Accounting Chapter on Bad Debts

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Questions and Answers

What is the key principle violated by the direct write-off method?

Expense recognition principle

Revenue recognition principle

Matching principle (correct)

Cost principle

Which type of companies primarily use the direct write-off method?

Non-profit organizations

Multinational firms

Small nonpublic companies (correct)

Large public corporations

What happens when an account receivable is written off using the direct write-off method?

The account is no longer pursued for collection (correct)

Collection efforts continue

The revenue is restated

The bad debt expense is recorded in the following year

What is the purpose of the Allowance for Bad Debts account?

To adjust for uncollectible accounts Signup and view all the answers

Which method properly aligns bad debts expense with sales revenue?

Allowance method Signup and view all the answers

What is a major consequence of using the direct write-off method?

Overstated net income in the recording year Signup and view all the answers

Which of the following is a limitation of the direct write-off method?

It does not comply with GAAP for many companies. Signup and view all the answers

What action is taken when a previously written-off account is unexpectedly collected?

The original bad debt expense is reversed Signup and view all the answers

How is the target balance for the Allowance for Bad Debts determined under the aging-of-receivables method?

By evaluating the age and collection probability of each account Signup and view all the answers

If Martin’s Music has a debit balance of $150 in its Allowance for Bad Debts, what will be the effect on the bad debts expense calculation?

It will increase the bad debts expense Signup and view all the answers

What is the method that applies different percentages to categories of accounts based on how long they have been outstanding?

Aging-of-Receivables Method Signup and view all the answers

In the aging-of-receivables method, what equation is used to determine bad debts expense?

Bad debts expense = Target balance + Unadjusted debit balance Signup and view all the answers

What would be the result if Smart Touch Learning’s target balance for Allowance for Bad Debts is $185?

The need for recording bad debts expense Signup and view all the answers

Which of the following statements is true regarding the percent-of-receivables method?

It estimates uncollectible accounts using a percentage of total receivables Signup and view all the answers

Why might a business utilize the aging-of-receivables method rather than the percent-of-receivables method?

To gather more detailed insights into the status of accounts Signup and view all the answers

What is a promissory note?

A written promise to pay a specific amount at a future date Signup and view all the answers

Who is referred to as the maker of a promissory note?

The entity that signs the note and promises payment Signup and view all the answers

What does the term 'interest' represent in the context of notes receivable?

Revenue to the payee for providing a loan Signup and view all the answers

How is maturity value determined?

The sum of the principal plus accrued interest Signup and view all the answers

What is the maturity date of a note?

The date by which the note must be paid back Signup and view all the answers

What does the interest rate in a promissory note typically represent?

The percentage charged on the principal for one year Signup and view all the answers

In a situation where the period of a note is specified in months, how is the maturity date determined?

It falls on the same day of the month as the issuance date Signup and view all the answers

If a note specifies a maturity period in days, what must be done to find the maturity date?

Count the specified days from the issue date, omitting the issue date Signup and view all the answers

How much interest revenue should Smart Touch Learning accrue on December 31, 2025, for a loan of $1,000 at an annual interest rate of 6%?

$15 Signup and view all the answers

If Smart Touch Learning lends $1,000 on September 30, 2025, for one year at 6%, what is the total interest earned by the maturity date?

$60 Signup and view all the answers

What is the calculated Bad Debts Expense using the percent-of-sales method for Smart Touch Learning?

$300 Signup and view all the answers

What entry does Smart Touch Learning make when the note receivable is honored at maturity?

Debit Cash, Credit Notes Receivable Signup and view all the answers

Which of the following equations best describes the process to determine Bad Debts Expense using the percent-of-receivables method?

Bad debts expense = Target balance - Unadjusted credit balance of Allowance for Bad Debts Signup and view all the answers

What is the interest income for Smart Touch Learning from the $1,000 loan after nine months?

$45 Signup and view all the answers

What should Blanding Services do when Sports Club cannot pay the accounts receivable of $5,000?

Accept a 60-day note receivable with 12% interest Signup and view all the answers

If Smart Touch Learning's accounts receivable balance is $6,375, what is the target balance for Allowance for Bad Debts at an estimated uncollectible rate of 4%?

$250 Signup and view all the answers

Which entry would Smart Touch Learning record on December 31 to recognize bad debts expense based on the percent-of-receivables method?

Debit Bad Debts Expense for $200 Signup and view all the answers

How should Rubinstein Jewelers handle the default of a note receivable signed by Mark Adair?

Transfer the dishonored note and unpaid interest to Accounts Receivable Signup and view all the answers

What is the total amount recorded by Rubinstein Jewelers if Mark Adair's note payable defaults?

$1,200 Signup and view all the answers

What is the method used by Smart Touch Learning to account for uncollectibles based on past credit sales experience?

Percent-of-sales method Signup and view all the answers

If collections on account during the year amount to $58,000, which of the following statements is true?

The net credit sales correspond to $300 in Bad Debts Expense Signup and view all the answers

If a maker of the note dishonors it, what is the next step for the holder of the note?

Transfer the note to a different type of receivable Signup and view all the answers

What is the credit balance of the Allowance for Bad Debts for Smart Touch Learning before adjusting for the current year?

$55 Signup and view all the answers

If $200 is adjusted to the Allowance for Bad Debts, what does this adjustment reflect?

The estimated uncollectible accounts needed to meet the target balance Signup and view all the answers

What is the primary characteristic of accounts receivable?

It represents a right to receive cash for goods or services. Signup and view all the answers

Which of the following best describes notes receivable?

They represent a promise to pay a fixed amount plus interest. Signup and view all the answers

How are accounts receivable typically classified on the balance sheet?

