Solutions to Case Reading 4-2
EXERCISES AND PROBLEMS
Exercise 1 (10 minutes) Reasons for Extending Credit to
Companies extend credit to customers to increase sales. As long as the
profit from increased sales is larger than the increased uncollectible
accounts expense resulting from the increased sales, the decision has a
positive impact on net income. It is a matter of managerial analysis and
judgment as to how liberal credit terms should be in order to increase
Exercise 2 (10 minutes) Why Use Uncollectible Accounts?
Yes, it would be simpler to wait until an account receivable became
uncollectible and then record it as an expense. However, this write-off
violates the matching principle where we match expenses incurred with
revenues earned during the same period. Usually an account receivable
becomes uncollectible during an accounting period following the period in
which the revenues were recognized as earned.
Exercise 3 (10 minutes) Advantages and Disadvantages of Direct
Advantages of using the direct write-off method are:
The method is simple to use.
The method is required for income tax purposes.
The method does not require the use of estimates in determining the
uncollectible accounts expense.
Disadvantages of using the direct write-off method are:
The direct write-off method violates the matching principle.
The direct write-off method does not show accounts receivable in the
balance sheet at net realizable value as does the allowance method.
The allowance method usually results in a more conservative
determination of net income.
Exercise 4 (10 minutes) Accounts Receivable Disclosure in the
When the allowance for uncollectible accounts method is used, accounts
receivable are disclosed in the balance sheet at their net realizable value.
For example, they may be disclosed as follows:
Accounts receivable $225,000
S188 Solutions To Exercises and Problems for Case Reading 4-2
Less: Allowance for uncollectible accounts 11,000
Net Accounts receivable $214,000
Exercise 5 (15 minutes) Evaluating Accounts Receivable.
The accounts receivable turnover tell us how quickly the average
accounts receivable was collected. For example, if a company had an
accounts receivable turnover of 10 and another firm had a turnover of 5,
the first firm would have its average accounts receivable outstanding half
as long as the second firm. Generally, a higher accounts receivable
turnover is desirable.
The accounts receivable collection period refers to how many days it
takes on the average to collect an accounts receivable. The accounts
receivable collection period is determined by dividing 365 days by the
accounts receivable turnover. To a certain extent, the accounts
receivable collection period is an indication of the efficiency of the credit
and collections department of a business.
Accounts receivable turnover and collection period can be used to
evaluate the collection efficiency of the company and may help in
determining the collectibility of past due accounts.
Exercise 6 (10 minutes) Use of Allowance Method by Publicly
Companies who trade their stock in the open market (public companies)
are required by the Securities Exchange and Commission (SEC) to use
Generally Accepted Accounting Principles (GAAP) in their annual reports.
The direct write-off method is not considered to be GAAP, primarily
because of the lack of good matching of revenues and expenses, and
thus the SEC will not allow it to be use for company reporting purposes.
Accordingly, public companies need to use the allowance method for
reporting uncollectible accounts.
Exercise 7 (10 minutes) Two Approaches to Using Allowance
To estimate uncollectible accounts expense by the percentage of sales
approach you simply multiply sales revenues for the period by the
estimated percent of sales that will become uncollectible. This is often
called the income statement approach to estimating uncollectible
The computation for estimating uncollectible accounts expense by the
aging of accounts receivable approach is more complex. First, you need
to age accounts receivable, then multiply each age category by the
percent that is likely to become uncollectible, then sum the results. The
Solutions to Exercises and Problems for Case Reading 4-2 S189
sum of all the estimated uncollectible age categories will give the
estimated allowance needed at that time and is what the allowance for
uncollectible accounts is adjusted to. This method is often called the
balance sheet approach to estimating uncollectible accounts.
