Chapter 8 Receivables Bad Debt Expense and Interest

Chapter 8 Receivables, Bad Debt Expense, and Interest Revenue Power. Point Authors: Brandy Mackintosh Lindsay Heiser Mc. Graw-Hill/Irwin Copyright © 2013 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Learning Objective 8 -1 Describe the trade-offs of extending credit. 8 -2

Pros and Cons of Extending Credit Advantage 1. Increases the seller’s revenues. Disadvantages 1. Increased wage costs. 2. Bad debt costs. 3. Delayed receipt of cash. 8 -3

Learning Objective 8 -2 Estimate and report the effects of uncollectible accounts. 8 -4

Accounts Receivable and Bad Debts Jan. 1 Record sales on account Bad debt known dr Accounts Receivable cr Sales Revenue Balance Sheet 8 -5 Income Statement Cash Sales Revenue Accounts Receivable Cost of Goods Sold Inventory Gross Profit … …

Accounts Receivable and Bad Debts Jan. 1 Jan. 31 Record sales on account dr Accounts Receivable cr Sales Revenue Record estimate of bad debts dr Bad Debt Expense (+E, -SE) cr Allowance for Doubtful Accounts (+x. A, -A) Balance Sheet 8 -6 Bad debt known Income Statement Cash Accounts Receivable Less: Allowance for Doubtful Accounts Inventory Accounts Receivable, Net Sales Revenue … Inventory … Debt Expense Bad … … Cost of Goods Sold Gross Profit

Accounts Receivable and Bad Debts Jan. 1 Jan. 31 Record sales on account dr Accounts Receivable cr Sales Revenue Balance Sheet Cash Accounts Receivable Less: Allowance for Doubtful Accounts Inventory Accounts Receivable, Net … Inventory … 8 -7 Record estimate of bad debts Bad debt known dr Bad Debt Expense (+E, -SE) cr Allowance for Doubtful Accounts (+x. A, -A) dr Allowance for Doubtful Accounts (-x. A) cr Accounts Receivable(-A)

Allowance Method The allowance method follows a two-step process, described below: 1. Make an end-of-period adjustment to record the estimated bad debts in the period credit sales occur. 2. Remove (“write off”) specific customer balances when they are known to be uncollectible. 8 -8

1. Adjust for Estimated Bad Debts Assume that VFC estimates $900 in bad debts at the end of the accounting period. 1 Analyze Assets Allowance for Doubtful Accounts (+x. A) -900 2 Liabilities Stockholders’ Equity + Bad Debt Expense (+E) -900 Record dr 8 -9 = Bad Debt Expense (+E, -SE) cr Allowance for Doubtful Accounts (+x. A, -A) 900

1. Adjust for Estimated Bad Debts 8 -10

2. Remove (Write-off) Specific Customer Balances VFC writes off $800 receivable from Fast Fashions because the company could not pay its account. 1 Analyze Assets = Liabilities + Stockholders’ Equity Allowance for Doubtful Accounts (-x. A) +800 Accounts Receivable (-A) -800 2 Record dr 8 -11 Allowance for Doubtful Accounts (-x. A, +A) cr Accounts Receivable (-A) 800

2. Remove (Write-off) Specific Customer Balances dr dr Bad Debt Expense (+E, -SE) cr Allowance for Doubtful Accounts (+x. A, -A) 900 Allowance for Doubtful Accounts (-x. A, +A) cr Accounts Receivable (-A) 800 Accounts Receivable (A) dr + 1/1 Bal. 900 800 cr - 200, 000 1/31 Bal. 200, 000 800 (2) Write-off 2/28 Bal. 199, 200 dr - Allow. For Doubtful Accts. (x. A) cr + 1/1 Bal. 14, 100 900 (1) Estimate (2) Write -off 8 -12 15, 000 1/31 Bal. 14, 200 2/28 Bal. 800 dr + Bad Debt Expene (E, SE) 1/1 Bal. (1) Estimate 0 900 1/31 Bal. 900 cr -

Methods for Estimating Bad Debts There are two acceptable methods of estimating the bad debts in a given period. 1. Percentage of Credit Sales Method. 2. Aging of Accounts Receivable. Simpler to apply. More accurate 8 -13

