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McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 8
Reporting and Interpreting
Receivables, Bad Debt Expense,
and Interest Revenue
PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Fred Phillips, Ph.D., CA

Learning Objective 1

Describe the trade-offs of


extending credit.

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Pros and Cons of Extending Credit


Advantage
1.Increases the sellers revenues.
Disadvantages
1.Increased wage costs.
2.Bad debt costs.
3.Delayed receipt of cash.

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Learning Objective 2

Estimate and report the effects


of uncollectible accounts.

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Accounts Receivable and Bad Debts


Jan. 1

Record sales on
account

Bad debt
known

dr Accounts
Receivable
cr Sales Revenue
Balance Sheet

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Income Statement

Cash

Sales Revenue

Accounts Receivable

Cost of Goods Sold

Inventory

Gross Profit

Accounts Receivable and Bad Debts


Jan. 1

Jan. 31

Record sales on
account
dr Accounts
Receivable
cr Sales Revenue
Balance
Sheet
Balance
Sheet

Bad debt
known

dr Bad Debt Expense (+E, -SE)


cr Allowance for Doubtful
Accounts (+xA, -A)
Income Statement

Cash
Cash
Accounts
Accounts Receivable
Receivable
Less: Allowance for Doubtful
Inventory
Accounts
Accounts
Receivable, Net

Sales Revenue

Inventory

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Record estimate of bad


debts

Cost of Goods Sold


Gross Profit

Bad
Debt Expense

Accounts Receivable and Bad Debts


Jan. 1

Jan. 31

Record sales on
account
dr Accounts Receivable
cr Sales Revenue

Balance
Sheet
Balance
Sheet
Cash
Cash
Accounts
Accounts Receivable
Receivable
Less: Allowance for Doubtful
Inventory
Accounts
Accounts
Receivable, Net

Inventory

8-8

Record estimate of bad


debts

Bad debt
known

dr Bad Debt Expense (+E, -SE)


cr Allowance for Doubtful Accounts (+xA, -A)

dr Allowance for Doubtful


Accounts (-xA)
cr Accounts Receivable(-A)

Allowance Method
The allowance method follows a two-step
process, described below:
1.Make an end-of-period adjustment to
record the estimated bad debts in the
period credit sales occur.
2.Remove (write off) specific customer
balances when they are known to be
uncollectible.

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1. Adjust for Estimated Bad Debts


Assume that Skechers estimates $900 in bad debts
at the end of the accounting period.
1 Analyze

2 Record

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1. Adjust for Estimated Bad Debts

8-11

2. Remove (Write-off) Specific Customer Balances


Skechers writes off $800 receivable from Fast Footwear
because the company could not pay its account.
1 Analyze

2 Record

8-12

2. Remove (Write-off) Specific Customer Balances

8-13

Methods for Estimating Bad Debts


There are two acceptable methods of estimating
the bad debts in a given period.
1.Percentage of Credit Sales Method.
2.Aging of Accounts Receivable.
Simpler
Simpler to
to apply.
apply.
More
More accurate
accurate

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Percentage of Credit Sales Method


The percentage of credit sales method
estimates bad debt expense by
multiplying the historical percentage of
bad debt losses by the current periods
credit sales.
Net credit sales for the period
Historical bad debt loss rate
= Bad debt expense of the period.

8-15

Percentage of Credit Sales Method


Skechers
Skechers has
has experienced
experienced bad
bad debt
debt losses
losses of
of
of
of 11
percent
percent of
of credit
credit sales
sales in
in prior
prior periods.
periods. Credit
Credit sales
sales in
in
January
January total
total $120,000,
$120,000,

2 Record

8-16

Aging of Accounts Receivable


While the percentage of credit sales method focuses on
estimating Bad Debt Expense (income statement approach) for
the period, the aging of accounts receivable method focuses on
estimating the ending balance in the Allowance for Doubtful
Accounts (balance sheet approach).

The aging method gets its name because it is based on the


age of each amount in Accounts Receivable at the end of the
period. The older and more overdue an account receivable
becomes, the less likely it is to be collectible.

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Aging of Accounts Receivable


Skechers applies the aging of accounts receivable method to its
Accounts Receivable balances on March 31, the end of its fiscal
quarter. The method includes three steps: (1) Prepare an aged list of
accounts receivable, (2) Estimate bad debt loss percentages for each
category, and (3) Compute the total estimated bad debts.

