Accounts Receivable and Bad Debts Quiz
What is the primary purpose of accounts receivable?
A) Record liabilities
B) Track sales on credit
C) Record cash sales
D) Manage inventory
Which of the following accounts is debited when a customer pays their outstanding balance?
A) Accounts Receivable
B) Sales Revenue
C) Cash
D) Bad Debts Expense
What type of account is “Allowance for Doubtful Accounts”?
A) Asset
B) Contra-asset
C) Liability
D) Revenue
The direct write-off method violates which accounting principle?
A) Matching principle
B) Cost principle
C) Revenue recognition principle
D) Full disclosure principle
What is the journal entry to record bad debts under the allowance method?
A) Debit Bad Debts Expense; Credit Accounts Receivable
B) Debit Bad Debts Expense; Credit Allowance for Doubtful Accounts
C) Debit Accounts Receivable; Credit Allowance for Doubtful Accounts
D) Debit Allowance for Doubtful Accounts; Credit Bad Debts Expense
Which method estimates uncollectible accounts based on the percentage of sales?
A) Direct write-off method
B) Aging of receivables method
C) Percentage of sales method
D) Percentage of accounts receivable method
Under the aging of receivables method, older receivables are:
A) Less likely to be collected
B) More likely to be collected
C) Ignored in bad debt estimation
D) Always written off
If a company uses the percentage of receivables method, what is the focus?
A) Net sales
B) Total sales
C) Year-end accounts receivable balance
D) Total expenses
What is the effect of recording bad debts expense on total assets?
A) Increases total assets
B) Decreases total assets
C) No effect on total assets
D) Increases liabilities
Which document authorizes the extension of credit to a customer?
A) Invoice
B) Sales order
C) Credit memo
D) Credit approval form
The term “net realizable value” refers to:
A) Total credit sales
B) Accounts receivable less allowance for doubtful accounts
C) Total cash received
D) Gross accounts receivable balance
A customer’s account is written off as uncollectible. This affects:
A) Net income
B) Total liabilities
C) Accounts receivable and allowance for doubtful accounts
D) Sales revenue
Which of the following is an internal control over accounts receivable?
A) Allowing any employee to approve credit sales
B) Regularly reviewing the aging schedule
C) Writing off accounts without documentation
D) Extending credit to all customers
How are bad debts recorded under the direct write-off method?
A) As an estimate
B) As an expense when specific accounts are deemed uncollectible
C) As a reduction to revenue
D) As a prepaid expense
Which method complies with GAAP for recording bad debts?
A) Direct write-off method
B) Allowance method
C) Accrual method
D) Cash method
An increase in Allowance for Doubtful Accounts will:
A) Increase total assets
B) Decrease total assets
C) Increase total liabilities
D) Have no effect on financial statements
Which account is debited when writing off an uncollectible account under the allowance method?
A) Bad Debts Expense
B) Cash
C) Allowance for Doubtful Accounts
D) Accounts Receivable
Accounts receivable turnover measures:
A) The average collection period for receivables
B) How quickly receivables are collected
C) The profitability of credit sales
D) The amount of credit sales
A higher accounts receivable turnover ratio indicates:
A) Slower collections
B) Faster collections
C) Greater credit sales
D) Poor liquidity
What is the primary disadvantage of the direct write-off method?
A) Violates the cost principle
B) Overstates net income
C) Fails to match expenses with revenues
D) Reduces net sales
A credit memo issued to a customer for a returned item will:
A) Increase accounts receivable
B) Decrease accounts receivable
C) Increase cash
D) Decrease cash
What is the typical balance of Allowance for Doubtful Accounts?
A) Debit
B) Credit
C) Zero
D) Depends on the accounting period
To record the reinstatement of a previously written-off account, the entry would include:
A) Debit Accounts Receivable; Credit Allowance for Doubtful Accounts
B) Debit Bad Debts Expense; Credit Cash
C) Debit Cash; Credit Accounts Receivable
D) Debit Allowance for Doubtful Accounts; Credit Bad Debts Expense
Which of the following is not included in net accounts receivable?
A) Gross accounts receivable
B) Allowance for doubtful accounts
C) Cash payments
D) Customer balances
When using the percentage of sales method, bad debts expense is calculated as:
A) A percentage of total assets
B) A percentage of total liabilities
C) A percentage of credit sales
D) A percentage of total cash sales
What type of analysis is performed to estimate the allowance for doubtful accounts using the aging method?
A) Horizontal analysis
B) Vertical analysis
C) Trend analysis
D) Aging schedule analysis
If a company’s Allowance for Doubtful Accounts has a debit balance before adjustment, it means:
A) The previous estimate was too low
B) The previous estimate was too high
C) There were no bad debts
D) Bad debts expense is understated
Recording a recovery of a previously written-off account will:
A) Increase net income
B) Decrease net income
C) Have no effect on net income
D) Increase total liabilities
Which of the following would not appear in an accounts receivable aging report?
A) Customer name
B) Credit limit
C) Amount past due
D) Invoice date
Writing off an account under the allowance method will:
A) Increase net income
B) Decrease net income
C) Have no effect on net income
D) Increase bad debts expense
What happens when a company’s Allowance for Doubtful Accounts is underestimated?
A) Total assets are overstated
B) Total liabilities are understated
C) Net income is overstated
D) Both A and C
What is the effect of recognizing bad debts expense on the income statement?
A) Increases net income
B) Decreases net income
C) Increases total revenue
D) No effect on net income
What happens if an account is collected after it was written off?
A) Record a new sale
B) Reverse the write-off and record the payment
C) Increase bad debts expense
D) Adjust net income
Which of the following is the most conservative approach to estimating bad debts?
A) Direct write-off method
B) Percentage of accounts receivable method
C) Aging of receivables method
D) Percentage of sales method
Which account is credited when recognizing bad debts under the allowance method?
A) Accounts Receivable
B) Allowance for Doubtful Accounts
C) Cash
D) Bad Debts Expense
If the Allowance for Doubtful Accounts has a credit balance before adjustment, this indicates:
A) All receivables are collectible
B) Previous bad debts estimates were accurate
C) Previous estimates exceeded actual uncollectibles
D) Bad debts expense needs to be increased
What type of analysis helps in estimating the collectibility of accounts receivable?
