Chapter 8 Flashcards
Advantages of Extending Credit:
(1) Increases the seller’s revenues.
Disadvantages of Extending Credit:
(1) Increased wage costs
(2) Bad debt costs
(3) Delayed receipt of cash
If credit is extended, the company will have to hire people to (a) evaluate whether each customer is creditworthy, (b) track how much each customer owes, and (c) follow up to collect the receivable from each customer.
Increased Wage Costs
Inevitably, some customers dispute what they owe ,or they run into financial difficulties and pay only a fraction of their account balances. These bad debt costs are considered an additional cost of extending credit.
Bad Debt Costs
Even if the company were to collect in full from customers, it will likely have to wait 30–60 days before receiving the cash.
Delayed Receipt of Cash
Allowance for Doubtful Accounts
Less on Balance Sheet
Bad Debt Expense
Income Statement
True or False: Matching requires that expenses be deducted from the revenue they helped earn.
True
Allowance Method Two Step Process:
(1) Make an end of period adjustment to record the estimated bad debts in the period credit sales occur.
(2) Remove specific customer balances when they are known to be uncollectible.
Methods for Estimating Bad Debts accepted by GAAP and IFRS:
(1) Percentage of Credit Sales Method
(2) Aging of Accounts Receivable
Advantage of Percentage of Credit Sales Method
Simpler to apply
Advantages of Aging of Accounts Receivable
More accurate
Estimates bad debt expense by multiplying the historical percentage of bad debt losses by the current period’s credit sales.
Percentage of Credit Sales Method
True or False: We must remember to remove cash sales from our total sales revenue to arrive at net credit sales. We will not experience any bad debts on cash sales. Notice that this method uses one income statement account (Sales) to estimate the amount to record in another income statement account (Bad Debt Expense).
True
Bad Debt Expense of the Period Equation
Net Credit Sales for the Period x Historical Bad Debt Loss Rate = Bad Debt Expense
The focus of the percentage of credit sales method is:
Determining the amount to record on the income statement as bad debt expense
While the percentage of credit sales method focuses on _____________ for the period, the aging of accounts receivable method focuses on _____________ in the Allowance for Doubtful Accounts.
(1) Estimating Bad Debt Expense
(2) Estimating the ending balance
The aging method gets its name because it is based on the “age” of each amount in Accounts Receivable. The ___________ an account receivable becomes, the less likely it is to be collectible.
(1) Older
Percentages of Credit Sales Equation
Net Credit Sales x % Estimated Uncollectible = Percentage of Credit Sales
Accounts Receivable Aging Equation
Accounts Receivable x % Estimated Uncollectible = Not Amount of Entry
Bad debt estimates usually differ from the amounts that are later written off. If these differences are material, companies are required to revise their bad debt estimates for the current period.
Revising Estimates
Collection of a previously written off account is called a recovery and it 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.
Accounts Recoveries
Reverse Original Write Off Journal Entry:
dr. Accounts Receivable
cr. Allowance for Doubtful Accounts
Collection of a write off Journal Entry:
dr. Cash
cr. Accounts Receivable
A company reports _____________ if it uses a promissory note to document its right to collect money from another party
Notes Receivable
Three Situations to report Notes Receivable:
(1) The company loans money to employees or businesses.
(2) The company sells expensive items for which customers require an extended payment period
(3) The company converts an existing account receivable to a note receivable to allow an extended payment period.
True or False: Unlike accounts receivable, which do not necessarily charge interest until they’ve become overdue, notes receivable charge interest from the day they are created to the day they are due (their maturity date).
True
Interest Equation
Interest (I) = Principal (P) x Interest Rate (R) x Time (T)
Amount of the note receivable
Principal (P)
The annual interest rate charged on the note
Interest Rate (R)
The time period of interest calculation
Time (T)
True or False: 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. We can express the time period in months or days. Many financial institutions use a 365-day year to calculate interest to the nearest day.
True
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.
Receivables Turnover Ratio
True or False: Rather than evaluate the number of times accounts receivable turn over during a year, some people find it easier to think in terms of the length of time (in days) it takes to collect accounts receivable (called days to collect).
True
Receivable Turnover Ratio
(Net Sales) / (Average Net Receivables)
(Beginning Net Receivables + Ending Net Receivables) / 2
Average Net Receivables
Days to Collect
365 / (Receivable Turnover Ratio)