Step
1
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Age Accounts
Receivable.

Aging of Accounts Receivable

Step
2
8-19

Estimate bad debt loss percentages for each category.

Aging of Accounts Receivable

Step
3
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Compute the total estimated bad debts.

Aging of Accounts Receivable

AJE = ($17,240 - $15,000) = $2,240


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Aging of Accounts Receivable


Prepare the AJE for Bad Debt Expense at March 31.
1 Analyze

2 Record

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Summarize

Other Issues
Revising Estimates -- Bad debt estimates always differ
from the amounts that are later written off. If these
differences are material, companies are required to
revise their bad debt estimates for the current period.
Account Recoveries -- Collection of a previously written
off account is called a recovery and it is accounted for in
two parts. First, put the receivable back on the books by
recording the opposite of the write-off. Second, record
the collection of the account.

8-23

Other Issues
Lets
Lets assume
assume that
that Skechers
Skechers collects
collects the
the $800
$800 from
from Fast
Fast Footwear
Footwear
that
that was
was previously
previously written
written off.
off. This
This recovery
recovery would
would be
be recorded
recorded
with
with the
the following
following journal
journal entries:
entries:

(1) Reverse the write-off.


(2) Record the collection.

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Learning Objective 3

Compute and report interest


on notes receivable.

8-25

Notes Receivable and Interest Revenue


A company reports Notes Receivable if it uses a
promissory note to document its right to collect money
from another party.
Unlike accounts receivable, which do not charge
charge
interest until theyve become overdue, notes receivable
charge interest from the day they are created to the
day they are due (their maturity date).

8-26

Calculating Interest
Interest (I) = Principal (P) Interest Rate (R) Time (T)
The amount of the
note receivable

The annual interest rate


charged on the note

The time period for


interest calculation

See if you can calculate the interest below using your calculator.

8-27

Recording Notes Receivable and Interest Revenue


The
The four
four key
key events
events that
that occur
occur with
with any
any note
note receivable
receivable are:
are:

Date
Date of
of Note
Note Receivable
Receivable
Annual
Annual Interest
Interest Rate
Rate
Amount
Amount of
of the
the Note
Note
Maturity
Maturity Date
Date of
of Note
Note
Year
Year End
End of
of Company
Company
8-28

November
November 1,
1, 2009
2009
6%
6%
$100,000
$100,000
October
October 31,
31, 2010
2010
December
December 31,
31, 2009
2009

(1) Establishing a Note Receivable


Assume that on November 1, 2009, Skechers lent $100,000 to a
researcher by creating a note that required the researcher to pay Skechers
6 percent interest and the $100,000 principal on October 31, 2010.
1 Analyze

2 Record

8-29

(2) Accruing Interest Earned


Accrue the interest earned at year-end, December 31, 2009.

Principal (P) Interest Rate (R) Time (T) = Interest (I)

$100,000 6% 2/12 = $1,000


8-30

(2) Accruing Interest Earned


Accrue the interest earned at year-end, December 31, 2009.
1 Analyze

2 Record

8-31

(3) Record Interest Received


Record interest received at maturity, October 31, 2010.

$5,000
Interest
Principal (P) Interest Rate (R) Time (T) = Interest (I)

$100,000 6% 12/12 = $6,000


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(3) Record Interest Received


Record interest received at maturity, October 31, 2010.
1 Analyze

$5,000 = $100,000 6% 10/12


2 Record

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(4) Recording Principal Received


The
The principal
principal amount
amount of
of the
the note
note is
is received
received on
on October
October 31,
31, 2010.
2010.
1 Analyze

2 Record

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Learning Objective 4

Compute and interpret the


receivables turnover ratio.

8-35

Receivables Turnover Analysis


The receivables turnover ratio indicates how many
times, on average, this process of selling and collecting
is repeated during the period. The higher the ratio, the
faster the collection of receivables.

