Chapter 6:
Reporting & Analyzing
Operating Assets
Part 1:
Accounts Receivable
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Accounts Receivable
Accounts receivable arise from selling goods
or services to customers on account.
 Recorded at face amount to be collected.
 However, we must also reflect the fact that a
portion of A/R may not be collected.
 Reasons for lack of collection:
(1) sales discounts
(2) sales returns
(3) uncollectible A/R (bad debts)

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Uncollected A/R
(1)Sales Discounts occur when a customer takes
advantage of a cash discount for early payment.
(2)Sales Returns occur when a customer returns a
purchase.
(3)Uncollectible A/R (bad debts) occur when a
customer defaults on the receivable, and the
company cannot collect the amount owed.
This item requires a separate expense account
(rather than a reduction of revenue).
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Uncollectible A/R
Method 1:Direct Write-Off Method
 Small (or privately held) companies may use this
technique to recognize uncollectible A/R.
 In the year that a specific A/R is deemed
uncollectible (usually 1 – 2 years after the initial
sale/service transaction), the company would
remove the A/R, and recognize bad debt expense:
Bad Debt Expense
xx
A/R
xx
 However, A/R is overstated until the write-off and
the Bad Debt Expense is not recognized in the
same period as the revenue (no matching).
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Uncollectible A/R
Method 2: the Allowance Method
 For matching, we estimate the A/R that will not
be collected, and match that expense to current
revenues.
 The AJE (adjusting journal entry) to record an
estimate for future uncollectibles in year of sale:
Bad Debt Expense
xx
Allowance for Uncoll.
xx
 The General JE in later periods, when a specific
A/R is deemed uncollectible (this is called the
write-off of a specific A/R):
Allowance for Uncoll.
xx
A/R
xx
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Estimation of Uncollectibles
Note that we do not know in the year of the
sale which A/Rs will not be collected in the
future. Therefore, we must estimate
uncollectibles. There are two methods to
estimate uncollectibles (for the AJE):
1. Percentage of sales
2. Percentage of accounts receivable
 Both methods are acceptable under
GAAP(generally accepted accounting
principles).

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Percentage of Sales Method
The percentage of sales method is very
simple. Based on some percentage,
derived from historical data, industry
averages, economic conditions, etc., the
estimated expense may be calculated:
Revenue x % = Bad Debt Expense
 This is also called the income statement
method.
 The AJE, based on this number, is
Bad Debt Expense
x
Allowance for Uncoll.
x

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Percentage of A/R Method
(using Aging Schedule)





Based on ending A/R and ending Allowance
account.
Calculation:
Ending A/R x % = Ending Allowance
(focus on the credit side of the AJE)
Called Balance Sheet approach, because:
ending asset x % = ending contra asset.
Requires the analysis of the Allowance account
before preparing the AJE.
An aging schedule of A/R is the most accurate
way to estimate uncollectibles (see Exhibit 6-1).
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Percentage of A/R Method
(using Aging Schedule)



The aging schedule is beneficial, even if the
Direct Write-off method is used.
The aging schedule highlights slow-payers
(including insurance companies), and allows the
company to develop additional collection
techniques.
Many billing programs will do an aging schedule,
and include the information on each customer’s
bill.
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T-Account Approach for
Percentage of A/R Method
Based on the analysis of the Allowance
account.
 Calculate the “desired ending balance”
based on an aging of A/R.
 Now, given the Beginning, Ending and
Write-off amounts, calculate the amount of
the current estimate that must be added to
the Allowance account to achieve the
“desired ending balance.”

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Allowance for Doubtful Accts.
(T-account)
Allowance for Doubtful Accts.
1. Beginning
Balance
1. The allowance established in
the prior period carries forward for
current period write-offs.
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Allowance for Doubtful Accts.
(T-account)
Allowance for Doubtful Accts.
2. Write-off
of specific
accounts
receivable
Beginning
Balance
Accounts Receivable
2. Write-off
of specific
accounts
receivable
2. As specific accounts are
determined uncollectible during
the year, they are written-off to
the allowance account as shown.
These write-offs may cause the
allowance account to have a
debit balance before the AJE if
the prior year’s expense was
underestimated.
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Allowance for Doubtful Accts.
(T-account)
Allowance for Doubtful Accts.
Beginning
Balance
Write-off of
accounts
receivable
3. Ending
Balance
Accounts Receivable
Write-off of
accounts
receivable
3. The “desired ending balance” in
the allowance account is
estimated using the percentage
calculation or the aging schedule.
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Allowance for Doubtful Accts.
(T-account)
Allowance for Doubtful Accts.
Beginning
Balance
Write-off of
accounts
receivable
Bad Debts Expense
4. Recognition of
bad debt expense
4. Recognition
of bad debt
expense
Ending
Balance
Accounts Receivable
Write-off of
accounts
receivable
4. The AJE to record the estimate
of uncollectibles is calculated
based on the amount necessary
to achieve the “desired ending
balance” in the allowance
account. The focus is on the
Allowance account.
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Class Problem
Given the following information:
At December 31, 2010, Company Z prepared
an aging schedule to determine that the
uncollectible accounts receivable at that date
were $18,000. The balance in the Allowance
for Doubtful Accounts at 1/1/10 was a $3,000
credit. During 2010, the company wrote off
$5,000 of specific accounts receivable that
were deemed to be uncollectible.
Required: prepare the AJE to record the
estimated uncollectibles at 12/31/10.
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Solution to Class Problems
(1) Post the beginning balance and write-off.
(2) Post the desired ending balance.
(3) Post the adjusting journal entry.
Allowance for Doubtful Accounts
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Manipulation of Sales and Bad Debt Expense

Financial statement users should be aware of the
fact that policies may vary from company to
company in recognition of sales and in estimation
of bad debt expense.
 Early recognition of sales (before revenue is
realizable) is not GAAP, and is a violation of SEC
Regulations.
 Estimation of bad debt expense may vary because
of legitimate reasons and the judgment of the
accountants, but may also vary because of
manipulation.
 Users should watch for inconsistencies in the
recognition of these amounts from period to period.
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Other Manipulations of
Revenues and Expenses

Historically, managers have used estimates and
AJEs to create “cookie jar reserves”, or to take a
“big bath” to manipulate income statement items.
 Cookie jar reserves: overestimate expense in
current period, and “draw” against estimate in
future periods (see Business Insight, page 6-9).
 Big bath: accrue a number of expenses and losses
into one year, so that future years look better.
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Analysis of A/R and Allowance
Basic analysis of the allowance account may
reveal inconsistencies in bad debt
estimation.
 Compare change in allowance to change in
A/R; growth in one with reduction in the other
may indicate manipulation.
 Review note in the financials relating to the
allowance account; the amounts for expense
and write-offs are disclosed in this section.
 See Exhibit 6.4, page 6-8.

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Ratios Relating to A/R Activity

A/R Turnover:
Sales
Average A/R
Indicates how often we “turn over” or collect our
A/R. High factor is a positive indicator.

Average Collection Period
(Days sales outstanding):
365
A/R Turnover
Indicates how many days A/R are outstanding.
Shorter periods are desirable.
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