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

Objective 8.1: Describe the trade-offs of extending credit.

Pros and Cons of Extending Credit

• Advantage: Encourages the customer to buy more goods/services, so revenue goes up.
• Disadvantages:
  • Increase in wage costs: Employees are hired to see if someone is creditworthy, see how much money people owe, and to collect from customers.
  • Bad debt costs: Sometimes people don’t pay what they owe.
  • Delays receipt of cash: Receiving cash from customers can take 30-60 days.

Objective 8.2: Estimate and report the effects of uncollectible accounts.

Accounts Receivable and Bad Debts

• When accounts receivables aren’t fully paid off, it results in bad debt.
• There are %%two objectives%% in relation to accounts receivable and bad debts:
  • Accounts Receivable is recorded at the value that is expected to be collected, aka “net realizable value”.
  • Match (matching principle) the estimated cost of bad debts to the accounting period related credit sales are made.
  • Both objectives result in a decrease in Accounts Receivable and Net Income by the credit estimated to not be collected.
• You must record Sales Revenue and Bad Debt Expense in the %%same period of the sale%%. This is called the expense recognition principle (matching).
• The allowance method is estimating bad debts that may not be collected and adjusting these estimations later.
• Allowance for Doubtful Accounts is a contra account to Accounts Receivable and has a normal credit balance.
• When an account can not be collected, the account must be written off.
  • The balance is removed from Accounts Receivable and Allowance for Doubtful Accounts.
  • Debit Allowance for Doubtful Accounts
  • Credit Accounts Receivable
• Write offs DO NOT appear on the Income Statement.
• ==Equation to calculate net receivable value:==
  • Accounts Receivable - Allowance for Doubtful Accounts = Net Receivable Value
• %%Journal entries:%%
  • Record sales on account:
  • Debit Accounts Receivable
  • Credit Sales Revenue
  • Record estimate of bad debts:
  • Debit Bad Debt Expense
  • Credit Allowance for Doubtful Allowance
  • Bad debt know (“write off” day):
  • Debit Allowance for Doubtful Accounts
  • Credit Accounts Receivable
• Example: A company sells a bike for $300 to a customer who pays on account. An asset increases and revenues increases.

• Example: The company expects to receive $300, but records it estimated bad debt. An expense increases and a contra account increases.

• Example: The company writes off the bad account. A contra account decreases and the asset decreases.

Methods for Estimating Bad Debts

• There are %%two methods%% to calculate the estimate of bad debt: Percentage of Credit Sales Method and Aging of Accounts Receivable
• Percentage of Credit Sales Method
  • Aka the Income Statement Account.
  • Estimates Bad Debt Expense for the period.
  • Not very precise.
  • ==Equation for estimating bad debt expense (% of credit sales method):==
  • Historical percentage of bad debt loss x Current period’s credit sales
• Example: A company has bad debt loss of 3/4. Their credit sales in March totaled $150,000.
  • Historical percentage of bad debt loss = 75%
  • Current period’s credit sales = $150,000
  • $150,000 x 0.0075 = $1,125
• Aging of Accounts Receivable
  • Aka the Balance Sheet Method.
  • Estimates the ending balance in the Allowance for Doubtful Accounts.
  • Bases its estimate off of the age of each amount in Accounts Receivable at the end of the accounting period.
  • If the account receivable is old and overdue, it is less likely to be collected.
  • More complicated than the first one, but it more accurate.
  • Steps for the Aging of Accounts Receivable:
  • Prepare an aged listing of accounts receivable.
  • Estimate the bad debt loss percentages for each category.
  • Compute the total estimated bad debts
• Example: $5,000 of a company’s Accounts Receivable are estimated to be uncollectible. The unadjusted credit balance for Allowance of Doubt Accounts is $500.
  • We know that the beginning balance in the Allowance for Doubtful Accounts is $500.
  • We know the ending balance is $5,000.
  • We want to fill in what the adjusted entry should look like on the T-account.

Other Issues

• We never expect the estimate to match perfectly. There is always going to be a little bit of a difference. If we are significantly off, we have to increase our percentages.
• Revising estimates is when a company revises their bad debt estimates for the current period.
• Account recovery is reviving written off accounts. The receivable is put back on the books by recording the opposite of what is done for writing off an account. After, a company records the collection of the account.
  • An example of an account recovery is getting a check in the mail after writing off an account. The company initially thought they would not receive payment, but they did so a journal entry is needed.
  • There will %%always be 2 journal entries for a recovery%%.
  • Journal entry for reversing the write off:
  • Debit Accounts Receivable
  • Credit Allowance for Doubtful Accounts
  • Journal entry for the collection of the account:
  • Debit Cash
  • Credit Accounts Receivable
• Example: A company collects $300 for a bike sold, but previously written off. Write the two journal entries: reverse the write off and collect the cash.

