Chapter 8 Reporting and Interpreting Receivables Bad Debt

Chapter 8: Reporting and Interpreting Receivables, Bad Debt Expense, and Interest Revenue Describe the trade-offs of extending credit. 8 -1

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

Estimate and report the effects of uncollectible accounts. 8 -3

Jan. 1 Record sales on account dr Accounts Receivable cr Sales Revenue Balance Sheet Cash Accounts Receivable Inventory … 8 -4 Bad debt known Income Statement Sales Revenue Cost of Goods Sold Gross Profit …

Jan. 1 Record sales on account dr Accounts Receivable cr Sales Revenue Balance Sheet Cash Accounts Receivable Cash Less: Allowance for Accounts Receivable Doubtful Accounts Inventory Receivable, Net Inventory … … 8 -5 Jan. 31 Record estimate of bad debts Bad debt known dr Bad Debt Expense (+E, -SE) cr Allowance for Doubtful Accounts (+x. A, -A) Income Statement Sales Revenue Cost of Goods Sold Gross Profit Bad Debt Expense …

Jan. 1 Record sales on account dr Accounts Receivable cr Sales Revenue Balance Sheet Cash Accounts Receivable Less: Allowance for Accounts Receivable Doubtful Accounts Inventory Accounts Receivable, Net Inventory … … 8 -6 Jan. 31 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)

The allowance method follows a twostep 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 -7

Assume that Skechers estimates $900 in bad debts at the end of the accounting period. 1 Analyze 2 8 -8 Record

8 -9

Skechers writes off $800 receivable from Fast Footwear because the company could not pay its account. 1 Analyze 2 8 -10 Record

8 -11

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 -12

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. Net credit sales for the period × Historical bad debt loss rate = Bad debt expense of the period. 8 -13

Skechers has experienced bad debt losses of ¾ of 1 percent of credit sales in prior periods. Credit sales in January total $120, 000, 2 8 -14 Record

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 -15

Skechers applies the aging of accounts receivable method to its Accounts Receivable balances on March 31, the end of its fiscal quarter. 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 -16 Age Accounts Receivable.

Step 2 8 -17 Estimate bad debt loss percentages for each category.

Step 3 8 -18 Compute the total estimated bad debts.

AJE = ($17, 240 - $15, 000) = $2, 240 8 -19

Prepare the AJE for Bad Debt Expense at March 31. 1 Analyze 2 3 8 -20 Record Summarize

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 -21

Let’s assume that Skechers collects the $800 from Fast Footwear 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 -22

Compute and report interest on notes receivable. 8 -23

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 do not charge interest until they’ve become overdue, notes receivable charge interest from the day they are created to the day they are due (their maturity date). 8 -24

Interest (I) = Principal (P) × Interest Rate (R) × Time (T) The amount of the note receivable The annual interest rate charged on the note The time period for interest calculation See if you can calculate the interest below using your calculator. 8 -25

The four key events that occur with any note receivable are: 2 1 Date of Note Receivable Annual Interest Rate Amount of the Note Maturity Date of Note Year End of Company 8 -26 3 4 November 1, 2009 6% $100, 000 October 31, 2010 December 31, 2009

Assume that on November 1, 2009, Skechers lent $100, 000 to a researcher by creating a note that required the researcher to pay Skechers 6 percent interest and the $100, 000 principal on October 31, 2010. 1 Analyze 2 8 -27 Record

Accrue the interest earned at year-end, December 31, 2009. 2 Principal (P) × Interest Rate (R) × Time (T) = Interest (I) $100, 000 × 6% × 2/12 = $1, 000 8 -28

Accrue the interest earned at year-end, December 31, 2009. 1 Analyze 2 8 -29 Record

Record interest received at maturity, October 31, 2010. $5, 000 Interest Principal (P) × Interest Rate (R) × Time (T) = Interest (I) $100, 000 × 6% × 12/12 = $6, 000 8 -30

Record interest received at maturity, October 31, 2010. 1 Analyze $5, 000 = $100, 000 × 6% × 10/12 2 8 -31 Record

The principal amount of the note is received on October 31, 2010. 1 Analyze 2 8 -32 Record

Compute and interpret the receivables turnover ratio. 8 -33

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 -34

$500, 000 = 10 times $ 50, 000 (Beginning net receivables + Ending net receivables) ÷ 2 Days to Collect 8 -35 = 365 Receivable Turnover Ratio 365 = 36. 5 days 10

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 -36

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 national credit cards. This not only speeds up the seller’s cash collection, but also reduces losses from customers writing bad checks. Credit card company charges a fee. 8 -37