8-1

Describe the trade-offs of extending credit.

8-2

Disadvantages

1.Increased wage costs.

2.Bad debt costs.

3.Delayed receipt of cash.

Advantage

1.Increases the seller’s revenues.

8-3

Estimate and report the effects of uncollectible accounts.

8-4

Record sales on accountdr Accounts Receivable cr Sales Revenue

Balance SheetCashAccounts ReceivableInventory …

Income StatementSales RevenueCost of Goods SoldGross Profit…

Bad debt known

Jan. 1

8-5

Record sales on account

dr Accounts Receivable cr Sales Revenue

Balance Sheet

Cash

Accounts Receivable

Inventory

…

Income Statement

Sales Revenue

Cost of Goods Sold

Gross Profit

…

Bad debt known

Balance SheetCashAccounts ReceivableLess: Allowance for Doubtful AccountsAccounts Receivable, NetInventory …

Income StatementSales RevenueCost of Goods SoldGross Profit Bad Debt Expense…

Record estimate of bad debts

Jan. 1 Jan. 31

dr Bad Debt Expense (+E, -SE) cr Allowance for Doubtful Accounts (+xA, -A)

8-6

Record sales on account

dr Accounts Receivable cr Sales Revenue

Balance Sheet

Cash

Accounts Receivable

Inventory

…

Bad debt known

Balance SheetCashAccounts ReceivableLess: Allowance for Doubtful AccountsAccounts Receivable, NetInventory …

Record estimate of bad debts

Jan. 1 Jan. 31

dr Bad Debt Expense (+E, -SE) cr Allowance for Doubtful Accounts (+xA, -A)

dr Allowance for Doubtful Accounts (-xA)

cr Accounts Receivable(-A)

8-7

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.

8-8

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

Assets = Liabilities + Stockholders' EquityAllowance for Bad Debt ExpenseDoubtful Accounts (+E) -900(+xA) -900

1 Analyze

2 Recorddr Bad Debt Expense (+E) (-SE) 900

cr Allowance for Doubtful Accounts (+xA) (-A) 900

8-9

8-10

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

Assets = Liabilities + Stockholders' EquityAllowance forDoubtful Accounts(-xA) (+A) +800

Accounts Receivable(-A) -800

1 Analyze

2 Recorddr Allowance for Doubtful Accounts (-xA) (+A) 800

cr Accounts Receivable (-A) 800

8-11

dr + Accounts Receivable (A) cr -Beg. Bal. 200,800

800 Write-offEnd. Bal. 200,000

dr - Allow. For Doubtful Accts (xA) cr +14,900 Beg. Bal.

Write-off 800 900 Est.15,000 End. Bal.

dr + Bad Debt Expense (E, SE)) cr -Beg. Bal. - Est. 900 End. Bal. 900

dr Bad Debts Expense (+E) (-SE) 900 cr Allowance for Doubtful Accounts (+xA) (-A) 900

dr Allowance for Doubtful Accounts (-xA) (+A) 800 cr Accounts Receivable (-A) 800

8-12

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 to apply.

More accurate

8-13

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.

Net credit sales for the period× Historical bad debt loss rate= Bad debt expense of the period.

8-14

Skechers has experienced bad debt losses of ¾ of 1 percent of credit sales in prior periods.

Credit sales in January total $120,000,

Credit sales for January 120,000$ Historical bad debt rate 0.75%Bad debt expense for January 900$

2 Recorddr Bad Debt Expense (+E) (-SE) 900

cr Allowance for Doubtful Accounts (+xA) (-A) 900

8-15

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.

8-16

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.

Customer Total 0-30 31-60 61-90 Over 90Adam's Sports 700$ 400$ 200$ 100$ Backyard Shoe 2,300 2,300$ Zoom Athletics 6,000 4,000 2,000 All other customers 189,000 97,600 49,800 37,900 3,700 Total accounts receivable 198,000$ 102,000$ 52,000$ 38,000$ 6,000$

Estimated uncollectible ($) 17,240$ 2,040$ 5,200$ 7,600$ 2,400$

Number of Days Unpaid

Age Accounts Receivable.Step

1

8-17

Customer Total 0-30 31-60 61-90 Over 90Adam's Sports 700$ 400$ 200$ 100$ Backyard Shoe 2,300 2,300$ Zoom Athletics 6,000 4,000 2,000 All other customers 189,000 97,600 49,800 37,900 3,700 Total accounts receivable 198,000$ 102,000$ 52,000$ 38,000$ 6,000$ Estimated uncollectible (%) × 2% × 10% × 20% × 40%Estimated uncollectible ($) 17,240$ 2,040$ 5,200$ 7,600$ 2,400$