Percentage of Credit Sales Method The percentage of credit sales method estimates bad debt expense by multiplying the historical percentage of bad debt losses by the current period’s credit sales. 8 -14

Percentage of Credit Sales Method VFC has experienced bad debt losses of ¾ of 1 percent of credit sales in prior periods. Credit sales in January total $120, 000, 2 $ 120, 000 0. 75% Bad debt expense for January $ 900 Record dr 8 -15 Credit sales for January Historical bad debt rate Bad Debt Expense (+E, -SE) cr Allowance for Doubtful Accounts (+x. A, -A) 900

Aging of Accounts Receivable While the percentage of credit sales method focuses on estimating Bad Debt Expense (income statement approach) for the period, the aging of accounts receivable method focuses on estimating the ending balance in the Allowance for Doubtful Accounts (balance sheet approach). The aging method gets its name because it is based on the “age” of each amount in Accounts Receivable at the end of the period. The older and more overdue an account receivable becomes, the less likely it is to be collectible. 8 -16

Aging of Accounts Receivable VFC applies the aging of accounts receivable method to its Accounts Receivable balances when its quarter ends on March 31. The method includes three steps: (1) Prepare an aged list of accounts receivable, (2) Estimate bad debt loss percentages for each category, and (3) Compute the total estimated bad debts. Step 1 8 -17 Age Accounts Receivable.

Aging of Accounts Receivable Step 2 8 -18 Estimate bad debt loss percentages for each category.

Aging of Accounts Receivable Step 3 8 -19 Compute the total estimated bad debts.

Aging of Accounts Receivable AJE = ($17, 240 - $14, 200) = $3, 040 8 -20

Aging of Accounts Receivable Prepare the AJE for Bad Debt Expense at March 31. 1 Analyze Assets = Liabilities Allowance for Doubtful Accounts (+x. A) -2, 240 2 Bad Debt Expense (+E) -2, 240 Record dr 3 Bad Debt Expense (+E, -SE) cr Allowance for Doubtful Accounts (+x. A, -A) 2, 240 Summarize dr - Allow. For Doubtful Accts (x. A) cr + 8 -21 Stockholders’ Equity + dr + Bad Debt Expense (E, SE) 15, 000 2, 240 Unadj. Bal. AJE Beg. Bal. AJE 900 2, 240 17, 240 Adj. Bal. End Bal. 3, 140 cr -

Other Issues Revising Estimates -- Bad debt estimates always differ from the amounts that are later written off. If these differences are material, companies are required to revise their bad debt estimates for the current period. Account Recoveries -- Collection of a previously written off account is called a recovery and it is accounted for in two parts. First, put the receivable back on the books by recording the opposite of the write-off. Second, record the collection of the account. 8 -22

Other Issues Let’s assume that VFC collects the $800 from Fast Fashions that was previously written off. This recovery would be recorded with the following journal entries: (1) Reverse the write-off. (2) Record the collection. 8 -23

Learning Objective 8 -3 Compute and report interest on notes receivable. 8 -24

Notes Receivable and Interest Revenue A company reports Notes Receivable if it uses a promissory note to document its right to collect money from another party. Unlike accounts receivable, which are interest free until they become overdue, notes receivable charge interest from the day they are created to the day they are due (their maturity date). 8 -25

Calculating Interest (I) = Principal (P) × Interest Rate (R) × Time (T) The amount of the note receivable 8 -26 The annual interest rate charged on the note The time period for interest calculation

Recording Notes Receivable and Interest Revenue The four key events that occur with any note receivable are: 3 1 2 Date of Note Receivable Annual Interest Rate Amount of the Note Maturity Date of Note Year End of Company 8 -27 4 November 1, 2012 6% $100, 000 October 31, 2013 December 31, 2012

(1) Establishing a Note Receivable Assume that on November 1, 2012, VFC lent $100, 000 to a company by creating a note that required the company to pay VFC 6 percent interest and the $100, 000 principal on October 31, 2013. 1 Analyze Assets = Liabilities + Stockholders’ Equity Notes Receivable +100, 000 Cash -100, 000 2 Record dr 8 -28 Notes Receivable (+A) cr Cash (-A) 100, 000

(2) Accruing Interest Earned Accrue the interest earned at year-end, December 31, 2012. 2 Principal (P) × Interest Rate (R) × Time (T) = Interest (I) $100, 000 × 6% × 2/12 = $1, 000 8 -29

