Problem #1
Mercy Care normally charges $200 for an annual physical exam. Currently, the company is
offering a $50 discount to expectant mothers. In addition, Mercy offers terms 2/10, n/30 to all
customers receiving services on account. The following events occur.
June 16 Mary, an expectant mother, calls to set up an appointment.
June 21 Mary visits Mercy and receives a physical exam for the discounted price.
June 27 Mary pays for her physical exam.
Required:
1. On what date should Mercy record patient revenue?
Answer: June 21 – the date the service is provided.
2. Record service revenue for Mercy.
June 21 Debit Credit
Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . 150
Service Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . 150
(Provide services on account)
($150 = $200 less $50 trade discount)
3. Mercy receives Mary’s payment in full on June 27 (within the discount period). Record
the cash collection for Mercy.
June 27 Debit Credit
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147
Sales Discount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . 150
(Receive cash on account less sales discount)
($3 = $150 × 2%)
4. Calculate the balance of accounts receivable and net revenue after the cash payment is
received.
Accounts Receivable
Credit sale from #2 150
Cash collection from #3
Ending balance
150
0
Patient revenue (from #2) $150
Less: Sales discount (from #3) (3)
Net revenue $147
Alternate Let’s Review
Problem #2
At the beginning of the year, Compassion Clinic’s allowance for uncollectible accounts has a
balance of $60,000 credit.
Required:
1. Record the write-off of $50,000 of accounts receivable during the year.
Debit Credit
Allowance for Uncollectible Accounts . . . . . . . . 50,000
Accounts Receivable. . . . . . . . . . . . . . . . . . 50,000
2. Estimate the allowance for future uncollectible accounts using the following ages and
estimated percentage uncollectible at the end of the year:
Age Group
Amount
Receivable
Estimated
Percent
Uncollectible
Estimated
Amount
Uncollectible
Not yet due $400,000 5% $20,000
1-45 days past due 100,000 15% 15,000
More than 45 days past due 25,000 40% 10,000
Total $525,000 $45,000
3. Use a T-account to determine the year-end adjustment to the allowance account.
Allowance for Uncollectible Accounts
60,000 Beginning balance
50,000 Write-offs
10,000 Balance before adjustment
?Year-end adjustment
45,000 Estimated ending balance
4. Record the year-end adjusting entry for bad debts expense.
December 31 Debit Credit
Bad Debt Expense . . . . . . . . . . . . . . . . . .. . . . . . . 35,000
Allowance for Uncollectible Accounts. . . . 35,000*
* Notice from #3 that the balance of the allowance account before adjustment is $10,000
credit. Based on the estimated allowance of $45,000 credit from #2, we need a credit
adjustment of $35,000.
5. Prepare a partial balance sheet showing accounts receivable and the allowance for
uncollectible accounts.
Compassion Clinic
Partial Balance Sheet
December 31
Assets
Current assets:
Accounts receivable $525,000
Less: Allowance for uncollectible accounts (45,000)
Net accounts receivable $480,000
Alternate Let’s Review
Problem #3
Northwest Hospital has a policy of lending any employee up to $5,000 for a period of up to 12
months at a fixed interest rate of 12%. Clark Lewis has worked for Northwest for more than ten
years and wishes to take his family on a winter vacation to the Pacific Coast. On November 1,
2010, he borrows $5,000 from Northwest by issuing a note to be repaid in six months.
Required:
1. Record the acceptance of the note receivable by Northwest Hospital.
November 1, 2010 Debit Credit
Notes Receivable. . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000
Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000
(Accept note receivable and pay cash)
2. Record Northwest Hospital’s year-end adjusting entry to accrue interest revenue.
December 31, 2010 Debit Credit
Interest Receivable. . . . . . . . . . . . . . . . . . . . . . . . . 100
Interest Revenue (2 months’ interest). . . . . . 100
(Accrue interest revenue)
(Interest revenue = $5,000 × 12% × 2/12)
3. Record the collection of the note with interest from Clark Lewis on May 1, 2011.
May 1, 2011 Debit Credit
Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,300
Notes Receivable. . . . . . . . . . . . . . . . . . . . . . . 5,000
Interest Receivable. . . . . . . . . . . . . . . . . . . . . 100
Interest Revenue (4 months’ interest). . . . . . 200
(Collect note receivable and interest)
(Interest revenue = $5,000 × 12% × 4/12)
Key Points by Learning Objective
LO5-1 Recognize accounts receivable.
