Learning Questions and Answers for Financial Accounting, Lesson 7.1 – Mastery Level

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(1) – During its first year of operations, Ace Company makes sales on credit of $500,000 and collects $300,000 in cash from these accounts creating an account receivable balance of $200,000. Why is Ace unlikely to report accounts receivable on its balance sheet as $200,000?

(2) – In (1), Ace Company has $200,000 in accounts receivable. What figure does the company report for this asset?

(3) – What is a contra account?

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(4) – In (1), Ace Company has $200,000 in accounts receivable. Assume the company estimates that it will collect only $190,000 from these accounts because $10,000 are expected to become uncollectible. How is this information reported on the company’s balance sheet so that decision makers will understand what they are seeing?

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(5) – In (4), the accounts receivable total is reported as $200,000 and the allowance for doubtful accounts is $10,000. On the balance sheet, they are netted together to report the asset’s net realizable value of $190,000. Why not simply reduce accounts receivable by $10,000 to a single balance of $190,000?

(6) – In simple terms, what is the purpose of reporting an allowance for doubtful accounts?

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(7) – In dealing with bad debts, there are normally only two journal/adjusting entries that you need to learn. The first is at the end of each year when the company is getting ready to prepare financial statements. The company wants its account balances adjusted properly. What is this adjusting entry?

(8) – In dealing with bad debts, there are normally only two journal/adjusting entries that you need to learn. How hard can that be? The second is the subsequent entry when an actual account is written off as uncollectible. What is the second journal entry?

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(9) – In (7), bad debt expense is reported before any actual accounts are removed as uncollectible. Why is the expense recognized in this initial period?

(10) – Ace Company makes a sale of $2,000 on account to Mr. Jones in Year One. In Year Two, Mr. Jones files for bankruptcy protection and Ace writes off the account as uncollectible. How much expense does Ace recognize when the account is deemed uncollectible?

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(11) – At the end of Year One, Ace Company estimates its bad debts as $10,000. In Year Two, the company finds that $11,000 of its accounts are uncollectible. What does the company do about the extra $1,000?

(12) – Ace Company feels that Ms. Green is not going to pay her $1,400 accounts receivable and writes that balance off as uncollectible. Later, Ms. Green does pay her balance to the company. How does the company handle this situation?

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These questions cover the first three sections of Chapter Seven. They look at how a company’s accounts receivable balances are reported at their net realizable value. The actual amount of expense to be reported is not described until the next section of the chapter. This part of the textbook is designed to explain how the process works.

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Now, repeat the questions with their answers until you are 100 percent comfortable with each one.

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(1) – During its first year of operations, Ace Company makes sales on credit of $500,000 and collects $300,000 in cash from these accounts creating an account receivable balance of $200,000. Why is Ace unlikely to report accounts receivable on its balance sheet as $200,000?

Virtually all companies make some amount of sales on account to customers who will eventually fail to pay. Customers will leave town, declare bankruptcy, die, or dispute the balance. Such losses are inevitable for any company that sells goods or services on account. Therefore, $200,000 is not a realistic value for Ace to report for its accounts receivable. It likely does not expect to get that much money.

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(2) – In (1), Ace Company has $200,000 in accounts receivable. What figure does the company report for this asset?

According to U.S. GAAP, the accounts receivable balance is reported at its net realizable value, the amount of cash that the company expects to collect from these accounts. The company reports its best guess at the amount of cash that will be received.

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(3) – What is a contra account?

A contra account is one that always appears in connection with another account balance but as a reduction. In this chapter, the Allowance for Doubtful Accounts is a contra asset account.

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(4) – In (1), Ace Company has $200,000 in accounts receivable. Assume the company estimates that it will collect only $190,000 from these accounts because $10,000 are expected to become uncollectible. How is this information reported on the company’s balance sheet so that decision makers will understand what they are seeing?

The $200,000 balance in accounts receivable is a factual amount. The $10,000 that the company feels will not be collected is merely a guess. These two balances are kept separate in the general ledger and then netted on the balance sheet to report the net realizable value. The accounts receivable total is $200,000. The $10,000 reduction is shown as an “Allowance for Doubtful Accounts,” a contra account to reduce accounts receivable to an appropriate net balance of $190,000. That is the net realizable value, the amount of cash the company expects to collect.