A) Ratio analysis
B) Sensitivity analysis
C) Aging analysis
D) Cost-benefit analysis
Which is a disadvantage of extending credit to customers?
A) Increased sales
B) Potential bad debts
C) Decreased cash flow
D) Both B and C
What is the primary objective of the accounts receivable aging method?
A) Estimate the total sales
B) Determine overdue accounts
C) Predict cash inflows
D) Estimate uncollectible accounts
Which of the following is not part of the credit approval process?
A) Evaluating the customer’s creditworthiness
B) Reviewing customer’s payment history
C) Recording cash payments
D) Assigning a credit limit
Writing off a bad debt under the direct write-off method impacts:
A) Only the balance sheet
B) Only the income statement
C) Both the income statement and balance sheet
D) No financial statements
Under GAAP, which method must be used to account for bad debts?
A) Direct write-off method
B) Allowance method
C) Percentage of net income method
D) Cash method
A longer average collection period for receivables indicates:
A) Improved cash flow
B) Slower collections
C) Greater profitability
D) Increased credit sales
Which of the following does not affect the balance of accounts receivable?
A) Sales on account
B) Write-offs
C) Cash collections
D) Depreciation expense
When recording a specific write-off under the direct write-off method, the journal entry includes:
A) Debit to Accounts Receivable
B) Debit to Allowance for Doubtful Accounts
C) Debit to Bad Debts Expense
D) Credit to Sales Revenue
Which of the following is a primary disadvantage of accounts receivable?
A) Increases revenue
B) Increases cash flow
C) Potential for uncollectible accounts
D) Decreases liabilities
When estimating bad debts using the percentage of receivables method, what is the key input?
A) Total credit sales
B) Ending accounts receivable balance
C) Net income
D) Total cash collected
A company’s credit policy is considered too lenient if:
A) Accounts receivable turnover is very high
B) The average collection period is very long
C) Bad debts are consistently low
D) Sales returns are frequent
To record the collection of a written-off account, the process includes:
A) Debit to Bad Debts Expense
B) Debit to Allowance for Doubtful Accounts
C) Debit to Accounts Receivable and then a Debit to Cash
D) Credit to Bad Debts Expense
Which principle justifies the use of the allowance method?
A) Consistency principle
B) Matching principle
C) Conservatism principle
D) Revenue recognition principle
Accounts receivable are typically classified as:
A) Long-term liabilities
B) Current assets
C) Fixed assets
D) Contra-assets
Which of the following reduces the accounts receivable balance?
A) Bad debts expense
B) Sales returns
C) New credit sales
D) Credit approvals
What is the primary purpose of credit terms such as “2/10, net 30”?
A) Offer a discount to encourage early payment
B) Increase credit sales
C) Reduce bad debts
D) Improve profitability
The accounts receivable turnover ratio is calculated by dividing:
A) Net credit sales by average accounts receivable
B) Net credit sales by total assets
C) Total sales by ending accounts receivable
D) Average accounts receivable by net income
What happens to bad debts expense when a previously written-off account is reinstated?
A) It increases
B) It decreases
C) It remains unchanged
D) It is debited
The direct write-off method is typically used by:
A) Large corporations
B) GAAP-compliant entities
C) Small businesses
D) Nonprofit organizations
Which of the following could result in an overstatement of accounts receivable?
A) Underestimating bad debts
B) Overestimating cash collections
C) Overestimating sales returns
D) Recognizing unearned revenue
Which type of account is used to estimate uncollectible accounts?
A) Revenue
B) Asset
C) Contra-asset
D) Liability
What financial statement impact occurs when accounts are written off under the allowance method?
A) Increases total expenses
B) No effect on total assets
C) Decreases total liabilities
D) Increases total liabilities
If a customer defaults on a payment, what action should be taken first?
A) Write off the account immediately
B) Attempt to collect payment
C) Record it as a bad debt expense
D) Increase credit sales
What is the typical classification of Notes Receivable that will mature within a year?
A) Current liability
B) Long-term liability
C) Current asset
D) Long-term asset
Under the allowance method, bad debts expense is recorded:
A) When an account is determined to be uncollectible
B) When cash is received from the customer
C) At the end of the period based on estimates
D) When receivables are sold to a third party
What is the key drawback of the direct write-off method?
A) Violates the matching principle
B) Requires complex calculations
C) Cannot be used for tax purposes
D) Requires allowance for doubtful accounts
When using the percentage of sales method to estimate bad debts, the calculation is based on:
A) Credit sales
B) Total sales
C) Total receivables
D) Ending inventory
A company’s Accounts Receivable Turnover ratio increases. What does this indicate?
A) Faster collections of receivables
B) Higher uncollectible accounts
C) Decreased credit sales
D) Increased average collection period
The write-off of an account under the allowance method affects:
A) Total assets and net income
B) Only net income
C) Only total assets
D) Neither total assets nor net income
Why is the Allowance for Doubtful Accounts used?
A) To comply with the cash basis of accounting
B) To estimate bad debts and match expenses with revenues
C) To increase net income
D) To reduce operating expenses
What is the adjusting entry for recording bad debts expense under the allowance method?
A) Debit Accounts Receivable; Credit Allowance for Doubtful Accounts
B) Debit Bad Debts Expense; Credit Allowance for Doubtful Accounts
C) Debit Allowance for Doubtful Accounts; Credit Bad Debts Expense
D) Debit Bad Debts Expense; Credit Accounts Receivable
What type of account is “Allowance for Doubtful Accounts”?
A) Contra-asset
B) Liability
C) Expense
D) Revenue
What happens to the Allowance for Doubtful Accounts when a specific account is written off?
A) It decreases
B) It increases
C) It has no effect
D) It is closed out
Which of the following does not impact the cash realizable value of accounts receivable?
