusting journal entry that increases Bad Debt Expense (debit) and increases the allowance for Doubtful Accounts (credit) 2. Identify and write off specific customer balances in the period that they are determined to be uncollectible

Let's assume that period 1 reports total sales revenues of 10,000 dollars, which includes sales that will never be collected and no bad debt expense has been recorded. What does this violate?

This violates the expense recognition, or the matching principle, which requires the matching of bad debt expense and sales.

How is this illustrated by a company?

To illustrate, assume a company decides to write off an 800 dollar receivable for one of its customers.

What must companies use under GAAP?

Under GAAP, companies must use the allowance method to account for uncollectibles

What happens when a business allows customers to purchase goods on credit?

When a business allows customers to purchase goods on credit, meaning they receive the goods today and pay for them at a later time, revenues typically increase, because this makes it easier for customers to buy products.

What are the possible cases when a business sells goods or services?

When a business sells goods or services, there are three possible cases for when payment is expected: at the time of purchase, prior to the purchase, or after the purchase has been made.

What does a receivable write off not affect?

a receivable write off does not affect income statement accounts.

A permanent account

allowance for doubtful accounts

Credited in the adjustment to record estimated bad debts

allowance for doubtful accounts

Its balance carries forward from one accounting period to the next.

allowance for doubtful accounts

What is an example of this?

when the company sells on credit

What would the company record?

. The company would record an entry with a debit to doubtful accounts and a credit to accounts receivable for 800 dollars.

What four key events occur with a note receivable?

1. Establishing the note 2. Accruing the interest earned but not yet received 3. Recording interest payments received 4. Recording principal amounts received

EX: Treadwell Tire Company had net accounts receivable of 67,900 dollars at the beginning of the year and 72,400 dollars at the end of the year. The company's net sales revenue during the year was 876,875 dollars. What was the receivables turnover ratio for the year?

12.5

at its December 31 year-end, accounts receivable totaled 86,600 dollars aged as follows 1) 1-30 days old, 71,000 dollars; 2) 31-90 days old, 12,000 dollars; and 3) more than 90 days old, 3,600 dollars. Experience has shown that for each age group, the stimated uncollectible is 1) 12 % 2) 24 % and 3) 48 % respectively. What is the balance to which the allowance for doubtful accounts will need to be adjusted at the end of this period.

13,128

On July 1, year 1, the Barley Company loaned 50,000 dollars to the Jackson Co. the note has a stated interest rate of 10 percent and will mature on June 30, year 2. All payments for principal and interest will be received at maturity. How much interest revenue will Barley report on its income statement for the year ended December 31, year 1?

2,500 dollars

What does a higher number of days to collect mean?

A higher number of days to collect means a longer or worse time to collect.

Why is a higher ratio better than a lower ratio?

A higher ratio is better than a lower ratio because the higher the turnover, the faster the collection of receivables.

What does a note receivable have?

A note receivable has a specified interest rate and maturity date.

What is a note receivable considered to be?

A note receivable is a more formal way for a business to document its right to collect money from another party.

When is a note receivable typically used?

A note receivable is typically used when the customers are purchasing large dollar-value items, in cases when payment periods have been extended, or when a business lends money to a customer

Which of the following are considered disadvantages of allowing custoemrs to purchase goods on credit? Select all that apply A. A delay in cash collections B. Bad debt costs C. Decreased revenues D. Increased wage costs to determine if customers are creditworthy E. Increased wage costs resulting from the collection process

ABDE

Why do analysts and creditors watch this ratio?

Analysts and creditors watch this ratio because a sudden decline may mean that a company is extending payment deadlines in an attempt to prop up lagging sales. Or it may mean that a company is recording sales of merchandise that customers are likely to return later.

What do analysts watch for changes in?

Analysts watch for changes in the receivables turnover ratio because a sudden decline may mean a company is recording sales of merchandise that customers are likely to return later.

What is another alternative to allow customers to purchase goods on credit?

Another alternative to allow customers to purchase goods on credit is to issue a note receivable, which is a formal written contract that is viewed as a stronger legal claim.

What happens as a result of this entry?

As a result, assets increase and stockholders equity increases because revenue increases.

