When a company lets customers buy on credit, the company attracts more customers. Allowing sales on credit is a part of doing business. However, it is not without risk. The result may be attracting some customers who will never pay the amount they owe to the business. When this money is not paid, the business has an uncollectible account which must be written-off. If a business has too many uncollectible accounts, the business suffers, and the end result can spell disaster.
There are two methods of writing off uncollectible accounts:
· The Allowance Method (recognized by GAAP)
· The Direct Write-off Method (not recognized by GAAP)
There are several different allowance methods:
· Percentage of Sales Method – also referred to as the Income Statement Method
· Percentage of Accounts Receivables Method – also referred to as the Balance Sheet Method
· Aging of Receivables Method
The difference between the Percentage of Sales Method and the Percentage of Accounts Receivables Method is how the allowance for doubtful accounts is treated when using the two methods.
Accounts receivable are amounts due from customers for credit sales. For a company selling on credit, it is important to assess both the quality and liquidity of its accounts receivable. The quality of accounts receivable is how likely you are to collect these accounts without any loss. The speed of collection, or how fast these accounts are paid or converted to cash, relates to the liquidity of collection. The accounts receivable turnover measures both the quality and liquidity of accounts receivable. In other words, it measures how likely collections are going to be and the speed of those collections.
Instructions
Imagine you own a business that sells to customers on trade credit. For example, you manufacture luxury soaps and you sell these soaps to boutique stores in your hometown area.
Prepare a one page report in which you respond to the following points and questions..
How would you manage the collection of receivables?
Even with careful planning, sometimes receivables become uncollectible. Which method would you use to write off an uncollectible account? Explain your reasons.
What procedures would you put into place to encourage customers to pay their bills on time?