Chapter 5: Measuring and Reporting Receivables.

Question 1

Classifying Receivables

Answer 1

Receivables can be classified in three common ways:

Current or Non-current: Depending on whether the cash is expected to be collected within one year of the statement date.

Account Receivable or Note Receivable:
Account Receivable: Created from sales on open account or when a company expects payments from parties it has fulfilled obligations to.
Note Receivable: A written promise by another party to pay a specified principal and interest at a future date.

Trade or Non-trade Receivables:
Trade Receivables: Open accounts owed by trade customers from sales of merchandise or services on credit.
Non-trade Receivables: Arise from transactions other than normal sales, such as insurance claims.

Question 2

Account Receivable

Answer 2

An account receivable is created when there is a sale of products and services on open account to customers or when a company expects to receive payments from other parties to whom the company has already fulfilled obligations or contracted for benefits.

Question 3

Note Receivable

Answer 3

A note receivable is a written promise made by another party to pay the company a specified amount of money (principal) at a definite future date (maturity date) and a specified amount of interest at one or more future dates.

It represents a contractual right to receive cash from debtors in the future.

Question 4

Trade Receivables

Answer 4

Trade receivables are open accounts owed to the business by trade customers and result from the normal sale of merchandise or services on credit within the course of business.

Question 5

Non-trade Receivables

Answer 5

Non-trade receivables arise from transactions other than the normal sale of merchandise or services.

For instance, insurance claims that result in reimbursement from insurance companies can be classified as non-trade receivables.

Question 6

Foreign Currency Receivables

Answer 6

Foreign currency receivables refer to accounts receivable denominated in currencies other than the company’s home currency.

In international sales, when buyers agree to pay in their local currency instead of the seller’s currency, accounts receivable must be converted into the seller’s home currency using the end-of-period exchange rate.

Question 7

End-of-Period Exchange Rate

Answer 7

The end-of-period exchange rate is the exchange rate between two currencies at the end of a specific period, such as a fiscal year.

It is used to convert foreign currency receivables into the company’s home currency for financial reporting purposes.

Question 8

Exchange Gain/Loss

Answer 8

An exchange gain or loss occurs when the value of a foreign currency changes between the transaction date and the date of settlement.

If the foreign currency appreciates, there is an exchange gain; if it depreciates, there is an exchange loss.

These gains or losses are reported on the company’s financial statements, impacting its overall financial performance.

Question 9

Uncollectible Accounts Receivable (Bad Debts)

Answer 9

Uncollectible accounts receivable, also known as bad debts, refers to the portion of accounts receivable that a company does not expect to collect from its customers.

These uncollectible amounts need to be estimated, recorded, reported, and evaluated to accurately reflect the company’s financial position.

Question 10

Credit Policies

Answer 10

Credit policies involve the guidelines set by a company regarding the extension of credit to customers.

These policies balance the potential increase in sales revenue with the risk of bad debts.

Restrictive policies may reduce bad debts but can lead to lost sales, while liberal policies may increase sales but raise the risk of uncollectible accounts.

Question 11

Allowance Method

Answer 11

The allowance method is an accounting technique used to estimate and record uncollectible accounts receivable.

It involves creating an allowance for doubtful accounts based on an estimate of expected bad debts.

This method ensures that bad debt expenses are recognized in the same accounting period as the related sales, adhering to the expense recognition principle.

Question 12

Prudence Principle

Answer 12

The prudence principle, also known as conservatism, guides accountants to be cautious when making estimates.

In the context of bad debts, it involves deducting the estimated amount of uncollectible accounts from the ending balance of accounts receivable.

This approach ensures that financial statements reflect a more conservative and realistic view of the company’s financial position.

Question 13

Net Realizable Value

Answer 13

Net realizable value represents the estimated amount a company expects to receive from its accounts receivable after accounting for uncollectible accounts.

It is calculated by deducting the estimated bad debts from the total accounts receivable.

This adjusted amount is reported on the statement of financial position, providing a more accurate representation of the company’s receivables’ true value.

Question 14

Write-Off of Doubtful Accounts

Answer 14

The write-off of doubtful accounts occurs when a specific customer is deemed unable to pay its debt, often due to bankruptcy or other financial issues.

This action involves removing the individual uncollectible receivable from the accounts receivable account and adjusting the allowance for doubtful accounts accordingly.