(2) Accruing Interest Earned Accrue the interest earned at year-end, December 31, 2012. 1 Analyze Assets Interest Receivable 2 Liabilities (+A) +1, 000 + Stockholders’ Equity Interest Revenue (+R, +SE) +1, 000 Record dr 8 -30 = Interest Receivable (+A) cr Interest Revenue (+R, +SE) 1, 000

(3) Record Interest Received Record interest received at maturity, October 31, 2013. Principal (P) × Interest Rate (R) × Time (T) = Interest (I) $100, 000 × 6% × 12/12 = $6, 000 8 -31

(3) Record Interest Received Record interest received at maturity, October 31, 2013. 1 Analyze Assets = Liabilities Cash (+A) +6, 000 Interest Receivable (-A) -1, 000 + Stockholders’ Equity Interest Revenue (+R, +SE) +5, 000 $5, 000 = $100, 000 × 6% × 10/12 2 Record dr 8 -32 Cash (+A) cr Interest Receivable (-A) cr Interest Revenue (+R, +SE) 6, 000 1, 000 5, 000

(4) Recording Principal Received The principal amount of the note is received on October 31, 2013. 1 Analyze Assets = Liabilities + Stockholders’ Equity Cash (+A) +100, 000 Note Receivable (-A) -100, 000 2 Record dr 8 -33 Cash (+A) cr Note Receivable (-A) 100, 000

Learning Objective 8 -4 Compute and interpret the receivables turnover ratio. 8 -34

Receivables Turnover Analysis The receivables turnover ratio indicates how many times, on average, this process of selling and collecting is repeated during the period. The higher the ratio, the faster the collection of receivables. Rather than evaluate the number of times accounts receivable turn over, some people find it easier to think in terms of the number of days to collect receivables (called days to collect). 8 -35

Receivables Turnover Analysis Receivable Turnover Ratio = Net Sales Revenue Average Net Receivables $500, 000 = 10 times $ 50, 000 (Beginning net receivables + Ending net receivables) ÷ 2 Days to = Collect 8 -36 365 Receivable Turnover Ratio 365 = 36. 5 days 10

Comparison to Benchmarks Credit Terms When companies sell on account, they specify the length of credit period (and any cash discounts for prompt payment). By comparing the number of days to collect to the length of credit period, you can gain a sense of whether customers are complying with the stated policy. 8 -37

Speeding Up Collections Factoring Receivables One way to speed up collections is to sell outstanding accounts receivable to another company (called a factor). Your company receives cash for the receivables it sells to the factor (minus a factoring fee). Credit Card Sales Another way to avoid lengthy collection periods is to allow customers to pay for goods using Pay. Pal or national credit cards. This not only speeds up the seller’s cash collection, but also reduces losses from customers writing bad checks. Pay. Pal and Credit card companies charges a fee for their services. 8 -38

Chapter 8 Supplement 8 A Direct Write-Off Method Mc. Graw-Hill/Irwin Copyright © 2013 by

Direct Write-Off Method The direct write-off method, does not estimate bad debt. Instead, it reports Sales when they occur and bad debt expense when it is discovered. This method is not acceptable for GAAP. The reason the method isn’t considered GAAP is because it reports receivables at the total amount owed by customers rather than what is estimated to be collectible and it violates the expense recognition principle (matching principle) by recording bad debt expense in the period the customer’s account is determined to be bad rather than the period when the credit sales are actually made. 8 -40

Direct Write-Off Method A customer account is determined to be uncollectible and $1, 000 of Bad Debt Expense needs to be recorded. 2 Record dr 8 -41 Bad Debt Expense (+E, -SE) cr Accounts Receivable (-A) 1, 000

Chapter 8 Solved Exercises M 8 -10, E 8 -7, E 8 -8, E

M 8 -10 Using the Interest Formula to Compute Interest Complete the following table by computing the missing amounts (? ) for the following independent cases. a. b. c. Principal Amount of Note Receivable Annual Interest Rate Time Period in Months Interest Earned $ 100, 000 $ 50, 000 ? 10% ? 10% 6 9 12 ? $ 3, 000 $ 4, 000 Case a. $100, 000 × 10% × (6/12) = $5, 000 Case b. $3, 000 ÷ [$50, 000 × (9/12)] = 8% Case c. [$4, 000 ÷ 10%] × (12/12) = $40, 000 8 -43

