Chapter 8 – Receivables, Bad Debt, and Interest Revenue

Learning Objectives

• LO 8-1: Describe the trade-offs of extending credit.
• LO 8-2: Estimate and report the effects of uncollectible accounts.
• LO 8-3: Compute and report interest on notes receivable.
• LO 8-4: Compute and interpret the receivables-turnover ratio.
• LO 8-S1 (Supplement 8A): Record bad debts using the direct write-off method.

Extending Credit: Pros and Cons

• Advantage
  • Increases seller’s revenues by attracting customers who need short-term financing.
• Disadvantages
  1. Increases wage costs (staff needed to evaluate credit, monitor A/R, pursue collections).
  2. Creates bad-debt costs (some customers will not pay).
  3. Delays receipt of cash, which can create liquidity issues.

Accounting for Bad Debts—Allowance Method

Rationale

• Required by GAAP because it satisfies the expense-recognition (matching) principle and reports A/R at net realizable value (amount expected to be collected).
• Uses adjusting entries to estimate bad-debt expense in the same period as related credit sales.

Core Two-Step Process

1. End-of-period adjustment to record estimated bad debts.
   • Journal entry (Jan. 31 example):
     • Dr Bad Debt Expense (+E, −SE)
     • Cr Allowance for Doubtful Accounts (+xA, −A)
2. Write-off specific customer balances when known to be uncollectible.
   • Journal entry (when identified):
     • Dr Allowance for Doubtful Accounts (−xA)
     • Cr Accounts Receivable (−A)

Effect of a Write-Off

• No impact on total assets or net income at the time of write-off.
  • Reduction in A/R is offset by reduction in Allowance (contra-asset).

Illustrative Numbers (VFC example)

• Estimated bad debts = $900$ ⇒ AJE increases Allowance and Bad Debt Expense by $900$.
• Later write-off of specific $800$ receivable reduces A/R and Allowance by $800$.
• T-accounts (after both steps):
  • A/R: Beg $200{,}000$ → End $199{,}200$.
  • Allowance: Beg $14{,}100$ → +$900$ estimate → −$800$ write-off ⇒ End $14{,}200$.
  • Bad-Debt Expense: $900$ for the month.

Methods to Estimate Bad Debt (Step 1)

1. Percentage-of-Credit-Sales Method

• Income-statement focus; simpler but less precise.
• Formula:
  $\text{Bad Debt Expense} = \text{Historical Loss Rate} \times \text{Current Period Credit Sales}$
• Example: Historical loss = $0.75\%$; January credit sales = $120{,}000$
  ⇒ $120{,}000 \times 0.0075 = 900$ bad-debt expense.

2. Aging-of-Accounts-Receivable Method

• Balance-sheet focus; more accurate.
• Three steps:
  1. Age each receivable at period-end.
  2. Assign an uncollectible % to each age category (older = higher %).
  3. Compute required ending Allowance balance; then back into required AJE.
• Example (Feb 28): Required Allowance $15{,}500$ − Existing $14{,}200$ = $1{,}300$ AJE.
  • Dr Bad Debt Expense $1{,}300$
  • Cr Allowance $1{,}300$.
  • Bad-debt expense to date now totals $2,200$ (prior $900$ + new $1,300$).

Other Issues

• Revising estimates: If prior estimates differ materially from actual write-offs, adjust current-period estimates.
• Recoveries: Two entries: (1) reverse prior write-off; (2) record cash collection.
  • Example recovery of previously written-off $800$:
  1. Dr A/R 800 ; Cr Allowance 800
  2. Dr Cash 800 ; Cr A/R 800

Notes Receivable & Interest Revenue

• Notes receivable are formal, interest-bearing claims documented with a promissory note.
• Key variables in interest calculation:$I = P \times R \times T$ where
  • $P$ = Principal
  • $R$ = Annual interest rate
  • $T$ = Fraction of year outstanding (in years or months/12).

Four Critical Events (Example: 6 % , $100,000, Nov 1 2021 – Oct 31 2022)

1. Establish note (Nov 1 2021)
   • Dr Notes Receivable 100,000 ; Cr Cash 100,000.
2. Accrue interest at year-end (Dec 31 2021)
   • $100,000 \times 6\% \times \frac{2}{12} = 1,000$
   • Dr Interest Receivable 1,000 ; Cr Interest Revenue 1,000.
3. Receive interest at maturity (Oct 31 2022)
   • Total interest $6,000$; $1,000$ previously accrued.
   • Dr Cash 6,000 ; Cr Interest Receivable 1,000 ; Cr Interest Revenue 5,000.
4. Collect principal (Oct 31 2022)
   • Dr Cash 100,000 ; Cr Notes Receivable 100,000.