Companies record an asset (accounts receivable) and revenue when they sell products and
services to their customers on account, expecting payment in the future.
LO5-2 Calculate net revenues using discounts, returns, and allowances.
Sales discounts, returns, and allowances are contra revenue accounts. We subtract the balances in
these accounts from total revenues when calculating net revenues.
LO5-3 Record an allowance for future uncollectible accounts.
We recognize accounts receivable as assets in the balance sheet and record them at their net
realizable values, that is, the amount of cash we expect to collect.
Under the allowance method, companies are required to estimate future uncollectible accounts
and record those estimates in the current year. Estimated uncollectible accounts reduce assets
and increase expenses.
Adjusting for estimates of future uncollectible accounts matches expenses (bad debts) in the
same period as the revenues (credit sales) they help to generate.
Recording an allowance for uncollectible accounts correctly reports accounts receivable at their
net realizable value.
LO5-4 Use the aging method to estimate future uncollectible accounts.
Using the aging method to estimate uncollectible accounts is more accurate than applying a
single percentage to all accounts receivable. The aging method recognizes that the longer
accounts are past due, the less likely they are to be collected.
LO5-5 Apply the procedure to write off accounts receivable as uncollectible.
Writing off a customer’s account as uncollectible reduces the balance of accounts receivable but
also reduces the contra asset—allowance for uncollectible accounts. The net effect is that there is
no change in the net receivable (accounts receivable less the allowance) or in total assets. We
recorded the decrease to assets as a result of the bad debt when we established the allowance for
uncollectible accounts in a prior year.
The year-end adjustment for future uncollectible accounts is affected by the current balance of
Allowance for Uncollectible Accounts before adjustment. The current balance before adjustment
equals the estimate of uncollectible accounts at the beginning of the year (or end of last year) less
actual write-offs in the current year.
LO5-6 Contrast the allowance method and direct write-off method when accounting for
uncollectible accounts.
The direct write-off method reduces accounts receivable and records bad debt expense at the
time the account receivable proves uncollectible. If the credit sale occurs in a prior reporting
period, bad debt expense is not properly matched with revenues (credit sales). Also, accounts
receivable will be overstated in the prior period. The direct write-off method typically is not
acceptable for financial reporting.
LO5-7 Apply the procedure to account for notes receivable, including interest calculation.
Notes receivable are similar to accounts receivable except that notes receivable are more formal
credit arrangements made with a written debt instrument, or note.
We calculate interest as the face value of the note multiplied by the stated annual interest rate
multiplied by the appropriate fraction of the year.
We record interest earned on notes receivable but not yet collected by the end of the year as
interest receivable and interest revenue.
Analysis
LO5-8 Calculate key ratios investors use to monitor a company’s effectiveness in managing
receivables.
The receivables turnover ratio and average collection period can provide an indication of
management’s ability to collect cash from customers in a timely manner.
Appendix:
LO5-9 Estimate uncollectible accounts using the percentage-of-credit-sales method.
When applying the percentage-of-credit-sales method, we adjust the allowance for uncollectible
accounts for the current year’s credit sales that we don’t expect to collect (rather than adjusting at
the end of the year for the percentage of accounts receivable we don’t expect to collect).
Common Mistakes
Common Mistake
Students sometimes misclassify contra revenue accounts—sales discounts,
returns, and allowances—as expenses. Like expenses, contra revenues have
normal debit balances and reduce the reported amount of net income.
However, contra revenues represent reductions of revenues, whereas expenses
represent the separate costs of generating revenues.
Common Mistake
Because the Allowance for Uncollectible Accounts has a normal credit
balance, students sometimes misclassify this account as a liability, which also
has a normal credit balance. Instead, a contra asset represents a reduction in a
related asset.
Common Mistake
Students often mistakenly record bad debt expense when they write off an
uncollectible account. The bad debt expense was recorded in a prior year at
the time of estimating uncollectible accounts.
Common Mistake
Some students erroneously think firms should reduce total assets and record
bad debt expense at the time the bad debt actually occurs. However,
companies anticipate future bad debts and establish an allowance for those
estimates.
