Chapter 8

Chapter 8

Reporting andInterpreting Receivables,Bad Debt Expense, and

Interest Revenue

Learning Objectives1. Describe the trade-offs of extending

credit.2. Estimate and report the effects of

uncollectible accounts.3. Compute and report interest on notes

receivable.4. Compute and interpret the receivables

turnover ratio.

Sales on Account When companies allow customers to purchase

merchandise on an open account, the customer agrees to pay the company in the future

For sales on account, credit is extended without a formal note for a short period (30 to 60 days)

Although cash is not received initially, if collection is reasonably certain, sales revenue and an account receivable are recorded at the time of the sale.

Advantages: Increases the seller’s revenues. Disadvantages:

Increased wage costs. Bad debt costs. Delayed receipt of cash.

Accounting for Bad Debts

Bad debts result from credit customers who will not pay the business the amount they owe, regardless of collection efforts.

Bad debts result from credit customers who will not pay the business the amount they owe, regardless of collection efforts.

Revenues 10,000$ Revenues 0Cost of goods sold 6,000 Cost of goods sold 0Bad debt expense 0 Bad debt expense 1,000 Net income 4,000$ Net income (1,000)$

Year 1(Credit Sale Occurs)

Year 2(Bad Debt discovered)

Bad debts are likely to be discovered in periods after the credit sale.

If bad debts are not reported until discovered,income is distorted in the periods of sale aswell as in the period of bad debt discovery.

Bad debts are likely to be discovered in periods after the credit sale.

If bad debts are not reported until discovered,income is distorted in the periods of sale aswell as in the period of bad debt discovery.


Can you find any problem in this example?


Matching Principle

Bad Debt Expense

Sales Revenue

Record in same accounting period.

Accounts receivable should be carried at net realizable value

Allowance method follows a two-step process:

1. It records an estimated bad debt expense in the period when the related sales take place, by making an adjusting journal entry at the end of that period.

2. It removes (write off) accounts receivable in the period they are determined to be uncollectible.

Allowance method follows a two-step process:

1. It records an estimated bad debt expense in the period when the related sales take place, by making an adjusting journal entry at the end of that period.

2. It removes (write off) accounts receivable in the period they are determined to be uncollectible.

Allowance Method for Uncollectible Accounts

Revenues 10,000$ Revenues 0Cost of goods sold 6,000 Cost of goods sold 0Bad debt expense 1,000 Bad debt expense - Net income 3,000$ Net income -$

Year 1(Credit Sale Occurs)

Year 2(Bad Debt discovered)

Revision of the example using Allowance Method: in Year 1, suppose the firm estimated and recorded a bad debt expense $1,000.

Revision of the example using Allowance Method: in Year 1, suppose the firm estimated and recorded a bad debt expense $1,000.


Recording Bad Debt Expense EstimatesTimberland estimated bad debt expense for

2009 to be $2,000,000.Prepare the adjusting entry.

GENERAL JOURNAL Page 78Date Description Debit Credit

Dec. 31


Dec. 31 Bad Debt Expense (+E, -SE) 2,000,000

Allowance for Doubtful Accounts(-A) 2,000,000

Recording Bad Debt Expense Estimates

Bad Debt Expense is normally classified as a selling expense and is closed at year-end.

Timberland estimated bad debt expense for 2009 to be $2,000,000.

Prepare the adjusting entry.

Contra asset account

Allowance for Doubtful Accounts

Accounts receivable 67,000,000

Less: Allowance for doubtful accounts (2,000,000)

Net realizable value of accounts receivable 65,000,000

Amount the businessexpects to collect.

Balance Sheet Disclosure

Writing Off Uncollectible Accounts

When it is clear that a specific customer’s account receivable will be uncollectible, the amount should be

removed from the Accounts Receivable account and charged to the Allowance for

Doubtful Accounts.



Timberland’s total write-offs for2009 were $1,480,000.