Question 15

Journal Entry Process for Uncollectibles

Answer 15

A journal entry is a formal accounting record of a business transaction.

When a specific account receivable is identified as uncollectible, a journal entry is made to reflect the write-off.

This entry removes the uncollectible amount from the accounts receivable and adjusts the allowance for doubtful accounts.

Question 16

Allowance for Doubtful Accounts

Answer 16

Allowance for doubtful accounts is a contra-asset account containing the estimated uncollectible accounts receivable.

When a specific account is written off, the corresponding amount in the allowance for doubtful accounts is no longer needed and should be removed, ensuring accurate reporting of the company’s financial position.

Question 17

Impact on Financial Statements (Writing off doubtful accounts)

Answer 17

Writing off specific doubtful accounts does not affect statement of earnings accounts since estimated bad debt expenses were already recorded with an adjusting entry.

Additionally, this action doesn’t change the carrying amount of accounts receivable, as the decrease in the asset account is offset by an equal decrease in the contra-asset account, maintaining the total assets unchanged.

Question 18

Individual Bad Debts

Answer 18

Individual bad debts are specific accounts receivable identified as uncollectible during the accounting period.

These accounts are written off individually when it is determined that the customer will not pay its debts, ensuring accurate financial reporting and reflecting the actual financial position of the company.

Question 19

Recovery of Bad Debts

Answer 19

Recovery of bad debts occurs when a customer previously deemed uncollectible makes a payment on their written-off account.

This process involves reversing the initial write-off entry and recording the cash collection.

The recovered amount is reinstated in accounts receivable to reflect the customer’s payment.

Question 20

Journal Entry Reversal

Answer 20

When a customer pays on a previously written-off account, the initial write-off entry is reversed.

This reinstates the receivable amount in the accounts receivable ledger.

The reversal ensures that the company’s records reflect the customer’s payment accurately.

Question 21

Recording Collection of Cash

Answer 21

After the journal entry reversal, another entry is made to record the collection of cash from the customer.

This entry reflects the actual receipt of funds and ensures accurate accounting of the cash inflow.

Question 22

Net Effect on Accounts Receivable

Answer 22

The net effect of the recovered amount on accounts receivable is zero.

Although the account is temporarily reinstated for the recovered amount, the subsequent cash collection offsets this reinstated amount, resulting in no net change in the accounts receivable balance.

Question 23

Impact on Financial Statements

Answer 23

The journal entries related to the recovery of bad debts, like the original write-off entries, do not affect total assets or net earnings.

The recovery process only reflects the accurate status of accounts receivable and the collection of cash, ensuring the company’s financial statements remain reliable.

Question 24

Accounting for Bad Debts: Three Steps

Answer 24

Question 25

Accounts Receivable (Gross)

Answer 25

Accounts receivable (gross) refers to the total amount of accounts receivable recorded on a company’s balance sheet.

It includes both collectible and uncollectible amounts before any adjustments for estimated bad debts.

Question 26

Allowance for Doubtful Accounts

Answer 26

The allowance for doubtful accounts is the portion of the accounts receivable balance that a company estimates to be uncollectible.

It is a contra-asset account that represents the estimated bad debts, reducing the net realizable value of accounts receivable.

Question 27

Accounts Receivable (Net)

Answer 27

Accounts receivable (net) is the portion of accounts receivable that a company expects to collect, also known as its estimated net realizable value.

It is the gross accounts receivable balance minus the allowance for doubtful accounts.

This figure represents the company’s anticipated cash inflow from receivables.

Question 28

Estimated Net Realizable Value

Answer 28

Estimated net realizable value is the amount a company expects to collect from its accounts receivable after accounting for estimated uncollectible accounts.

It reflects the realistic value of accounts receivable and is calculated by deducting the allowance for doubtful accounts from the gross accounts receivable balance.

Question 29

Usefulness for External Users

Answer 29

Details about accounts receivable (gross), the allowance for doubtful accounts, and accounts receivable (net) are valuable for external users of financial statements.

These details help external stakeholders assess the quality of a company’s receivables, providing insights into the likelihood of collection and the company’s financial health.

Question 30

Estimating Bad Debts

Answer 30

Estimating bad debts involves predicting the amount of uncollectible accounts receivable that will arise during a specific period.

This estimation is crucial for accurate financial reporting and is typically done using methods like the percentage of credit sales or aging of accounts receivable.