Current assets Signup and view all the answers

What terminology is used for the party that owes money in a credit transaction?

Debtor Signup and view all the answers

What is the typical collection period for accounts receivable?

30 to 60 days Signup and view all the answers

Which of the following represents an uncollectible account?

An overdue account determined not collectible Signup and view all the answers

Which method involves estimating bad debt expense based on the sales percentage?

Percent-of-sales method Signup and view all the answers

Which statement about the maturity date of a note receivable is true?

It is the date on which the note is due for payment. Signup and view all the answers

Study Notes

Chapter 8: Receivables

Receivables arise when a business sells goods or services on credit.
A receivable represents a monetary claim against another party.
A receivable is a current asset, representing a right to receive cash.
Creditors are the parties receiving receivables.
Debtors are the parties obligated to pay later.

Accounts Receivable

Accounts receivable, also called trade receivables, represent the right to receive cash from customers for goods or services performed.
These receivables are usually collected within 30-60 days.
Accounts receivables are reported as a current asset on the balance sheet.

Notes Receivable

Notes receivable typically have longer terms than accounts receivable.
Sometimes called promissory notes, notes receivable represent a promise to pay a fixed amount of principal plus interest by a certain due date.
The maturity date is the date when the note receivable is due.

Other Receivables

Other receivables include various other types, such as dividends receivable, interest receivable, and taxes receivable.
These are classified as either current or long-term depending on whether they are due within one year or more.

Internal Control Over Receivables

Internal control over cash payments is essential.
The separation of cash handling and cash accounting duties is critical.
Credit departments should not have access to cash.
Cash handlers should not be in a position to grant credit.

Recording Sales on Credit

Sales on account are recorded by debiting accounts receivable and crediting sales revenue.
Companies maintain a control account for accounts receivable and subsidiary accounts for each customer.
When cash is collected, cash is debited and accounts receivable is credited.

Recording and Writing Off Uncollectible Accounts—Direct Write-Off Method

The direct write-off method records bad debts expense when a customer's account is deemed uncollectible.
This method is primarily used by small, non-public companies.
The company writes off the uncollectible account and stops pursuing collection.

Recovery of Accounts Previously Written Off—Direct Write-Off Method

If the previously written-off account is collected, an entry reverses the write-off.
Accounts receivable and bad debt expense are credited (for the amount collected).
Cash is debited.

Limitations of the Direct Write-Off Method

Violates the matching principle, mismatching revenue and expenses in different accounting periods.
Overstates net income in some periods and understates it in others.
Overstates accounts receivable in the periods where sales are recognized and bad debts are not recognized/recorded until later periods.
Only suitable for companies with very few uncollectible receivables.

Applying the Allowance Method for Uncollectibles

The allowance method is used to estimate bad debts expense.
It's based on the matching principle, recording bad debts expense as a rough estimate in the period of related sales.
A contra asset account, Allowance for Bad Debts, reduces accounts receivable to the net realizable value.

Recording Bad Debts Expense—Allowance Method

A company estimates uncollectible accounts and creates the allowance for bad debt when needed.
Bad debts expense is recorded by debiting bad debts expense and crediting allowance for bad debts.
The accounts receivable is not directly affected until the specific account is written off.

Writing Off Uncollectible Accounts—Allowance Method

An allowance is established for estimated uncollectible accounts.
A debit to Allowance for Bad Debts (rather than Bad Debts Expense) is recorded when an account is written off.
The entry to write off an account under the allowance method does not impact net income.

Recovery of Accounts Previously Written Off—Allowance Method

A debit to accounts receivable, and a credit to allowance for bad debts, is recorded when a previously written-off account is collected.
The recovery is not recorded until the money is received.

Estimating and Recording Bad Debts Expense—Allowance Method

Companies estimate bad debt expense using past experience, industry data, and other relevant factors.
Three common methods are percent-of-sales, percent-of-receivables, and aging-of-receivables.

Percent-of-Sales Method

Computes bad debts expense as a percentage of net credit sales.
Can use all sales to determine percentage rate.
Resulting bad debts expense is recorded as an adjusting entry.

Percent-of-Receivables Method

Estimates bad debts as a percentage of accounts receivable.
Calculates target target balance of the allowance for bad debts.
Evaluates the allowance account to determine bad debt expense.

Aging-of-Receivables Method

Groups accounts based on how long the receivable has been outstanding (how long the invoice or other documentation is outstanding).
Different percentages are applied to receivables based on how long they are outstanding.

Account for Notes Receivable

A promissory note is a written promise to pay.
The maker of the note (debtor) is the party legally obligated to pay.
The payee (creditor) is the party to receive the payment from the note.

Compute Interest on a Note

Interest is the revenue to the creditor and expense to the debtor.
Interest is calculated by multiplying the principal, interest rate, and time.
Time can be expressed in months or days.

Recording Dishonored Notes Receivable

When a maker fails to pay the note, it becomes dishonored.
Note and related interest are transferred to Accounts Receivable if not paid on the maturity date or the payment date.

Use Acid-Test Ratio, Accounts Receivable Turnover Ratio, and Days' Sales in Receivables

Balance sheet data shows relationships between assets, liabilities, and revenues.
Acid-test ratio assesses the company's ability to pay short-term obligations.
Accounts receivable turnover ratio indicates how quickly receivables are collected.
Days' sales in receivables measures the average collection period for receivables.

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Description

This quiz covers key concepts related to the direct write-off method and the allowance for bad debts in accounting. It explores principles, applications, limitations, and methods relevant to managing uncollectible accounts. Test your knowledge of how these methods affect financial statements and business practices.