Prepare a summary journalentry for these write-offs.



Allowance for Doubtful Accounts(+A) 1,480,000

Accounts Receivable(-A) 1,480,000

Timberland’s total write-offs for2009 were $1,480,000.

Prepare a summary journalentry for these write-offs.


Assume that before the write-off, Timberland’s Accounts Receivable balance was $81,000,000 and the Allowance for Doubtful Accounts

balance was $2,000,000.

Let’s see what effect the total write-offs of $1,480,000 had on these accounts.

Assume that before the write-off, Timberland’s Accounts Receivable balance was $81,000,000 and the Allowance for Doubtful Accounts

balance was $2,000,000.

Let’s see what effect the total write-offs of $1,480,000 had on these accounts.


Before Write-Off

After Write-Off

Accounts receivable 81,000,000$ 79,520,000$ Less: Allow. for doubtful accts. (2,000,000) (520,000) Net realizable value 79,000,000$ 79,000,000$

Notice that the total write-offs of $1,480,000 did not change the net realizable value nor did it affect any

income statement accounts.

Notice that the total write-offs of $1,480,000 did not change the net realizable value nor did it affect any

income statement accounts.

Write-off of Uncollectible Accounts Write-off of A/R deemed uncollectible

DOES NOT create an expense. Write-offs decrease A/R and the Allowance

for Doubtful Accounts by like amounts, therefore it DOES NOT affect the net receivable balance.

There is no net effect on the total assets

Allowance Method Recap The ADA is a contra-asset that is subtracted

from accounts receivable It is “fed” with bad debt expense It is “eaten up” by account write-offs

Allowance for doubtful accounts

Bad debt expense

Write-offs

Summary of allowance method

Step Timing Accounts F/S effects

1.Record End of Bad debts E Net Incomeestimated period inbad debts which sales ADA Assetsadjustment are made

2. Identify Throughout Accounts R Net income (N)And write period asoff actual bad debts ADA Assets (N)bad debts become known

Methods for Estimating Bad Debts

????

Income Statement Approach Percent of Credit Sales

Balance Sheet Approach Aging of Accounts Receivable

Percentage of Credit Sales

Bad debt percentage is based on actual uncollectible accounts

from prior years’ credit sales.

Focus is on determining the amount to record on the income statement as

Bad Debt Expense.


Net Credit Sales % Estimated Uncollectible

Amount of Journal Entry


In 2009, Kid’s Clothes had credit sales of $60,000. Past experience indicates that

bad debts are one percent of credit sales.

What is the estimate of bad debts expense for 2009?


In 2009, Kid’s Clothes had credit sales of $60,000. Past experience indicates that

bad debts are one percent of credit sales.

What is the estimate of bad debts expense for 2009?

$60,000 × .01 = $600

Now, prepare the adjusting entry.



Dec. 31 Bad Debt Expense 600

Allowance for Doubtful Accounts 600

Methods for Estimating Bad Debts

% of Sale methodNet Credit Sales

% Estimated UncollectibleAmount of Journal Entry

Bad debt expense XXX Allowance for doubtful accounts XXX

Existing BalanceXXX adjustment

End. Balance


Aging of A/R method

Accounts Receivable *

% estimated uncollectible

Desired balance in ADA

Balance Sheet Approach1. Determine the amount of A/R that are expected

to be uncollectible2. This is equal to the required ADA balance3. If existing ADA balance is not high enough then

increase the balance by recognizing bad debt expense

Hint: Use of t-accounts is very helpful here!

Existing BalanceXXX adjustment

End. Balance


Aging of A/R method

Accounts Receivable *

% estimated uncollectible

Desired balance in ADA

Aging Schedule

Each customer’s account is aged by breaking down the balance by

showing the age (in number of days) of each part of the balance.

An aging of accounts receivable for Kid’s Clothes in 2009 might look like

this . . .

Each customer’s account is aged by breaking down the balance by

showing the age (in number of days) of each part of the balance.

