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CH. 7 Reporting and Analyzing Receivables Accounts receivable- are amounts due from customers for credit sales. Credit sales are recorded by increasing (debiting) accounts receivable. General ledger- has a single Accounts Receivable account called a control account. A company uses a separate account for each customer to track how much that customer purchases, has already paid, and still owes. A supplementary record has a separate account for each customer and is called the accounts receivable ledger or accounts receivable subsidiary ledger. Does not predict bad debts expense. Direct write-off Accounts receivable on the balance sheet is reported at net realize value. Allowance The write-off of a specific account does not affect net income. Allowance When an account is written off, the debit is to Bad Debts expense. Direct write-off Usually does not best match sales and expenses because bad debts expense is not recorded until an account becomes uncollectible, which usually occurs in a period after the credit sale. Direct write-off Estimates bad debts expense related to the sales recorded in that period. Allowance Companies are forced to sell to customers on account to remain competitive. If they had a choice they would demand a payment at the time of the sale, but if their competitors offer the “on account” option, they have no choice but offer it as well. The biggest issue is that some of the customers that promised to pay later may never pay. The consequence is that the company shows a number for receivable greater than the cash they will collect, and they are facing an additional expense (they gave goods that never received payment for). These facts should be reflected on the financial statements otherwise the users of the financial statements will be misled. The most common reason to have Accounts Receivable on the books is when a sale is made or service is provided on account. In this case we need to debit the asset Accounts Receivable account to increase it and credit a revenue account. As the payment is collected, Cash account is debited and Accounts receivable account is credited to record the fact that the future amounts to be received from customers have decreased. (These entries are shown in Exhibit 7.3 on page 268.)

Credit Card Sales The company may also accept a credit card payment. In doing so they remain competitive, receive the payment sooner, and eliminate the risk of non- payment. The downside is that they have to pay a fee for the service. The company may receive the cash immediately (nearly all debit cards work this way) or they may have to submit documentation and receive the cash in a matter of days (depending on the credit card company’s terms). The journal entries to handle credit card sales are shown on page 268-269. In the entry for a bank card there is a fee charged by the credit card company for their services. In the example on page 305 the fee is 4% of the sale amount or $4 (100*.04). The credit card fee is an expense and comes out of the sales amount so when the credit card company pays the company they only give them the sale amount less the credit card fee $96 ($100-$4). Valuing Accounts Receivable There are two methods to account for uncollectible accounts for the companies that extend credit to their customers: . Direct write-off method – Page 269 This method records the additional expense for the company when it is evident that the customer has defaulted on the account. The company has exhausted all methods to force the customer to pay (letters, calls, collecting agencies, etc.) and only then records the following journal entry to write off a specific customers balance. (Also see the example on page 270) Account Title Debit Credit Bad Debt Expense $Actual uncollectible amount Accounts Receivable- Name of Customer $Actual uncollectible amount To write off an uncollectible account This method is easy and straight forward, but it fails to follow the matching principle – usually revenues are recognized in a different period then the expense for bad debt. For example, for a calendar year company, if a sale occurred in October, we may not determine that the customer is defaulting until February. This would mean that the revenue was recognized in the previous year and the expense in the following, even though they arise from the same transaction and they should be recognized in the same year. As a consequence, the total revenues for the Some companies are using the Direct Write-Off method even though it is not in accordance with GAAP. This is acceptable only when the amounts of bad debts are immaterial, and this distortion will have no significant effect on the overall financial picture of the company. And the direct write-off method is the only method acceptable on a company’s tax return.

