22107 Lecture Notes - Lecture 6: Liquid Oxygen, Accounts Receivable, Income Statement
Lecture 6 - Receivables
LO1 Receivables
All businesses run on credit. While consumers using credit cards seem to be the credit transaction, the
shop will receive the money usually within 24 hours. But for many of the transactions before the final
retail sale, these are conducted on ‘credit’ or ‘account’
Recording and Reporting Accounts Receivable
→ A receivable represents a business’s claim on the asset of another entity.
→ The most common type (accounts receivable)
→ An account receivable is an amount owed by a customer who has purchased the company’s
product or service.
→ Sometimes these receivables are referred to as trade receivables because they arise from the
trade of the company.
→ Receivables are not the sales made by Woolworths to customers using their credit card.
Reporting Accounts Receivable
• Classified and reported as current assets (expected to be collected quickly)
• Companies must follow the principle of conservatism & report their accounts receivable at fair
value (net realisable value).
• Net Realisable value: amount of cash that a business expected to collect from its total or gross
accounts receivable balance. Calculated by subtracting from gross receivables the amount that a
company does not expect to collect.
LO2 Uncollectible Receivables
Understand the methods used to account for uncollectible receivables
Because uncollectible accounts are a normal part of any business, bad debt expense is considered an
operating expense.
Uncollectible Accounts
• Bad debts expense is included in the calculation of profits (or losses) but is usually combined
with other expenses on the income statement.
• An uncollectible account is written-off (the asset is removed) and an expense is recognised.
• When the expense is recognised, it depends on the method of accounting for uncollectible
accounts.
• There are two methods to account for bad debt expense:
• Direct write-off method
• Allowance method
Direct Write-Off Method
• Bad debt expense is recorded when the business determines that a receivable is uncollectible
and removes it from its records
• While this method is required for most tax purposes and is simple, it violates GAAP (matching
principle)
Shortcomings of the Direct Write-Off Method
• Shortcomings of the direct write-off method
• (1) it fails to match bad debt expense with revenue, since it delays the expense until the account
is determined to be uncollectable;
• (2) it provides an opportunity to manipulate earnings each period by strategically writing-off
accounts (would people really do that for tax?);
• (3) it does not provide the best estimate of how accounts receivable affect expected cash inflow.
LO3 Estimating Bad Debts
Understand the methods for estimating bad debt expense
There are two basis methods of estimating bad debts. In business, often each overdue debt is looked at
and a probability of collecting each estimated. At that time the action to be taken to increase the
chances of collection is often decided – polite phone call, send to debt collector.
Estimating the Amount of Uncollectible Accounts
When estimating bad debt expense using the allowance method, companies may use one or both of two
different approaches:
• Percentage-of-sales approach
Calculated by multiplying sales for the period by some percentage set by the company. Typically, this is
between 1-2% of credit sales, but will vary with the volume of business, the ease with which credit is
granted and the general economic conditions.
• Aging of Accounts Receivable
(this is a function of a company’s receivables balance, where the allowance account is adjusted to reflect
the estimate of the uncollectibles from existing accounts.
The Allowance Method
Splits accounting into two entries:
1. To record an estimate of bad debt expense
2. To write off receivables when they become uncollectible.
Setting up the Allowance
• When setting up the allowance, the allowance account is a contra asset account with a credit
balance.
Document Summary
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