Guided Readings for Financial Accounting, Lesson 7.1 – Mastery Level

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“In Financial Reporting, What Information Is Conveyed about Receivables?” The following guided readings cards were created to accompany the updated third edition of Chapter Seven (Version 3.1) of Financial Accounting authored by Joe Hoyle, C. J. Skender, and Leah Kratz and published by FlatWorld.

Copyright 2022 by Joe Hoyle

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Watch the opening video for Chapter Seven in the textbook: Introduction to Chapter Seven.

This chapter begins a new section in your study of financial accounting. The first six chapters looked at financial statements, journal entries, and the financial reporting process as a whole. Chapter Seven examines one account in detail: accounts receivable. What should a business person know about accounts receivable and its reporting?

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Read the first section of Chapter Seven (“Accounts Receivable and Net Realizable Value”). This section (it is only four pages) discusses the reporting of accounts receivable on a company’s balance sheet. Assume Jones Company reports net accounts receivable as $733,976. What does that figure represent? How did the company arrive at that balance? These first few pages in Chapter Seven examine these important questions.

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(7Q1) – Where are accounts receivable presented on a set of financial statements?

(7A1) – Accounts receivable arise from sales transactions with customers and are normally collected within the following year. Thus, the account appears on the balance sheet as a current asset. If a formal note is signed by a customer for the amount, the balance is labeled as a note receivable. Notes receivable are reported as either current assets or noncurrent assets depending on the length of time until the cash will be collected.

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(7Q2) – Ace Company has $1 million in accounts receivable but believes that $40,000 of those accounts will not be collected. Several of the customers will likely leave town, die, go bankrupt, or decide that they do not owe the amount for some reason. In the asset section of Ace’s balance sheet, what amount is reported for these receivables?

(7A2) – Accounts receivable are reported at their net realizable value. That balance reflects the amount of cash that is expected to be collected from those accounts. Thus, Ace Company reports its “net accounts receivable” on the balance sheet as $960,000. That is the estimated amount of cash that the company believes that it will eventually collect from these receivables. This balance is reported within the company’s assets.

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(7Q3) – In determining the net realizable value to report for accounts receivable, a company must estimate what portion of the various account balances will be collected. How does the company arrive at that figure?

(7A3) – The amount of cash a company expects to collect is normally estimated based on past experience. This prediction is adjusted for any current changes in the economy (better economic times usually means more collections) and changes in the company (giving credit to a wider range of customers often leads to more bad accounts).

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SUGGESTION: Work the first Test Yourself question in Section 7.1 of Chapter Seven (“Hawthorne Company operates a local hardware store …”). This question seeks to ensure that you understand the meaning of the monetary balance a company reports for its net accounts receivable. Select your answer and then read the explanation. Read the material carefully and you should be able to answer this question.

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SUGGESTION: Work the second Test Yourself question in Section 7.1 of Chapter Seven (“Gerwitz Corporation manufactures and sells shoes.…”). Three of the available answers should help company officials estimate the net realizable value of its receivables, but one is not relevant to that decision. Which of these answers is not useful in anticipating the amount of cash to be collected from accounts receivable?

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SUGGESTION: Read the second section of Chapter Seven (“Accounting for Uncollectible Accounts”). This section focuses on one journal entry and one adjusting entry. The journal entry records a sales transaction made on credit. The adjusting entry estimates the amount of uncollectible accounts and then records that expense. In this adjusting entry, notice the use of the Allowance for Doubtful Accounts, a contra account, to reduce the reported balance of accounts receivable.

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(7Q4) – Ace Company has $1 million in accounts receivable but believes that $40,000 of those accounts will not be collected. The company reports its “net accounts receivable” as $960,000 on its balance sheet. How is that amount actually presented?

(7A4) – Because no accounts have yet been written off, the accounts receivable total is $1 million and is reported at that balance. Of this total, $40,000 is not expected to be collected so net realizable value is $960,000. The $1 million is a debit balance in accounts receivable. The $40,000 is separately recorded as a credit in the allowance for doubtful accounts. On the balance sheet, the two are netted together to arrive at the $960,000 net realizable value. The bottom section of Table 7.4 provides a good example.

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(7Q5) – The allowance for doubtful accounts is referred to as a contra account. What does that term mean?

(7A5) – A contra account is one that is always shown with another account but as a decrease. It reduces the other balance to the net amount that is to be reported. The allowance for doubtful accounts decreases the accounts receivable balance to bring it down to its net realizable value—the amount that is expected to be collected.