E 8 -7 Computing Bad Debt Expense Using Aging of Accounts Receivable Method Brown Cow Dairy uses the aging approach to estimate Bad Debt Expense. The balance of each account receivable is aged on the basis of three time periods as follows: (1) 1– 30 days old, $12, 000; (2) 31– 90 days old, $5, 000; and (3) more than 90 days old, $3, 000. Experience has shown that for each age group, the average loss rate on the amount of the receivable due to uncollectibility is (1) 5 percent, (2) 10 percent, and (3) 20 percent, respectively. At December 31, 2013 (end of the current year), the Allowance for Doubtful Accounts balance was $800 (credit) before the end-of -period adjusting entry is made. Required: 1. Prepare a schedule to estimate an appropriate year-end balance for the Allowance for doubtful accounts. 2. What amount should be recorded as Bad Debt Expense for the current year? 3. If the unadjusted balance in the Allowance for Doubtful Accounts was a $600 debit balance, what would be the amount of Bad Debt Expense in 2013? 8 -44

E 8 -7 Computing Bad Debt Expense Using Aging of Accounts Receivable Method Req. 1 Total 1 - 30 $ 20, 000 $ 12, 000 $ 5, 000 $ 3, 000 5% 10% 20% 500 $ 600 $ 1, 700 Req. 2 $ 31 -90 600 $ >90 Estimate Balance in Allowance Existing Credit Balance in Allowance Adjusting Journal Entry Amount Allowance for Doubtful Accounts 800 Unadj. Bal. 900 AJE 1, 700 Bal. Req. 3 Allowance for Doubtful Accounts Unadj. Bal. 600 2, 300 AJE 1, 700 Bal. 8 -45 $ 1, 700 800 $ 900

E 8 -8 Recording and Reporting Allowance for Doubtful Accounts Using the Percentage of Credit Sales and Aging of Accounts Receivable Methods Innovative Tech, Inc. (ITI) uses the percentage of credit sales method to estimate bad debts each month and then uses the aging method at year-end. During November 2013, ITI sold services on account for $100, 000 and estimated that ½ of one percent of those sales would be uncollectible. At its December 31 year-end, total Accounts Receivable is $89, 000, aged as follows: (1) 1– 30 days old, $75, 000; (2) 31– 90 days old, $10, 000; and (3) more than 90 days old, $4, 000. Experience has shown that for each age group, the average rate of uncollectibility is (1) 10 percent, (2) 20 percent, and (3) 40 percent, respectively. Before the endof-year adjusting entry is made, the Allowance for Doubtful Accounts has a $1, 600 credit balance at December 31, 2013. Required: 1. Prepare the November 2013 adjusting entry for bad debts. 2. Prepare a schedule to estimate an appropriate year-end balance for the Allowance for Doubtful Accounts. 3. Prepare the December 31, 2013, adjusting entry. 4. Show the various accounts related to accounts receivable should be shown on the December 31, 2013, balance sheet. 8 -46

E 8 -8 Recording and Reporting Allowance for Doubtful Accounts Using the Percentage of Credit Sales and Aging of Accounts Receivable Methods Req. 1 November 30, 2013 AJE dr Bad Debt Expense (+E, -SE) cr Allowance for Doubtful Accounts (+x. A, -A) ($500 = $100, 000 x 0. 005) Req. 2 Total 1 - 30 31 -90 $ 89, 000 $ 75, 000 $ 10, 000 $ 4, 000 10% 20% 40% 2, 000 $ 1, 600 $ 11, 100 Req. 3 $ 7, 500 $ >90 Allowance for Doubtful Accounts 1, 600 Unadj. Bal. 9, 500 AJE 11, 100 Bal. 8 -47 500

E 8 -8 Recording and Reporting Allowance for Doubtful Accounts Using the Percentage of Credit Sales and Aging of Accounts Receivable Methods Req. 4 The accounts related to the accounts receivable can be shown one of two ways on the December 31, 2013 balance sheet: Accounts Receivable $ 89, 000 Less: Allowance for Doubtful Accounts (11, 100) Accounts Receivable, net of allowance $ 77, 900 OR Accounts Receivable, net of Allowance for Doubtful Accounts of $11, 100 8 -48 $ 77, 900