Objective 8.3: Compute and report interest on notes receivable.

Notes Receivable and Interest Revenue

• A Notes Receivable is reported when a promissory note is used for a transaction. It has a stronger legal claim.
• Notes receivables %%charge interest%% from the date they are created to when they are due.
• The day the Notes Receivable is due is called the maturity date.
• A company may use a Notes Receivable for:
  • Loaning money out to employees or businesses.
  • Receiving extended payment on expensive items.
  • Switching from Accounts Receivable to Notes Receivable to extend the payment period.

Calculating Interest

• Three numbers are needed to calculate interest:
  • Principal - the amount of the Note Receivable.
  • Interest Rate - interest percentage charged on the note. They are always an annual percentage.
  • Time Period - the amount of time covered in the interest. Can be in months or days (12, 365)
• ==Equation to calculate interest:==
  • Principal (P) x Interest Rate (R) x Time (T) = Interest (I)
• Example: The interest period for a company is from January 1 - June 1 (6 months). The principal is $100,000 and the rate is 6%. What would equation look like and what is the interest?
  • Principal (P) x Interest Rate (R) x Time (T) = Interest (I)
  • Time is in terms of months in this example. The interest period (# of months) goes over 12 (total # of months in a year).
  • $100,000 x 6% x 6/12 = $3,000

Recording Notes Receivable and Interest Revenue

• %%The four key events for a Note Receivable:%%
  • Establishing the note.
  • Accruing interest earned but not received (make an adjusting journal entry).
  • Recording interest payments received.
  • Recording principal payments received.
• First, do a journal entry that shows the increase of the Note Receivable.
  • Debit Notes Receivable
  • Credit Cash
• Interest revenue is earned over time.
  • For this next step, use the formula P x R x T = Interest.
  • Do the journal entry:
    • Debit Interest Receivable
    • Credit Interest Revenue
• Third, we calculate the rest of the interest for the remaining time period.
  • Create the journal entry:
  • Debit Cash
  • Credit Interest Receivable
  • Credit Interest Revenue
• Lastly, we create the journal entry for the principal amount of the note
  • Debit Cash
  • Credit Note Receivable
• Example (part A): On November 1st, 2021, a company lent $100,000 to a business using a note. The business must pay the company 6% interest and $100,000 principal on October 31st, 2022.

• Example (part B): Accrue the interest at the end of the year (December 31, 2021).
• Find the amount of interest to be paid at this time.
• P = 100,000; R = 6%; T = 2 months
• $100,000 x 6% x 2/12 = $1,000

• Example (part C): Received interest at the maturity date (October 31, 2022).
  • Find the total amount of interest the company earns.
  • $100,000 x 6% x 12/12 = $6,000
  • We already received 2 months of interest, so we subtract the $1,000 from $6,000.
  • $5,000 is the amount we earned in 2022.

• Example (part D): Record the principal amount from the note that is received on October 31, 2022.

Objective 8.4: Compute and interpret the receivables turnover ratio.

Receivables Turnover Analysis

• A receivables turnover analysis helps see the effectiveness of a company’s credit-granting and collection activity.
• Selling goods or services makes the receivables balance increase.
• Collecting the money from customers makes the receivables balance decrease.
• Receivables turnover is the constant selling and collecting cycle.
• The receivables turnover ratio indicates how many times the cycle is repeated during the accounting period.
  • The higher the ratio, the faster the collection of receivables.
  • When the ratio is low, the company is giving their customers too long of a period to pay. Uncollected accounts become a risk.
• Days to collect is the number of days to collect receivables.
  • A higher ratio means it takes more days to collect, but we want a lower ratio.
• ==Equation to calculate the receivable turnover ratio:==
  • Net Sales Revenue/Average Net Receivables = Receivable Turnover Ratio
• ==Equation to calculate days to collect:==
  • 365/Receivables Turnover Ratio = Days to Collect
• Example: A company has Net Sales Revenue of $500,000 and Average Net Receivables of $50,000.

Comparison to Benchmarks

• Credit terms is an agreement between the buyer and seller about the timings and payment to be made for the goods bought on credit.
• You can compare the numbers of days to collect to the length of the credit period to see if credit terms are being followed.

Speeding Up Collections

• %%There are two ways you can speed up collections%%:
  • Factoring Receivables
  • Credit Card Sales
• A factor is when you sell outstanding accounts to a different company. By doing so, your company is paid for the receivables it sells to the factors. A factoring fee must be considered.
• Credit cards speed up cash collection and make it less likely to receive bad checks from customers. Credit card companies so however charge a fee for their services.