An aging of accounts receivable for Kid’s Clothes in 2009 might look like

this . . .

Aging ScheduleDays Past Due

CustomerNot Yet

Due 1-30 31-60 61-90 Over 90

Total A/R

BalanceAaron, R. 235$ 235$ Baxter, T. 1,200$ 300 1,500 Clark, J. 50$ 200$ 500$ 750

Zak, R. 325 325 Total 3,500$ 2,550$ 1,830$ 1,540$ 1,240$ 10,660$

Based on past experience, the business estimates the percentage of uncollectible

accounts in each time category.

Aging ScheduleDays Past Due

CustomerNot Yet

Due 1-30 31-60 61-90 Over 90

Total A/R


Zak, R. 325 325 Total 3,500$ 2,550$ 1,830$ 1,540$ 1,240$ 10,660$% Uncollectible 0.01 0.04 0.10 0.25 0.40

These percentages are then multiplied by the appropriate column totals.

Aging of Accounts Receivable

Days Past Due

CustomerNot Yet

Due 1-30 31-60 61-90 Over 90

Total A/R


Zak, R. 325 325 Total 3,500$ 2,550$ 1,830$ 1,540$ 1,240$ 10,660$% Uncollectible 0.01 0.04 0.10 0.25 0.40 EstimatedUncoll. Amount 35$ 102$ 183$ 385$ 496$ 1,201$

Record the Dec. 31, 2009, adjusting entry assuming that the Allowance for Doubtful Accounts currently has a $50

credit balance.

Kids clothes’ balance in the allowance account is credit $50.

We estimated the proper balance to be $1,201.

Kids clothes’ balance in the allowance account is credit $50.

We estimated the proper balance to be $1,201.

50

1,151 1,201



GENERAL JOURNAL Page 76

Date DescriptionPost. Ref. Debit Credit

Dec. 31 Bad Debt Expense 1,151

Allowance for Doubtful Accounts 1,151



50 Balance at 12/31/2003before adj.

1,251 2003 adjustment1,201 Balance at

12/31/2003after adj.

What if the existing balance of ADA is debit??


Accounts Receivable % Estimated Uncollectible

Desired Balance in Allowance Account- Allowance Account Credit Balance


Accounts Receivable % Estimated Uncollectible

Desired Balance in Allowance Account+ Allowance Account Debit Balance


Balance Sheet Approach

Balance Sheet Approach

Emphasis on Net Realizable Value

Emphasis on Net Realizable Value

Accts. Rec. All. for

Uncoll. Accts.

Income Statement

Focus

Income Statement

Focus

Balance Sheet Focus

Balance Sheet Focus

Income Statement Approach

Income Statement Approach

Emphasis on Matching

Emphasis on Matching

SalesBad

Debts Exp.

Summary of Methods to Estimate Bad Debts

Subsequent collections on accounts written off require that the original write-off entry be reversed before the cash collection is recorded.

Subsequent collections on accounts written off require that the original write-off entry be reversed before the cash collection is recorded.

Recovery of a Bad Debt

DR CRFeb. 8 Accounts Receivable - Martin 300

Allowance for Doubtful Accounts 300 To reinstate account previously written off

Feb. 8 Cash 300 Accounts Receivable - Martin 300

To record full payment on account

A note is a written

promise to pay a

specific amount at a

specific future date.

Notes Receivable

Accounts receivable do notcharge interest until they

become overdue, but notesreceivable start charging

interest the day they are created.

