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					     Chapter 6:
Reporting & Analyzing
  Operating Assets
       Part 1:
Accounts Receivable

         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.
 Reasons for lack of collection:
   (1) sales discounts
   (2) sales returns
   (3) uncollectible A/R (bad debts)

               Uncollected A/R
(1)Sales Discounts occur when a customer takes
   advantage of a cash discount for early payment.
(2)Sales Returns occur when a customer returns a
(3)Uncollectible A/R (bad debts) occur when a
   customer defaults on the receivable, and the
   company cannot collect the amount owed.
  This item requires a separate expense account
  (rather than a reduction of revenue).

              Uncollectible A/R
Method 1:Direct Write-Off Method
 Small (or privately held) companies may use this
  technique to recognize uncollectible A/R.
 In the year that a specific A/R is deemed
  uncollectible (usually 1 – 2 years after the initial
  sale/service transaction), the company would
  remove the A/R, and recognize bad debt expense:
      Bad Debt Expense        xx
           A/R                      xx
 However, A/R is overstated until the write-off and
  the Bad Debt Expense is not recognized in the
  same period as the revenue (no matching).
             Uncollectible A/R
Method 2: the Allowance Method
 For matching, we estimate the A/R that will not
  be collected, and match that expense to current
 The AJE (adjusting journal entry) to record an
  estimate for future uncollectibles in year of sale:
      Bad Debt Expense                   xx
            Allowance for Uncoll.             xx
 The General JE in later periods, when a specific
  A/R is deemed uncollectible (this is called the
  write-off of a specific A/R):
      Allowance for Uncoll.              xx
            A/R                               xx
     Estimation of Uncollectibles
 Note that we do not know in the year of the
  sale which A/Rs will not be collected in the
  future. Therefore, we must estimate
  uncollectibles. There are two methods to
  estimate uncollectibles (for the AJE):
   1. Percentage of sales
   2. Percentage of accounts receivable
 Both methods are acceptable under
  GAAP(generally accepted accounting

    Percentage of Sales Method
 The percentage of sales method is very
  simple. Based on some percentage,
  derived from historical data, industry
  averages, economic conditions, etc., the
  estimated expense may be calculated:
    Revenue x % = Bad Debt Expense
 This is also called the income statement
 The AJE, based on this number, is
     Bad Debt Expense            x
           Allowance for Uncoll.     x
       Percentage of A/R Method
         (using Aging Schedule)
 Based on ending A/R and ending Allowance
 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 Exhibit 6-1).
       Percentage of A/R Method
         (using Aging Schedule)
 The aging schedule is beneficial, even if the
  Direct Write-off method is used.
 The aging schedule highlights slow-payers
  (including insurance companies), and allows the
  company to develop additional collection
 Many billing programs will do an aging schedule,
  and include the information on each customer’s

       T-Account Approach for
      Percentage of A/R Method
 Based on the analysis of the Allowance
 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.”
 Allowance for Doubtful Accts.
Allowance for Doubtful Accts.

                1. Beginning

                           1. The allowance established in
                           the prior period carries forward for
                           current period write-offs.

Allowance for Doubtful Accts.
Allowance for Doubtful Accts.

 2. Write-off   Balance
 of specific
                                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
    Accounts Receivable
                                debit balance before the AJE if
                2. Write-off    the prior year’s expense was
                of specific     underestimated.
                receivable                                   12
Allowance for Doubtful Accts.
Allowance for Doubtful Accts.

 Write-off of
                 3. Ending
                                3. The “desired ending balance” in
                                the allowance account is
    Accounts Receivable         estimated using the percentage
                                calculation or the aging schedule.
                Write-off of
                receivable                                    13
Allowance for Doubtful Accts.
Allowance for Doubtful Accts.             Bad Debts Expense
                Beginning        4. Recognition of
                                 bad debt expense
 Write-off of   4. Recognition
 accounts       of bad debt
 receivable     expense

                                 4. The AJE to record the estimate
                                 of uncollectibles is calculated
    Accounts Receivable          based on the amount necessary
                                 to achieve the “desired ending
                Write-off of     balance” in the allowance
                accounts         account. The focus is on the
                receivable       Allowance account.              14
               Class Problem
Given the following information:
 At December 31, 2010, 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 1/1/10 was a $3,000
  credit. During 2010, 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 12/31/10.

   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

    Manipulation of Sales and Bad Debt Expense
 Financial statement users should be aware of the
  fact that policies may vary from company to
  company in recognition of sales and in estimation
  of bad debt expense.
 Early recognition of sales (before revenue is
  realizable) is not GAAP, and is a violation of SEC
 Estimation of bad debt expense may vary because
  of legitimate reasons and the judgment of the
  accountants, but may also vary because of
 Users should watch for inconsistencies in the
  recognition of these amounts from period to period.

              Other Manipulations of
             Revenues and Expenses
 Historically, managers have used estimates and
  AJEs to create “cookie jar reserves”, or to take a
  “big bath” to manipulate income statement items.
 Cookie jar reserves: overestimate expense in
  current period, and “draw” against estimate in
  future periods (see Business Insight, page 6-9).
 Big bath: accrue a number of expenses and losses
  into one year, so that future years look better.

      Analysis of A/R and Allowance
 Basic analysis of the allowance account may
  reveal inconsistencies in bad debt
 Compare change in allowance to change in
  A/R; growth in one with reduction in the other
  may indicate manipulation.
 Review note in the financials relating to the
  allowance account; the amounts for expense
  and write-offs are disclosed in this section.
 See Exhibit 6.4, page 6-8.

            Ratios Relating to A/R Activity
   A/R Turnover:
                    Average A/R

    Indicates how often we “turn over” or collect our
    A/R. High factor is a positive indicator.

   Average Collection Period
    (Days sales outstanding):
                  A/R Turnover

    Indicates how many days A/R are outstanding.
    Shorter periods are desirable.

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