Problem 1 (15 minutes) Allowance with Percentage of Sales
a. Sales of $200,000 × 1.5% = $3,000 uncollectible accounts expense
b. The allowance for uncollectible accounts balance is computed as
Balance, Jan. 1, 2000 $4,000
Accounts written off during year -3,700
Subtotal $ 300
Added as adjustment, Dec. 31, 2000 3,000 (See a, above)
Balance, Dec. 31, 2000 $3,300
Problem 2 (15 minutes) Allowance with Aging of Accounts
a. The balance in the allowance for uncollectible accounts account
should be $4,200 at the end of the year. Its current balance it $300
($4,000 less $3,700 written off). Thus it needs to be increased by
$3,900 ($4,200 needed less $300 balance before adjustment) and is
the amount of uncollectible expense for 2000.
b. The balance in the allowance for uncollectible accounts at December
31, 2000 should be $4,200 as determined by aging of accounts
Problem 3 (30 minutes) Aging of Accounts Receivable Approach
With Receivable Recovered.
a. The balance in the allowance for uncollectible accounts account at
December 31, 2000, before adjustment is ($700) ($9,000 less $9,700
written off ). The balance needed in the allowance account is stated at
$10,000. Therefore, an adjustment of $10,700 is needed, which is the
amount of the uncollectible accounts expense for Aumend Company in
b. The write-off of an account receivable has no effect on the net
realizable value of accounts receivable in the balance sheet. The
reason there is no effect is because both accounts receivable and the
contra account, allowance for uncollectible accounts, are reduced by
the exact same amount. Thus, the difference between the two
accounts does not change by the write-off of an uncollectible account.
S190 Solutions To Exercises and Problems for Case Reading 4-2
c. The balance in the allowance for uncollectible accounts account at
December 31, 2000, before adjustment is $500 ($9,000 less $9,700
written off plus $1,200 recovered). The balance needed in the
allowance account is stated at $10,000. Therefore, an adjustment of
$9,500 ($10,000 less $500 balance in allowance account) is needed,
which is the amount of the uncollectible accounts expense for Aumend
Company in 2000.
Problem 4 (20 minutes) Evaluating Credit Terms.
The accounts receivable collection period for Aumend Company is 54.75
days, computed as follows:
Accounts receivable turnover = Sales ÷ Average accounts receivable =
$500,000 ÷ [($70,000+$80,000) ÷ 2] = 6.667 times
365 ÷ 6.667 = 54.75 days average collection period for accounts
With terms of 2/10, net 45 days Aumend Company is doing a poor job of
collecting accounts receivable on a timely basis. If some customers are
paying within the 10 day discount period and the rest paying within the 45
day limit, the average collection period would be less than 45 days, and
probably less than 40 days. Since it is taking them almost 55 days to
collect the average account receivable, their collection experience is poor.
Aumend Company needs to closely evaluate their credit and collections
policies and practices.
Problem 15 (20 minutes) Interpreting Accounts Receivable Ratios.
Donaldson Company is slightly larger than the average company in the
industry and uses the same credit terms as is normal for the industry.
What is probably concerning Ms. Quick is the slower turnover of accounts
receivable and, therefore, the accounts receivable collection period is
longer for the Donaldson Company than for the industry. She should be
concerned about the almost 11 days longer collection period (31% longer)
than the industry norm. If the credit and collections process is now her
responsibility, she will be the one responsible to reduce the gap between
her company and the norm.
Both the industry norm and Donaldson Co. average collection period is
longer than the maximum collection period given in their credit terms.
This should be a concern to both Ms. Quick and the industry. The
Donaldson Co. experience shows an average collection period 52%
longer than its credit terms (45.6 days – 30 days = 15.6 days ÷ 30 days).
Why is the Donaldson Co. performance so much poorer than the
Solutions to Exercises and Problems for Case Reading 4-2 S191
Additional data desired would be is there differences in industry norms by
size of firm? Donaldson company is 20% larger than the normal firm.
Does this make any difference in the accounts receivable collection
period? It probably should not. Also, what has been the trend in
accounts receivable collection period for Donaldson Company over the
last three to five years? And, is there some other logical explanation
(other than inefficiency) for the slower collection experience of Donaldson
S192 Solutions To Exercises and Problems for Case Reading 4-2