Principles of Financial Accounting: Receivables - Recognition of Accounts Receivable

What It Is

Accounts Receivable (AR) is a current asset account representing the amount of money customers owe to a company for goods or services sold on credit. It's essential to recognize AR accurately, as it affects a company's liquidity, profitability, and financial position. For example, if a company sells $10,000 worth of merchandise on credit to a customer, the AR account would increase by $10,000.

Key Concepts & Formulas

• Accounts Receivable (AR): A current asset account representing the amount of money customers owe to a company.
  • Example: A company sells $5,000 worth of merchandise on credit, increasing AR by $5,000.
• Allowance for Doubtful Accounts (ADA): A contra-asset account representing the estimated amount of uncollectible accounts.
  • Example: A company estimates 2% of AR will be uncollectible, so ADA increases by $100 (2% of $5,000).
• Bad Debt Expense (BDE): An expense account representing the amount of uncollectible accounts.
  • Example: A company writes off $500 of AR as uncollectible, increasing BDE by $500.
• Days Sales Outstanding (DSO): A ratio representing the average number of days it takes to collect AR.
  • Formula: DSO = (AR / Net Sales) * 365
  • Example: A company has $50,000 in AR and $200,000 in net sales, so DSO = (50,000 / 200,000) * 365 = 91.25 days.
• Gross Profit: A formula representing the difference between sales and COGS.
  • Formula: Gross Profit = Sales - COGS
  • Example: A company has $100,000 in sales and $60,000 in COGS, so Gross Profit = $40,000.

Journal Entry Examples

Example 1: Sales on Credit

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

Explanation: When a company sells merchandise on credit, the AR account increases, and the Sales Revenue account increases by the same amount.

Example 2: Write-off of Uncollectible Accounts

Dr. Bad Debt Expense $500 Cr. Allowance for Doubtful Accounts $500 Cr. Accounts Receivable $500

Explanation: When a company writes off uncollectible accounts, the BDE account increases, the ADA account increases, and the AR account decreases by the same amount.

Common Mistakes

Mistake 1: Confusing Debits and Credits for Expense Accounts

• Correction: Remember that debits increase asset accounts and decrease liability and equity accounts, while credits decrease asset accounts and increase liability and equity accounts. Use the mnemonic "ADE" (Assets, Drawings, Expenses) to help you remember.

Mistake 2: Not Accounting for Uncollectible Accounts

• Correction: Always account for uncollectible accounts by estimating the ADA and increasing BDE when writing off uncollectible accounts.

Mistake 3: Not Calculating DSO

• Correction: Calculate DSO regularly to monitor the average number of days it takes to collect AR.

Exam Tips

• Tip 1: Remember that debits increase assets AND expenses – remember "ADE" (Assets, Drawings, Expenses).
• Tip 2: Be careful when reversing normal balances – remember that reversing normal balances can affect financial statements.
• Tip 3: Always account for uncollectible accounts and calculate DSO regularly.

Quick Practice

Problem 1: Sales on Credit

A company sells $10,000 worth of merchandise on credit. What is the adjusting entry?

Answer: Dr. Accounts Receivable $10,000 Cr. Sales Revenue $10,000

Explanation: When a company sells merchandise on credit, the AR account increases, and the Sales Revenue account increases by the same amount.

Problem 2: Write-off of Uncollectible Accounts

A company writes off $1,000 of AR as uncollectible. What is the adjusting entry?

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

Explanation: When a company writes off uncollectible accounts, the BDE account increases, the ADA account increases, and the AR account decreases by the same amount.

Problem 3: Calculating DSO

A company has $20,000 in AR and $100,000 in net sales. What is the DSO?

Answer: DSO = (20,000 / 100,000) * 365 = 73 days

Explanation: Calculate DSO by dividing AR by net sales and multiplying by 365.

Last-Minute Cram Sheet

• Accounts Receivable (AR): A current asset account representing the amount of money customers owe to a company.
• Allowance for Doubtful Accounts (ADA): A contra-asset account representing the estimated amount of uncollectible accounts.
• Bad Debt Expense (BDE): An expense account representing the amount of uncollectible accounts.
• Days Sales Outstanding (DSO): A ratio representing the average number of days it takes to collect AR.
• Gross Profit: A formula representing the difference between sales and COGS.
• Debits increase assets AND expenses – remember "ADE" (Assets, Drawings, Expenses).
• Always account for uncollectible accounts and calculate DSO regularly.
• Dividends are NOT an expense – they go directly to retained earnings.
• Reversing normal balances can affect financial statements.
• Uncollectible accounts must be written off and accounted for.