Rather than evaluate the number of times accounts


receivable turn over, some people find it easier to think
in terms of the number of days to collect receivablese
(called days to collect).
8-36

Receivables Turnover Analysis


$500,000 = 10 times
$ 50,000

(Beginning net receivables + Ending net receivables) 2

Days to
=
Collect

8-37

365
Receivable Turnover Ratio

365
10

= 36.5 days

Comparison to Benchmarks
Credit Terms
When companies sell on account, they specify the length of credit
period (and any cash discounts for prompt payment). By comparing the
number of days to collect to the length of credit period, you can gain a
sense of whether customers are complying with the stated policy.

8-38

Speeding Up Collections
Factoring Receivables
One way to speed up collections is to sell outstanding
accounts receivable to another company (called a
factor). Your company receives cash for the receivables
it sells to the factor (minus a factoring fee).

Credit Card Sales


Another way to avoid lengthy collection periods is to allow customers to
pay for goods using national credit cards. This not only speeds up the
sellers cash collection, but also reduces losses from customers writing
bad checks. Credit card company charges a fee.

8-39

Chapter 8
Supplement 8A
Direct Write-Off Method

Direct Write-Off Method


The direct write-off method, does not estimate bad debt. Instead, it
reports Sales when they occur and bad debt expense when it is
discovered. This method is not acceptable for GAAP.

The reason the method isnt considered GAAP is because it breaks the
conservatism concept by not reporting receivables realizable value the
method violates the matching principle by recording bad debt expense
in the period the customers account is determined to be bad.
8-41

Direct Write-Off Method


On
On October
October 13,
13, 2009,
2009, we
we sold
sold merchandise
merchandise on
on account
account to
to
Fast
Fast Footwear
Footwear for
for $1,000.
$1,000. On
On February
February 1,
1, 2010,
2010, Fast
Fast
Footwear
Footwear declared
declared bankruptcy
bankruptcy and
and had
had made
made no
no payments
payments
toward
toward the
the $1,000
$1,000 balance
balance in
in its
its account
account receivable.
receivable.

February 1, 2009
2 Record

8-42

Chapter 8
Solved Exercises
M8-10, E8-7, E8-8, E8-9, C8-1, CP84

M8-10 Using the Interest Formula to Compute Interest


Complete the following table by computing the missing amounts (?) for
the following independent cases.

Case a. $100,000 10% (6/12) = $5,000


Case b. [$4,000 10%] (12/12) = $40,000
Case c. $3,000 [$50,000 (9/12)] = 8%

8-44

E8-7 Computing Bad Debt Expense Using Aging of Accounts


Receivable Method
Brown Cow Dairy uses the aging approach to estimate Bad Debt Expense.
The balance of each account receivable is aged on the basis of three time
periods as follows: (1) 130 days old, $12,000; (2) 3190 days old, $5,000;
and (3) more than 90 days old, $3,000. Experience has shown that for each
age group, the average loss rate on the amount of the receivable due to
uncollectibility is (1) 3 percent, (2) 15 percent, and (3) 30 percent,
respectively. At December 31, 2010 (end of the current year), the Allowance
for Doubtful Accounts balance was $800 (credit) before the end-of-period
adjusting entry is made.
Required:
1.Prepare a schedule to estimate an appropriate year-end balance for the
Allowance for doubtful accounts.
2.What amount should be recorded as Bad Debt Expense for the current
year?
3.If the unadjusted balance in the Allowance for Doubtful Accounts was a
$600 debit balance, what would be the amount of Bad Debt Expense in
2010?

8-45

E8-7 Computing Bad Debt Expense Using Aging of Accounts


Receivable Method
Req. 1

Req. 2

Req. 3

8-46

E8-8 Recording and Reporting Allowance for Doubtful Accounts Using


the Percentage of Credit Sales and Aging of Accounts Receivable
Methods
Innovative Tech, Inc. (ITI) uses the percentage of credit sales method to estimate
bad debts each month and then uses the aging method at year-end. During
November 2010, ITI sold services on account for $100,000 and estimated that
of one percent of those sales would be uncollectible. At its December 31 year-end,
total Accounts Receivable is $89,000, aged as follows: (1) 130 days old,
$75,000; (2) 3190 days old, $10,000; and (3) more than 90 days old, $4,000.
Experience has shown that for each age group, the average rate of uncollectibility
is (1) 1 percent, (2) 15 percent, and (3) 40 percent, respectively. Before the end-ofyear adjusting entry is made, the Allowance for Doubtful Accounts has a $1,600
credit balance at December 31, 2010.
Required:
1.Prepare the November 2010 adjusting entry for bad debts.
2.Prepare a schedule to estimate an appropriate year-end balance for the
Allowance for Doubtful Accounts.
3.Prepare the December 31, 2010, adjusting entry.
4.Show how the various accounts related to accounts receivable should be shown
on the December 31, 2010, balance sheet.

