Principles of Financial Accounting: Receivables - Accounts Receivable, Turnover and Days Sales Outstanding

What It Is

Accounts Receivable Turnover (ART) and Days Sales Outstanding (DSO) are financial metrics used to evaluate a company's efficiency in collecting its accounts receivable. ART measures how quickly a company sells and collects its accounts receivable, while DSO measures the average time it takes to collect these receivables. If a company buys $10,000 of inventory on credit and sells it to a customer for $12,000, the accounts receivable balance would be $12,000. A high ART ratio (e.g., 10 times) and a low DSO (e.g., 30 days) indicate efficient collection of accounts receivable.

Key Concepts & Formulas

• Accounts Receivable Turnover (ART): A ratio that measures how quickly a company sells and collects its accounts receivable. ART = Net Sales / Average Accounts Receivable Example: If a company has net sales of $100,000 and average accounts receivable of $10,000, ART = $100,000 / $10,000 = 10 times.
• Days Sales Outstanding (DSO): A measure of the average time it takes to collect accounts receivable. DSO = Average Accounts Receivable / (Net Sales / 365) Example: If a company has average accounts receivable of $10,000 and net sales of $100,000, DSO = $10,000 / ($100,000 / 365) = 36.5 days.
• Accounts Receivable: A current asset account that represents the amount customers owe to the company.
• Bad Debt Expense: An expense account that represents the estimated amount of accounts receivable that will become uncollectible.
• Allowance for Doubtful Accounts: A contra-asset account that represents the estimated amount of accounts receivable that will become uncollectible.
• Net Sales: The total sales revenue minus returns and allowances.
• Average Accounts Receivable: The average balance of accounts receivable over a specific period.

Journal Entry Examples

1. Debit Bad Debt Expense and Credit Allowance for Doubtful Accounts: When a company estimates that a certain percentage of accounts receivable will become uncollectible, it debits Bad Debt Expense and credits Allowance for Doubtful Accounts.

   Dr. Bad Debt Expense $1,000 Cr. Allowance for Doubtful Accounts $1,000

2. Debit Accounts Receivable and Credit Sales: When a customer pays their account receivable, the company debits Accounts Receivable and credits Sales.

   Dr. Accounts Receivable $5,000 Cr. Sales $5,000

Common Mistakes

1. Mistake: Confusing debits and credits for expense accounts. Correction: Remember that debits increase assets and expenses, while credits increase liabilities and equity.
2. Mistake: Not considering the normal balance of accounts receivable. Correction: Accounts receivable has a normal debit balance.
3. Mistake: Not adjusting the allowance for doubtful accounts when estimating bad debt expense. Correction: Adjust the allowance for doubtful accounts when estimating bad debt expense to reflect the estimated amount of uncollectible accounts receivable.

Exam Tips

1. Tip: When calculating ART, use the net sales figure and the average accounts receivable balance.
2. Tip: When calculating DSO, use the average accounts receivable balance and the net sales figure divided by 365.
3. Tip: Remember that accounts receivable has a normal debit balance.

Quick Practice

1. Problem: A company has net sales of $100,000 and average accounts receivable of $10,000. What is the accounts receivable turnover? Answer: ART = $100,000 / $10,000 = 10 times.
2. Problem: A company has average accounts receivable of $10,000 and net sales of $100,000. What is the days sales outstanding? Answer: DSO = $10,000 / ($100,000 / 365) = 36.5 days.
3. Problem: A company estimates that 2% of accounts receivable will become uncollectible. If the accounts receivable balance is $100,000, what is the adjusting entry for bad debt expense? Answer: Debit Bad Debt Expense $2,000 and credit Allowance for Doubtful Accounts $2,000.

Last-Minute Cram Sheet

1. Accounts Receivable Turnover (ART) = Net Sales / Average Accounts Receivable
2. Days Sales Outstanding (DSO) = Average Accounts Receivable / (Net Sales / 365)
3. Accounts Receivable has a normal debit balance
4. Bad Debt Expense is an expense account
5. Allowance for Doubtful Accounts is a contra-asset account
6. Net Sales = Total Sales Revenue - Returns and Allowances
7. Average Accounts Receivable = (Beginning Accounts Receivable + Ending Accounts Receivable) / 2
8. Dividends are NOT an expense - they go directly to Retained Earnings
9. Accounts Receivable is a current asset account
10. Bad Debt Expense is estimated based on the Allowance for Doubtful Accounts