Question

In: Accounting

George Jetson owns and operates a restaurant and catering business which has seen the business show...

George Jetson owns and operates a restaurant and catering business which has seen the business show an increase in revenue over the last 6 months. With an increase in revenues George realized the expenses would also increase, but expected to see an increase in the cash position of the business. In reviewing the cash position and bank account, he has realized there has been a decrease in the cash position. The business receives cash and credit cards at the restaurant and also extends credit to customers for the catering business.

  1. Explain the internal controls George needs to have in place for the receipt of both cash and credit cards for the restaurant.
  2. Explain the issues involved with extending credit to customers in regards to both trade receivables and notes receivables.
  3. Select and defend one of the methods to handle the write-off of bad debt.

Solutions

Expert Solution

Internal Controls to be placed for the receipt of both cash and credit cards for the restaurant:

  1. Segregation of duties, or mitigating controls, exists within transaction processes, custody, and recording functions.
  2. Transactions and events are properly recorded.
  3. Staff understands their duties, responsibilities, and accountabilities.
  4. Cash handling practices are documented and in compliance with state laws and regulations and, credit cards are in compliance with Payment Card Industry Standards.
  5. Transaction activities are properly authorized.
  6. Cash records for authorization and transactions are maintained in accordance with established requirements.
  7. Transactions are properly verified before disbursement and records are maintained according to established requirements.
  8. Accountability for refunds and credits are maintained.
  9. Accounting records are protected from theft, obsolescence, or destruction.
  10. There is an accurate statement of cash on hand and in the bank.

The issues involved with extending credit to customers in regards to both trade receivables and notes receivables:

TRADE RECEIVABLES or ACCOUNT RECEIVABLES:

Accounts or Trade receivables are usually current assets that arise from selling merchandise or providing services to customers on credit.

NOTES RECEIVABLES:

Notes receivable is an asset of a company, bank or other organization that holds a written promissory note from another party. For example, if a company lends one of its suppliers $10,000 and the supplier signs a written promise to repay the amount, the company will enter the amount in its asset account Notes Receivable. The supplier will also enter the amount in its liability account Notes Payable.

  1. Getting paid in a timely manner or getting paid within the agreed upon terms.
  2. Actually getting paid or getting the money, vs. receiving empty promises from customers.
  3. Maintaining good customer relations with late paying customers.
  4. Having enough time to manage the collections process.
  5. Actually reaching customers or the right person when trying to follow up.
  6. Dealing with credit approvals and offering lines of credit.
  7. Collecting from customers that appear to be failing.
  8. Resolving payment disputes.

Writing off of Bad debts:

Writing off of Bad debts can be made as per two methods:

  1. Allowance method
  2. Direct Write off method

Allowance Method:

The Allowance method is used to calculate the amounts to be reported on a corporation's financial statements as the result of selling goods and/or providing services on credit. Under the allowance method, the corporation should record an adjusting entry at the end of each accounting period for the amount of the losses it anticipates as the result of extending credit to its customers. The adjustment that increases the amount of the losses is a debit to the operating expense account Bad Debts Expense and a credit to the contra-asset account Allowance for Doubtful Accounts. Under this method, the entry to write off a specific uncollectible account will require a debit to Allowance for Doubtful Accounts and a credit to Accounts Receivable.

There are two reasons why the allowance method is preferred over the direct write-off method:

  • The income statement will report the bad debts expense earlier, and
  • The balance sheet will report a more realistic net amount of accounts receivable.

The allowance method can be applied in one or both of the following ways:

  • Focusing on the bad debts expense that is needed on the income statement
  • Focusing on the balance needed in Allowance for Doubtful Accounts (which will be reported on the balance sheet).

We will contrast these two techniques by assuming that a corporation begins operations on November 1 in an industry where it is common to give credit terms of net 30 days. In this industry approximately 0.3% of credit sales will not be collected.

Focusing on the bad debts expense:

If the corporation's actual credit sales for November are $800,000 it will record an adjusting entry dated November 30 to debit Bad Debts Expense for $2,400 and credit Allowance for Doubtful Accounts for $2,400 ($800,000 X 0.003). As a result, the November income statement will be matching $2,400 of bad debts expense with the credit sales of $800,000. If no amounts were collected as of November 30, the balance sheet will report Accounts Receivable of $800,000 minus a $2,400 credit balance in the Allowance for Doubtful Accounts for a net amount of $797,600.

Focusing on the allowance for doubtful accounts:

With this balance sheet focus, a corporation will adjust the balance in the account Allowance for Doubtful Accounts so that the combination of its credit balance and the debit balance in Accounts Receivable will be equal to the amount that is expected to turn to cash. The expected amount is often determined by aging the accounts receivable.

Focusing on both:

A corporation that prepares weekly financial statements might prepare weekly adjusting entries that are focused on the amount of bad debts expense reported on the income statement. However, at the end of each fiscal quarter its adjusting entry will be focused on reporting the most realistic amount for the allowance for doubtful accounts that will be reported on the balance sheet.

Direct Write off Method:

A U.S. corporation uses the direct write-off method for calculating the amount for its Income tax return.


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