Question 31

Percentage of Credit Sales Method

Answer 31

The percentage of credit sales method estimates bad debt expense based on a historical percentage of credit sales that result in bad debts.

The calculation involves dividing total bad debts by total credit sales.

This method provides a straightforward estimate of the current period’s bad debt expense.

Question 32

Aging of Accounts Receivable

Answer 32

Aging of accounts receivable is a method of estimating bad debts that categorizes accounts by the length of time they have been outstanding.

Older accounts are considered more likely to be uncollectible.

This method provides a more accurate estimate by considering the aging patterns of receivables.

Question 33

Simpler vs. More Accurate Methods

Answer 33

Companies often use simpler methods like percentage of credit sales on a frequent basis (weekly or monthly) for quick estimates. More accurate methods like aging analysis are applied less frequently (monthly or quarterly) to validate the accuracy of earlier estimates. Striking a balance between simplicity and precision is key in estimating bad debts.

Question 34

Importance of Historical Data

Answer 34

Historical data on bad debts are vital for estimating future uncollectible accounts.

A company’s past experience, especially with established customers, helps project probable future bad debts.

This historical perspective informs the estimation process, ensuring a more informed prediction of bad debt expenses.

Question 35

Aging of Accounts Receivable Method

Answer 35

The aging of accounts receivable method estimates uncollectible accounts based on the age of each receivable.

Older, overdue accounts are considered less likely to be collectible.

The method categorizes receivables into age categories, assigning different bad debt rates to each category.

This approach provides a more accurate estimate of uncollectible amounts.

Question 36

Age Categories

Answer 36

Receivables are split into age categories (e.g., not yet due, 1-30 days past due, 31-60 days past due, etc.).

The probability of collection decreases as receivables become older and overdue. Different bad debt rates are applied to each category to estimate the likelihood of non-payment.

Question 37

Estimating Uncollectible Amounts

Answer 37

The aging schedule calculates the estimated uncollectible amounts based on the bad debt rates assigned to each age category.

The total uncollectible amount is determined from the aging schedule, providing the basis for the adjustment to the allowance for doubtful accounts.

Question 38

Adjustment Calculation

Answer 38

The adjustment to record bad debt expense and increase the allowance for doubtful accounts is computed by comparing the estimated ending balance from the aging schedule with the current balance in the allowance account.

The adjustment ensures that the allowance reflects the estimated uncollectible amounts based on the aging analysis.

Question 39

Three-Step Process

Answer 39

The aging of accounts receivable method involves a three-step process:

categorizing receivables into age categories,

applying appropriate bad debt rates to each category,

and calculating the adjustment by comparing the estimated ending balance in the allowance for doubtful accounts with the current account balance.

This method provides a detailed and accurate estimation of uncollectible accounts.

Question 40

Comparison of Methods: Percentage of Credit Sales

Answer 40

The percentage of credit sales method computes the bad debt expense directly for the period.

It involves determining the estimated bad debts as a percentage of total credit sales and recording this amount as an adjusting entry for the period.

Question 41

Comparison of Methods: Aging of Accounts Receivable

Answer 41

The aging of accounts receivable method computes the estimated ending balance of the allowance for doubtful accounts.

The difference between the current balance in the account and the estimated balance is recorded as the adjusting entry for bad debt expense for the period.

This method considers the aging of individual accounts for a more precise estimation.

Question 42

Gildan’s Disclosure: Aging of Accounts Receivable

Answer 42

Gildan disclosed its accounts receivable aging analysis in its annual report.

The report showed that as receivables age, the likelihood of collection decreases. Receivables due within 30 days have a higher probability of collection, while those beyond 121 days have a very doubtful collectibility.

Such disclosures aid shareholders, lenders, and analysts in assessing potential future impairments of accounts receivable.

Question 43

Impact of Economic Factors: Increase in Allowance

Answer 43

Gildan’s increase in the allowance for doubtful accounts from $7.2 million in 2019 to $19.0 million in 2021 reflects the adverse economic impacts of the COVID-19 pandemic.

Economic uncertainties led to concerns about the financial viability of some customers, necessitating a higher allowance to account for potential uncollectible amounts.

Question 44

Importance for Stakeholders

Answer 44

Details provided by Gildan about the aging of accounts receivable and the increase in the allowance for doubtful accounts offer valuable insights to shareholders, lenders, and analysts.