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(5) – In (4), the accounts receivable total is reported as $200,000 and the allowance for doubtful accounts is $10,000. On the balance sheet, they are netted together to report the asset’s net realizable value of $190,000. Why not simply reduce accounts receivable by $10,000 to a single balance of $190,000?

At that point in time, no account has yet been deemed as uncollectible. The accounts receivable balance is still literally $200,000. Use of the allowance account allows the company to maintain the $200,000 accounts receivable balance (until actual accounts are judged to be uncollectible) while still reporting the net realizable value as only $190,000.

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(6) – In simple terms, what is the purpose of reporting an allowance for doubtful accounts?

The allowance is merely a temporary reduction that is created so that financial statements can be made. The estimated reduction stays in that account until actual bad debts are uncovered. At that point, the reduction moves from the allowance for doubtful accounts to the accounts receivable T-account.

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(7) – In dealing with bad debts, there are normally only two journal/adjusting entries that you need to learn. The first is at the end of each year when the company is getting ready to prepare financial statements. The company wants its account balances adjusted properly. What is this adjusting entry?

At the end of the year when financial statements are to be prepared, the adjusting entry for bad debts is a debit to bad debt (or uncollectible accounts) expense and a credit to the allowance for doubtful accounts. Notice this answer does not yet address how the amount is determined. It merely shows how the year-end adjusting entry is going to appear.

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(8) – In dealing with bad debts, there are normally only two journal/adjusting entries that you need to learn. How hard can that be? The second is the subsequent entry when an actual account is written off as uncollectible. What is the second journal entry?

At some point, one or more accounts will be judged as uncollectible. At that time, this specific bad debt is no longer an estimate. It is a reality. The allowance for doubtful accounts is debited for the amount of that account and accounts receivable is credited. Notice that this entry merely switches the reduction out of the temporary account (the allowance for doubtful accounts) and into the permanent account (accounts receivable).

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(9) – In (7), bad debt expense is reported before any actual accounts are removed as uncollectible. Why is the expense recognized in this initial period?

It is the original sale on account that ultimately leads to the expense. The company makes a sale to a customer who will eventually not pay. The sales revenue is reported in the first year so the related expense should be in the same period. Furthermore, by recognizing the potential bad debt in the first year, the accounts receivable balance is reported at its net realizable value.

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(10) – Ace Company makes a sale of $2,000 on account to Mr. Jones in Year One. In Year Two, Mr. Jones files for bankruptcy protection and Ace writes off the account as uncollectible. How much expense does Ace recognize when the account is deemed uncollectible?

The expense is recognized through an estimation in the year of sale (Year One). The expense is only recognized once. It is not recognized a second time in Year Two. The allowance is debited and the account receivable is credited but no expense is recognized at that time.

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(11) – At the end of Year One, Ace Company estimates its bad debts as $10,000. In Year Two, the company finds that $11,000 of its accounts are uncollectible. What does the company do about the extra $1,000?

Virtually all estimates will prove to be incorrect. That is just the nature of an estimate. Under normal circumstances, companies do not worry about estimates that are wrong. However, in this case, the company might well want to make a higher estimate in the subsequent year.

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(12) – Ace Company feels that Ms. Green is not going to pay her $1,400 accounts receivable and writes that balance off as uncollectible. Later, Ms. Green does pay her balance to the company. How does the company handle this situation?

When the account was written off, Ace debited the allowance for doubtful accounts and credited accounts receivable for $1,400. Now, Ace must first reverse that entry to put the account back on the books. Accounts receivable is debited for $1,400 and the allowance for doubtful accounts is credited for the same amount. Then, the collection is recorded normally with a debit to cash for $1,400 and a credit to accounts receivable. As an alternative, cash can be debited for $1,400 and the allowance account credited for $1,400. The overall effect is the same.

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Before moving on the next assignment in this lesson, make certain that you understand all of these twelve questions and answers. You are building a foundation of knowledge about the financial reporting of accounts receivable. It is important that you learn each step along the way before moving ahead.

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