What happens as time passes and interest is earned on the note?

As time passes and interest is earned on the note, accountants must record an adjusting journal entry that accrues the interest revenue that is receivable on the note

What happens at maturity?

At maturity, two journal entries are prepared:

What is needed at year end?

At year end, a journal entry is needed to accrue interest earned, but not yet received. This entry includes a debit to interest receivable and a credit to interest revenue

What is bluefox company required to do at year end?

At year-end, December 31 year 1, bluefox company is required to accrue interest revenue earned, although it will not be received in cash until the maturity date, September 30 year 2.

Which of the following is the term used to describe the process of selling and collecting? A. Credit-granting activities B. Receivables turnover C. Operating cycle D. Turnover ratio

B

Which of the following statements about credit sales are true? Select all that apply A. Revenue is reported when the company is paid by the customer B. Accounts receivable arises from credit sales C. Accounts receivable should be reported at net realizable value D. Revenue is reported when the company fulfills its promise to transfer control of a good or service to a customer E. The cost of a bad debt should be recorded in the accounting period in which a business realizes that a customer will not pay the amount owed

BCD

For example, assume total credit sales for the period were 100,000 dollars and based on past experience, 2 percent of total credit sales are expected to be uncollected. what would bad debt expense for this period be?

Bad debt expense for the period would be 2,000 dollars or 100,000 dollars credit sales times 2 percent.

Where is bad debt expense reported?

Bad debt expense is reported on the income statement as an expense which reduces net income.

What type of account is bad debt expense?

Bad debt expense, which is a temporary account will have its balance closed (zeroed out) at the end of each year.

What will a business generally not know?

Generally, a business will not know which accounts will be collected until a period of time after the credit sales are made, rather than at the time they are made.

What would happen if the business knew beforehand which customers will not pa their bills?

If the business knew beforehand which customers will not pay their bills, then it would not allow them to purchase goods on credit.

If we compare this data to another company, what would a turnover rate of 10 be considered?

If we compare this data to another company, then a turnover rate of 10 times would be more desirable than a turnover rate of 8

Assume 17,240 dollars is the total amount estimated to be uncollectible. In other words, this is the desired ending balance in the allowance for doubtful accounts. Also, assume the balance in the allowance for doubtful accounts is zero. in this case, what would the amount of bad debt expense recognized for the period be?

In this case, the amount of bad debt expense recognized for the period would be 17,240 dollars (desired ending balance of 17,240 dollars minus 0 dollars of existing balance = bad debt expense of 17,240 dollars), which is the amount needed to bring allowance for doubtful accounts to the desired ending balance of 17,240 dollars

Is it better for this ratio to be higher or lower?

In this case, the lower the average number of days it takes to collect receivables, the more the better.

What is the estimates for each aging category in this example?

In this example, the estimates for each aging category of 2,040 dollars plus 5,200 dollars plus 7,600 dollars, plus 2,400 dollars equals 17,240 dollars.

How is interest calculated?

Interest is calculated by multiplying the principal interest rate, and time period (number of months out of 12).

How is interest revenue computed?

Interest revenue is computed based on 100,000 dollars times 12 percent interest rate times 3/12 months = 3,000 dollars

What is interest computed based on?

Interest, whether it is interest revenue or interest expense, is computed based on a 12 month period. Although most financial institutions compute interest based on 365 days, we simplify the formula by using number of months instead of worrying about counting the number of days

What may this also mean?

It also may mean the company is selling to less financially secure customers. It also may mean the company is allowing customers more time to pay their accounts to entice them to buy more than they need, a practice known as channel stuffing

What does this ratio reflect?

It reflects how many times average trade receivables were recorded and collected during the period.

How does the fourth journal entry compare to the first?

Notice the fourth journal entry is the opposite of the first journal entry.

When will the company realize it won't be able to collect an amount due from a customer?

Often, some time will pass before the company realizes that it will not be able to collect an amount due form a particular customer.

What will be recorded on september 30 year 2?

On September 30 year 2, Bluefox company will record the receipt of the cash interest for one year. The journal entry will include a debit to cash of 12,000 dollars, a credit to interest receivable of 3,000 dollars, and a credit to interest revenue of 9,000 dollars.