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(7Q6) – Ace Company has $1 million in accounts receivable but estimates that $40,000 of those accounts will never be collected. Why is this $40,000 recorded in a separate allowance for doubtful accounts account rather than as a direct reduction in the accounts receivable balance? Either way, the net balance is reduced to $960,000.

(7A6) – Until specific accounts are found to be uncollectible, the actual total of accounts receivable is $1 million and the T-account should reflect that reality. Direct reduction is delayed until specific accounts are deemed to be uncollectible. Until then, the reduction is recorded indirectly in the allowance account. The uncertainty of the $40,000 estimate is easier to understand when isolated in the contra account. The uncertainty of the estimate is better conveyed by using two separate accounts to arrive at the net balance.

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(7Q7) – Ace Company makes $500,000 in sales on account in Year One. The company debits accounts receivable and credits sales revenue because the performance obligation has been satisfied. When preparing financial statements at year end, Ace estimates that $3,000 of this amount will eventually prove to be uncollectible. How did company officials arrive at the $3,000 figure?

(7A7) – Bad debts, as well as many of the other estimations that a company must make for reporting purposes, are normally calculated by studying historical trends and then applying necessary adjustments because of any current changes in the company or in its environment. For example, if 3 percent of receivables have proven uncollectible in the past but the current economy is in recession, a higher percentage is now likely to be more appropriate.

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(7Q8) – Ace Company makes $500,000 in sales on account in Year One. It debits accounts receivable and credits sales revenue because the performance obligation has been satisfied. The company estimates that $3,000 of this amount will never be collected. The actual identify of those customers will not be known until Year Two. When is the expense recognized? What adjusting entry is made in Year One?

(7A8) – The company incurs the $3,000 expense in Year One. Sales were made in that year that will never be collected. The expense should be recognized at that time. As shown in Figure 7.2, the Year One adjusting entry is a debit to bad debt expense (an increase) of $3,000 and a credit to the allowance for doubtful accounts (an increase) also for $3,000.

Accounts receivable is not directly decreased. Until a specific account is judged to be bad, the reduction is reflected in the allowance account.

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(7Q9) – Ace Company makes $500,000 in sales on account in Year One. It debits accounts receivable and credits sales revenue because the performance obligation has been satisfied. The company estimates that $3,000 of this amount will never be collected. Bad debt expense is recognized for that amount and the allowance for doubtful accounts is also recorded. What purpose does the allowance for doubtful accounts serve?

(7A9) – The allowance for doubtful accounts temporarily holds the reduction in the accounts receivable until the actual identity of the uncollectible balances is uncovered. At that point, the reduction is moved from the allowance to the accounts receivable T-account. Because the estimate is recorded before any account proves to be uncollectible, this contra account is needed to temporarily hold the reduction.

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(7Q10) – Ace Company makes $500,000 in sales on account in Year One. The company estimates that $3,000 of this amount will not be collected. The actual identify of those customers will not be known until Year Two. The company debits bad debt expense for $3,000 and credits the allowance for doubtful accounts by $3,000. When is this adjusting entry made?

(7A10) – Adjusting entries are made when a company is ready to prepare financial statements. Big companies usually make adjusting entries at the end of each month or quarter. Smaller companies wait until the end of the year. Either way, the bad debt expense must be recognized in Year One when the sale is made. Table 7.1 records the sale. Table 7.2 subsequently records the estimated bad accounts.

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SUGGESTION: Read the third section of Chapter Seven (“The Problem With Estimations”). This section examines two events and is only five pages long. The first event is the discovery that an account receivable balance is believed to have become uncollectible. The second is the eventual collection of a balance that had been written off previously as uncollectible.

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(7Q11) – Ace Company makes $500,000 in sales on account in Year One. The company estimates that $3,000 of this amount will not be collected. At the end of Year One, the company debits bad debt expense $3,000 and credits the allowance for doubtful accounts $3,000. Early in Year Two, the company learns that one customer who owes $800 has gone bankrupt. As a result, the balance will never be collected. What journal entry is recorded at that time?

(7A11) – As shown in Table 7.5, when an account receivable is judged to be bad, only one entry is ever recorded. The balance is removed from the allowance for doubtful accounts to become a reduction in accounts receivable. The reduction is shifted because it is now known. That entry is a debit (or decrease) to the allowance for doubtful accounts for $800 and a credit (also a decrease) to the accounts receivable for $800.

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SUGGESTION: Work the first Test Yourself question in Section 7.3 of Chapter Seven (“Near the end of Year One, a company …”) as well as the One Step Further question. A company has discovered an uncollectible account receivable and written off the balance as shown in Table 7.5. You can see the debit and the credit entries in that table. What is the effect of that write off? Think about this carefully and you should get both of these practice problems correct.

