Financial Accounting - Lecture Notes 5

Chapter 5 226-255  Accounts receivable represent the amount of cash owed to a company by its customers from the sale of goods or services on account.  Credit Sales transfer goods or services to a customer today while bearing the risk of collecting payment from that customer in the future.  Credit sales transactions are also called services on account.  An invoice is a source document that identifies the date of sale, the customer, the specific items sold, the dollar amount of the sale, and the payment terms. o Even though no cash is received at the time of the credit sale, the seller records revenue immediately once goods or services are provided to the customer and future collection from the customer is probable.  The legal right to receive cash is valuable and represents an asset of the company. o This asset is referred to as accounts receivable (sometimes called trade receivables)  The benefit of extending credit is that the seller makes it more convenient for the buyer to purchase goods and services  The cost of extending credit is the delay in collecting cash from customers, and as already discussed, some customers may end up not paying at all.  Nontrade receivables are receivables that originate from forces other than customers  They include tax refund claims interest receivable and loans by the company to other entities  When receivables are accompanied by formal credit arrangements made with written debt instruments or notes we refer to them as notes receivable  Trade discounts represent a reduction in the listed price of a good or service.  Sales return occurs if a customer returns goods previously purchased.  Sales allowance occurs if the customer doesn’t return goods, but the seller instead reduces the customer’s balance owed for goods or services provided.  We reduce revenue for sales returns ruling a Contra revenue account- sales returns  A contra revenue account is an account with a balance that is opposite, or “contra,” to that of its related revenue account.  The reason we use a Contra revenue account is to keep a record of the total revenue recognized separate from the reduction due to subsequent sales returns  We record the sales allowance in the Contra revenue account sales allowances.  A sales discount represents a reduction, not in the selling price of a good or service, but in the amount to be received from a credit customer if collection occurs within a specified period of time.  The sales discount is intended to provide incentive to the customer for quick payment  Discount terms such as 2/10, n/30, are a shorthand way to communicate the amount of the discount and the time period within which it’s available. o Example: “2/10” indicates the customer will receive a 2% discount if the amount owed is paid within 10 days. “n/30”, pronounced “net thirty” means that if the customer does not take the discount, full payment net of any returns or allowances is due within 30 days.  We record sales discounts in a contra revenue account- Sales Discounts 1. Revenues are reported for the amount of cash a company expects to be entitled to receive from customers for providing goods and services 2. Total revenues are reduced by sales returns, sales allowances, and sales discounts that occur during the year 3. total revenues are further reduced by an adjusting entry at the end of the year for the estimate of additional sales return sales allowances and sale discounts by date occur in the future but that relate to the current year  The upside of extending credit to customers is that it boosts sales by allowing customers the ability to purchase on account and pay cash later  The accounts receivable account is an asset, reported in the company’s balance sheet.  The downside of extending credit to customers is that not all customers will pay fully on their accounts.  Under the allowance method, a company reports its accounts receivable for the net amount expected to be collected.  Under the allowance method, companies are required to estimate future uncollectible accounts and report those estimates in the current year. 1. At the end of the initial year, establish an allowance by estimating future uncollectible accounts 2. During the subsequent year, write off actual bad debts as uncollectible. Note that actual write-offs may differ from the previous year’s estimate. 3. At the end of the subsequent year, once again estimate future uncollectible accounts.  The receivables not expected to be collected should not be counted in the assets of the company.  Companies report their estimate of future bad debts using an allowance for uncollectible accounts.  The allowance account provides a way to reduce accounts receivable indirectly, rather than decreasing the accounts receivable balance itself.  We report the allowance for uncollectible accounts in the asset section of the balance sheet, but it represents a reduction in the balance of accounts receivable.  The difference between total accounts receivable and the allowance for uncollectible accounts equals net accounts receivable  Bad debt expense is the offsetting debit in the entry to establish the allowance account  Bad debt expense represents the cost of estimated future bad debts that is reported as an expense in the current year’s income statement, along with other expenses.  The write-off of the account receivable has no effect on the total amounts reported in the balance sheet or in the income statement.  Collecting cash on an account previously written off also has no effect on total assets and no effect on net income.  The percentage-of-receivables method is sometimes referred to as a balance sheet method because we base the estimate of bad debts on a balance sheet accountaccounts receivable.                      The aging method occurs when you consider the various ages of individual accounts receivable, using a higher percentage of uncollectible for “old” accounts than for “new” accounts. The older the account, the less likely it is to be collected. A credit balance before adjustment indicates that the balance of the allowance account at the beginning of the year (or end of last year) may have been too high. A debit balance before adjustment indicates that the balance of the allowance account at the beginning of the year was too low. The year-end adjusting entry is affected by the extent to which the previous year’s ending balance of Allowance for Uncollectible Accounts differs from the current year’s actual amount of uncollectible accounts. A subsidiary ledger contains a group of individual accounts associated with a particular general ledger control account. o Subsidiary ledgers are also used for accounts payable, property and equipment, investments, and other accounts. Under the direct write-off method, we write off bad debts only at the time actually become uncollectible, unlike the allowance method which requires estimation of uncollectible accounts before they even occur. It is important to emphasize that the direct write-off method is generally not allowed for financial reporting under GAAP. The direct write-off method is primarily used for tax reporting. The direct write-off method of accounting for uncollectible accounts is generally not permitted for financial reporting purposes except in limited circumstances. The direct write-off method is less timely in recognizing uncollectible accounts. o The difference between the two methods is in the timing Notes receivable are similar to accounts receivable but are more formal credit arrangements evidenced by a written debt instrument or note. Recognize that the transaction has no impact on the accounting equation; it is simply a matter of reclassifying assets. Two important ratios that help in understanding the company’s effectiveness in managing receivables are the receivables turnover ratio and the average collection period. The receivables turnover ratio provides a measure of a company’s ability to collect cash from customers. The ratio shows the number of times during a year that the average accounts receivable balance is collected (or “turns over”). Receivables turnover ratio = Net credit sales/ Average accounts receivable The more frequently a business is able to “turn over” its average accounts receivable, the more effective a company is at granting credit to and collecting cash from its customers. The average collection period is another way to express the same efficiency measure. This ratio shows the approximate number of days the average accounts receivable balance is outstanding. Average collection period = 365 days/ Receivables turnover ratio   Notice that the two methods for estimating uncollectible accounts result in different adjustments. The percentage-of-receivables method (balance sheet method) is the preferable method, while the percentage-of-credit-sales method (income statement method) is allowed only if amounts do not differ significantly from estimates using the percentageof-receivables method.