4. Accounts Receivable

Question 1

where do bad debt losses generally come from

Answer 1

• extending credit to customers
• there is a risk that some accounts receivable will not be collected
• this is what is referred to as an uncollectible account

Question 2

what is one way of minimizing bad debt losses

Answer 2

• to permit sales on accounts only to credit–worthy customers
• but this can be hard to determine in advance

Question 3

if a corp issues a credit sale to a company on x date, and a year later at y date it is determined that the credit receivable would never be collected, which date would you record this bad debt arising from the credit sale

Answer 3

• it should be matched to the period in which the sale occurred
• so x date

Question 4

what is the allowance for doubtful accounts

Answer 4

• its a contra account to accounts receivable in the general ledger
• its purpose is to record estimated uncollectible receivables

Question 5

how does the allowance for doubtful accounts influence the balance sheet

Answer 5

• it is subtracted from accounts receivable
• to give the estimated net realizable accounts receivable

Question 6

what are the two methods for estimating uncollectible accounts

Answer 6

• income statement method: estimating bad debt expense on the income statement
• balance sheet method: estimating the desired balance in allowance for doubtful accounts on the balance sheet

Question 7

how does the income statement method work

Answer 7

• bad debt expense is calculated by applying an estimated loss percentage on credit sales for the period
• the percentage is based on actual losses experienced in prior years

Question 8

how does the balance sheet method work

Answer 8

• it uses a process called aging of accounts receivable
• at the end of the period, the total of estimated uncollectible accounts is calculated by analyzing accounts receivable according to how long each account has been outstanding
• an aging analysis approach assumes that the longer a receivable is outstanding, the less likely it is to be collected

Question 9

how is the bad debt expense calculated in the balance sheet method

Answer 9

• bad debt expense = estimated uncollectible amount - allowance for doubtful accounts from the previous period

Question 10

what is a write-off

Answer 10

• when a specific account is deemed to be uncollectible
• so its removed from the accounts receivable account

Question 11

if you had to write off x amount from an account receivable, which accounts would be affected and how

Answer 11

• the accounts receivable would decreases by x
• the allowance for doubtful accounts would also decrease by x
• the net realizable accounts receivable would not decrease because it is the difference between the two
• bad debts expense would also not be affected

Question 12

if you were using the balance sheet method for estimating uncollectible amounts, how would you first go about recording a journal entry for the write-off of a clients account of x amount

Answer 12

• first you would need to acknowledge that the accounts receivables balance has decreased by x and therefore the allowance for doubtful accounts has also decreased by x
• in a journal entry, this is shown by a debit of x into AFDA (-contra asset to +Asset
• and a credit of x into accounts receivables (-Asset)
• the brackets are the notes in the journal, dont forget

Question 13

how would you then calculate the bad debt expense

Answer 13

• calculate the estimated uncollectible amount using the accounts receivable * estimate bad debt percentage
• this is your ending AFDA balance
• dont forget to subtract x from its matching accounts receivable
• then draw a T-account for AFDA with the write-off on the left, the beginning balance (credit) on the right and the ending AFDA balance at the bottom
• do some math to get the missing value in the credit section, this is the bad debt expense

Question 14

how would you finally fully journal the write-off

Answer 14

• in the journal entry, bad debt expense is debited (+expense to -Equity)
• AFDA is credited the same amount (+contra asset to -asset)

Question 15

explain two earning manipulation techniques related to sales and allowance for bad debt you should check out for as an auditor

Answer 15

• check that the probability of default for each existing category is accurate and not estimated too low
• check that the company is not engaging in channel stuffing activities (selling to insolvent customers, forcing sales, offering very large rebates)

Question 16

what is bad debt expense

Answer 16

• the amount of expected default losses associated with the balance of accounts receivable
• it is typically the adjustment needed to change the allowance for bad debt from period to period
• often done with an ageing schedule

Question 17

why do investors care about a companys bad debt rate

Answer 17

• because investors ultimately care about cash flows more so than earnings
• earnings needs to generate cash flows or the company cant remain liquid

Question 18

what are some ways companies can avoid recording slight losses and record slight gains instead

Answer 18

• the company can cancel some unnecessary costs at the end of year (legitimate way of doing things)
• the company can delay some costs like waiting til next year to buy supplies or anticipate future gains like close deals before year end
• the company can generate artificial revenue by selling assets
• the company can manipulate the accounts via creative accounting using complex financial structures

Question 19

what is the big bath concept

Answer 19

• the big bath in accounting is an earnings management technique
• whereby a one-time charge is taken against income to reduce assets
• which results in lower expenses in the future