Key Points to Remember

Bank Reconciliations

  1. You are trying to figure out what the REAL balance should be so you can adjust your book balance (your ledger) to this real amount.
  2. You compare your book and bank statement in order to determine if there are items on the books that haven’t shown up on the bank statement. (There are usually deposits in transit and outstanding checks. Items that appear on the books but not the bank are items that aren’t accounted for as a deposit in transit or an outstanding check may indicate money that has been stolen.)
  3. You then determine if there are any items on the bank statement that haven’t shown up on the books. (These will be the items you have to make adjusting entries for.
  4. The fact that your adjusted book balance agrees with the adjusted bank balance is an indication that you have discovered all the missing items you need to.
  5. As we discovered in class, it is possible to fail to record items on the reconciliations and have the bank and book adjusted balance agree. This is why you never want the person keeping the books preparing the reconciliation.

Accounts Receivable

  1. The accounts receivable balance shown in the general ledger (the summary account) should always tie to the detail in the subsidiary ledger (where each account is shown together with how much each account owes).
  2. The accounts receivable represents a substantial amount of money that will be collected within a month. It is one of the most liquid of current assets.
  3. At any given time, we know we won’t be able to collect every one of the accounts we have that makes up that balance.
  4. Since our desire is to show accounts receivable as an asset on the balance sheet at a value that reflects what is likely to be realized in collections, we need to estimate how much of the balance will NOT be collected. We do NOT deduct this amount from the receivable account since we don’t know which specific accounts will be uncollected. Instead, we put it in a ”contra” called “Allowance for doubtful accounts”. We “net” the Allowance for doubtful accounts with the Accounts Receivable in order to get an estimate of what we really expect to collect from Accounts Receivable
  5. There are two basic ways to determine what the balance should be in the “Allowance for Doubtful Accounts” at any given time. These methods DO NOT YIELD THE SAME ESTIMATES!
  6. The aging method.
    This method looks at the specific accounts that make up the accounts receivable balance and based on their age, and the probability of being able to collect them, determines how many of the accounts will likely be collected and how many will not. THIS METHOD DETERMINES WHAT THE BALANCE SHOULD BE IN THE ALLOWANCE FOR DOUBTFUL ACCOUNTS. You then prepare the adjusting entry that is needed to get the Allowance for Doubtful Accounts to be the amount you desire. The Allowance for Doubtful Accounts is credited and Bad Debt Expense is debited. Under this method, the bad debt expense will be whatever amount is needed to get the Allowance Account to be what we want it to be.
  7. The percentage of sales method.
    This method looks at sales for the period and estimates the amount of sales revenue that won’t be collected. An adjusting entry is made to debit the Bad Debt Expense and credit the Allowance for Doubtful Accounts. Over time, it will become necessary to review what is actually in the Allowance for Doubtful Accounts to determine if it in fact reflects what we expect NOT to collect out of our Accounts Receivable balance.
  8. When you are using an “allowance” method, you will record collections of accounts as you normally would. But, when you finally determine that an account is not going to be collected, you will remove it from the accounts receivable balance (by crediting the receivable account) but you will debit the Allowance for Doubtful Accounts. (Basically, you are using up the balance you have established as an estimate of the amount of accounts receivable that will have to be written off.) If the person later pays on an account that has been written off, just reverse this entry. If you are not using an “allowance” method, you will still write-off the account but your debit will be to Bad Debt Expense. This is referred to as the “direct write-off” method and does not reflect the “matching” principle of accrual accounting.

NOTE RECEIVABLE

  1. A note is a longer term debt but usually will be collected within a year. The issues involving notes have to do with accruing interest on them and what to do with them when they are dishonored.
  2. We accrue interest on notes at the end of a period when we are trying to bring our books up to date in order to prepare financial statements.
  3. Interest is earned from the second day of the note through the last day when it is due. You will need to be careful not to count both the beginning day of the note and the last day of the note in computing interest. (I count on my fingers just to make sure.)
  4. The Interest that you will be receiving is NOT recorded in the Note Receivable Account, (we only show the principle of the note in that account). Instead it is shown in the “Interest Receivable Account”. Don’t ask me why. It is just the way it is done.
  5. When calculating the daily interest on a note, business people use the “banker’s rule” of 360 being contained within a year, (as opposed to 365). Although it is easier to use 360 in computations rather than 365, the truth is that 360 yields greater interest at a daily rate.
  6. When a note is dishonored, we don’t write it off. We transfer it into accounts receivable where we try to collect it. As an account receivable, we may or may not be able to collect it and eventually we may or may not have to write it off as an account receivable. At the time we transfer the note to receivables, the account receivable will need to reflect both the principle on the note and its accrued interest. If there is interest that has not been recorded as earned yet, we record it. (The idea is that we still believe at this point that we will collect on the note. ) We will also need to take any interest we have previously recorded on the note out of the Interest Receivable account and transfer it as well to the Account Receivable we have set up for the dishonored note. At the end of all this, interest revenue will have reflected the interest earned on the note. (The fact that we may not collect it at some point is not relevant at this time.
  7. When we collect the note, we will need to accrue interest earned after the dishonor of the note. This will be recorded to interest revenue.
  8. If we can’t collect it, we would treat it as a bad debt expense. If we do write off a note that has been transferred to an account receivable because it was dishonored, we would record the write off according to the allowance method we have chosen to use for accounts receivable. Since the account receivable reflects both the principle of the note as well as the interest that we earned on it, the entire principle and interest is written off to bad debt expense.