This information helps these stakeholders assess the financial health of the company, anticipate potential losses, and make informed decisions regarding their investments or credit relationships.

Question 45

Actual Write-offs vs. Estimates

Answer 45

The actual amount of uncollectible accounts written off may differ from the estimated amount previously recorded.

Discrepancies between estimates and actual write-offs are taken into consideration when determining bad debt expenses for the next accounting period.

However, past financial statement values are not retroactively corrected due to these discrepancies.

Question 46

Prudence in the Valuation of Accounts Receivable

Answer 46

Prudence involves exercising caution and making judgments under conditions of uncertainty.

Managers and accountants are responsible for safeguarding business assets.

Prudent credit policies, reflecting stakeholders’ preferences, help avoid overstatement of revenue and assets (like receivables) and understatement of liabilities and expenses (such as bad debts).

Prudent measures, including a larger allowance for doubtful accounts, provide a more accurate reflection of accounts receivable’s actual value.

Question 47

Legal Duty of Care

Answer 47

Managers have a legal duty of care to make decisions based on expertise, experience, and the best available information.

This responsibility includes implementing prudent credit policies, which align with stakeholders’ preferences, to ensure the safeguarding of assets and accurate financial reporting.

Question 48

Accountants’ Professional Duty of Care

Answer 48

Accountants must exercise professional duty of care, skepticism, and judgment in alignment with the Professional Code of Conduct.

They investigate how well the reported accounts receivable align with the reasonably expected collection amounts.

Prudent assessment results in a larger allowance for doubtful accounts, covering potential losses and ensuring accurate financial reporting.

Question 49

Receivables Turnover Ratio

Answer 49

The receivables turnover ratio is computed by managers and analysts to assess the effectiveness of credit granting and collection activities.

This ratio helps measure how efficiently a company manages its accounts receivable by evaluating the frequency at which receivables are converted into cash, indicating the effectiveness of credit policies and collection efforts.

Question 50

Receivables Turnover Ratio

Answer 50

The receivables turnover ratio measures how many times average accounts receivable are recorded and collected during a specific period.

**It is calculated by dividing net credit sales (or net sales) by average net accounts receivable.
**
A higher ratio indicates faster collection of receivables.

Question 51

Average Collection Period

Answer 51

The average collection period, derived from the receivables turnover ratio, represents the average number of days required to collect accounts receivable once.

It is computed by dividing 365 days by the receivables turnover ratio, providing insight into a company’s efficiency in collecting receivables.

Question 52

Interpretation: Receivables Turnover Ratio

Answer 52

A higher receivables turnover ratio indicates faster collection of receivables, benefiting the company by enabling investment of cash for interest income or reducing borrowings and interest expenses.

A sudden decline in the ratio may signal extended payment deadlines or potentially inflated sales.

Analysts often compute the average collection period to assess customer payment trends.

Question 53

Focus Company Analysis: Gildan

Answer 53

Gildan’s receivables turnover ratio decreased from 10.38 in 2018 to 7.66 in 2020, reflecting a longer time to convert receivables into cash (from 35.2 days in 2018 to 47.7 days in 2020).

This shift was attributed to the financial challenges faced by customers during the COVID-19 pandemic.

Question 54

Cautions in Ratio Comparison

Answer 54

Differences in financing practices and industries can cause significant variations in receivables turnover ratios.

It’s essential to compare a company’s ratio with its own historical data and similar firms within the same industry to draw meaningful conclusions.

Comparisons across industries or dissimilar financing methods may not provide accurate insights into a company’s performance.

Question 55

Change in Accounts Receivable and Cash Flow

Answer 55

The change in accounts receivable significantly impacts a company’s cash flow from operations.

Sales on account increase accounts receivable, while cash collections from customers reduce it.

The change in accounts receivable from the beginning to the end of the period represents the difference between sales revenue and cash collections.

Question 56

Effect on Statement of Cash Flows: Net Decrease in Accounts Receivable

Answer 56

When there is a net decrease in accounts receivable, indicating that cash collected from customers exceeds revenue, the decrease is added to revenue or net earnings in the computation of cash flows from operations.

This adjustment reflects the excess cash collected during the period.