A) Write-offs of specific accounts
B) Collection of accounts receivable
C) Recording of credit sales
D) Adjustment for estimated bad debts
A company writes off $2,000 of accounts receivable under the allowance method. What is the journal entry?
A) Debit Bad Debts Expense; Credit Accounts Receivable
B) Debit Allowance for Doubtful Accounts; Credit Accounts Receivable
C) Debit Accounts Receivable; Credit Allowance for Doubtful Accounts
D) Debit Cash; Credit Allowance for Doubtful Accounts
What does a high accounts receivable turnover ratio indicate?
A) Inefficient collection processes
B) Good liquidity and collection efficiency
C) High levels of uncollectible accounts
D) Over-reliance on credit sales
In the aging method, which accounts are assigned the highest percentage of uncollectibility?
A) Current accounts
B) Accounts 31–60 days overdue
C) Accounts 61–90 days overdue
D) Accounts over 90 days overdue
Which of the following is not a method for estimating uncollectible accounts?
A) Aging of receivables method
B) Percentage of receivables method
C) Percentage of sales method
D) Direct write-off method
How does a company account for accounts receivable sold to a factor?
A) As a loan repayment
B) As an asset disposal
C) As a liability adjustment
D) As an off-balance-sheet transaction
When using the percentage of receivables method, what balance is adjusted?
A) Accounts Receivable
B) Allowance for Doubtful Accounts
C) Bad Debts Expense
D) Revenue
A credit sale of $10,000 on terms 2/10, net 30, was paid within 10 days. How much cash is received?
A) $9,800
B) $10,000
C) $9,700
D) $10,200
If a company underestimates bad debts expense, what is the effect?
A) Overstatement of net income and total assets
B) Understatement of net income and total assets
C) No effect on financial statements
D) Overstatement of liabilities
What type of journal entry reverses a previously written-off account?
A) Debit Bad Debts Expense; Credit Accounts Receivable
B) Debit Allowance for Doubtful Accounts; Credit Accounts Receivable
C) Debit Accounts Receivable; Credit Allowance for Doubtful Accounts
D) Debit Accounts Receivable; Credit Revenue
Which of the following impacts both the income statement and the balance sheet?
A) Adjustment for bad debts expense
B) Write-off of accounts receivable
C) Credit sales transaction
D) Collection of receivables
Under the direct write-off method, bad debts are recognized:
A) When the sale is made
B) At the end of the accounting period
C) When an account is deemed uncollectible
D) Based on an aging schedule
Which of the following would increase the accounts receivable balance?
A) Cash collections
B) Credit sales
C) Write-offs
D) Bad debts expense adjustment
Which financial ratio indicates the effectiveness of credit and collection policies?
A) Debt-to-equity ratio
B) Current ratio
C) Accounts receivable turnover
D) Gross margin percentage
What is the primary benefit of offering discounts for early payment?
A) Reduce bad debts expense
B) Improve liquidity
C) Increase gross profit
D) Decrease sales returns
The term “net realizable value” of accounts receivable refers to:
A) The total amount of receivables recorded in the books
B) Receivables after adjusting for doubtful accounts
C) Receivables minus cash discounts offered
D) The amount of receivables expected to be written off
Which of the following is a limitation of the direct write-off method?
A) It is complicated to implement
B) It does not recognize expenses in the same period as revenue
C) It requires allowance for doubtful accounts
D) It is required by GAAP
When a customer pays an account previously written off, which accounts are affected?
A) Accounts Receivable and Revenue
B) Allowance for Doubtful Accounts and Cash
C) Accounts Receivable, Allowance for Doubtful Accounts, and Cash
D) Bad Debts Expense and Cash
Which of the following actions will reduce the balance of accounts receivable?
A) Recording bad debts expense
B) Writing off uncollectible accounts
C) Estimating uncollectible accounts
D) Recording credit sales
The aging of accounts receivable method primarily focuses on:
A) Total credit sales
B) Length of time receivables are outstanding
C) Historical percentages of bad debts
D) Current period’s bad debt expense
How does the direct write-off method impact financial statements when an account is written off?
A) Net income is reduced
B) Total assets remain unchanged
C) Total assets are reduced
D) No impact on net income
When an account is reinstated after being written off, the first step is to:
A) Reverse the previous write-off entry
B) Record the payment
C) Record bad debts expense
D) Credit Cash
The percentage of receivables method for estimating bad debts bases the calculation on:
A) Current period credit sales
B) All receivables, including those past due
C) Accounts determined to be uncollectible
D) A historical average of write-offs
An increase in the Allowance for Doubtful Accounts will:
A) Decrease net income
B) Increase net income
C) Have no effect on total assets
D) Increase accounts receivable
The term “factoring” refers to:
A) Selling receivables to a third party at a discount
B) Using receivables as collateral for a loan
C) Writing off uncollectible accounts
D) Allocating bad debt expense
If a company’s collection period is increasing, it may indicate:
A) More efficient collection processes
B) A decrease in credit sales
C) Slower collections from customers
D) Higher turnover of receivables
Which of the following scenarios typically requires the use of an Allowance for Doubtful Accounts?
A) Cash basis accounting
B) Credit sales
C) Factoring of receivables
D) Loan repayments
What is the journal entry to record the recovery of a previously written-off account?
A) Debit Cash; Credit Bad Debts Expense
B) Debit Bad Debts Expense; Credit Allowance for Doubtful Accounts
C) Debit Accounts Receivable; Credit Allowance for Doubtful Accounts
D) Debit Cash; Credit Accounts Receivable
The accounts receivable turnover ratio is calculated as:
A) Net credit sales ÷ Average accounts receivable
B) Average accounts receivable ÷ Net credit sales
C) Accounts receivable ÷ Total sales
D) Net credit sales ÷ Ending accounts receivable
A customer has a credit limit of $10,000 and an outstanding balance of $9,500. If the company approves a $1,000 sale, this is an example of:
A) Violating internal controls
B) Good credit management
C) Increasing bad debt risk
D) Factoring receivables
A specific account is written off under the allowance method. How is this treated?
A) As a revenue deduction
B) As a reduction in total receivables
C) As an increase in net income
D) As a liability
When a company applies the percentage of sales method, which account is adjusted?
