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.
Accounts Receivable$300
Sales Revenue$300
  • Example: The company expects to receive $300, but records it estimated bad debt. An expense increases and a contra account increases.
Bad Debt Expense$300
Allowance for Doubtful Accounts$300
  • Example: The company writes off the bad account. A contra account decreases and the asset decreases.
Allowance for Doubtful Accounts$300
Accounts Receivable$300

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.

    The adjusted entry is a credit of 4500. (Allowance = Allowance for Doubtful Accounts)

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.
Account Receivables$300
Allowance$300
Cash$300
Accounts Receivable$300

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

    P is $100,000, R is 6%, and T is 6/12

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.
Notes Receivable$100,000
Cash$100,000
  • 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
Interest Receivable$1,000
Interest Revenue$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.
Cash$6,000 (total earned)
Interest Receivable$1,000 (earned 2021)
Interest Revenue$5,000 (earned 2022)
  • Example (part D): Record the principal amount from the note that is received on October 31, 2022.
Cash$100,000
Note Receivable$100,000

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.

    Top calculates the receivable turnover ratio, which then is plugged into the days to collect equation.

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.