Copyright © 2016 by McGraw-Hill Education Chapter 8 Receivables, Bad Debt Expense, and Interest Revenue PowerPoint Author: Brandy Mackintosh, CA

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

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

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

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

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

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

8-8 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. 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.

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

Adjust for Estimated Bad Debts

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

Remove (Write-off) Specific Customer Balances Bad Debt Expense Allowance for Doubtful Accounts (+xA) 900 Allowance for Doubtful Accounts (-xA) Accounts Receivable 800 1/1 Bal. 1/31 Bal. End Bal. (2) Write-off Accounts Receivable (A) dr + cr - 200, , (2) Write -off 1/1 Bal. (1) Estimate 1/31 Bal. End Bal. Allow. For Doubtful Accts. (xA) dr - cr , ,000 14,200 1/1 Bal. (1) Estimate 1/31 Bal. Bad Debt Expense (E, SE) dr + cr

8-13 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

8-14 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.

8-15 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 Record Bad Debt Expense Allowance for Doubtful Accounts (+xA) 900

8-16 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.

8-17 Aging of Accounts Receivable VFC applies the aging of accounts receivable method to its Accounts Receivable balances on February 28, after taking into account February sales and cash collections. 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. Age Accounts Receivable. Step 1

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

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

8-20 Aging of Accounts Receivable AJE = ($15,500 - $14,200) = $1,300

8-21 Aging of Accounts Receivable Prepare the AJE for Bad Debt Expense at February Analyze Liabilities Assets = Stockholders’ Equity + Allowance for Doubtful Accounts (+xA) -1,300 Bad Debt Expense (+E) -1,300 2 Record Bad Debt Expense Allowance for Doubtful Accounts (+xA) 1,300 3 Summarize Unadj. Bal. AJE Adj. Bal. Allow. For Doubtful Accts (xA)dr - cr + 14,200 1,300 15,500 Beg. Bal. AJE End Bal. Bad Debt Expense (E,SE)dr + cr ,300 2,200

8-22 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.

8-23 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.

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

8-25 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 generally interest free, notes receivable charge interest from the day they are created to the day they are due (their maturity date).

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

8-27 Recording Notes Receivable and Interest Revenue The four key events that occur with any note receivable are: Date of Note ReceivableNovember 1, 2015 Annual Interest Rate6% Amount of the Note$100,000 Maturity Date of NoteOctober 31, 2016 Year End of CompanyDecember 31, 2015 Date of Note ReceivableNovember 1, 2015 Annual Interest Rate6% Amount of the Note$100,000 Maturity Date of NoteOctober 31, 2016 Year End of CompanyDecember 31, 2015

8-28 (1) Establishing a Note Receivable Assume that on November 1, 2015, 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, Analyze Liabilities Assets = Stockholders’ Equity + Notes Receivable +100,000 Cash -100,000 2 Record Notes Receivable Cash 100,000

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

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

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

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

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

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

8-35 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).

8-36 Receivables Turnover Analysis (Beginning net receivables + Ending net receivables) ÷ 2 $500,000 $ 50,000 = 10 times Days to Collect = 365 Receivable Turnover Ratio = 36.5 days

8-37 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.

8-38 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 PayPal or national credit cards. This not only speeds up the seller’s cash collection, but also reduces losses from customers writing bad checks. PayPal and Credit card companies charge a fee for their services.

Copyright © 2016 by McGraw-Hill Education Chapter 8 Supplement 8A Direct Write-Off Method

8-40 Learning Objective 8-S1 Record bad debts using the direct write-off method.

8-41 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.

8-42 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 Bad Debt Expense Accounts Receivable 1,000

8-43 End of Chapter 8