A) Bad Debts Expense
B) Allowance for Doubtful Accounts
C) Accounts Receivable
D) Cash
Which method complies with GAAP for recording uncollectible accounts?
A) Direct write-off method
B) Allowance method
C) Percentage of completion method
D) Net realizable value method
A debit balance in the Allowance for Doubtful Accounts indicates:
A) Overestimation of bad debts
B) Underestimation of bad debts
C) Normal operations
D) Accurate estimation of bad debts
Notes Receivable are classified as a current asset when:
A) They are due within one year
B) They are overdue
C) They bear interest
D) They are larger than $10,000
Writing off an account directly impacts:
A) Bad Debts Expense
B) Allowance for Doubtful Accounts
C) Retained Earnings
D) Sales Revenue
The entry to establish a Note Receivable includes a debit to:
A) Accounts Receivable
B) Note Receivable
C) Bad Debts Expense
D) Cash
If bad debts are understated in one period, what is the impact on the next period?
A) Higher net income
B) Lower net income
C) Overstated liabilities
D) Higher cash flow
How are Notes Receivable reported on the balance sheet?
A) At cost
B) At present value
C) At maturity value
D) At net realizable value
How does a company decide the amount for the Allowance for Doubtful Accounts?
A) Based on cash receipts
B) Using historical data and estimates
C) Fixed percentage of total revenue
D) Regulatory guidelines
Which of the following is the primary purpose of maintaining an Allowance for Doubtful Accounts?
A) To match expenses with revenues
B) To simplify write-offs
C) To comply with the cash basis of accounting
D) To eliminate the need for bad debt expense
What type of account is the Allowance for Doubtful Accounts?
A) Liability
B) Contra-asset
C) Expense
D) Revenue
Under the allowance method, bad debt expense is recorded:
A) When a specific account is determined uncollectible
B) At the time of each credit sale
C) At the end of the accounting period based on estimates
D) Only when cash collections decrease
When estimating bad debts using the percentage of sales method, which financial statement is directly affected?
A) Balance Sheet
B) Income Statement
C) Statement of Cash Flows
D) Statement of Changes in Equity
What happens when a company writes off a specific receivable under the allowance method?
A) Total assets decrease
B) Bad debt expense increases
C) Net realizable value of receivables remains unchanged
D) Accounts receivable turnover ratio decreases
Which method is not compliant with GAAP for bad debts?
A) Allowance method
B) Percentage of receivables method
C) Direct write-off method
D) Aging of receivables method
Notes Receivable differ from Accounts Receivable because they typically include:
A) A due date and interest
B) Larger balances
C) Only cash transactions
D) A reserve for bad debts
A debit to Bad Debts Expense and a credit to Allowance for Doubtful Accounts reflects:
A) Writing off uncollectible accounts
B) Reinstating an account
C) Estimating uncollectible accounts
D) Recording a credit sale
Factoring accounts receivable involves:
A) Using receivables as collateral for a loan
B) Selling receivables to a third party
C) Writing off uncollectible accounts
D) Applying the aging method to receivables
The maturity value of a note receivable is:
A) Its face value
B) Its face value plus interest
C) Its net realizable value
D) Its discounted value
A long collection period may indicate:
A) High liquidity
B) Inefficient credit policies
C) Effective credit control
D) Reduced risk of bad debts
Which of the following would not affect the balance of Accounts Receivable?
A) Credit sales
B) Write-offs
C) Estimation of bad debts
D) Customer payments
When bad debts are understated, what is the impact on total assets?
A) No impact
B) Overstated
C) Understated
D) Correctly stated
Under the percentage of receivables method, the focus is on:
A) Income statement accounts
B) Balance sheet accounts
C) Cash flows
D) Sales transactions
A credit balance in the Allowance for Doubtful Accounts indicates:
A) Underestimated bad debts
B) Overestimated bad debts
C) Normal operation
D) A loss for the period
When using the allowance method, writing off an account will:
A) Affect both net income and total assets
B) Affect only net income
C) Affect only total assets
D) Not affect net income or total assets
To record a dishonored note, the appropriate entry includes a debit to:
A) Notes Receivable
B) Accounts Receivable
C) Bad Debts Expense
D) Cash
How is the accounts receivable turnover ratio calculated?
A) Average accounts receivable ÷ Net credit sales
B) Ending accounts receivable ÷ Total revenue
C) Net credit sales ÷ Average accounts receivable
D) Net credit sales ÷ Total accounts receivable
Which account is credited when recovering a previously written-off account?
A) Bad Debts Expense
B) Accounts Receivable
C) Cash
D) Allowance for Doubtful Accounts
If a company uses the aging method and estimates $10,000 as uncollectible, but the Allowance for Doubtful Accounts has a $2,000 debit balance, the adjusting entry will:
A) Debit Bad Debts Expense $10,000
B) Credit Allowance for Doubtful Accounts $10,000
C) Debit Bad Debts Expense $12,000
D) Credit Allowance for Doubtful Accounts $12,000
The Allowance for Doubtful Accounts appears on which financial statement?
A) Income Statement
B) Balance Sheet
C) Statement of Cash Flows
D) Statement of Retained Earnings
When estimating bad debts using the percentage of sales method, the adjusting entry focuses on:
A) Accounts Receivable
B) Allowance for Doubtful Accounts
C) Bad Debts Expense
D) Net Income
To compute interest revenue on a note receivable, you need:
A) Principal amount and maturity date
B) Interest rate, principal, and time period
C) Principal amount and discount rate
D) Only the maturity value
Which of the following is true about the direct write-off method?
A) It matches expenses with revenues
B) It is required under GAAP
C) It recognizes bad debts as they occur
D) It requires an adjusting entry for allowance
Allowance for Doubtful Accounts is closed:
A) At the end of each fiscal year
B) When receivables are written off
C) When estimating bad debts
D) Never; it is a permanent account
A higher accounts receivable turnover ratio suggests:
A) Efficient credit management
B) Poor credit policies
C) Longer collection periods
D) Ineffective receivables management
What is the purpose of a note receivable’s interest?