Assume that on October 1 year 1, blue fox company loaned 100,000 dollars to star shine company (principal) by creating a note with a 12 percent interest rate and a maturity date of 1 year, or September 30 year 2. What was the journal entry for bluefox on this date?

On the day the loan was made, Bluefox company's journal entry included a debit to note receivable for 100,000 dollars and a credit to cash for 100,000 dollars. Overall, total assets remained unchanged.

What is made on the day the note is established?

On the day the note is established, a debit is made to note receivable and a credit is made to cash. Overall, total assets are unchanged as one asset, note receivable is swapped for another, cash

What can a low turnover ratio be?

On the other hand, a low turnover ratio can be a warning sign suggesting the company is allowing too much time for customers to pay.

Let's assume a check in the amount of 800 dollars is received from this customer. This recovery is accounted for in two parts. what two methods are used to estimate bad debt expense?

One based on the percentage of credit sales for the period and another based on the aging of accounts receivable.

Even though all cash for interest will be received the next year on the maturity date, what does accrual accounting require?

Remember, even though all cash for interest will be received the next year on the maturity date, accrual accounting requires that revenues are recorded in the period they are earned, regardless of when cash is received.

What are bad debt costs incurred from?

Second, bad debt costs are incurred from customers simply not paying what they owe.

What are the additional costs of extending credit?

The additional costs of extending credit include increased wage costs, bad debt costs, and delayed receipt of cash

What does the adjusting journal entry in number 1 do?

The adjusting entry (in number 1) reduces Net Income as well as net accounts receivable.

What will the adjusting journal entry on december 31 year 1 include?

The adjusting journal entry on December 31, year 1, will include a debit to interest receivable of 3,000 dollars and a credit to interest revenue of 3,000 dollars.

How does the aging method get its name?

The aging method gets its name because it is based on the age of each amount in accounts receivable.

What is the two step process for the allowance method?

The allowance method follows a two step process: 1. Record the estimated bad debts in the period credit sales occur, using an end-of period adjustment 2. Remove (that is, write-off) specific customer balances when they are known to be uncollectable.

Assume 17,240 dollars is the total amount estimated to be uncollectible. In other words, this is the desired ending balance in the allowance for doubtful accounts. Also, assume there is a credit balance of 2,000 dollars in allowance for doubtful accounts. What is teh amount of bad debt expense recognized?

The amount of bad debt expense recognized will then be 15,240 dollars or the difference between the desired ending balance of 17,240 dollars and the existing credit balance of 2,000 dollars.

What is the bottom line in this case?

The bottom line is some customers will not pay their bills and bad debt results.

What does the business promise to do in this situation?

The business fulfills its promise to transfer control of a good or service to the customer, an account receivable arises, and the customer later pays the amount owed. Unfortunately, collecting cash from 100 percent of credit sales made is not always the case.

Why is the credit of 3,000 dollars to interest receivable required?

The credit of 3,000 dollars to interest receivable is required because Bluefox company is now receiving cash for the interest revenue accrued in the prior year.

What is the credit of 9,000 dollars based on?

The credit of 9,000 dollars to interest revenue is based on nine months of interest earned in the current year.

What is the days to collect ratio then?

The days to collect is then 45.6 days, so it took an average of 45.6 days from sale on account to collection.

How is the days to collect receivables computed based on?

The days to collect receivables is computed based on 365 days in a year divided by the receivables turnover ratio

How is the days to collect receivables computed?

The days to collect receivables is computed by dividing 365 by the receivables turnover ratio

What will the final journal entry prepared by bluefoc company include?

The final journal entry prepared by Bluefox Company will include a debit to cash and a credit to note recievable for 100,000 dollars, which was the original amount loaned.

What is the first entry?

The first is a debit to cash based on the total amount of interest revenue received, a credit to interest revenue based on interest accrued in the current year, and a credit to interest receivable, based on the amount of interest accrued in the prior year

What is the fourth and final journal entry for a note receivable?

The fourth and final journal entry for a note receivable is recognize collection of the principal: Cash is debited and note receivable is credited equal to the principal amount

What is the most obvious disadvantage to extending credit to customers?

