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Chapter 8

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Chapter 8

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  1. Chapter 8 Receivables, Bad Debt Expense, and Interest Revenue PowerPoint Authors: Brandy Mackintosh Lindsay Heiser

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

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

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

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

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

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

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

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

  10. 1. Adjust for Estimated Bad Debts

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

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

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

  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.

  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, 900 900 dr Bad Debt Expense (+E, -SE) cr Allowance for Doubtful Accounts (+xA, -A) Credit sales for January Historical bad debt rate Bad debt expense for January $ 120,000 0.75% $ 900 Record 2

  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.

  17. 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 Age Accounts Receivable.

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

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

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

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

  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 recoveryand 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.

  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.

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

  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 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).

  26. Calculating Interest Interest (I) = Principal (P) × Interest Rate (R) × Time (T) The annual interest ratecharged on the note The amount of thenote receivable The time period forinterest calculation

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

  28. Stockholders’ Equity + Notes Receivable +100,000 Cash -100,000 (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. 100,000 100,000 dr Notes Receivable (+A) cr Cash (-A) Record Analyze Liabilities Assets = 1 2

  29. (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

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

  31. (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

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

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

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

  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).

  36. Receivables Turnover Analysis ReceivableTurnover Ratio Net Sales Revenue Average Net Receivables $500,000 $ 50,000 = = 10 times (Beginning net receivables + Ending net receivables) ÷ 2 Days toCollect 365Receivable Turnover Ratio = 365 10 = 36.5 days

  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.

  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 charges a fee for their services.

  39. Chapter 8Supplement 8A Direct Write-Off Method

  40. 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.

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

  42. Chapter 8Solved Exercises M8-10, E8-7, E8-8, E8-9, CP8-4, C8-1

  43. M8-10 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 $ 100,000 $ 50,000 ? Annual Interest Rate 10% ? 10% Time Period in Months 6 9 12 Interest Earned ? $ 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

  44. E8-7 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: Prepare a schedule to estimate an appropriate year-end balance for the Allowance for doubtful accounts. What amount should be recorded as Bad Debt Expense for the current year? 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?

  45. E8-7 Computing Bad Debt Expense Using Aging of Accounts Receivable Method Req. 1 Total $ 20,000 $ 1,700 1 - 30 $ 12,000 5% $ 600 31-90 $ 5,000 10% $ 500 >90 $ 3,000 20% $ 600 Estimate Balance in Allowance Existing Credit Balance in Allowance Adjusting Journal Entry Amount $ 1,700 800 $ 900 Req. 2 Allowance for Doubtful Accounts Allowance for Doubtful Accounts Unadj. Bal. 600 Unadj. Bal. AJE Bal. AJE Bal. 800 900 1,700 2,300 1,700 Req. 3

  46. E8-8 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 end-of-year adjusting entry is made, the Allowance for Doubtful Accounts has a $1,600 credit balance at December 31, 2013. Required: Prepare the November 2013 adjusting entry for bad debts. Prepare a schedule to estimate an appropriate year-end balance for the Allowance for Doubtful Accounts. Prepare the December 31, 2013, adjusting entry. Show how the various accounts related to accounts receivable should be shown on the December 31, 2013, balance sheet.

  47. E8-8 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 Total $ 89,000 $ 11,100 1 - 30 $ 75,000 10% $ 7,500 31-90 $ 10,000 20% $ 2,000 >90 $ 4,000 40% $ 1,600 500 dr Bad Debt Expense (+E, -SE) cr Allowance for Doubtful Accounts (+xA, -A) ($500 = $100,000 x 0.005) 500 Req. 2 Allowance for Doubtful Accounts Unadj. Bal. AJE Bal. 1,600 9,500 11,100 Req. 3

  48. E8-8 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 Less: Allowance for Doubtful Accounts Accounts Receivable, net of allowance Accounts Receivable, net of Allowance for Doubtful Accounts of $11,100 $ 89,000 (11,100) $ 77,900 $ 77,900 OR

  49. E8-9 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: • Prepare journal entries for each transaction below. • On March 31, 10 customers were billed for detection services totaling $25,000. • On October 31, a customer balance of $1,500 from a prior year was determined to be uncollectible and was written off. • On December 15, a customer paid an old balance of $900, which had been written off in a prior year. • 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.

  50. E8-9 Recording and Determining the Effects of Write-Offs, Recoveries, and Bad Debt Expense Estimates on the Balance Sheet and Income Statement. Req. 1 a. dr Accounts Receivable (+A) 25,000 cr Service Revenue (+R, +SE) 25,000 b. dr Allowance for Doubtful Accounts (-xA, +A) 1,500 cr Accounts Receivable (-A) 1,500 c. dr Accounts Receivable (+A) 900 cr Allowance for Doubtful Accounts (+xA, -A) 900 dr Cash (+A) 900 cr Accounts receivable (-A) 900 d. dr Bad Debt Expense (+E, -SE) 500 cr Allowance for Doubtful Accounts (+xA, -A) 500