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.