$1,000.00 July 10, 2007

Ninety days

Barton Company, Los Angeles, CA

One thousand and no/100 --------------------------------- Dollars

First National Bank of Los Angeles, CA

42

12%

Julia Browne

after date I promise to pay to

the order of

Payable atValue received with interest at per annumNo. Due Oct. 8, 2007

Term

Payee

Maker

Notes Receivable

$1,000.00 July 10, 2007

Ninety days

Barton Company, Los Angeles, CA

One thousand and no/100 --------------------------------- Dollars

First National Bank of Los Angeles, CA

42

12%

Julia Browne

after date I promise to pay to

the order of

Payable atValue received with interest at per annumNo. Due Oct. 8, 2007

Due Date

Notes Receivable

Principal

Interest Rate

Interest Computation

Interest is the compensation to the lender for giving up the use of money

for a period of time.To the lender, interest is a revenue.

To the borrower, interest is an expense.

Interest is the compensation to the lender for giving up the use of money

for a period of time.To the lender, interest is a revenue.

To the borrower, interest is an expense.

Principal of the note

×Annual interest

rate ×

Time expressed

in years = Interest

Number of months out of

twelvethat interest

period covers.

Number of months out of

twelvethat interest

period covers.

Even for maturities less than one year,

the rate is annualized.

Even for maturities less than one year,

the rate is annualized.

Interest (less than one year) Computation

On March 1, 2009, Matrix, Inc. purchased a copier for $12,000 from Office Supplies, Inc. Matrix gave Office Supplies a 9% note due on May 30, 2009 in payment for the copier.

On March 1, 2009, Matrix, Inc. purchased a copier for $12,000 from Office Supplies, Inc. Matrix gave Office Supplies a 9% note due on May 30, 2009 in payment for the copier.

Computing Maturity and Interest

Principal of the note

×Annual interest

rate ×

Time expressed

in years = Interest

$ 12,000 × 9% × 3/12 = $ 270

Total interest due at May 30.

Computing Maturity and Interest

Recognizing Notes Receivable

Here are the entries to record the note on March 1, and the settlement on May 30, 2009.Here are the entries to record the note on March 1, and the settlement on May 30, 2009.

DR CRMar. 1 Notes Receivable 12,000

Sales 12,000 Sold goods in exchange for note

DR CRMay 30 Cash 12,270

Interest Revenue 270 Notes Receivable 12,000

Collected note and interest due

When a note receivable is outstanding at the end of an accounting period, the company must prepare an adjusting entry to accrue interest income.

When a note receivable is outstanding at the end of an accounting period, the company must prepare an adjusting entry to accrue interest income.

Recording End-of-Period Interest Adjustments

Reporting Interest onNotes Receivable

11/01/07 12/31/07 10/31/08

Recordnote

receivableAccrueinterest

Record interestand principal

received

On November 1, 2007, Skechers loaned $100,000 cash and accepted a $100,000 one-year, 12

percent note. Skechers will receive the principal and all interest earned on October 31, 2008.



2007 Interest 2008 Interest

Recording Notes Receivable on Nov. 1

Debit CreditNote Receivable (+A) 100,000

Cash (-A) 100,000

Accounts

On November 1, to record the note:





$ 100,000 × 12% × 2/12 =

$ 2,000

Accruing Interest Earned at fiscal year end (12/31/2007)

On December 31, to accrue $ 2,000 interest receivable:

Debit CreditInterest Receivable (+A) 2,000

Interest Revenue (+R, +SE) 2,000

Accounts

Debit CreditCash (+A) 112,000

Interest Revenue (+R, +SE) 10,000 Interest Receivable (-A) 2,000 Note receivable (-A) 100,000

Accounts

On October 31, to record $112,000 cash received:

Recording Interest Received and Principal at Oct 31, 2008

$100,000 principal (note receivable) $2,000 interest receivable (2007 interest revenue) $100,000 x 12% x 10/12 = $10,000 (2008 interest revenue)

Quick check On July 1, Barton Co. received a $1,000, 3 months, 10%

note in exchange for merchandise sold to a customer (the merchandise cost was $600). Perpetual inventory system.

