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.
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
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.
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.