8-47

E8-8 Recording and Reporting Allowance for Doubtful Accounts Using the
Percentage of Credit Sales and Aging of Accounts Receivable Methods

Req. 1

Req. 2

Req. 3

8-48

E8-8 Recording and Reporting Allowance for Doubtful Accounts Using the
Percentage of Credit Sales and Aging of Accounts Receivable Methods

Req. 4 The
The accounts
accounts related
related to
to the
the accounts
accounts receivable
receivable can
can be
be shown
shown
one
one of
of two
two ways
ways on
on the
the December
December 31,
31, 2010
2010 balance
balance sheet:
sheet:

OR

8-49

E8-9 Recording and Determining the Effects of Write-Offs, Recoveries,


and Bad Debt Expense Estimates on the Balance Sheet and Income
Statement.
Academic Dishonesty Investigations Ltd. operates a plagiarism detection service for
universities and community colleges.
Required:
1.Prepare journal entries for each transaction below.
a. On March 31, 10 customers were billed for detection services totaling $25,000.
b. On October 31, a customer balance of $500 from a prior year was determined
to be uncollectible and was written off.
c. On December 15, a customer paid an old balance of $900, which had been
written off in a prior year.
d. On December 31, $500 of bad debts were estimated and recorded for the year.
2. Complete the following table, indicating the amount and effect ( + for
increase, - for decrease, and NE for no effect) of each transaction. Ignore
income taxes.

8-50

E8-9 Recording and Determining the Effects of Write-Offs, Recoveries, and


Bad Debt Expense Estimates on the Balance Sheet and Income Statement.

Req. 1
a.

b.
c.

dr

dr
dr
dr

d.

8-51

dr

Accounts Receivable (+A)


cr Service Revenue (+R, +SE)

25,000
25,000

Bad Debt Expense (+E, -SE)


cr Allowance for Doubtful Accounts (+xA, -A)

500

Accounts Receivable (+A)


cr Allowance for Doubtful Accounts (+xA, -A)

900

Cash (+A)
cr Accounts receivable (-A)

900

Bad Debt Expense (+E, -SE)


cr
Allowance for Doubtful Accounts (+xA, -A)

500

500
900
900

500

E8-9 Recording and Determining the Effects of Write-Offs, Recoveries, and


Bad Debt Expense Estimates on the Balance Sheet and Income Statement.

Req. 2

8-52

CP8-4 Accounting for Accounts and Notes Receivable


Transactions
Execusmart Consultants has provided business consulting services for several years.
The company uses the percentage of credit sales method to estimate bad debts for
internal monthly reporting purposes. At the end of each quarter, the company adjusts its
records using the aging of accounts receivable method. The company entered into the
following selected transactions during the first quarter of 2010.
a.During January, the company provided services for $200,000 on credit.
b.On January 31, the company estimated bad debts using 1 percent of credit sales.
c.On February 4, the company collected $100,000 of accounts receivable.
d.On February 15, the company wrote off a $500 account receivable.
e.During February, the company provided services for $150,000 on credit.
f.On February 28, the company estimated bad debts using 1 percent of credit sales.
g.On March 1, the company loaned $12,000 to an employee who signed a 10% note, due
in 3 months.
h.On March 15, the company collected $500 on the account written off one month earlier.
i.On March 31, the company accrued interest earned on the note.
j.On March 31, the company adjusted for uncollectible accounts, based on the aging
analysis shown on the next screen. Allowance for Doubtful Accounts has an unadjusted
credit balance of $6,000.

8-53

CP8-4 Accounting for Accounts and Notes Receivable


Transactions (continued)

Required:
1.For items a j, analyze the amount and direction (or) of effects on specific financial
statement accounts and the overall accounting equation and prepare journal entries.
2.Show how the receivables related to these transactions would be reported in the
current assets section of a classified balance sheet.
3.Name the accounts related to Accounts Receivable and Notes Receivable that would
be reported on the income statement and indicate whether they would appear before, or
after, Income from Operations.

