Flashcards in unit 5 Deck (13):
When a company directly grants credit to its customers, it expects that some customers will not pay what they promised. The accounts of these customers are uncollectible accounts, commonly
percent of sales method, (also called the income statement method)
is based on the idea that a percent of a company’s credit sales for the period is uncollectible.
accounts receivable methods, (also called balance sheet methods)
use balance sheet relations to estimate bad debts—mainly the relation between accounts receivable and the allowance amount. The goal of the bad debts adjusting entry for these methods is to make the Allowance for Doubtful Accounts balance equal to the portion of accounts receivable that is estimated to be uncollectible. The estimated balance for the allowance account is obtained in one of two ways: (1) computing the percent uncollectible from the total accounts receivable or (2) aging accounts receivable.
percent of accounts receivable method
assumes that a percent of a company’s receivables is uncollectible. This percent is based on past experience and is impacted by current conditions such as economic trends and customer difficulties. The total dollar amount of all receivables is multiplied by this percent to get the estimated dollar amount of uncollectible -accounts—reported in the balance sheet as the Allowance for Doubtful Accounts.
aging of accounts receivable method
uses both past and current receivables information to estimate the allowance amount. Specifically, each receivable is classified by how long it is past its due date. Then estimates of uncollectible amounts are made assuming that the longer an amount is past due, the more likely it is to be uncollectible. Classifications are often based on 30-day periods. After the amounts are classified (or aged), experience is used to estimate the percent of each uncollectible class. These percents are applied to the amounts in each class and then totaled to get the estimated balance of the Allowance for Doubtful Accounts.
Accounts receivable turnover
is a measure of both the quality and liquidity of accounts receivable. It indicates how often, on average, receivables are received and collected during the period.(net sales/average accounts recievable, net)
Explain how receivables can be converted to cash before maturity
Receivables can be converted to cash before maturity in at least two ways. First, a company can sell accounts receivable to a factor, who charges a factoring fee. Second, a company can borrow money by signing a note payable that is secured by pledging the accounts receivable.
Describe accounts receivable and how they occur and are recorded.
Accounts receivable are amounts due from customers for credit sales. A subsidiary ledger lists amounts owed by each customer. Credit sales arise from at least two sources: (1) sales on credit and (2) store credit card sales. Sales on credit refers to a company’s granting credit directly to customers. Store credit card sales involve customers’ use of store credit cards.
Describe a note receivable, the computation of its maturity date, and the recording of its existence
A note receivable is a written promise to pay a specified amount of money at a stated future date. The maturity date is the day the note (principal and interest) must be repaid. Interest rates are normally stated in annual terms. The amount of interest on the note is computed by expressing time as a fraction of one year and multiplying the note’s principal by this fraction and the annual interest rate. A note received is recorded at its principal amount by debiting the Notes Receivable account. The credit amount is to the asset, product, or service provided in return for the note.
Credit risk ratio
Ratio of the Allowance for Doubtful Accounts divided by Accounts Receivable; the higher this ratio, the higher is credit risk
Direct Write Off Method
the seller plays the waiting game, till the customer totally defaults: This option is taken by the seller when they want to wait till the very last moment when it is very clear that there is no doubt that the customer will not pay them. At that point in time, the seller would write off that point. This is called the Direct Write off Method. Debit bad debt Expense, and Credit A/R
The direct write off method is not allowed under GAAP. The reason being it violates the Matching Principle.
This method is approved under GAAP as it does not violate the matching principle. In this method, an allowance for doubtful account is created. Taking historical past trends, each company sets a policy of estimating how much percentage of A/R is going to be doubtful or turn out bad.