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(7Q12) – A company makes $500,000 in sales on account in Year One and estimates that $3,000 will not be collected. In a Year One adjusting entry, the company debits bad debt expense for $3,000 and credits allowance for doubtful accounts by $3,000. In Year Two, the company learns that one customer has gone bankrupt. As a result, an $800 account will not be collected. To remove that account, the allowance for doubtful accounts is debited and accounts receivable is credited. Why is no expense recognized at that time?

(7A12) – The expense was recognized previously in Year One when it was incurred as a result of making sales on account. Even though the $3,000 total had to be estimated, it was recorded as an expense at that time. This expense should not be reported a second time in Year Two when an actual uncollectible account is identified.

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(7Q13) – Ace Company is near the end of its fiscal year and is getting ready to prepare financial statements. Just before making those statements, a $4,000 account receivable is judged to be bad and written off. How did this entry change the total reported asset balance on the company’s balance sheet? What is the effect of the discovery?

(7A13) – When an account is written off as uncollectible, the allowance for doubtful accounts is debited (reduced) and accounts receivable is credited (reduced). Both the asset and the contra asset are reduced by the same amount. Thus, the two reductions offset each other. The net asset balance stays the same. If receivables are $500,000 and the allowance is $12,000, the net balance is $488,000. After a $4,000 write off, the receivables are $496,000 and the allowance is $8,000 for the same net $488,000 reported figure.

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SUGGESTION: Study Table 7.8. It shows how the four related account balances (sales, bad debt expense, accounts receivable, and the allowance for doubtful accounts) are affected during any year prior to making the final bad debt expense estimation. Sales and bad debt expense are temporary accounts and start off each year with a zero balance because of previous closing entries. Accounts receivable and the allowance for doubtful accounts carry their balances over from the previous year.

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(7Q14) – An adjusting entry is made to recognize an estimated amount of bad debts at the end of each year. A different journal entry is made whenever any account balance is judged to be uncollectible. These are the basic entries here. Purely for review purposes, what are these two entries?

(7A14) – At the end of each year (or whenever financial statements are prepared), the amount of uncollectible accounts is estimated and an adjusting entry recorded debiting (increasing) bad debt expense and crediting (also increasing) the allowance for doubtful accounts.

Later, when an actual account is judged to be uncollectible, it is written off. The allowance for doubtful accounts is debited (as a decrease) and accounts receivable is credited (also a decrease).
Those are the two basic entries for bad debts.

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The following statement is included in the end-of-chapter material as a True or False question. “A company ends Year Two with bad debt expense of $29,000 and an allowance for doubtful of $27,000. On April 8, Year Three, a $1,900 receivable is written off as uncollectible. Net income is reduced by $1,900 on that date.” That statement is False. Why is that statement False?

The previous statement is False. Bad debt expense was recognized as the result of an estimation in the prior year because that was the same time period as the sale. The expense cannot be recognized a second time when an actual bad account is discovered. Instead, the reduction in the allowance is moved into accounts receivable because the actual bad account is now known.

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(7Q15) – On December 31, Year One, Lars Company recognizes bad debt expense of $12,000. Then, on February 8, Year Two, the company learns that a customer has left town without paying a $9,000 receivable. The account is written off as uncollectible. However, on October 11, Year Two, this customer returns and pays the entire debt. It sometimes happens. What journal entries will the company make in Year Two?

(7A15) – On February 8, Lars removes the bad account by debiting (decreasing) the allowance for doubtful accounts $9,000 and crediting (also decreasing) accounts receivable $9,000.

On October 11, two entries are made for the payment:
Accounts receivable is debited (increased) by $9,000 and the allowance account is credited (increased) by $9,000 to reinstate both balances. Then, cash is debited (increased) and accounts receivable credited (decreased) by $9,000 to record the cash collection

These two October 11 entries can be combined—debit cash and credit the allowance for doubtful accounts for $9,000.

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(7Q16) – A company estimates that $3,000 of its accounts receivable will never be collected. At the end of Year One, the company debits bad debt expense for $3,000 and credits the allowance for doubtful accounts by $3,000. During Year Two, the company determines that a total of $3,200 of its accounts will not be collected. Should the company immediately record an additional expense of $200?

(7A16) – The $3,000 was an estimate for Year One and no one expected it to be exactly correct. No retroactive correction is made when actual bad debts turn out to be either higher or lower than the estimate. Instead, in recording bad debts at the end of Year Two, the amount of actual bad accounts will likely influence the new estimation. The estimate at the end of Year One proved to be a little too low. Thus, the company might choose to use a slightly higher estimate at the end of Year Two. Makes sense and accounting should make sense.