8-54

CP8-4 Accounting for Accounts and Notes Receivable Transactions


Req. 1

8-55

CP8-4 Accounting for Accounts and Notes Receivable Transactions


Req. 1

8-56

CP8-4 Accounting for Accounts and Notes Receivable Transactions


Req. 1

8-57

CP8-4 Accounting for Accounts and Notes Receivable Transactions


Req. 1

8-58

CP8-4 Accounting for Accounts and Notes Receivable Transactions


Req. 1

8-59

CP8-4 Accounting for Accounts and Notes Receivable Transactions


Req. 1

Desired $8,390 Current -$6000 = Adjustment $2,390

8-60

CP8-4 Accounting for Accounts and Notes Receivable Transactions


Req. 2

Req. 3
Execusmart Consultants would report Bad Debt Expense above income
from Operations, and Interest Revenue below Income for Operations.

8-61

C8-1 Comprehensive Exercise for Recording and Reporting Credit Sales and Bad
Debts Using the Aging of Accounts Receivable Method
Okay Optical, Inc. (OOI) began operations in January 2010 selling inexpensive sunglasses to large
retailers like Walgreens and other smaller stores. Assume the following transactions occurred
during its first six months of operations.
January 1 - Sold merchandise to Walgreens for $20,000; the cost of goods to OOI was $12,000.
February 12 - Received payment in full from Walgreens.
March 1 - Sold merchandise to Tonys Pharmacy on account for $3,000; the cost of goods to OOI
was $1,400.
April 1 - Sold merchandise to Travis Pharmaco on account for $8,000. The cost to OOI was $4,400.
May 1 - Sold merchandise to Anjuli Stores on account for $2,000; the cost to OOI was $1,200.
June 17 - Received $6,500 on account from Travis Pharmaco.
Required:
1.Complete an aged listing of customer accounts for the four months ended June 30.
2.Estimate the Allowance for Doubtful Accounts required at June 30, 2010, assuming the following
uncollectible rates: one month, 1 percent; two months, 5 percent; three months, 20 percent; more
than three months, 40 percent.
3.Show how OOI would report its accounts receivable on its June 30 balance sheet. What amounts
would be reported on an income statement prepared for the six-month period ended June 30, 2010?
4.Bonus Question: In July 2010, OOI collected the balance due from Tonys Pharmacy but
discovered that the balance due from Travis Pharmaco needed to be written off. Using this
information, determine how accurate OOI was in estimating the Allowance for Doubtful Accounts
needed for each of these two customers and in total.

8-62

C8-1 Comprehensive Exercise for Recording and Reporting Credit Sales and Bad Debts
Using the Aging of Accounts Receivable Method

Req. 1

Req. 2

8-63

C8-1 Comprehensive Exercise for Recording and Reporting Credit Sales and Bad Debts
Using the Aging of Accounts Receivable Method

Req. 3
OKAY OPTICAL, INC.
Partial Balance Sheet
At June 30, 2010
Accounts Receivable, Net of Allowance of $1,600

OKAY OPTICAL, INC.


Partial Income Statement
For the Six Months Ended June 30, 2010
Sales Revenue
Cost of Goods Sold
Gross Profit
Bad Debt Expense
Income from Operations
8-64

$30,000
19,000
14,000
1,600
$12,400

$4,900

C8-1 Comprehensive Exercise for Recording and Reporting Credit Sales and Bad Debts
Using the Aging of Accounts Receivable Method

Req. 4 OOI did not accurately estimate the precise amounts that would
be collected from each customer, yet the total estimate was
reasonably accurate at $1,600. OOI underestimated the amount
collectible from Tonys Pharmacy (40% of $3,000, or $1,200,
was estimated uncollectible where it later turned out to be
collectible in full). It overestimated the amount collectible from
Travis Pharmaco (20% of $1,500, or $300, was estimated
uncollectible where it later turned out to show that $1,500 was
uncollectible). Looking at Travis Pharmaco and Tonys
Pharmacy combined, the estimated bad debt for both
customers was $1,500, which is only $100 less than the amount
the company wrote off.

8-65

End of Chapter 8