A) To compensate for bad debts
B) To reward early payment
C) To provide income to the lender
D) To reduce the principal amount owed
The net realizable value of receivables equals:
A) Total receivables plus allowance for doubtful accounts
B) Total receivables minus allowance for doubtful accounts
C) Credit sales minus write-offs
D) Cash collected plus ending receivables
Why is the percentage of receivables method often preferred over the percentage of sales method?
A) It is easier to apply
B) It provides a more accurate balance sheet valuation
C) It is based on historical data
D) It reduces bad debt expense
A higher bad debt expense results in which of the following?
A) Increase in net income
B) Increase in accounts receivable
C) Decrease in net income
D) Decrease in total liabilities
Which of the following does NOT affect the Allowance for Doubtful Accounts?
A) Estimating bad debts
B) Writing off uncollectible accounts
C) Recovering previously written-off accounts
D) Recording credit sales
The main difference between the direct write-off and allowance methods is:
A) The timing of recognizing bad debts
B) The calculation of interest
C) The effect on cash flow
D) The treatment of recovered accounts
What is the primary disadvantage of the direct write-off method?
A) It does not provide for bad debts
B) It violates the matching principle
C) It increases accounts receivable turnover
D) It is difficult to apply
If the Allowance for Doubtful Accounts has a credit balance of $1,500 and estimated uncollectibles are $7,000, the adjusting entry will:
A) Debit Bad Debts Expense $8,500
B) Credit Allowance for Doubtful Accounts $5,500
C) Debit Bad Debts Expense $7,000
D) Credit Allowance for Doubtful Accounts $7,000
What happens to the Allowance for Doubtful Accounts when a specific account is written off?
A) It increases
B) It decreases
C) It remains unchanged
D) It is closed out
The aging method estimates uncollectibles by:
A) Applying a single percentage to all receivables
B) Assigning higher percentages to older receivables
C) Using historical write-offs as a guide
D) Applying a flat rate to credit sales
What type of journal entry is made to reinstate a previously written-off account?
A) Debit Bad Debts Expense, Credit Accounts Receivable
B) Debit Accounts Receivable, Credit Allowance for Doubtful Accounts
C) Debit Allowance for Doubtful Accounts, Credit Bad Debts Expense
D) Debit Cash, Credit Allowance for Doubtful Accounts
Which document is created when a customer owes money but disputes the amount?
A) Invoice
B) Credit memo
C) Debit memo
D) Dispute report
A note is classified as dishonored when:
A) It is not paid by the maturity date
B) Interest is not collected
C) The maker requests an extension
D) The lender sells it to another party
The credit period offered to customers affects which ratio?
A) Gross profit margin
B) Accounts receivable turnover
C) Debt-to-equity ratio
D) Quick ratio
The entry to record bad debt expense includes a:
A) Debit to Allowance for Doubtful Accounts
B) Credit to Accounts Receivable
C) Debit to Bad Debts Expense
D) Credit to Interest Revenue
Why might a company use factoring?
A) To manage inventory
B) To accelerate cash inflow
C) To avoid recording bad debts
D) To improve interest revenue
A short collection period for receivables is typically desirable because:
A) It increases interest income
B) It enhances liquidity
C) It reduces operating expenses
D) It eliminates bad debt risk
Which of the following is not included in the calculation of net realizable value?
A) Total accounts receivable
B) Allowance for doubtful accounts
C) Bad debts expense
D) Recoveries of previously written-off accounts
If a company underestimates its bad debts, what is the effect on net income?
A) No effect
B) Net income is overstated
C) Net income is understated
D) Net income is unaffected until write-offs occur
A long collection period for receivables indicates:
A) Efficient credit management
B) Potential liquidity issues
C) Strong cash flow
D) Reduced need for bad debt allowances
Which ratio measures how efficiently a company collects receivables?
A) Current ratio
B) Accounts receivable turnover
C) Debt ratio
D) Return on assets
To record the acceptance of a note in settlement of an account, the journal entry includes:
A) Debit Accounts Receivable, Credit Notes Receivable
B) Debit Notes Receivable, Credit Accounts Receivable
C) Debit Notes Receivable, Credit Cash
D) Debit Cash, Credit Notes Receivable
A company using the allowance method writes off an account. What is the effect on total assets?
A) Total assets decrease
B) Total assets increase
C) Total assets remain the same
D) It depends on the amount written off
The entry to record interest earned on a note includes:
A) Debit to Cash
B) Debit to Notes Receivable
C) Debit to Interest Revenue
D) Credit to Interest Revenue
What does the accounts receivable aging schedule provide?
A) A breakdown of receivables by customer
B) A detailed analysis of overdue accountsa
C) An estimate of cash collections
D) An analysis of inventory turnover
If a note receivable is dishonored, the company should:
A) Write off the note
B) Record it as bad debt expense
C) Transfer it back to accounts receivable
D) Record interest earned in the period of dishonor
A customer’s payment on a dishonored note includes:
A) Principal only
B) Principal plus penalties
C) Principal plus interest
D) Interest only
Which of the following is NOT a reason for a company to offer credit to customers?
A) Increase sales
B) Foster customer loyalty
C) Accelerate cash inflows
D) Compete with rivals
Recovering a written-off account under the allowance method involves:
A) A debit to Bad Debts Expense
B) A debit to Cash and a credit to Accounts Receivable
C) A debit to Accounts Receivable and a credit to Allowance for Doubtful Accounts
D) A debit to Accounts Receivable and a credit to Bad Debts Expense
Essay Questions and Answers for Study Guide
1. Explain the difference between the direct write-off method and the allowance method for accounting for bad debts. Which method is preferred under GAAP, and why?
Answer:
The direct write-off method involves directly writing off uncollectible accounts as bad debts when they are deemed uncollectible. The journal entry usually debits Bad Debt Expense and credits Accounts Receivable. This method violates the matching principle because bad debt expense may not be recorded in the same period as the related revenue. As such, it is not preferred under Generally Accepted Accounting Principles (GAAP) unless the amounts are immaterial.
