Chapter_8

Chapter 8: Receivables, Bad Debt Expense, and Interest Revenue

Learning Objectives

  • Objective 8-1: Describe the trade-offs of extending credit.

  • Objective 8-2: Estimate and report the effects of uncollectible accounts.

  • Objective 8-3: Compute and report interest on notes receivable.

Extending Credit

Pros and Cons of Extending Credit

  • Disadvantages:

    • Increases wage costs associated with managing credit accounts.

    • Delays receipt of cash, impacting cash flow.

    • Potential for bad debt costs (accounts that will not be collected).

  • Advantage:

    • Increases the seller’s revenues as customers are more likely to purchase on credit.

Estimating Uncollectible Accounts

Recording Sales on Account

  • Journal Entry:

    • Debit: Accounts Receivable

    • Credit: Sales Revenue

  • Balance Sheet includes:

    • Cash, Accounts Receivable, Inventory

  • Income Statement includes:

    • Sales Revenue, Cost of Goods Sold, Gross Profit

Accounting for Bad Debt

  • Recognize Bad Debt:

    • Record known bad debts at the beginning of the period (January 1).

  • Estimated Bad Debts:

    • Journal Entry on January 31:

      • Debit: Bad Debt Expense (+E, -SE)

      • Credit: Allowance for Doubtful Accounts (+xA, -A)

    • Represents amount the business does not expect to collect.

Allowance Method

  • Process:

    1. End-of-period adjustment to record estimated bad debts in the period of credit sales.

    2. Remove specific customer balances upon identification of uncollectibility.

  • Journal Entries:

    • Bad Debt Expense (+E, -SE)

    • Allowance for Doubtful Accounts (+xA)

    • Followed by removing the account from Receivables when written off:

      • Allowance for Doubtful Accounts (-xA)

      • Accounts Receivable (-A)

Methods for Estimating Bad Debts

  • Two Methods:

    1. Percentage of Credit Sales Method: Simplistically estimates based on historical percentage of bad debts relative to current period's credit sales.

    2. Aging of Accounts Receivable: More accurate; focuses on the age of receivables, assessing likely uncollectible amounts based on how overdue debts are.

Steps in Aging of Accounts Receivable

  1. Prepare aged list of Accounts Receivable

  2. Estimate bad debt loss percentages for each category

  3. Compute total estimated bad debts

Accounting for Interest on Notes Receivable

  • Interest Calculation:

    • Formula: Interest (I) = Principal (P) × Interest Rate (R) × Time (T)

  • Key Events for Notes Receivable:

    1. Establishing a note receivable.

    2. Accruing interest earned.

    3. Recording interest received.

    4. Recording principal received.

Establishing a Note Receivable

  • Example:

    • Amount: $100,000

    • Interest Rate: 6%

    • Maturity Date: October 31, 2022

  • Record Entry:

    • Debit: Notes Receivable

    • Credit: Cash

Accruing Interest Earned

  • At year-end calculation for interest earned.

  • Example Calculation: $100,000 × 6% × 2/12 = $1,000

  • Record Entry for Interest:

    • Debit: Interest Receivable

    • Credit: Interest Revenue

Recording Interest Received

  • Total interest calculated at maturity:

    • $100,000 × 6% × 12/12 = $6,000

  • Record Entry:

    • Debit: Cash

    • Credit: Interest Receivable

    • Credit: Interest Revenue

Recording Principal Amount Received

  • Upon maturity, principal received:

    • Record Entry:

      • Debit: Cash

      • Credit: Note Receivable