The last and most obvious disadvantage to extending credit to customers is that there will be a delay in cash collections.

What happens the older and more overdue an account receivable becomes?

The older and more overdue an account receivable becomes, the less likely it is to be collectible.

What is the only difference?

The only difference is the way in which bad debt expense is calculated.

How does the percentage of credit sales method compare to the aging of accounts receivable method?

The percentage of credit sales method is simpler to apply, but the aging of accounts receivable method uses more detailed data and therefore is generally more accurate. Whereas the percentage of credit sales method focuses on estimating this period's bad debt expense, the aging of accounts receivable method focuses on estimating the allowance for doubtful accounts ending balance.

What two measures are commonly used by managers?

The receivables turnover ratio and the days to collect receivables are two measures commonly used by mangers, directors, investors, and creditors to determine the effectiveness of a company's credit granting and collection activities.

How is the receivables turnover ratio computed?

The receivables turnover ratio is computed by taking net sales revenue divided by the average net receivables.

What does the receivables turnover ratio measure?

The receivables turnover ratio measures the effectiveness of credit-granting and collection activities.

What is the total cash received equal to?

The total cash received is equal to last year's interest revenue of 3,000 dollars or 3 months of interest revenue, plus the current year's interest revenue of 9,000 dollars, or the remaining nine months of interest revenue recognized in the year of maturity

Let's assume that Blue fox Company reports net sales revenue of 400,000 dollars and average net receivables of 50,000 dollars for the current year. what does this result in a receivables turnover ratio of?

This gives a receivables turnover ratio of 8, meaning accounts receivable turned over 8 times during the year.

What does it become clear throughout the year?

Throughout the year, when it becomes clear that some or all of the customers' has virtually no chance of collection, the amount that is deemed uncollectible is removed from accounts receivable.

Which ratios are better in collecting receivables?

To collect receivables, the higher the receivables turnover ratio, the better and the lower the days to collect receivables, the better.

While the receivable turnover ratio calculates the number of times receivables turnover during the year, what is it often more useful to compute?

While the receivable turnover ratio simply calculates the number of times receivables turnover during the year, it is often more useful to compute the number of days it takes to collect accounts receivable.

What does the ability to generate additional revenue do to the risks and potential costs in extending credit?

While there are certainly risks and potential costs involved in extending credit, generally the ability to generate additional revenues through credit sales outweighs these.

What are you directly assessing with this method?

With this method, you are directly assessing the amount of accounts receivable you expect to be uncollectible as a function of how long the amounts have been outstanding

If we compare this data to another company, what would an average days to sell of 40 be considered?

an average of 40 days to collect receivables would be more desirable than an average of 45.6 days.

What does the receivables turnover ratio indicate?

at the receivables turnover ratio, which indicates how many times on average, the process of selling and collecting is repeated during the period.

Increased by a debit

bad debt expense

What is the simpler approach?

calculating bad debt expense by taking the total credit sales for the period multiplied by the percentage estimated to be uncollectible based on past experience.

Bellows Company uses the allowance method to account for uncollectible accounts. After making a concerted effort, bellows' management determined that it will not be able to collect the 1200 dollars owed to it by its customer Acme Inc. Prepare the appropriate journal entry to record the receivable write-off

debit allowance for doubtful accounts for 1200 and credit accounts receivable for 1200

EX: Broadway Company reported a balance in accounts receivable of 50,000 dollars and a zero balance in the allowance for doubtful accounts. The company's aging of accounts receivable determined 12,200 dollars to be uncollectible Prepare the end of period adjusting entry to record bad debt expense

debit bad debt expense for 12,200 dollars and credit allowance for doubtful accounts for 12,200 dollars

Knelling company reported a balance in accounts receivable of 50,000 dollars and a credit balance of 3,000 dollars in the allowance for doubtful accounts. The company's aging of accounts receivable determined 12,000 dollars to be uncollectible. Prepare the end-of-period adjusting entry to record bad debt expense

debit bad debt expense for 9000 dollars and credit allowance for doubtful accounts for 90000 dollars

What happens the faster the collection of receivables?

the faster the collection of receivables, the shorter the company's operating cycle, which means more cash available for running the business.