E 8 -9 Recording and Determining the Effects of Write-Offs, Recoveries, and Bad Debt Expense Estimates on the Balance Sheet and Income Statement. Fraud Investigators Inc. operates a fraud detection service. Required: 1. Prepare journal entries for each transaction below. a. On March 31, 10 customers were billed for detection services totaling $25, 000. b. On October 31, a customer balance of $1, 500 from a prior year was determined to be uncollectible and was written off. c. On December 15, a customer paid an old balance of $900, which had been written off in a prior year. d. On December 31, $500 of bad debts were estimated and recorded for the year. 2. Complete the following table, indicating the amount and effect ( + for increase, - for decrease, and NE for no effect) of each transaction. Ignore income taxes. 8 -49

E 8 -9 Recording and Determining the Effects of Write-Offs, Recoveries, and Bad Debt Expense Estimates on the Balance Sheet and Income Statement. Req. 1 a. b. c. dr dr d. 8 -50 dr Accounts Receivable (+A) cr Service Revenue (+R, +SE) Allowance for Doubtful Accounts (-x. A, +A) cr Accounts Receivable (-A) 25, 000 1, 500 Accounts Receivable (+A) cr Allowance for Doubtful Accounts (+x. A, -A) 900 Cash (+A) cr Accounts receivable (-A) 900 Bad Debt Expense (+E, -SE) cr Allowance for Doubtful Accounts (+x. A, -A) 500 900 500

E 8 -9 Recording and Determining the Effects of Write-Offs, Recoveries, and Bad Debt Expense Estimates on the Balance Sheet and Income Statement. Req. 2 8 -51

CP 8 -4 Accounting for Accounts and Notes Receivable Transactions Execusmart Consultants has provided business consulting services for several years. The company uses the percentage of credit sales method to estimate bad debts for internal monthly reporting purposes. At the end of each quarter, the company adjusts its records using the aging of accounts receivable method. The company entered into the following selected transactions during the first quarter of 2013. a. During January, the company provided services for $200, 000 on credit. b. On January 31, the company estimated bad debts using 1 percent of credit sales. c. On February 4, the company collected $100, 000 of accounts receivable. d. On February 15, the company wrote off a $500 account receivable. e. During February, the company provided services for $150, 000 on credit. f. On February 28, the company estimated bad debts using 1 percent of credit sales. g. On March 1, the company loaned $12, 000 to an employee who signed a 10% note, due in 3 months. h. On March 15, the company collected $500 on the account written off one month earlier. i. On March 31, the company accrued interest earned on the note. j. On March 31, the company adjusted for uncollectible accounts, based on the aging analysis shown on the next screen. Allowance for Doubtful Accounts has an unadjusted credit balance of $6, 000. 8 -52

CP 8 -4 Accounting for Accounts and Notes Receivable Transactions (continued) Required: 1. For items a – j, analyze the amount and direction (+ or -) of effects on specific financial statement accounts and the overall accounting equation and prepare journal entries. 2. Show the accounts receivable and related accounts would be reported in the current assets section of a classified balance sheet. 3. Name the accounts related to Accounts Receivable and Notes Receivable that would be reported on the income statement and indicate whether they would appear before, or after, Income from Operations. 8 -53

CP 8 -4 Accounting for Accounts and Notes Receivable Transactions Req. 1 8 -54

CP 8 -4 Accounting for Accounts and Notes Receivable Transactions Req. 1 8 -55

CP 8 -4 Accounting for Accounts and Notes Receivable Transactions Req. 1 8 -56

CP 8 -4 Accounting for Accounts and Notes Receivable Transactions Req. 1 8 -57

CP 8 -4 Accounting for Accounts and Notes Receivable Transactions Req. 1 8 -58

CP 8 -4 Accounting for Accounts and Notes Receivable Transactions Req. 1 Desired $8, 390 – Current -$6000 = Adjustment $2, 390 8 -59

