2. Chapter 6: Cash and Accounts Receivable

3. Accounts Receivable
Accounts receivable arise from selling goods or services to customers on account.
Recorded at face amount to be collected.
However, we must also reflect the fact that a portion of A/R may not be collected.
Net Realizable Value
Reasons for lack of collection:
1. sales discounts (cash discounts)
2. sales returns
3. sales allowances
4. uncollectible A/R (bad debts)

4. 1. Cash Discounts Offered to encourage early payment Examples
2, 10, net 30
2, 10, EOM
Accounting approaches
Gross Method - records discounts when taken by customers
Net Method - records discounts not taken by customers

5. Recording sales discounts The gross method
Assume a $100 sale, terms 2/10, n/30
The sale is recorded:
Debit
Credit
Accounts Receivable
100
Sales
100 14

6. Recording sales discounts The gross method
If paid within 10 days:
Debit
Credit
Cash 98
Sales Discounts 2
Accounts Receivable
100
A contra-account to Sales Revenue 15

7. Recording sales discounts The gross method
If paid after 10 days:
Debit
Credit
Cash
100
Accounts Receivable
100
Will not disclose that discount was not taken 15

8. Gross Method
Make year end estimate of amount of discounts expected to be taken
Adjusting entry:
SALES DISCOUNTS
ALLOWANCE FOR SALES DISCOUNTS

9. Recording sales discounts The net method
Assume a $100 sale, terms 2/10, n/30
The sale is recorded:
Debit
Credit
Accounts Receivable 98
Sales 98 14

10. Recording sales discounts The net method
If paid within 10 days:
Debit
Credit
Cash 98
Accounts Receivable 98
Will not disclose that discount was taken 15

11. Recording sales discounts The net method
If paid after 10 days:
Debit
Credit
Cash
100 2
Sales Discounts Forfeited
Accounts Receivable 98
Report as miscellaneous revenue 15

12. Net Method Record sale net of cash discounts
Record discounts not taken (similar to interest income)
Make year end adjustment for accounts that are past the discount period
Adjusting entry:
ACCOUNTS RECEIVABLE
SALES

13. Theory Discounts are more like interest If so, the Gross Method
Overstates Sales
Understates Interest Income
Defense for use of the Gross Method?
Materiality

14. 2. Sales Returns and Allowances
If sales returns are small in amount, adjust A/R and create a contra to Sales called Sales Returns when the merchandise is returned. Sales allowances are negotiated reductions in sales price after the sale.
Sales Allowance xx
Sales Returns xx
A/R xx
If sales returns are significant (e.g., bookstore), company must estimate the amount of sales returns expected, and adjust A/R (with a contra account similar to Allowance for Bad Debts) at the end of the period.
Estimated Sales Returns xx
Allowance for Returns xx

15. 3. Allowance for Doubtful Accounts
Created as a contra account to A/R to indicate the portion of A/R that will not be collected due to defaults on payments by customers.
Reason for Allowance account: Assume $1,000 sale in 2004 and default on collection in 2005.
Record sale in 2004:
A/R 1,000
Sales Revenue ,000
Record default in 2005:
Bad Debt Expense 1,000
A/R ,000
Note: this is called the direct method, and is not GAAP, for the reasons listed on the next page.

16. Problems with Direct Method
Problem: the direct method, on the previous slide, does not achieve matching (revenues recognized in 2004, but a related expense was recognized in 2005).
Problem: the direct method does not correctly value the asset, A/R. The assets are overvalued until 2005, when the receivable is written off.

17. Solution: the Allowance Method
Solution: create a contra to A/R, and estimate the A/R that will not be collected.
The AJE to record an estimate for uncollectibles in 2004 (for all uncollectibles):
Bad Debt Expense 4,000
Allowance ,000
The GJE during 2005, when a specific A/R is deemed uncollectible (this is called the write-off of a specific A/R):
Allowance 1,000
A/R ,000
When are the income statement and balance sheet affected?
At the 2004 estimate.

18. Estimation of Uncollectibles
Note that we do not know in 2004 which A/Rs will not be collected in Therefore, we must estimate uncollectibles. There are two methods:
1. Percentage of sales
2. Percentage of accounts receivable
Both methods are used to estimate uncollectibles for the AJE. The percentage of sales method is simpler, but the percentage of A/R method is more accurate.