Receivables-Turnover Analysis

• Receivables Turnover Ratio
  $\text{Receivables Turnover} = \frac{\text{Net Sales Revenue}}{\text{Average Net Receivables}}$
• Days to Collect
  $\text{Days to Collect} = \frac{365}{\text{Receivables Turnover}}$
• Example: $500,000/50,000 = 10\text{ times}$; $365/10 = 36.5$ days.
• Interpretation: Higher turnover (lower days) ⇒ faster cash collection & better liquidity.
• Benchmarking: Compare days-to-collect with stated credit terms or industry averages.

Speeding Up Collections

• Factoring: Sell receivables to a factor for cash minus a fee.
• Credit-card or PayPal sales: Immediate cash (net of service fee) & reduced bad-debt exposure.

Direct Write-Off Method (Supplement 8A)

• Records bad-debt expense when discovered, not estimated.
• Simple but not GAAP-compliant because:
  • Overstates A/R (no allowance).
  • Violates matching principle.
• Example write-off: Dr Bad Debt Expense 1,000 ; Cr Accounts Receivable 1,000.

Summary of Exercises & Numerical Illustrations

M8-10 – Using $I = P \times R \times T$

• Case a: $100{,}000 \times 10\% \times 6/12 = 5{,}000$ interest.
• Case b: Solve for $R$ ⇒ $R = \frac{3,000}{50,000 \times 9/12} = 8\%$.
• Case c: Solve for $P$ ⇒ $P = \frac{4,000}{10\%} \times 12/12 = 40,000$.

E8-7 – Aging Method (Brown Cow Dairy)

• A/R aging:
  • 1-30 days $12,000$ @5% = $600$
  • 31-90 days $5,000$ @10% = $500$
  • >90 days $3,000$ @20% = $600$
  • Required Allowance = $1,700$.
• If unadjusted Allowance credit $800$ ⇒ AJE $900$.
• If unadjusted Allowance debit $600$ ⇒ AJE $2,300$.

E8-8 – Switching Methods (Innovative Tech Inc.)

1. Nov 30: Bad-debt expense $500$ via %-of-credit-sales method.
2. Dec 31 aging schedule: Required Allowance $11,100$.
3. Unadjusted Allowance credit $1,600$ ⇒ AJE $9,500$.
4. Balance-sheet presentation either:
   • A/R 89,000
   • Less Allowance (11,100)
   • Net A/R 77,900.

E8-9 – Write-Offs, Recoveries, & Estimates (Fraud Investigators Inc.)

• Journalized: sales on account, write-off $1,500$, recovery $900$, year-end estimate $500$.
• Table (not shown here) tracks effects on A/R, Allowance, Assets, Equity, Revenue, Expense.

CP8-4 – Comprehensive Quarter (Execusmart Consultants)

• Monthly %-of-sales estimates followed by quarterly aging adjustment.
• Issued employee note $12,000$ @10% for 3 months.
• March 31 interest accrual $12,000 \times 10\% \times 1/12 = 100$.
• Desired Allowance $8,390$ − Unadjusted credit $6,000$ = AJE $2,390$.
• Partial balance sheet (Mar 31):
  • A/R 90,000
  • Less Allowance 8,390
  • Net A/R 81,610
  • Note Rec. 12,000
  • Interest Rec. 100.

C8-1 – Six-Month Start-Up (Okay Optical)

• Aging at June 30 produced Allowance $1,600$ on total A/R $6,500$ (net $4,900$).
• Income statement (six months):
  • Sales $33,000$
  • COGS $19,000$
  • Gross Profit $14,000$
  • Bad-Debt Expense $1,600$
  • Income from Operations $12,400$.
• July events showed total estimate close to actual but offsetting errors by customer.

Ethical, Conceptual & Practical Notes

• Matching Principle: Estimates ensure expenses (bad debts) recorded in same period as related sales.
• Net Realizable Value: Users need realistic asset values; allowance contra-account provides this.
• Liquidity Management: High receivables turnover improves cash flow; low turnover may trigger factoring or stricter credit terms.
• GAAP Compliance: Direct write-off violates GAAP except when amounts are immaterial.
• Internal Controls: Separation of credit approval, billing, and collections limits fraud opportunities.

Key Formulas Summary

• Interest: $I = P \times R \times T$.
• Bad-debt (%-sales): $\text{BDE} = \text{Credit Sales} \times \text{Loss Rate}$.
• Receivables Turnover: $\frac{\text{Net Sales}}{\text{Avg Net A/R}}$.
• Days to Collect: $\frac{365}{\text{Receivables Turnover}}$.