Number of Days Unpaid

Estimate bad debt loss percentages for each category.Step

2

8-18

Customer Total 0-30 31-60 61-90 Over 90Adam's Sports 700$ 400$ 200$ 100$ Backyard Shoe 2,300 2,300$ Zoom Athletics 6,000 4,000 2,000 All other customers 189,000 97,600 49,800 37,900 3,700 Total accounts receivable 198,000$ 102,000$ 52,000$ 38,000$ 6,000$ Estimated uncollectible (%) × 2% × 10% × 20% × 40%Estimated uncollectible ($) 17,240$ 2,040$ 5,200$ 7,600$ 2,400$

Number of Days Unpaid

Compute the total estimated bad debts.Step

3

8-19

Customer Total 0-30 31-60 61-90 Over 90Adam's Sports 700$ 400$ 200$ 100$ Backyard Shoe 2,300 2,300$ Zoom Athletics 6,000 4,000 2,000 All other customers 189,000 97,600 49,800 37,900 3,700 Total accounts receivable 198,000$ 102,000$ 52,000$ 38,000$ 6,000$ Estimated uncollectible (%) × 2% × 10% × 20% × 40%Estimated uncollectible ($) 17,240$ 2,040$ 5,200$ 7,600$ 2,400$

Number of Days Unpaid

dr - Allow. For Doubtful Accts (xA) cr +15,000 Beg. Bal.

? AJE17,240 End. Bal.

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

8-20

Assets = Liabilities + Stockholders' EquityAllowance for Bad Debt ExpenseDoubtful Accounts (+E) -$2,240(+xA) -$2,240

1 Analyze

Prepare the AJE for Bad Debt Expense at March 31.

2 Recorddr Bad Debt Expense (+E, -SE) 2,240

cr Allowance for Doubtful Accounts (+xA, -A) 2,240

3 Summarize

8-21

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.

8-22

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:

(1) Reverse the write-off.

(2) Record the collection.

8-23

Compute and report interest on notes receivable.

8-24

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 interest until they’ve become overdue, notes receivable charge interest from the day they are created to the day they are due (their maturity date).

8-25

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

The time period forinterest calculation

The amount of thenote receivable

Terms of Note Interest Period Principal Rate Time Interest$10,000, 6%, due in two years Jan 1 - Mar 31 10,000$ × 6% × 3/12 = 150$ $10,000, 6%, due in one year Mar 1 - Mar 31 10,000 × 6% × 1/12 = 50 $10,000, 6%, due in 100 days Mar 1 - Mar 31 10,000 × 6% × 1/12 = 50

Information Given Interest Calculation

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

The annual interest ratecharged on the note

8-26

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

Date of Note Receivable November 1, 2009Annual Interest Rate 6%Amount of the Note $100,000Maturity Date of Note October 31, 2010Year End of Company December 31, 2009

8-27

Assets = Liabilities + Stockholders' EquityNotes Receivable +$100,000Cash -$100,000

1 Analyze

2 Recorddr Notes Receivable (+A) 100,000

cr Cash (-A) 100,000

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.

8-28

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

8-29

Assets = Liabilities + Stockholders' EquityInterest Receivable Interest Revenue(+A) +$1,000 (+R, +SE) +$1,000

1 Analyze

2 Recorddr Interest Receivable (+A) 1,000

cr Interest Revenue (+R, +SE) 1,000

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

8-30

Record interest received at maturity, October 31, 2010.

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

$100,000 × 6% × 12/12 = $6,000

$5,000$5,000InterestInterest

8-31

2 Recorddr Cash (+A) 6,000

cr Interest Receivable (-A) 1,000 cr Interest Revenue (+R, +SE) 5,000

Assets = Liabilities + Stockholders' EquityCash (+A) +$6,000 Interest RevenueInterest Receivable (+R, +SE) +$5,000(-A) -$1,000

1 Analyze

$5,000 = $100,000 × 6% × 10/12

Record interest received at maturity, October 31, 2010.

8-32

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

2 Recorddr Cash (+A) 100,000

cr Note Receivable (-A) 100,000

Assets = Liabilities + Stockholders' EquityCash (+A) $100,000Note Receivable(-A) $100,000

1 Analyze

8-33

Compute and interpret the receivables turnover ratio.

8-34

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 receivables (called days to collect).

8-35

(Beginning net receivables + Ending net receivables) ÷ 2

$500,000$ 50,000

= 10 times

Days toCollect =

365Receivable Turnover Ratio

365 10

= 36.5 days

8-36

Credit TermsWhen 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.

8-37

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