Question 57

Effect on Statement of Cash Flows: Net Increase in Accounts Receivable

Answer 57

In case of a net increase in accounts receivable, indicating that cash collected from customers is less than revenue, the increase is subtracted from net earnings when calculating cash flows from operations.

This adjustment compensates for the lower cash collected compared to sales revenue during the period.

Question 58

Focus Company Analysis: Gildan’s Cash Flow from Operations

Answer 58

In Gildan’s statement of cash flows for 2020, the decrease in trade accounts receivable led to a net increase in cash flow from operations.

The decrease in accounts receivable was added to net earnings because cash collected from customers exceeded the recorded revenue.

Conversely, when trade accounts receivable increased in 2019, the corresponding increase was subtracted from net earnings to calculate cash flow from operating activities due to lower cash collected than sales revenue.

Question 59

Internal Control

Answer 59

Internal control refers to the process implemented by a company’s board of directors, audit committee, management, and personnel to provide reasonable assurance that the accounting system minimizes the risk of fraud (both misappropriation of assets and material misstatement of financial information).

It also ensures the effectiveness and efficiency of operations and compliance with laws and regulations.

Question 60

Components of Internal Control

Answer 60

Internal control systems must prevent and detect both fraud and inadvertent material misstatements of a company’s financial position.

Accountants assess the effectiveness of these systems, evaluating their ability to safeguard assets, maintain accurate financial records, and comply with regulations.

Question 61

Regulations and Internal Control in Canada

Answer 61

Canadian scandals, such as those involving Nortel Networks Corp. and Livent Inc., led to regulations like National Instrument (NI) 52-109. This regulation mandates the CEO and CFO to sign Form 52-109F1, certifying the quality of the internal control system.

They attest to the reliability of financial reporting, adherence to accounting standards, and effectiveness of the internal control and financial reporting system. Annual reports must disclose deficiencies, related risks, and plans for remediation. While no audit is required, auditors may find it unusual if executives certify a deficient system.

Question 62

Executive Responsibility and Attestation

Answer 62

Executives, especially the CEO and CFO, are responsible for certifying the reliability of financial reporting, adherence to accounting standards, and the effectiveness of internal control systems.

They must also attest to the accuracy of disclosures made on Form 52-109F1. Any deficiencies in the internal control procedures, associated risks, and plans for correction must be disclosed in the annual report.

Question 63

Ethics and Internal Control

Answer 63

Strong internal control procedures are crucial for preventing fraud and theft within companies.

While the majority of employees are trustworthy, internal fraud remains a significant concern.

Weak internal control systems can provide opportunities for employees to rationalize criminal behavior, leading to financial losses for businesses.

The presence of a formal code of ethics and robust internal control procedures communicates management’s commitment to high ethical standards.

Question 64

PricewaterhouseCoopers 2020 Survey

Answer 64

In a 2020 survey by PricewaterhouseCoopers, 47 percent of global organizations reported experiencing economic crime in the previous two years.

**The main types of economic crime included customer fraud, cybercrime, asset misappropriation, bribery, corruption, and accounting fraud. **

The survey emphasized the significance of internal control validation over financial reporting and highlighted the financial impact of economic crimes.

Question 65

Role of Accountants in Assessing Internal Control

Answer 65

Accountants, particularly external auditors, play a vital role in assessing the strength of a company’s internal control system.

They identify weaknesses and communicate them internally to management.

If necessary, accountants act in the public interest, reporting suspected crimes to external authorities, and refusing to assure the quality of financial information if ethical concerns or legal violations are identified.

Question 66

Control Over Accounts Receivable

Answer 66

Effective control over accounts receivable is essential to prevent excessive tying up of current assets and to minimize bad debts.

Managers must balance increasing sales revenue with prudent credit extension practices to protect the company’s financial stability.

Question 67

Impact of Extending Credit on Net Earnings

Answer 67

Extending credit increases sales revenue but does not directly impact net earnings.

Companies need to ensure that credit sales are collected efficiently to avoid tying up excessive resources in accounts receivable.

Question 68

Practices to Minimize Bad Debts

Answer 68

Require Credit Approval: Ensure an independent person approves customers’ credit history, separate from sales and collection functions.

Monitor Accounts Receivable Age: Regularly monitor the age of accounts receivable and promptly contact customers with overdue payments.

Incentivize Speedy Collections: Reward both sales and collection personnel for efficient collections, encouraging teamwork between sales and finance departments.