Question

Compare and contrast the following:

1A) allowance method and the direct write-off method of accounting for uncollectible accounts.

1B) accounts receivable and notes receivable.

1C) accounts receivable turnover ratio with previous ratios (i.e., inventory turnover ratio, gross margin percent, return on sales, return on assets and return on equity).

Answer 1

1A) Allowance method and the direct write off method

The primary differences between the direct write-off and the allowance method for accounting for bad debts are the timing of when bad debts are reported on the books and their ultimate impact on the income statement and balance sheet.

The first difference between the direct write-off method and the allowance method of accounting for bad debt expense is the timing of when bad debt expense is recorded. The impact on the income statement differs under the methods. Bad debts are recorded when estimated under the allowance method, thereby matching revenues and expenses. No such estimates are made under the direct write-off method. Rather, bad debts are only recorded when an actual write-off occurs, which might cause revenues and related expenses to be recorded in different periods. The direct write-off method has the effect of understating expense and overstating net income in a particular reporting period when an account is determined to be uncollectible in a period subsequent to the period in which the related sales or revenue was reported. As a result of this failure to match revenue with expenses, the direct write-off method is not permitted for use for financial reporting purposes unless bad debts are insignificant to a company.

The second difference between the direct write-off method and the allowance method of accounting for bad debt expense is the use of estimates. The allowance method uses the allowance for doubtful accounts to capture accumulated estimates of bad debts. This method appropriately reduces the accounts receivable balance to its net realizable value, or the amount a company can expect to collect from those receivables in the future. When bad debt estimates are recorded, the allowance for doubtful accounts is increased. Because it is a contra asset account, this increase has a decreasing effect on the receivables account to which the allowance for doubtful accounts is related. As a result, the allowance method provides a relevant presentation of the balance sheet at all times. The direct write-off method does not report bad debt estimates; therefore, it does not use the allowance for doubtful accounts when reporting bad debts. As a result there is no reporting of net realizable value under the direct write-off method, which reduces the relevancy of the balance sheet.

Summary of the above difference is as follows :-

Under the direct write-off method, a bad debt is charged to expense as soon as it is apparent that an invoice will not be paid. Under the allowance method, an estimate of the future amount of bad debt is charged to a reserve account as soon as a sale is made. This results in the following differences between the two methods:

• Timing. Bad debt expense recognition is delayed under the direct write-off method, while the recognition is immediate under the allowance method. This results in higher initial profits under the direct write-off method.

• Accuracy. The exact amount of the bad debt expense is known under the direct write-off method, since a specific invoice is being written off, while only an estimate is being charged off under the allowance method.

• Receivable line item. The receivable line item in the balance sheet tends to be lower under the allowance method, since a reserve is being netted against the receivable amount

1B - Key differences between note receivable and accounts receivable:

Even though both are line items of the financial statements and fall under the same head – current assets; there exist some fundamental differences between them.

1. Meaning:

Note receivable is a written promissory note extending a line of credit to the other party, receivable in the future at a specified date along with interest.

On the other hand, money owed by customers for purchasing goods or services on credit is known as accounts receivable.

2. Time period:

Notes receivable can be either a current asset or a non-current asset. If it matures within one year period, it is reported under current assets. If it is payable over a period of more than one year, the portion maturing within one year will be reported under current assets whereas the rest of the amount will be reported under non-current assets.

Accounts receivable is a current asset since the amount is mostly payable within twelve months of issuance of invoice. Usually, a time period of thirty to ninety days is provided to clear the debt.

3. Legal impact:

Notes receivable is a legally binding agreement between the issuer and the payee.

Accounts receivable, on the other hand, has no written agreement between the buyer and customer. The only document available is the sales invoice.

4. Transferability:

Notes receivable is a negotiable instrument and can be transferred further to clear dues. It needs to be highlighted, though, that the transferability doesn’t affect the ownership of a notes receivable since each bearer has exactly the same claim over it as the original lender had.

Accounts receivable can be sold to a financial institution for a fee. This action is known as discounting or factoring accounts receivable. Accounts receivable can’t be used as a negotiable financial instrument like note receivable.

5. Financial cost:

Notes receivable is a financial instrument that has an interest component attached to it.

Accounts receivable has no financial component attached to it.

1C

The asset turnover ratio measures the value of a company's sales or revenues relative to the value of its assets. The asset turnover ratio is an indicator of the efficiency with which a company is using its assets to generate revenue. The higher the asset turnover ratio, the more efficient a company. Conversely, if a company has a low asset turnover ratio, it indicates it's not efficiently using its assets to generate sales.

The accounts receivable turnover ratio measures a company's effectiveness in collecting its receivables or money owed by clients. The ratio shows how well a company uses and manages the credit it extends to customers and how quickly that short-term debt is collected or being paid.

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