previous year are overstated (making Net Income too high) and the expenses in the following year are overstated (making Net Income too low). As you can see the financial statements have been distorted under this method, which could lead to misinterpretation for those that use the financial statements to make decisions. This is why this method is not acceptable under GAAP. Notice the second entry on page 270 where the company has recovered a bad debt. This involves two entries. The first entry reverses (does the opposite of) what was done to write the customer off. The second entry shows the customer paid just we would have done back in chapter 2, etc. Allowance method – P. 271-277 This method is the GAAP approved method. The problems of the previous method are eliminated and we achieve the matching requirement of the accrual basis of accounting – bad debt expense is recognized in the period the sale is made. This way our financial statements are not misleading. This is achieved by making an estimation of the amount of the bad debt expense for the period and is recorded as an adjusting entry at the end of the period. We will learn two ways of estimating the bad debts: 1) Percentage of Sales Method (Income Statement Method) and 2) Percentage of Receivables Method (Balance Sheet Method) Recording Bad Debt Expense (Estimating Bad Debt) The Allowance Method will include more steps than the Direct Write-Off Method. The first entry is to estimate the bad debts. Notice is takes place before we actually have a customer’s name to associate with the amounts of receivables that won’t be collected so we create a new account, Allowance for Doubtful Accounts to put these estimated bad debts (instead of crediting A/R like we did with the Direct Write-Off Method). Account Title Debit Credit Bad Debt Expense $ estimated bad debts Allowance for Doubtful accounts $ estimated bad debts To record estimated bad debts When it comes to the estimation of the bad debt amount, companies can choose between two allowance methods: a) Percentage of Sales or b) Percentage of Receivables (Aging of Receivables). Now we will continue looking at the Allowance Method’s other journal entries and come back to how we calculate the estimate when we get to page 273. Allowance for Doubtful Accounts is a new account that we have not used before. It is a contra asset account. It has a normal credit balance, it is a permanent account (we do not close it at the end of the period), and always accompanies the Accounts Receivable account on the balance sheet. The balance of the Allowance for Doubtful Accounts decreases the balance of the Accounts Receivable account to arrive at Realizable Value. Realizable Value signifies how much the company is expecting to actually collect from their customers. You can see an example of the Balance Sheet presentation on page

272, exhibit 7.5. The way we can read these numbers is: Credit sales have been made for $20,000, the company estimates that $1,500 are never to be collected, so the actual amount of cash to be received is expected to be $18,500. Writing off a Bad Debt Journalize the writing off of an actual Bad Debt, not an estimate, we need to decrease the amount out of the Allowance for Doubtful Accounts and decrease the Accounts Receivable. The adjusting entry would be: Account Title Debit Credit Allowance for Doubtful Accounts Balance owed by the customer that we will never receive Accounts Receivable – Name of Customer Balance owed by the customer that we will never receive Recovering a Bad Debt In rare occasions some customers that were written off the books, do send a payment. In the case of a recovered Bad Debt , we need to reinstate the customer’s receivable and the Allowance for Doubtful Accounts account - basically a reverse of the entry above - and then record the receipt of the payment. The two journal entries are as follows: Account Title Debit Credit Accounts Receivable – Name of Customer Amount of payment Allowance for Doubtful Accounts Amount of payment Cash Amount of payment Accounts Receivable Amount of payment Now we will go into more depth of how we calculate the amount of estimated bad debts. Remember w e have two ways of estimating the bad debts: 1) Percentage of Sales Method (Income Statement Method) or 2) Percentage of Receivables Method (Balance Sheet Method) Notice we are still under the allowance method. We’re looking at how we came up the first journal entry where we estimated the bad debt expense. a) Percentage of Sales Method (Income Statement Method) The bad debts amount is calculated by multiplying the company’s credit sales by a percentage representing an estimate of uncollectible sales . This estimate percentage is determined by a thorough analysis of past sales and the relation to uncollected sales. If there are new trends or influences they will be factored in this percentage as well. See the example on page 273 where they say the sales are $400,000 and they estimate that .6% of credit sales to be uncollectible. To find the amount to record for estimated bad debts they multiply $400,000 x .006 which equals $2,400 and they make the entry below. The key is that this is a one step process—multiply and you have the number for your journal entry.