CP 8 -4 Accounting for Accounts and Notes Receivable Transactions Req. 2 Assets EXECUSMART CONSULTANTS Partial Balance Sheet At March 31, 2013 Current Assets: Accounts Receivable Less: Allowance for Doubtful Accounts Receivable, Net of Allowance Note Receivable Interest Receivable $ 90, 000 8, 390 $ 81, 610 12, 000 100 Req. 3 Execusmart Consultants would report Bad Debt Expense before Income from Operations, and Interest Revenue after Income for Operations. 8 -60

C 8 -1 Comprehensive Exercise for Recording and Reporting Credit Sales and Bad Debts Using the Aging of Accounts Receivable Method Okay Optical, Inc. (OOI) began operations in January 2013 selling inexpensive sunglasses to large retailers like Walgreen’s and other smaller stores. Assume the following transactions occurred during its first six months of operations. January 1 - Sold merchandise to Walgreen’s on account for $20, 000; the cost of goods to OOI was $12, 000. February 12 - Received payment in full from Walgreen’s. March 1 - Sold merchandise to Bravis Pharmaco on account for $3, 000; the cost of goods to OOI was $1, 400. April 1 - Sold merchandise to Tony’s Pharmacy on account for $8, 000. The cost to OOI was $4, 400. May 1 - Sold merchandise to Anjuli Stores on account for $2, 000; the cost to OOI was $1, 200. June 17 - Received $6, 500 on account from Tony’s Pharmacy. Required: 1. Complete an aged listing of customer accounts at June 30. 2. Estimate the Allowance for Doubtful Accounts required at June 30, 2013, assuming the following uncollectible rates: one month, 1 percent; two months, 5 percent; three months, 20 percent; more than three months, 40 percent. 3. Show OOI would report its accounts receivable on its June 30 balance sheet. What amounts would be reported on an income statement prepared for the six-month period ended June 30, 2013? 4. Bonus Question: In July 2013, OOI collected the balance due from Bravis Pharmaco but discovered that the balance due from Tony’s Pharmacy needed to be written off. Using this information, determine how accurate OOI was in estimating the Allowance for Doubtful Accounts needed for each of these two customers and in total. 8 -61

C 8 -1 Comprehensive Exercise for Recording and Reporting Credit Sales and Bad Debts Using the Aging of Accounts Receivable Method Req. 1 Total Customer Anjuli Stores $ May April >3 (1 Month) (2 Months) (3 Months) Months 2, 000 Bravis Pharmaco 3, 000 Tony’s Pharmacy 1, 500 $ 2, 000 $ 3, 000 $ 1, 500 - Walgreens Total June $ 6, 500 Req. 2 $ Total Accounts Receivable $ 6, 500 $ 2, 000 8 -62 $ 1, 600 $ 3, 000 2 months 3 months >3 months $ 2, 000 $ 1, 500 $ 3, 000 5% 20% 40% 300 $ 1, 200 Estimated Uncollectible (%) Estimated Uncollectible ($) $ 1, 500 $ 100 $

C 8 -1 Comprehensive Exercise for Recording and Reporting Credit Sales and Bad Debts Using the Aging of Accounts Receivable Method Req. 3 OKAY OPTICAL, INC. Partial Balance Sheet At June 30, 2013 Accounts Receivable, Net of Allowance of $1, 600 OKAY OPTICAL, INC. Partial Income Statement For the Six Months Ended June 30, 2013 Sales Revenue Cost of Goods Sold Gross Profit Bad Debt Expense Income from Operations 8 -63 $33, 000 19, 000 14, 000 1, 600 $12, 400 $4, 900

C 8 -1 Comprehensive Exercise for Recording and Reporting Credit Sales and Bad Debts Using the Aging of Accounts Receivable Method Req. 4 OOI did not accurately estimate the precise amounts that would be collected from each customer, yet the total estimate was reasonably accurate at $1, 600. OOI underestimated the amount collectible from Bravis Pharmaco (40% of $3, 000, or $1, 200, was estimated uncollectible where it later turned out to be collectible in full). It overestimated the amount collectible from Tony’s Pharmacy (20% of $1, 500, or $300, was estimated uncollectible where it later turned out to show that $1, 500 was uncollectible). Looking at Bravis Pharmaco and Tony’s Pharmacy combined, the estimated bad debt for both customers was $1, 500, which is only $100 less than the amount the company wrote off. 8 -64

End of Chapter 8 8 -65