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The term receivables refers to amounts due from individuals and other companies and are expected to
be collected in cash. Accounts receivable are amounts owed by customers on account. They result from
the sale of goods and services.
Accounts
Receivable
Company
Customers
Invoice
Payments
A customer signs a legal contract with your company in January, receives product from you
in February, and pays in March. When does equity increase?
0% 0% 0% 0%
d. It depends on your accounting policy.
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Copyright © 2016 AME Learning Inc.
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CHAPTER 2
Each customer must satisfy the credit requirements of the seller before the credit sale is approved.
Inevitably, though, some accounts receivable become uncollectible. The latter is referred to as bad
debt. Bad debt is considered an operating expense, and must be recorded in a way that is consistent
with ASPE or IFRS principles. To record bad debt in a way that satisfies expense recognition, accountants
have created an account called allowance for doubtful accounts (AFDA).
Uncollectible
Sales Invoice Bad Debt
Accounts
Example
At the end of 2016, Columbo Company’s customers owe a total of $100,000. After analyzing the existing
data and the current economy, it has been determined that $5,000 of the accounts receivable may not
be collectable.
The accounts receivable account of $100,000 does not change. It remains as a debit on the balance
sheet. Instead, the AFDA contra account is credited with $5,000, resulting in a net realizable value of
$95,000.
For the debit side of this transaction, bad debt expense is increased by $5,000 and this amount is
reported as an expense for the period in the income statement. The journal entry at the end of 2016 for
this transaction is shown below.
The net realizable value of accounts receivable is $95,000 and this figure would be presented on the
balance sheet. The presentation of this part of the balance sheet for Columbo Company is shown below.
After companies anticipate bad debt by setting up the AFDA contra account, several scenarios can
exist.
1. A customer is unable or unwilling to pay the debt and the amount is considered uncollectible.
2. After an account is written off as uncollectible, the customer informs you that he or she will pay the
amount.
3. The customer is unable to pay the debt when it is due, but will be able to pay it in the future.
Scenario 1: On February 16, 2017, a customer who owes you $250, informs you that he is unable or
unwilling to pay his account.
Usually, a company will attempt to contact and collect from a customer for many months. After a period
of time, the company may realize the customer just will not pay or cannot be contacted.
Scenario 2: The customer in scenario 1 has improved his cash flow and is now willing to pay his account
(which was previously written off as uncollectible). He pays the amount on June 25, 2017.
Scenario 3: The customer is unable to pay the debt by the due date, but will be able to pay in the future.
Even customers with a good credit record sometimes take time to settle their bills. If the customer talks to
the company and lets them know about the delay in payment, nothing needs to be done. The original
amount in accounts receivable will remain on the books and will be credited when the account is finally
paid.
After many months of attempting to collect from a customer, the company would face the decision of
writing off the account as uncollectable. If the amount is written off , the transaction in scenario 1 would
be made. If the customer finally does pay, the two transactions in scenario 2 would be made.
Sales in 2016 are $1,000,000 and it is estimated that about $50,000 will not be collected. However,
this will only be known for sure in fiscal year 2017. Which of the following is true for 2016?
Dr. Cr.
Bad Debt Expense $50,000
a. (a)
Account Receivable $50,000
- Equity decreases
b. Account
(b) Receivable $50,000
Bad Debt Expense $50,000
- Equity decreases
c.
Bad
(c)
Debt Expense $50,000
AFDA $50,000
- No change to equity
Bad Debt Expense $50,000
d. (d)
AFDA $50,000
- Equity decreases
0% 0% 0% 0%
14
)
(c)
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(a
(b
(d
Self Study Question
Corning Distributors’ fiscal year end is July 2016 and their accounts receivable outstanding
are $120,000. It has been established that $5,000 may not be collected. Which of the
following is correct?
Dr. Cr.
Accounts Receivable $5,000
a. (a) Bad Debt Expense $5,000
AFDA $5,000
c. (c) Accounts
$5,000
Receivable
d. Bad
(d) Debt Expense $5,000
AFDA $5,000
0% 0% 0% 0%
15
)
(c)
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(a
(b
(d
Self Study Question
If an amount of $1,000 is recovered from a customer that was previously written off, which of
the following is correct?
Dr. Cr.
Cash X
a. (a) Bad Debt Expense X
Dr. Cr.
Bad Debt Expense X
b. (b)
Cash X
Dr. Cr.
Bad Debt Expense X
c. (c)
AFDA X
Dr. Cr.
d. Accounts
(d) Receivable X
AFDA X
Cash X
Accounts Receivable X
0% 0% 0% 0%
16
)
(c)
Copyright © 2016 AME Learning Inc.
(a
(b
(d
CHAPTER 2
Companies must estimate the amount of bad debt when they use the allowance method. Two methods
to determine this amount are (1) the income statement approach, and (2) the Balance sheet approach.
The income statement approach, or the percentage of sales method, is so called because credit sales
from the income statement are used as a basis to estimate future bad debt. This percentage is based on
past experience and anticipated credit policy.
