Ch. 8 Synchronotes for
Fundamentals of Financial Accounting, 3e
by Phillips/Libby/Libby
Chapter 8: Reporting and Interpreting Receivables, Bad Debt Expense, and Interest Revenue
Pros and Cons of Extending Credit
Advantage
1. Increases the seller’s revenues.
Disadvantages
1. Increased wage costs.
2. Bad debt costs.
3. Delayed receipt of cash.
Accounts Receivable and Bad Debts
Allowance Method
In summary, the allowance method follows a two-step process:
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.
1. Adjust for Estimated Bad Debts
Assume that Skechers estimates $900 in bad debts at the end of the accounting period.
Ch. 8 - p. 1
2. Remove (Write-off) Specific Customer Balances
Skechers writes off $800 receivable from Fast Footwear because the company could not pay its account.
Posting the Estimate and Write-off to T-accounts
dr
dr
Bad Debts Expense (+E) (-SE)
cr Allowance for Doubtful Accounts (+xA) (-A)
Allowance for Doubtful Accounts (-xA) (+A)
800
cr Accounts Receivable (-A)
dr +
Accounts Receivable (A) cr Beg. Bal.
12,000
800 Write-off
End. Bal.
11,200
900
900
800
dr + Bad Debt Expense (E, SE))
Beg. Bal.
Est.
900
End. Bal.
900
cr - dr - Allow. For Doubtful Accts (xA) cr +
1,050 Beg. Bal.
Write-off
800
900 Est.
1,150 End. Bal.
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 - Simpler to Apply
2. Aging of Accounts Receivable - More Accurate
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 period’s credit sales.
Ch. 8 - p. 2
Skechers has experienced bad debt losses of ¾ of 1 percent of credit sales in prior periods. Credit sales in
January total $120,000
Aging of Accounts Receivable
While the percentage of credit sales method focuses on estimating Bad Debt Expense for the period, the aging
of accounts receivable method focuses on estimating the ending balance in the Allowance for Doubtful
Accounts. The aging method gets its name because it is based on the “age” of each amount in Accounts
Receivable. The older and more overdue an account receivable becomes, the less likely it is to be collectible.
Skechers applies the aging of accounts receivable method to its Accounts Receivable balances on March 31,
the end of its fiscal quarter. The method includes three steps:
(1): Age customer account balances
Customer
Adam's Sports
Backyard Shoe
Zoom Athletics
All other customers
Total accounts receivable
Estimated uncollectible (%)
Estimated uncollectible ($)
(2): Estimate loss percents
Total
$
700
2,300
6,000
189,000
$ 198,000
$
17,240
$
(3): Compute total estimate
Number of Days Unpaid
0-30
31-60
61-90
400
$
200
$
100
Over 90
$
4,000
97,600
$ 102,000
× 2%
$
2,040
2,000
49,800
$ 52,000
× 10%
$
5,200
37,900
$ 38,000
× 20%
$
7,600
2,300
3,700
$ 6,000
× 40%
$ 2,400
Prepare the AJE for Bad Debt Expense at March 31.
Ch. 8 - p. 3
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.
Let’s assume that Skechers collects the $800 from Fast Footwear that was previously written off. This recovery
would be recorded with the following journal entries:
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.
Notes receivable charge interest from the day they are created to the day they are due (their maturity date).
Calculating Interest
Interest (I) = Principal (P) × Interest Rate (R) × Time (T)
Information Given
Terms of Note
Interest Period
$10,000, 6%, due in two years
Jan 1 - Mar 31
$10,000, 6%, due in one year
Mar 1 - Mar 31
$10,000, 6%, due in 100 days
Mar 1 - Mar 31
Interest Calculation
Principal
Rate
Time
Interest
$ 10,000 ×
6% × 3/12 = $ 150
10,000 ×
6% × 1/12 =
50
10,000 ×
6% × 1/12 =
50
Recording Notes Receivable and Interest Revenue
The four key events that occur with any note receivable are:
(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.
Ch. 8 - p. 4
(2) Accruing Interest Earned
Accrue the interest earned at year-end, December 31, 2009.
(3) Record Interest Received
Record interest received at maturity, October 31, 2010
Interest (I) = Principal (P) × Interest Rate (R) × Time (T)
$6,000 = $100,000 × 6% × 12/12
$5,000 = $100,000 × 6% × 10/12
(4) Recording Principal Received
The principal amount of the note is received on October 31, 2010
Ch. 8 - p. 5
Receivable Turnover Analysis
The receivables turnover is a measure of how many times, on average, this process of selling and collecting is
repeated during the period. The higher the receivable turnover ratio, the faster the collection of receivables.
Average Net Receivables = (Beginning Net Receivables + Ending Net Receivables)
2
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 receivables (called days to collect).
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.
Speeding Up Collections
Factoring Receivables
Your company sells outstanding accounts receivable to another company (called a factor) and receives cash
(minus a factoring fee).
Credit Card Sales
Allowing customers to pay for goods using national credit cards not only speeds up the seller’s cash collection
but also reduces losses from customers writing bad checks. Credit card company charges a fee.
Ch. 8 - p. 6
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 isn’t 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 customer’s account is determined to be bad.
On October 13, 2009, we sold merchandise on account to Fast Footwear for $1,000. On February 1, 2010, Fast
Footwear declared bankruptcy and had made no payments toward the $1,000 balance in its account
receivable.
February 1, 2009
Ch. 8 - p. 7
Exercises
M8-10 Using the Interest Formula to Compute Interest
Complete the following table by computing the missing amounts (?) for the following independent cases.
Principal Amount of
Note Receivable
a.
$ 100,000
b.
?
c.
$ 50,000
Annual
Interest Rate
10%
10%
?
Time Period
in Months
6
12
9
Interest
Earned
?
$ 4,000
$ 3,000
Ch. 8 - p. 8
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) 1–30 days old, $12,000; (2) 31–90 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?
Ch. 8 - p. 9
E8-8 Recording and Reporting Allowance for Doubtful Accounts Using the Percentage of Credit Sales and
Aging of Accounts Receivable Methods
InnovativeTech, 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 ½ 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) 1–30 days old, $75,000; (2) 31–90 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-of-year
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.
Ch. 8 - p. 10
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 $1,500 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.
Ch. 8 - p. 11
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.
Ch. 8 - p. 12
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
Walgreen’s and other smaller stores. Assume the following transactions occurred during its first six months of
operations.
January 1
Sold merchandise to Walgreen’s for $20,000; the cost of goods to OOI was $12,000.
February 12
Received payment in full from Walgreen’s.
March 1
Sold merchandise to Tony’s 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 Tony’s 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.
Ch. 8 - p. 13