The allowance method, on the other hand, estimates uncollectible accounts in advance, ensuring that bad debt expense is recorded in the same period as the related revenue. This method uses an Allowance for Doubtful Accounts to adjust accounts receivable to their net realizable value. GAAP prefers this method because it adheres to the matching principle and provides a more accurate representation of a company’s financial position.
2. What is an aging schedule of accounts receivable, and how is it used to estimate bad debts?
Answer:
An aging schedule of accounts receivable categorizes outstanding receivables based on the length of time they have been outstanding, typically in intervals such as 0-30 days, 31-60 days, 61-90 days, and over 90 days.
The company applies varying percentages of uncollectibility to each category based on historical experience, with older receivables usually having higher percentages. For example:
- 0-30 days: 1% uncollectible
- 31-60 days: 5% uncollectible
- 61-90 days: 15% uncollectible
- Over 90 days: 30% uncollectible
By multiplying the balances in each category by the respective percentages, the company calculates the estimated uncollectible amount, which is used to adjust the Allowance for Doubtful Accounts. This method ensures that the accounts receivable are reported at their net realizable value.
3. How does the recovery of a previously written-off account impact the financial statements?
Answer:
The recovery of a previously written-off account involves two journal entries:
- Reinstatement of the account: Debit Accounts Receivable and credit Allowance for Doubtful Accounts.
- Collection of cash: Debit Cash and credit Accounts Receivable.
The recovery does not affect net income because the bad debt expense was already recognized in a prior period. It increases both accounts receivable and the Allowance for Doubtful Accounts in the reinstatement entry, and then it increases cash and decreases accounts receivable in the collection entry. This ensures accurate financial reporting without overstating revenues.
4. Discuss the significance of net realizable value in the presentation of accounts receivable on the balance sheet.
Answer:
Net realizable value (NRV) is the amount of cash a company expects to collect from its accounts receivable. It is calculated as:
Accounts Receivable – Allowance for Doubtful Accounts = NRV
The NRV provides users of the financial statements with a realistic estimate of the cash inflows expected from receivables, which is critical for assessing a company’s liquidity and financial health. It adheres to the principle of conservatism by accounting for potential losses and ensuring that assets are not overstated. Proper estimation of NRV enhances the reliability and usefulness of the financial statements.
5. What is factoring, and how does it benefit a company’s accounts receivable management?
Answer:
Factoring involves selling accounts receivable to a third party, known as a factor, at a discounted price. The company receives immediate cash from the factor, while the factor assumes responsibility for collecting the receivables.
Benefits of factoring include:
- Improved liquidity: Companies can access cash quickly, improving cash flow for operational needs.
- Reduced credit risk: The risk of non-payment shifts to the factor.
- Efficient receivables management: The factor handles the collection process, allowing the company to focus on core operations.
However, factoring can be expensive due to the fees charged by the factor, and it may result in a loss of control over the customer relationship.
6. Why is the estimation of bad debts important, and how does it align with the matching principle?
Answer:
The estimation of bad debts is crucial for presenting accounts receivable at their net realizable value and ensuring that revenues and related expenses are matched in the same period. This process involves forecasting the amount of uncollectible accounts based on historical data and current economic conditions.
By estimating bad debts, companies adhere to the matching principle, which states that expenses must be recognized in the same period as the revenues they help generate. This prevents the overstatement of income in one period and ensures that the financial statements accurately reflect the company’s performance and financial position.
7. Compare and contrast notes receivable and accounts receivable.
Answer:
Both notes receivable and accounts receivable represent amounts owed to a company, but they differ in key aspects:
- Accounts Receivable:
These are amounts owed by customers for goods or services sold on credit. They are typically short-term, non-interest-bearing, and governed by less formal agreements. - Notes Receivable:
These are written promises to pay a specified amount on a specific date, often with interest. They are more formal than accounts receivable and can be either short-term or long-term.
Key differences:
- Documentation: Notes receivable require a formal written agreement; accounts receivable do not.
- Interest: Notes receivable often include interest; accounts receivable do not.
- Timeframe: Notes receivable may have longer payment terms than accounts receivable.
Both are reported as assets, but notes receivable are classified separately on the balance sheet.
8. What internal controls can a company implement to manage its accounts receivable effectively?
Answer:
Effective management of accounts receivable is essential to ensure timely collections and minimize bad debts. Key internal controls include:
- Credit approval process: Establish clear credit policies and assess customer creditworthiness before extending credit.
- Segregation of duties: Separate responsibilities for credit approval, billing, and collections to reduce the risk of fraud.
- Regular reconciliation: Reconcile accounts receivable records with the general ledger to detect discrepancies.
- Timely follow-ups: Implement a systematic follow-up process for overdue accounts to ensure prompt collection.
- Use of aging schedules: Regularly review aging schedules to identify and address delinquent accounts.
- Write-off policies: Establish policies for writing off uncollectible accounts to maintain accurate records.
These controls help maintain accurate financial reporting, improve cash flow, and reduce the risk of fraud.
9. Discuss the ethical considerations involved in managing bad debt expense and its impact on financial reporting.
Answer:
Managing bad debt expense involves estimating uncollectible accounts, which directly affects a company’s financial statements. Ethical considerations arise because management has discretion in choosing the estimation methods and assumptions. Overestimating or underestimating bad debt expense can manipulate profits and mislead stakeholders.
- Overestimating bad debts reduces net income, potentially deferring income for future periods (income smoothing).
- Underestimating bad debts inflates income, making the company appear more profitable in the short term.
To uphold ethical standards, companies must:
- Use reasonable and consistent assumptions based on historical data and current economic conditions.
- Adhere to GAAP and maintain transparency in reporting.
- Avoid manipulative practices that distort the financial position.
Ethical management ensures accurate financial reporting and builds trust with investors, creditors, and other stakeholders.
10. How does the write-off of accounts receivable under the allowance method differ from the direct write-off method in terms of journal entries?