Example
If the collection history of a company suggests that 1% of credit sales will result in bad debt, that rate is
used to estimate the portion of each period’s sales that will not be collectible.
Total credit sales for Columbo Company in 2016 amounted to $1,000,000, of which $200,000 is currently
owing by customers. On the basis of historical sales, 1% of $1,000,000 is expected to be uncollectible.
Therefore, the bad debt expense for the period is
Under the balance sheet approach, a company can calculate allowance for bad debt using either the
percentage of total accounts receivable method or the aging method. The percentage of total
accounts receivable method, as the name implies, uses a percentage of receivables to estimate bad
debt.
Under the aging method, percentages are applied to groupings based on the age of outstanding
accounts receivable amounts. Let us look at an example to illustrate this procedure.
The chart contains three groups of customers and their outstanding balances on December 31, 2016.
In this example, $5,800 of the accounts receivable balance of $200,000 is estimated to be uncollectible.
The $5,800 of estimated bad debt will become the ending balance of AFDA for the period regardless of
AFDA’s existing balance.
Credit sales are $60,000 and bad debt is expected to be $7,000 relating to this year’s credit
sales. Identify the correct transaction using the allowance method:
Dr. Cr.
Bad Debt Expense $7,000
a. (a) AFDA $7,000
c. Bad
(c) Debt Expense $4,000
AFDA $4,000
d. AFDA
(d) $4,000
Bad Debt Expense $4,000
0% 0% 0% 0%
26
)
(c)
Copyright © 2016 AME Learning Inc.
(a
(b
(d
Self Study Question
The amount of bad debt is expected to be $42,500 in relation to the amount of credit sales
last month. AFDA currently has a balance of $37,500. What is the journal entry for bad debt
expense?
Dr. Cr.
Bad Debt Expense $37,500
d. AFDA
(d) $5,000
Bad Debt Expense $5,000
-Equity Increases by $5,000
0% 0% 0% 0%
27
)
(c)
Copyright © 2016 AME Learning Inc.
(a
(b
(d
Self Study Question
What is the correct journal entry to record an increase of $3,000 to the Allowance for Doubtful
Account?
Dr. Cr.
Bad Debt Expense $3,000
Account
a. (a) Receivable $3,000
Dr. Cr.
Bad Debt Expense $3,000
b. (b)
AFDA $3,000
Dr. Cr.
AFDA $3,000
c. (c)
Bad Debt Expense $3,000
Dr. Cr.
d. AFDA
(d) $42,500
Bad Debt
$42,500
Expense
0% 0% 0% 0%
28
)
(c)
Copyright © 2016 AME Learning Inc.
(a
(b
(d
Self Study Question
If the Allowance for Doubtful Accounts increases from $5,000 to $8,000, will equity increase or
decrease?
a. Decrease
b. Increase
0% 0%
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Copyright © 2016 AME Learning Inc.
Self Study Question
The current AFDA has a credit balance of $37,500. Based on the aging of accounts
receivable, expected losses from all unpaid accounts are expected to be $42,500. Which of
the following is the correct adjustment to AFDA?
Dr. Cr.
Bad Debt Expense $37,500
Account
$37,500
a. (a) Receivable
-Equity decreases by $37,500
AFDA $42,500
b. (b) Bad Debt Expense $42,500
-Equity decreases by $42,500
d. AFDA
(d) $42,500
Bad Debt Expense $42,500
-Equity decreases by $5,000
0% 0% 0% 0%
30
)
(c)
Copyright © 2016 AME Learning Inc.
(a
(b
(d
Self Study Question
The current AFDA has a credit balance of $17,250. Based on the aging of accounts
receivable, expected losses from all unpaid accounts are expected to be $15,500. Which of
the following correctly adjusts AFDA?
Dr. Cr.
Bad Debt Expense $15,500
Account
$15,500
a. (a) Receivable
-Equity decreases by $15,500
AFDA $15,500
b. (b) Bad Debt Expense $15,500
-Equity decreases by $15,500
d. AFDA
(d) $1,750
Bad Debt Expense $1,750
-Equity increases by $1,750
0% 0% 0% 0%
31
)
(c)
Copyright © 2016 AME Learning Inc.
(a
(b
(d
CHAPTER 2
Accounts receivable plays such a prominent role in the financial well-being of a company, it is important
that information about this asset is efficiently organized.
The yellow area shows an amount of $150 from Beta Company that has not been paid for more than
90 days.
The amount marked in red, $1,200, represents a significant portion of the outstanding balance.
The green area of this chart is notable because, unlike all the other customers on the list, Cooper
Limited does not have an outstanding balance for the 61–90 day period.
Overdue accounts
Which of the following information can be found in the accounts receivable subledger?
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Copyright © 2016 AME Learning Inc.
CHAPTER 2
Another approach to measuring the effectiveness of the company’s collection efforts is through the use
of financial ratios.
Days sales outstanding tracks how long customers take to pay their bills. This is done by using two basic
figures from the financial records: average net accounts receivable and net credit sales for the past 12
months.