Decision Points
Question Accounting
Information
Analysis & Decision
Does a company
have a recurring
problem with
customer
satisfaction?
Total sales and sales
returns and allowances
If sales returns and allowances
are routinely high relative to
total sales, this might indicate
that customers are not satisfied
with the company’s products
or services.
Question Accounting
Information
Analysis & Decision
Are the
company’s credit
sales policies too
lenient?
Accounts receivable and
the allowance for
uncollectible accounts
A high ratio of the allowance
for uncollectible accounts to
total accounts receivable could
be an indication that the
company extends too much
credit to high-risk customers.
Question Accounting
Information
Analysis & Decision
How likely is it
that the
company’s
accounts
receivable will be
collected?
Notes to the financial
statements detailing the
age of individual
accounts receivable
Older accounts are less likely
to be collected.
Question Accounting
Information
Analysis & Decision
Is the company
effectively
managing its
receivables?
Receivables turnover
ratio and average
collection period
A high receivables turnover
ratio (or low average collection
period) generally indicates that
the company’s credit sales and
collection policies are
effective.
Career Corner
Career Corner
Companies that make large amounts of credit sales often employ credit
analysts. These analysts are responsible for deciding whether to extend credit
to potential customers. To make this decision, credit analysts focus on the
customer’s credit history (such as delinquency in paying bills) and
information about current financial position, generally found using amounts
in the financial statements. When the credit risk is too high, the analyst will
advise management to reject the customer’s request for goods and services, or
perhaps limit the amount of credit extended. Management must then face a
difficult trade-off: the potential gains from additional customer revenues
versus the risk of an eventual uncollectible account. Credit analysts are most
commonly employed by financial institutions ranging from banks to credit
rating agencies and investment companies.
Ethical Dilemma
Ethical Dilemma
Philip Stanton, the executive manager of Thomson Pharmaceutical, receives a
bonus if the company’s net income in the current year exceeds net income in
the past year. By the end of 2015, it appears that net income for 2015 will
easily exceed net income for 2014. Philip has asked Mary Beth Williams, the
company’s controller, to try to reduce this year’s income and “bank” some of
the profits for future years. Mary Beth suggests that the company’s bad debt
expense as a percentage of accounts receivable for 2015 be increased from
10% to 15%. She believes 10% is the more accurate estimate but knows that
both the corporation’s internal and external auditors allow some flexibility in
estimates. What is the effect of increasing the estimate of bad debts from 10%
to 15% of accounts receivable? How does this “bank” income for future
years? Why does Mary Beth’s proposal present an ethical dilemma?
Key issues
Increasing the bad debt estimate from 10% to 15% of accounts receivable increases bad
debt expense in the current year, reducing net income. If 10% ends up being the correct
estimate of future bad debts, then the company will be able to report less bad debt
expense in the following year, increasing net income in the following year. The effect of
this change in estimate is to shift profits from this year to next year.
How do you define “accurate” reporting?
Option 1: Record the estimate of bad debts for 10% of accounts receivable
An assumption of financial reporting is that accountants present financial information
that is reliable and accurate. Knowing that 10% is the correct percentage for bad debts
expense, Mary Beth should not make the adjustment.
One key factor in Philip’s decision is the opportunity to receive a bonus. While tempting,
he needs to be able to remove any personal benefits in making the best decision for the
company and its investors.
Option 2: Record the estimate of bad debts for 15% of accounts receivable
In the long run, it is likely that the bad debts expense will smooth itself out, so a
temporary adjustment is not going to change investors’ decisions.
The adjustment to bad debts expense is allowable under GAAP, as the overriding
principles of GAAP allow us to use discretion. Further, Mary Beth has good reason to
believe the auditors will approve this change, thus this is not that big of an issue.
Ultimately, Mary Beth should not feel responsible for this decision to change the
percentage. Her boss is advising her what to do, so is it worth her job to oppose/confront
him on this decision?
We have extra profits this year, so why not hang onto them. We may need some in future
years when profits are not as high. Thus, we are really protecting our investors by
maintaining smooth earnings.
Since the direction of “earnings manipulation” is to lower profits in the current year, we
are actually understating our current performance. Understating performance is
acceptable, since no one is misled into thinking the company is better than it really is.