7. Receivables

Question 1

What is credit risk?

Answer 1

Credit risk is also known as default risk. It measures the risk that a customer will not ultimately pay the organization what they promised at the time of sale.

Question 2

Briefly describe the two ways organizations account for bad debts.

Answer 2

1. Allowance method: The organization estimates the amount of bad debt it will incur and records the expense in the same period as the related sales using an allowance account. This method is based on accrual accounting and is used for GAAP purposes.
2. Direct write-off method: The organization waits until a specific account is identified as not collectible and removes the accounts receivable with an offsetting entry to bad debt expense. This method is more like a cash basis and is used for tax purposes.

Question 3

What are the two approaches for estimating uncollectible receivables under the allowance method of accounting for bad debts?

Answer 3

1. Percentage of receivables or balance sheet approach: The organization assumes a percentage of existing accounts receivable will not be collectible and adjusts the allowance account to reflect that.
2. Percentage of revenues or income statement approach: The organization assumes a certain percentage of sales are uncollectible and records bad debt expense based on that.

Question 4

What is factoring a receivable?

Answer 4

When receivables are factored, they are sold for cash immediately, rather than waiting for the cash to be collected from customers. This usually involves a discount from the recorded value of the receivables to cover the risk of non-payment by customers.

Question 5

What does it mean to factor receivables with recourse?

Answer 5

The organization selling accounts receivable bears the risk of loss relative to collecting the customers’ balances. One advantage to factoring with recourse is that the fees are typically lower than factoring without recourse. The selling organization is required to compensate the factor for any loss so they estimate the amount of the resulting recourse obligation and record it at the time of the factoring.

Question 6

What does it mean to factor receivables without recourse?

Answer 6

This means that the factor (the organization purchasing the accounts receivable from the selling organization) bears the risk of loss relative to collecting the customers’ balances. The selling organization typically receives less cash on the sale because the buyer has increased risk. If the customer does not ultimately pay the factor, the selling organization is not impacted.