Company 1
Assume that the total average net accounts receivable amount for Company 1 is $200,000, and the total
net credit sales amount for the past year was $1,200,000. The DSO ratio is calculated as shown below.
= 61 days
Company 2
Assume that the total average net accounts receivable amount for Company 2 is $135,000, and the total
net credit sales for the past year was $1,650,000. The DSO ratio is calculated as shown below.
= 30 days
The accounts receivable turnover (ART) ratio measures how often during the year a company will collect
its entire accounts receivable amount. The formula is shown below.
Company 1
In the previous example, Company 1 had an average net accounts receivable of $200,000 and net
credit sales of $1,200,000. The accounts receivable turnover is calculated as shown below.
= 6 times
Company 2
In the example above, Company 2 had an average net accounts receivable of $135,000 and net credit
sales of $1,650,000. The accounts receivable turnover is calculated as shown below.
= 12.2 times
a. 34.5 days
b. 36.5 days
c. 40 days
0% 0% 0% 0%
d. There is insufficient information to calculate
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Copyright © 2016 AME Learning Inc. 44
Self Study Question
How many days is it taking on average to collect outstanding accounts?
Cash = $82,000
Average Accounts Receivable = $265,813
Gross Profit = $840,000
Sales = $1,270,000
a. 66.4 days
b. 94.6 days
c. 76.4 days
0% 0% 0% 0%
d. 68.2 days
s
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da
da
da
da
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66
94
76
68
Copyright © 2016 AME Learning Inc.
Self Study Question
a. Company 1
b. Company 2
Company 1
DSO 89
Company 2
Net Credit Sales $6,349,583 0% 0%
Average Net Accounts Receivable $1,345,365
DSO 77
y1
y2
n
n
pa
pa
m
m
46
Co
Co
Copyright © 2016 AME Learning Inc.
Self Study Question
a. Company 1
b. Company 2
Company 1
ART 3.82
Company 2
Net Credit Sales $5,295,482 0% 0%
Average Net Accounts Receivable $1,035,265
ART 5.12
y1
y2
n
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pa
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Co
Co
Copyright © 2016 AME Learning Inc.
CHAPTER 2
The purpose of accounts receivable internal controls is to help a company get the most out of one of its
largest and most crucial asset
A promissory note is a written promise to pay a specified amount of money at some date in the future.
Usually, the customer will be required to pay interest on the amount owing. This is to compensate the
company for the extended payment terms.
Example
On April 1, 2016, Kay Fernandez Alonso has $1,000 of outstanding accounts receivable with Columbo
Company. She cannot pay immediately, so Columbo will give her more time to pay by turning the
accounts receivable into a notes receivable. Interest of 6% will be charged and collected when the
note is due. Kay promises to pay on April 1, 2017.
Example
On October 31, when Columbo Company prepares its financial statements, it will need to accrue the
interest earned from Kay. The interest is 6% of $1,000 that has been earned from April 1 to October 31,
2016.
Example
When Kay pays the amount due on April 1, 2017, the entry is recorded on the statements of Columbo
Company.
Example
It is possible that on April 1, 2017, Kay may not pay the amount owing to Columbo Company. If a note is
not paid at maturity, it is considered a dishonoured note. Thus, it will convert the note back to accounts
receivable.
Dr. Cr.
Notes Receivable $5,000
d. Accounts
(d) Receivable $42,500
AFDA $42,500
-No change to equity
0% 0% 0% 0%
56
)
(c)
Copyright © 2016 AME Learning Inc.
(a
(b
(d
Self Study Question
The promissory note for $5,000 was signed on June 1 at 10% per annum. On June 30, one
months interest is owing but has yet to be received. Which of the following correctly records
the interest owed?
Dr. Cr.
Account Receivable $41.67
0% 0% 0%
57
(c)
Copyright © 2016 AME Learning Inc.
(a
(b
CHAPTER 2
The company and its accounting department are responsible for managing accounts receivable
accurately and ethically. This includes properly recording credit sales and receipt of cash, as well as
properly estimating bad debt. Accounts receivable is an important asset on the balance sheet and
managing and accounting for this asset must be done without unethical manipulation.
Estimate bad debt using income statement and balance sheet approaches
The income statement approach estimates bad debt based on credit sales of the year.
The balance sheet approach estimates bad debt based the balance of accounts receivable or
on the aging of accounts receivable at year end.
Utilize reports, including the accounts receivable subledger, to manage accounts receivable information
The accounts receivable subledger shows accounts receivable balance by customer and by the
length of time the debt has been outstanding. Detailed examination of the accounts receivable
subledger can help the company highlight important areas that require management focus or
changes in credit policies.
Using computer software, a company can generate various accounts receivable related reports
that are tailored to management’s needs.
Signet Enterprise had a balance of accounts receivable on December 31, 2016 of $400,000. It is
estimated that 1% of accounts receivable will be uncollectable. The AFDA account had a credit
balance of $1,500. Prepare the journal entry to record the estimate of bad debt.
JOURNAL
?
Dec 31 ?
Bad Debt Expense
?
$2,500
AFDA? ?
$2,500