Answer:
Under the allowance method, the write-off does not affect the income statement because the bad debt expense is already accounted for in a prior period. The journal entry reduces the Allowance for Doubtful Accounts and Accounts Receivable, as follows:
- Debit: Allowance for Doubtful Accounts
- Credit: Accounts Receivable
Under the direct write-off method, bad debts are written off directly to the Bad Debt Expense account when deemed uncollectible, impacting the income statement:
- Debit: Bad Debt Expense
- Credit: Accounts Receivable
The allowance method aligns with the matching principle, while the direct write-off method does not, which is why the allowance method is preferred under GAAP.
11. Describe the process and purpose of adjusting the Allowance for Doubtful Accounts.
Answer:
Adjusting the Allowance for Doubtful Accounts ensures that accounts receivable are reported at their net realizable value. This process involves analyzing past data and current trends to estimate uncollectible accounts accurately.
Steps to adjust the allowance:
- Prepare an aging schedule or apply a percentage to the total accounts receivable based on historical uncollectibility rates.
- Calculate the required balance in the Allowance for Doubtful Accounts.
- Determine the adjustment needed by comparing the existing allowance balance to the required balance.
- Record the adjustment:
- Debit: Bad Debt Expense
- Credit: Allowance for Doubtful Accounts
This adjustment aligns the financial statements with the matching principle and provides a realistic view of expected cash inflows.
12. Why might a company use an accounts receivable turnover ratio, and how is it calculated?
Answer:
The accounts receivable turnover ratio measures how efficiently a company collects receivables. A high ratio indicates effective credit and collection policies, while a low ratio may signal issues with collections or overly lenient credit terms.
Formula:
Accounts Receivable Turnover=Net Credit SalesAverage Accounts Receivable\text{Accounts Receivable Turnover} = \frac{\text{Net Credit Sales}}{\text{Average Accounts Receivable}}
Steps:
- Compute net credit sales (total credit sales minus returns and allowances).
- Calculate average accounts receivable (beginning balance + ending balance / 2).
- Divide net credit sales by average accounts receivable.
The ratio helps stakeholders evaluate liquidity and operational efficiency, guiding decisions on credit policies and cash flow management.
13. What are the advantages and disadvantages of extending credit to customers?
Answer:
Advantages:
- Increased sales: Offering credit attracts more customers who may prefer delayed payments.
- Customer loyalty: Flexible credit terms enhance customer satisfaction and retention.
- Competitive advantage: Credit terms can differentiate a company from competitors.
Disadvantages:
- Bad debts: Some customers may default, leading to financial losses.
- Cash flow issues: Delayed payments can strain liquidity.
- Administrative costs: Managing credit accounts, collections, and bad debts increases operational expenses.
While extending credit can boost revenue, companies must implement effective credit policies and internal controls to mitigate risks.
14. How do economic conditions impact the estimation of bad debts?
Answer:
Economic conditions directly affect customers’ ability to pay their debts, influencing the estimation of bad debts.
- During economic growth: Customers are more likely to pay on time, reducing the need for high allowances for doubtful accounts.
- During recessions: Higher unemployment and reduced disposable income increase the likelihood of defaults, requiring a larger bad debt estimate.
Companies must adjust their bad debt expense and allowance for doubtful accounts based on current economic indicators, such as GDP growth, unemployment rates, and industry-specific conditions, to ensure accurate financial reporting.
15. What are the accounting implications of pledging accounts receivable as collateral?
Answer:
Pledging accounts receivable as collateral involves using receivables to secure a loan. The company retains ownership of the receivables but agrees to use collections to repay the loan.
Accounting treatment:
- Disclose the pledged receivables in the notes to the financial statements.
- Record the loan as a liability.
- Continue recognizing accounts receivable and related collections in the normal course of business.
While pledging improves liquidity, it creates an obligation and reduces the availability of receivables for future financing, which must be transparently reported.
16. How can a company manage the risk of bad debts when dealing with international customers?
Answer:
Managing bad debts for international customers involves addressing risks like currency fluctuations, political instability, and differing legal systems. Key strategies include:
- Credit insurance: Protects against non-payment risks.
- Advance payments or letters of credit: Ensure payment security.
- Currency hedging: Mitigates the impact of exchange rate fluctuations.
- Thorough credit checks: Assess the creditworthiness of foreign customers.
- Clear terms and conditions: Use legally enforceable contracts with jurisdiction clauses.
By implementing these measures, companies can reduce bad debt risk while expanding their global market presence.
17. Explain how the sale of receivables differs from borrowing against receivables.
Answer:
Sale of receivables (factoring): The company sells its accounts receivable to a third party (factor) at a discount. The receivables are removed from the balance sheet, and the company receives immediate cash. The risk of collection shifts to the factor.
Borrowing against receivables: The company uses receivables as collateral for a loan. The receivables remain on the balance sheet, and the company retains the responsibility for collections.
While factoring improves cash flow and reduces collection risks, it is often costlier than borrowing. Borrowing preserves customer relationships but requires repayment, potentially straining liquidity.
18. What are the challenges of estimating bad debts in a rapidly growing business?
Answer:
Rapidly growing businesses face unique challenges in estimating bad debts:
- Limited historical data: New customer bases lack sufficient payment history for accurate estimation.
- High credit exposure: Growth often involves extending credit to untested customers, increasing default risks.
- Dynamic economic conditions: Rapid expansion may occur in volatile markets, complicating forecasts.
- Resource constraints: Growth may divert focus from credit monitoring and collections.
To address these challenges, companies should adopt conservative estimates, invest in credit evaluation systems, and regularly review receivables to adjust for risks.
19. How does implementing a credit policy help reduce bad debts?
Answer:
A well-structured credit policy minimizes the risk of bad debts by ensuring that credit is extended only to customers with the ability and intent to pay. Key elements include:
- Creditworthiness assessment: Evaluating customer financial health through credit reports, payment history, and financial statements.
- Defined payment terms: Clear expectations for payment deadlines and penalties for late payments.
- Credit limits: Setting maximum credit thresholds to limit exposure to individual customers.
- Regular monitoring: Periodically reviewing customer accounts to detect potential risks early.
