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Expense Estimation Expense Estimation Accountancy 301 Spring 2011 Flora Zhou 14
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Today Today ’s agenda ’s agenda • Expense recognition revisited – Matching principle – Asset/liability approach – Conservatism • Accounts receivables and doubtful accounts – Income Statement approach – Balance Sheet approach • Contingent liabilities and assets
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Expense recognition principles Expense recognition principles • Expense definition:  – Expenses are outflows or other using up of assets or  incurrence of liabilities from delivering or producing  goods, rendering services, or other activities that  constitute the entity’s ongoing major or central  operations • Recognition principles: – Matching principle • Match costs incurred in a period with revenues in the same  period – Assets/liabilities approach • Write offs of impaired assets such as inventory, and fixed  assets – Conservatism principle • Recognition of contingent losses
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Accounts receivable: Accounts receivable: Assessing net realizable value Assessing net realizable value GAAP requires that accounts receivable be shown on the  balance sheet at their  net realizable value . Two things must be estimated to determine the net  realizable value of receivables: 1. Uncollectibles —the amount that will not be collected because  customers are unable to pay. 2. Returns and allowances —the amount that will not be  collected because customers return the merchandise or are  allowed a reduction in the amount owed. NRV of receivables Gross amount owned Estimated uncollectibles Estimated returns & allowances = - -
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Accounts receivable: Accounts receivable: Why estimating allowances is important Why estimating allowances is important Most companies establish credit policies by weighing the  expected cost  of credit sales against the  benefit  of increased  sales. Customer collection and billing costs plus potential bad debts $0 $2,000 $4,000 $6,000 $8,000 $10,000 $12,000 $14,000 $16,000 $18,000 0 1 2 3 4 5 6 7 8 9 10 Credit Risk Profit before  bad debts  expense Bad debts  expense Net  profit
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Accounts receivable: Accounts receivable: Why estimating allowances is important Why estimating allowances is important This tradeoff illustrates that bad debts are often unavoidable. The  matching principle  requires that some estimate of  uncollectible accounts be offset against current period sales. Today Some future dates Time $10,000 current  period sales $500 is  uncollectible $500  estimated  expense
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Allowance method Allowance method Estimate  uncollectible amounts and provide  allowance in the period of sales before A/R  becomes uncollectible- required by GAAP • Two alternative approaches – Income Statement Approach  (or Percentage of Sales  method) Estimate
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