We explore more complicated adjustments that we have hinted at but not faced directly. Up to now, the adjustments we have made involve either:
- Keeping up with the passage of time; or,
- Recording implicit transactions.
Adjustments in which we amortized prepaid expenses, such as rent and insurance, depreciated fixed assets, amortized intangible assets, and accrued interest on liabilities are required because of the passage of time. Adjustments involving recognizing liabilities for wages earned but not paid and recognizing cost of goods sold (except when using a perpetual system) are required to recognize implicit transactions.
The adjustments we consider now involve using information beyond what is contained in any transaction and the simple passage of time. This information is used to:
- Decide whether an adjustment should be made (a recognition) step.
- If an adjustment is to be made, what accounts and amounts should be recorded (classification and valuation.)
We use three types of assets for our exploration:
- Accounts Receivable
- Marketable Securities
- Long-lived Assets
Accounts Receivable are the rights to collect cash in the future arising from a sale of products or the provision of a service.
Marketable Securities are passive (there is no participation in decision making, managing or operating) investments in equity and debt securities of other entities. Depending on the depth of the market for these securities, they may be highly liquid – i.e., easily, quickly and cheaply converted into cash.
Long-lived assets are land, buildings, equipment, intellectual property, brands, copyrights, patents and so forth. Tangible assets are things like land and buildings and have a physical presence. Intangible assets are brands, intellectual property, copyrights, and do not have a physical presence.
For each of these types of assets, accounting conventions require that attention be paid to how the value might change as conditions change. For example, a customer could default on an account. The market price of a marketable security might go up or down unexpectedly. Long-lived assets may prove to be more or less useful than originally thought, or useful in entirely different ways.
With accounts receivable, we are aware that customers buying on account might not pay. We don’t know which ones won’t pay (otherwise, we wouldn’t have sold to them), but we might be quite sure that some of them won’t pay. Therefore, we must establish an Allowance for Doubtful Accounts as a contra-asset to Accounts Receivable to reduce the gross amount we are owed down to the net amount we expect to collect. Accomplishing this requires estimating the amounts that will ultimately turn out to be uncollectible.
The entry to set up an Allowance for Doubtful Accounts or to add to it once it has been established, involves a debit to the expense account, Bad Debts Expense, and a credit to Allowance for Doubtful Accounts. To recognize a specific account that becomes uncollectible, the entry is to debit Allowance for Doubtful Accounts and credit Accounts Receivable. This removes part of the allowance and the specific account receivable from the records.
There are two points in the accounting for uncollectible accounts where managerial discretion can be exercised. Since no one knows what the uncollectible accounts will be, the amounts must be estimated. Management is ultimately responsible for making these estimates and can exercise some discretion in choosing the exact amount of the estimate.
Unless a customer declares formal bankruptcy and their debts legally become legally forgiven, it is often unclear and to when the entity should give up its collection efforts and write the account receivable off. Again, management is ultimately responsible for determining the timing of write-offs, and typically can exercise some discretion in its determination.
Estimation
[Under Construction]
Write-offs
[Under Construction]