By implementing and enforcing a credit policy, companies can balance sales growth with financial stability, reducing the likelihood of uncollectible receivables.
20. Compare and contrast the methods of estimating bad debts: percentage of sales and aging of accounts receivable.
Answer:
Both methods estimate bad debts but differ in focus and application:
Percentage of Sales Method:
- Estimates bad debts as a fixed percentage of net credit sales.
- Simple to apply and suitable for stable businesses with consistent credit patterns.
- Focuses on the income statement, emphasizing the matching principle.
Aging of Accounts Receivable Method:
- Categorizes receivables by age to determine the likelihood of collection.
- Accounts older than a certain period are more likely to be uncollectible.
- Provides a detailed analysis, focusing on the balance sheet to ensure accurate valuation.
While the percentage of sales method is faster, the aging method offers greater accuracy by considering the specific risks associated with overdue accounts.
21. Why is it important to disclose accounts receivable and bad debts in financial statements?
Answer:
Disclosure of accounts receivable and bad debts ensures transparency and helps stakeholders evaluate a company’s financial health. Important reasons include:
- Assessing liquidity: Reveals the quality of receivables and the likelihood of conversion to cash.
- Evaluating credit risk: Indicates the extent of uncollectible accounts and management’s ability to mitigate losses.
- Compliance with GAAP: Accurate reporting ensures adherence to accounting standards.
- Investor confidence: Transparent disclosures foster trust among investors, creditors, and other stakeholders.
Such disclosures provide critical information for decision-making and protect the company’s reputation.
22. Explain the impact of bad debt expense on financial ratios.
Answer:
Bad debt expense affects several financial ratios by influencing net income and accounts receivable balances:
- Profitability Ratios:
- Net Profit Margin: Increases in bad debt expense reduce net income, lowering this ratio.
- Return on Assets (ROA): Declining net income decreases the efficiency of asset utilization.
- Liquidity Ratios:
- Current Ratio: High bad debts reduce accounts receivable, which may lower this ratio.
- Quick Ratio: Similar impact as the current ratio, especially in businesses reliant on receivables.
- Accounts Receivable Turnover:
- Uncollectible accounts reduce turnover, reflecting inefficiencies in collections.
Understanding these impacts helps management refine credit and collection policies to maintain financial stability.
23. What role does technology play in managing accounts receivable and bad debts?
Answer
Technology enhances the efficiency and accuracy of managing accounts receivable and mitigating bad debts through:
- Automation: Reduces manual errors in invoicing, payment tracking, and reminders.
- Credit analysis tools: Provides real-time creditworthiness assessments of customers.
- Data analytics: Predicts customer payment behavior and potential defaults using historical data.
- Integration: Synchronizes accounts receivable management with enterprise systems like ERP software.
By leveraging technology, companies can streamline operations, improve collections, and reduce the likelihood of bad debts.
24. Discuss the legal and ethical responsibilities of collecting overdue accounts receivable.
Answer:
Collecting overdue accounts must balance assertiveness with adherence to legal and ethical standards:
Legal responsibilities:
- Comply with debt collection laws, such as the Fair Debt Collection Practices Act (FDCPA) in the U.S.
- Avoid harassment, false statements, or unlawful threats during collection efforts.
Ethical responsibilities:
- Maintain respect and professionalism when communicating with customers.
- Offer payment plans or negotiations for customers facing genuine financial hardships.
Ensuring legal compliance and ethical conduct protects the company’s reputation and fosters long-term customer relationships.
25. How do write-offs and recoveries affect the financial statements under the allowance method?
Answer:
Under the allowance method:
Write-offs:
- Reduce Accounts Receivable and the Allowance for Doubtful Accounts without affecting the income statement, as bad debt expense was already recognized earlier.
Journal Entry:
- Debit: Allowance for Doubtful Accounts
- Credit: Accounts Receivable
Recoveries:
- Increase Cash and reinstate the written-off receivable by reversing the earlier write-off. The reinstatement does not affect the income statement, but subsequent collection increases cash inflow.
Journal Entries:
- Reverse the write-off:
- Debit: Accounts Receivable
- Credit: Allowance for Doubtful Accounts
- Record the collection:
- Debit: Cash
- Credit: Accounts Receivable
This method maintains the accuracy of both the income statement and the balance sheet.
26. How can a company balance aggressive sales targets with prudent management of accounts receivable?
Answer:
Balancing sales targets with prudent accounts receivable management involves:
- Setting realistic credit policies: Avoid overly lenient terms to prevent excessive credit risk.
- Incentivizing early payments: Offer discounts for prompt payments to accelerate cash flow.
- Monitoring receivables: Regularly review aging schedules to identify at-risk accounts.
- Aligning sales and collections teams: Encourage collaboration to ensure that sales growth aligns with payment discipline.
- Performance metrics: Evaluate sales team performance not just on revenue but also on the quality of receivables generated.
This approach supports sustainable growth while minimizing financial risks.
27. What are the benefits and risks of factoring accounts receivable?
Answer:
Benefits:
- Immediate cash flow: Provides liquidity for business operations.
- Reduced collection burden: Shifts the responsibility to the factor.
- Improved credit management: The factor assesses credit risks, reducing bad debts.
Risks:
- Cost: Factoring fees and discounts reduce overall profitability.
- Customer relations: The factor’s collection methods may affect customer relationships.
- Dependency: Over-reliance on factoring can signal weak cash flow management.
While factoring offers quick liquidity, it must be strategically used to balance short-term needs with long-term financial stability.
28. Explain how economic downturns influence accounts receivable management.
Answer:
During economic downturns:
- Increased default risk: Customers face financial difficulties, leading to higher bad debts.
- Delayed payments: Strained cash flows result in longer collection periods.
- Stricter credit policies: Companies may tighten credit terms, potentially reducing sales.
To mitigate risks, businesses should:
- Enhance credit evaluations.
- Diversify customer portfolios to reduce dependency on high-risk industries.
- Offer flexible payment plans to maintain customer relationships while encouraging timely payments.
Proactive strategies ensure cash flow stability during challenging times.