19. 1. Percentage of Sales Method
Usually based on credit sales, but may use total sales or net sales as basis.
Calculation:
Sales x % = Bad Debt Expense
(focus on the debit side of the AJE)
Called the Income Statement approach, because: revenues x % = expense.

20. 2. Percentage of A/R Method (using Aging Schedule)
Based on ending A/R and ending Allowance account.
Calculation:
Ending A/R x % = Ending Allowance
(focus on the credit side of the AJE)
Called Balance Sheet approach, because: ending asset x % = ending contra asset.
Requires the analysis of the Allowance account before preparing the AJE.
An aging schedule of A/R is the most accurate way to estimate uncollectibles (see Figure 6-11).

21. T-Account Approach for Percentage of A/R Method
Based on the analysis of the Allowance account.
Calculate the “desired ending balance” based on an aging of A/R.
Now, given the Beginning, Ending and Write-off amounts, calculate the amount of the current estimate that must be added to the Allowance account to achieve the “desired ending balance.”

22. Allowance for Doubtful Accts. (T-account)
1. Beginning
Balance
1. The allowance established in the prior period carries forward for current period write-offs.

23. Allowance for Doubtful Accts. (T-account)
Beginning
Balance
2. Write-off of specific accounts
receivable
2. As specific accounts are determined uncollectible during the year, they are written-off to the allowance account as shown. These write-offs may cause the allowance account to have a debit balance before the AJE if the prior year’s expense was underestimated.
Accounts Receivable
2. Write-off of specific accounts
receivable

24. Allowance for Doubtful Accts. (T-account)
Beginning
Balance
Write-off of
accounts
receivable
3. Ending
Balance
3. The “desired ending balance” in the allowance account is estimated using the percentage calculation or the aging schedule.
Accounts Receivable
Write-off of
accounts
receivable

25. Allowance for Doubtful Accts. (T-account)
Beginning
Balance
Write-off of
accounts
receivable
4. Recovery of
write-offs
4. The recovery of an account receivable that has been written off must first be reversed back into A/R and the Allowance account. Then the collection is like the collection of any other A/R.
Ending
Balance
Accounts Receivable
4. Recovery of
write-offs
Write-off of
accounts
receivable

26. Allowance for Doubtful Accts. (T-account)
Bad Debts Expense (RE)
Beginning
Balance
5. Recognition of bad debt expense
Write-off
recovery
Write-off of
accounts
receivable
5. Recognition of bad debt expense
Ending
Balance
5. The AJE to record the estimate of uncollectibles is calculated based on the amount necessary to achieve the “desired ending balance” in the allowance account. The focus is on the Allowance account.
Accounts Receivable
Write off recovery
Write-off of
accounts
receivable

27. Class Problem Given the following information:
At December 31, 2004, Company Z prepared an aging schedule to determine that the uncollectible accounts receivable at that date were $18,000. The balance in the Allowance for Doubtful Accounts at 1/1/04 was a $3,000 credit. During 2004, the company wrote off $5,000 of specific accounts receivable that were deemed to be uncollectible.
Required: prepare the AJE to record the estimated uncollectibles at 12/31/04.

28. Solution to Class Problems
(1) Post the beginning balance and write-off.
(2) Post the desired ending balance.
(3) Post the adjusting journal entry.
Allowance for Doubtful Accounts
3, Beginning (1)
(1) W/O 5,000
20, AJE (3)
18,000 End. Balance (2)
AJE: Bad debt expense 20,000
Allowance for D.A. 20,000

29. Problem 6-4, Part (a) Percentage of Sales method (a) 2008
Net sales = Sales - SD - SR - SA
= 1,800, , ,000
= 1,650,000
B.D. Expense = 3% of net sales
= .03 (1,650,000) = $49,500
AJE at 12/31:
Bad debt expense 49,500
Allow. for D.A ,500

30. Allowance for Doubtful Accounts
Problem 6-4, Part (b)
Note that, for the percentage of sales method, the AJE is posted before calculating the ending balance.
Allowance for Doubtful Accounts
65, Beginning (1)
(1) W/O 70,000
49, AJE (2)
44,500 End. Balance (3)

31. % Sales vs % Receivables What is the Difference?
Allowance for Doubtful Accts.
Beginning
Balance
Write-off of
accounts
receivable
Recognition of bad debt expense
Calculated as
% of Sales
Calculated as
% of Receivables
Ending Balance

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