The adjusting entry would be: Account Title Debit Credit Bad Debt Expense $ credit sales X % of est. uncollectible sales Allowance for Doubtful Accounts $ credit sales X % of est. uncollectible sales b) Percentage of Receivables Method (Balance Sheet Method) The bad debts here are calculated either by applying an average percentage of the total Accounts Receivable (as they do on page 273 (50,000 x 5%), or applying an explicit percentage on every age group of the Accounts Receivable (aging Accounts Receivable). An example of schedule of aging Accounts Receivable is illustrated on page 274, Exhibit 7.8. Note how the receivables are divided into groups based on their due date: “Not Yet Due” (the sale has just occurred and the due date of the bill is still in the future), “1 to 30 days past due”, ..., “Over 90 Days Past Due”. Each of these groups has its own estimated uncollectible percentage. Note how the older the receivable gets the higher the percentage increases. These estimated percentages are based on the company’s past experience, but any new practices or industry/economy specifics may be factored in as well. The percentage values will be part of the premises of the problem (you wouldn’t be required to estimate them; you just need to know how to use them). Both methods are acceptable, but the aging receivables method is more accurate. The main objective of the percentage of receivables method is to make the Allowance for Doubtful Accounts balance equal the number that we just discussed how to be calculated in the previous paragraph. This method will include two steps . The key is that with this calculation you established what the adjusted balance in the Allowance for Doubtful Accounts account should be, and there is a second step to calculate the amount for the adjusting entry for Bad Debts. The amount for the adjusting entry will be influenced by the beginning balance in the Allowance for Doubtful Accounts account. Step 1 calculates Let’s take a look at the example the Estimated balance using the aging schedule on pg. 274. in the Allowance for The Allowance for Doubtful Doubtful Accounts Accounts needs in to have an estimated balance in of $2,270 (See Exhibit 7.8 page 274.) Notice the $2,270 is the sum of the columns to the right of it (740+325+370+475+360).

The second calculation, or the second step of the process, calculates the amount for the adjusting entry. See below: Allowance for Doubtful Accounts Unadj Bal. $200 Let’s assume that the balance before adjustments is $200 credit balance. In order to bring this account to the desired Req. Adj . $2,070 balance we need to increase it by the difference of the Est. Bal. and unadjusted balance or 2,070 ($2,270-$200). This increase is the required adjustment amount that we need to use for the adjusting entry for Bad Debts. Allowance for Doubtful Accounts Let’s assume that the balance before adjustments is $500 debit balance. In order to bring this account to the desired Req. Adj . $2,770 Estimated Balance we need to increase it by the sum of the Estimated Balance and unadjusted balances $2,270+$500, or 2,770. Note that we need to add more to compensate for the Est. Bal. $2,270 debit balance in the account because it has a normal credit balance. Allowance for Doubtful Accounts Est. Balance, $2,270 Allowance for Doubtful Accounts Unadj. Bal $500 This is what the journal entries would look like: First scenario, when the unadjusted balance in the Allowance for Doubtful Accounts was a $200 credit: Second scenario, when the unadjusted balance in the Allowance for Doubtful Accounts was a $500 debit: Bad Debt Expense $2,070 Bad Debt Expense $2,770 Allowance for Doubtful Accounts $2,070 Allowance for Doubtful Accounts $2,770 Note that the accounts affected by the adjustment are the same for each method – both Percentage of Sales and Percentage of Receivables, only change how we calculate the amount for the adjusting entry. Unadjusted Balance in the Allowance for Doubtful Accounts. You may wonder how it is possible to have a debit unadjusted balance in the Allowance for Doubtful Accounts. To answer this question let’s look what affects this account: Adj. Bala $2,270 , this is the adjusted balance that we start with in the new Actual accounting period. As time passes by , we discover which of our customers is not going to pay us and we would deduct these actual uncollectible accounts from the Allowance for Doubtful Accounts account, or we will debit it. At the end of the new year if we had estimated more than the Actual write-offs, we will end up with a credit balance. Write-off are debited. If we write off more than we anticipated, we will end up with a debit balance . If we write off less than we anticipated, we will end up with a credit balance. Summary of Direct Write-off Method and allowance Method Direct Write- off Method Allowance Method Ch. 7 text book questions The advantages of using the allowance method to account for bad debts include which of the Matches expenses with related sales; Reports accounts receivable balance at net realizable value

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