Question

In: Accounting

What are the pros and cons of extending credit? Define net realizable value. Bad debt expense...

What are the pros and cons of extending credit?

Define net realizable value.

Bad debt expense should be recorded in same period as the sale to avoid violating the expense recognition (matching) principle. Under the allowance method an estimate of the bad debts are recorded and later adjusted. Describe the following two steps of the allowance method and provide the required journal entries.

Adjust for estimated bad debts

Remove (write off) specific customer balances

Small companies are allowed to use the direct write-off method instead of the allowance method. Explain this method and the cons to using it.

What kind of account is allowance for doubtful accounts? Is it permanent or temporary? Which financial statement can it be found on?

Bad debt expense can be estimated using two different methods. Describe each of the below methods and provide an example journal entry.

Percentage of sales method

Aging of accounts receivable method

Explain how account recoveries are treated. What is the journal entry?

What is the difference between a note receivable and an account receivable?

What is the formula to calculate interest on a note receivable? Explain each of the three variables.

Provide the following journal entries:

Establish note receivable

Accrue interest earned

Record interest received

Record principal received

What is the receivables turnover ratio formula and what does it tell you?

What is the days to collect formula and what does it tell you?

Solutions

Expert Solution

1. What are the pros and cons of extending credit?

Answer:

Pros of Extending Credit to Customers

  1. Increase sales: Extending credit to customers helps in increasing sales as many times customers are less concerned with price when they can buy now but defer the payment.
  2. Gain a competitive edge: As all businesses do not extend credit, so extending credit will help attain a competitive advantage. This will make the customers choose the business extending credit to other businesses.
  3. Establishing trust with customers: A business which offers credit is reliable and trustworthy, all of which helps in building trust with potential customers.

Cons of Extending Credit to Customers

  1. Late Payments: There are possibility that some customers do not pay on time and it will lead to bad debts, thus decreasing profits.
  2. Negatively affect cash flow: Selling on credit defers the cash inflow with respect to sales, and thus it negatively affects the cash flow.
  3. Extra cost: At times, collecting receivables from customers may incur extra cost, such as collection fees, accounts receivable management fees, etc.

2) Define net realizable value.

Answer:

Net realizable value is the amount expected to be recoverable from the customer net of any expenses of realisation expenses and other losses on account of allowance for doubtful debts.

For example: Suppose a customer John is required to pay us $1000, but we expect that only 50% can be recovered by incurring an additional cost of $50.

Thus, the net realizable value is $450 ( 1000 – 500- 50)

3) Bad debt expense should be recorded in same period as the sale to avoid violating the expense recognition (matching) principle. Under the allowance method an estimate of the bad debts are recorded and later adjusted. Describe the following two steps of the allowance method and provide the required journal entries.

Adjust for estimated bad debts

Remove (write off) specific customer balances

Answer:

In the year of sale, a specific portion is debited to Profit and Loss account as Provision for doubtful debts.

(Adjust for estimated bad debts)

Journal:

Profit and Loss account   Dr

           To Provision for doubtful debts A/c

In the year when bad debts actually occur, the accounts receivable are written off against the Provision for doubtful debts a/c.

(Remove (write off) specific customer balances)

Journal:

Provision for Doubtful debts A/c

          To Debtors A/c

4) Small companies are allowed to use the direct write-off method instead of the allowance method. Explain this method and the cons to using it.

Answer:

Under the direct write off method, a bad debt is charged to expenses when it is actually known that the amount will not be realized. It amounts to recognition of expense when it actually occurs and does not follow the matching concept.

The cons of using this method are:

Timing difference: Bad debt recognition is delayed under the direct write-off method. This results in higher profits in the initial period under the direct write-off method.

Lack of true and fair view: In direct write off method, the balance sheet tends to be inflated as the receivables shown are always more than what can actually be recovered.

5) What kind of account is allowance for doubtful accounts? Is it permanent or temporary? Which financial statement can it be found on?

Answer:

Allowance for doubtful debts is a contra asset account.

It is generally a permanent account as it’s balance is carried forward each year.

The financial statement where this account can be found is the Balance Sheet.


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