On Sep 30, the customer paid interest and principal on the note. $1,000 × 10% × 3/12 = $25

Notes receivable $1,000 Sales revenue $1,000

Cost of Goods sold $600 Inventory $600

Cash $1,025 Interest revenue $25 Notes receivable $1,000

On Nov 1, received $2,000 cash plus a one year, 12 %, $10,000 note from another customer in exchange for merchandise (its cost was $8,000).

On Dec 31, prepare the adjusting entry for the above note $10,000 × 12% × 2/12 = $200

On Oct 31 of the next year, received interest and principal on the note.

Cash $2,000Notes receivable $10,000 Sales revenue $12,000

Cost of Goods sold $8,000 Inventory $8,000

Interest receivable $200 Interest revenue $200

Cash $11,200 Interest revenue $1,000 Interest receivable $200 Notes receivable $10,000

This ratio measures how many times average receivables are recorded and collected for the year.

This ratio measures how many times average receivables are recorded and collected for the year.

Net Sales

Average Net Accounts Receivables

Accounts

Receivable

Turnover

=

Accounts Receivable Turnover

Accounts Receivable Turnover

= 11.8 times

$1,091,478,000

($105,727,000 + $78,696,000) ÷ 2

Receivable

Turnover=

Net Sales

Average Net Accounts Receivables

Receivable

Turnover=

Timberland reported 2008 net sales of $1,091,478,000.December 31, 2007, net receivables were $78,696,000 and

December 31, 2008, net receivables were $105,727,000.

Timberland reported 2008 net sales of $1,091,478,000.December 31, 2007, net receivables were $78,696,000 and

December 31, 2008, net receivables were $105,727,000.

In-class problem #1 At the start of 2009, Accounts receivable showed a

$35,000 debit balance, and the Allowance for doubtful accounts showed an $1,000 credit balance. During the year of 2009, the firm had sales revenue of $200,000, of which $100,000 was on credit. Collections of accounts receivable during 2009 amounted to $88,000.

(a) On April 5, 2009, a customer balance of $1,500 from a prior year was determined to be uncollectible, so it was written off.

(b) On December 31, 2009, the firm estimated bad debt expense for 2009 to be $2,000.

Give the required journal entries for the two events, Show how the amounts related to Accounts receivable and Bad debt expense would be reported on the balance sheet and income statement for 2009.

In class problem #2 Barton’s year-end unadjusted trial balance

shows accounts receivable of $1,000, allowance for doubtful accounts of $6 (debit), and credit sales of $2,000, uncollectibles are estimated to be 1% of credit sales. Prepare the year-end adjust entry for uncollectibles. Show the A/R accounts in B/S.

In-class problem #3Suppose the beginning balance of A/R is $55,000, and

ADA is $290 (credit). Assuming Perpetual inventory system. During the period.

Writes off a $750 account receivable arise from a sale to Briggs Co. the dates to 10 months ago.

Received the full amount of $750 from Briggs Co. that was previously written off.

Collected cash $5,250 from A/R. Sold $7,000 of merchandise to customers on credit,

which cost the firm $4,000. In the end of the period, the company estimated 1% of

accounts receivable bill be uncollectible.Give the required journal entries and show how the

Accounts receivable and Bad debt expense would be reported on the balance sheet and income statement.

In-class problem #4

Q1) The unadjusted balance of the allowance for doubtful accounts of Johnstone Supplies, Inc., is a credit balance in the amount of $20,000 on July 31, 2005, its fiscal year end. Assuming that Johnstone uses the accounts receivable aging report, prepare the adjusting journal entry to report bad expense.

Q2) August 5, 2005: YOC corporation, Johnstone’s customer, filed bankruptcy. Accordingly, Johnston writes off $10,000 account receivable from YOC. Prepare a journal entry to record the account receivable write-off.

Q3) October 15, 2005: Based on the bankruptcy court’s decision, Johnstone collects $5,000 accounts receivable from YOC that they previously wrote off. Prepare a journal entry to record the recovery of the accounts receivable.

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Chapter 8

Economy & Finance