Chapter 5

Common Mistake

Students often mistakenly record bad debt expense when they write off an uncollectible account. The bad debt expense was recorded in a prior year at the time of estimating uncollectible accounts.

Common Mistake

Students sometimes misclassify contra revenue accounts—sales returns and sales allowances—as expenses. Like expenses, contra revenues have normal debit balances and reduce the reported amount of net income. However, contra revenues represent reductions of revenues, whereas expenses represent the separate costs of generating revenues.

Average Collection Period

365/accounts receivable turnover

Common Mistake

Because Allowance for Uncollectible Accounts has a normal credit balance, students sometimes misclassify this account as a liability, which also has a normal credit balance. Instead, this contra asset represents a reduction in a related asset account.

Collection of Accounts Previously Written Off

Collection has no effect on total assets or net income

how do credit sales work

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.

Aging Method

Considers the age of receivables Older accounts are more likely uncollectible More accurate than using a single percentage 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.

Key Point

The receivables turnover ratio and average collection period can provide an indication of management's ability to collect cash from customers in a timely manner.

Key Point

Writing off a customer's account as uncollectible reduces the balance of accounts receivable but also reduces the contra asset—allowance for uncollectible accounts. The net effect is that there is no change in the net receivable (accounts receivable less the allowance) or in total assets.

Accounts Receivable

•Cash owed to the company by its customers from sales or services on account •Recorded at the time of the sale or service •Also called trade receivables

Establishing an Allowance for Uncollectible Accounts

Bad Debt Expense Expense reported in the income statement Allowance For Uncollectible Accounts Contra asset reported in the balance sheet Reduces the balance of accounts receivable

When an entry is made to write off an uncollectible account,

Overall, the write-off of an account receivable has no effect on total assets reported in the balance sheet or total expenses in the income statement.

Allowance Method in the Following Year

Recall that using the aging method, Kimzey estimated bad debts at the end of 2021 to be $6 million (future write-offs of $6 million) Actual bad debts were only $4 million (write-offs in 2022). In other words, the year-end 2021 amount was overestimated by $2 million Using the aging method, Kimzey estimated bad debts at the end of 2022 to be $7 million How does Kimzey record its $7 million estimate of future bad debts at the end of 2022?

Note Receivable

Similar to accounts receivable but include a written debt agreement, or note Normal debit balance Classified as either current or noncurrent asset depending on time until due date

Common Mistake

Some students erroneously think firms should reduce total assets and record bad debt expense at the time the bad debt actually occurs. However, companies anticipate future bad debts and establish an allowance for those estimates.

On December 31 before adjusting entries, a company's balance of Allowance for Uncollectible Accounts is a credit of $2,000. What does a "credit" balance prior to adjusting entries indicate?

The Allowance for Uncollectible Accounts is a contra account with a credit balance. The balance is reduced (debited) for actual bad debts. If the account balance at the end of the year is a credit, then estimated bad debts for this year are greater than this year's actual bad debts.

Which of the following is true regarding Allowance for Uncollectible Accounts?

The allowance account is a contra asset and is used to record estimated future uncollectible accounts. The balance is subtracted from Accounts Receivable in the balance sheet to arrive at Accounts Receivable's carrying value.

The effect of a sales allowance will result in which of the following:

The effect of a sales allowance is to decrease net income. A sales allowance decreases sales revenue in the income statement. A sales allowance also decreases assets by decreasing the balance of accounts receivable.

is a note a long term asset

note is a long term asset if it is to be collected in more than a year, else its short term

how is percentage of recievables different from percentage of credit sales when it comes to the balance sheet adjustment?

the percentage of recievables adjustment adjusts the allowance account so its ending balance is equal to the new estimate for uncollectibles while the percentage of credit sales adjustment simply adds the new estimate of uncollectibles on top of the previous amount within that account

Percentage-of-Credit-Sales Method

•Estimates uncollectible accounts based on the percentage of credit sales qAlso called the income statement method •Adjusts the allowance for uncollectible accounts for the current year's credit sales that we don't expect to collect

Other Types of Receivables

•Nontrade receivables: receivables that originate from sources other than customers qTax refund claims, interest receivable, and loans by the company to other entities, including stockholders and employees •Notes receivable: formal credit arrangements evidenced by written debt instruments (or "notes")

Receivables Turnover Ratio

•Number of times during a year the average accounts receivable balance is collected

Sales Discounts

•Offer a customer a reduction if payment is made within a specified period of time Sales Discounts = Contra revenue account Reported with total revenues in the income statement, but with a negative balance

Trade Discounts

•Reduction in list price of a product or service qUsed to provide incentives to larger customers or certain consumer groups (senior citizens, military) qRecognized by recording revenue for lower amount •Example: typical price for eye surgery is $3,000. Eye doctor runs a "special" for $2,400 by offering trade discount of $600.

Allowance Method (GAAP)

•Some accounts receivable will not be collected •Companies are required to: qEstimate future uncollectible accounts qRecord estimates in the current year •Estimated uncollectible accounts qReduce assets (accounts receivable) qIncrease expenses (bad debt expense)

Credit Sales

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

Writing Off Accounts Receivable

•When it becomes clear a customer will not pay, the company writes off the customer's account balance as uncollectible •The write-off: qReduces the balance of Accounts Receivable qReduces the balance of the Allowance for Uncollectible Accounts •The write-off has no effect on total assets (balance sheet) or total expenses (income statement) •Negative effects of bad debts were recorded in an adjusting entry at the end of the previous year.

Direct Write-Off Method (Not GAAP)

•Write off bad debts only at the time they actually become uncollectible qUnlike the allowance method, which requires estimation of uncollectible accounts before they even occur •Used: qWhen uncollectible accounts are not anticipated or are immaterial qPrimarily used for tax reporting

Sales Allowances

••Customer does NOT return a product (a) Seller issues a cash refund if original sale was for cash (b) Seller reduces balance of accounts receivable if original sale was on account

Sales Return

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