Chapter 8 Reporting and Interpreting Receivables, Bad Debt Expense and Interest Revenue 1© McGraw-Hill Ryerson. All rights reserved.

Extending Credit Advantages: © McGraw-Hill Ryerson. All rights reserved.2 Disadvantages: Helps customers to buy the product, and therefore increases revenue. Increased wage costs of credit and collection department employees. Bad debt costs will be higher. Delayed receipt of cash because customer will take days to pay. Often, the increased revenue is greater than the increased costs for business customers. Often, the increased revenue is not greater than the increased costs for individual consumers. LO1

Accounts Receivable and Bad Debts © McGraw-Hill Ryerson. All rights reserved.3 Accounts Receivable – The amounts owed to a business by its customers. Uncollectible Accounts – The amount of credit that will not be collected. – This amount is never known in advance. Bad Debt Expense – Reports the estimated amount of this period’s credit sales that customers will not pay. LO2

Allowance Method The Allowance Method reduces accounts receivable for an estimate of uncollectable accounts. The Allowance Method follows a two-step process: © McGraw-Hill Ryerson. All rights reserved.4 The allowance method reports accounts receivable at the net realizable value, and records bad debt expense in the accounting period the related credit sale was made. Make an end-of-period adjustment to record the estimated bad debts in the period credit sales occur. 1. Remove (“write-off”) specific customer balances when they are known to be uncollectible. 2. LO2

(1) Adjust for Estimated Bad Debts Bad Debts are estimated to be $900 at the end of the accounting period. LO2 © McGraw-Hill Ryerson. All rights reserved.5 1 Analyze 2 Record Allowance for Doubtful Accounts is a contra-asset account that reduces Accounts Receivable.

© McGraw-Hill Ryerson. All rights reserved.6 Accounts Receivable and Allowance for Doubtful Accounts are both permanent accounts. They are Balance Sheet accounts. Sales Revenue and Bad Debt Expense are both temporary accounts. They are Income Statement accounts. LO2

(2) Remove (Write-Off)Specific Customer Balances After trying to collect, it is determined that one customer will never pay $800 owed. LO2 © McGraw-Hill Ryerson. All rights reserved.7 1 Analyze 2 Record A write-off does not affect income statement accounts.

Methods for Estimating Bad Debts Percentage of Credit Sales Method – Also called the income statement approach. – Estimates bad debts based on percentage. © McGraw-Hill Ryerson. All rights reserved.8 The Percentage of Credit Sales Method is easy to apply. 2 Record LO2

Let’s try it E8-3 © McGraw-Hill Ryerson. All rights reserved.9

10 Aging of Accounts Receivable Method – Also called the balance sheet approach. – Estimates uncollectable accounts based on the age of each account receivable. 1.Prepare an aged listing of accounts receivable. 2.Estimate bad debt loss percentages for each category. 3.Compute the total estimate. The Aging of Accounts Receivable Method is generally more accurate. LO2

© McGraw-Hill Ryerson. All rights reserved.11 The amount calculated is the required ending balance in the Allowance for Doubtful Accounts. The amount of the entry must be determined: 1 Analyze 2 Record 3 Summarize LO2

Let’s try it E8-6 © McGraw-Hill Ryerson. All rights reserved.12

Revising Estimates Bad Debts are estimates. If there is a material difference, companies must revise their bad debt estimates for the current period. © McGraw-Hill Ryerson. All rights reserved.13 Account Recoveries Collection of a previously written-off account is called a recovery and it is accounted for in two parts: 1. Reverse the write-off 2. Record the collection LO2

Let’s try it E8-4 © McGraw-Hill Ryerson. All rights reserved.14

Notes Receivable and Interest Revenue Notes Receivable – A promissory note requires another party to pay according to a written agreement. – Used when loaning money, selling expensive items with extended payment terms, or converting accounts receivable to notes receivable. – Notes Receivable charge interest. © McGraw-Hill Ryerson. All rights reserved.15 LO3

Calculating Interest © McGraw-Hill Ryerson. All rights reserved.16 Interest (I) = Principal (P) x Interest Rate (R) x Time (T) The amount of the Note Receivable The annual Interest Rate The time period Example:Terms of Note:$200,000, 6%, due in two years Interest Period:January 1 – October 31 $200,000 x 6% x 10/12 months = $10,000 interestCalculation: This calculation uses 12 months. In reality, interest is usually calculated using 365 days in Canada. LO3

Establishing a Note Receivable On November 1, 2011, a company issued a $100,000, 6%, one year promissory note. LO3 © McGraw-Hill Ryerson. All rights reserved.17 1 Analyze 2 Record Interest is not recorded when the note is established. Interest is earned over time.

Accruing Interest Earned On December 31, 2011, accrued interest revenue is recorded. LO3 © McGraw-Hill Ryerson. All rights reserved.18 Note Receivable Timeline Interest= P x R x T = $100,000 x 6% x 2/12 = $1,000 1 Analyze 2 Record

Recording Interest Received On October 31, 2012, the company receives a $6,000 cash interest payment. LO3 © McGraw-Hill Ryerson. All rights reserved.19 The total interest is $6,000; $1,000 was earned in 2011 and accrued December 31, 2011, and $5,000 was earned in Analyze 2 Record

Recording Principal Received On October 31, 2012, the company receives the $100,000 principal that is due. LO3 © McGraw-Hill Ryerson. All rights reserved.20 1 Analyze 2 Record

Let’s try it E8-10 © McGraw-Hill Ryerson. All rights reserved.21

Receivables Turnover Analysis Receivables turnover is the process of selling and collecting on account. © McGraw-Hill Ryerson. All rights reserved.22 The Receivables Turnover Ratio determines the average number of times this process occurs during one year. Days to collect measures the average number of days from the time a credit sale is made until cash is collected. LO4

© McGraw-Hill Ryerson. All rights reserved.23 Receivable Turnover Ratio Net Sales Revenue Average Net Receivables 365 Receivables Turnover Ratio Days to Collect The number of times receivables turn over during the period A higher ratio means fast (better) turnover Average number of days from sale on account to collection A higher number means a longer (worse) time to collect LO4 Comparison to Benchmarks

Speeding Up Collections Receivables are sold to another company (called a factor) for immediate cash (minus a fee). © McGraw-Hill Ryerson. All rights reserved.24 Credit Card Sales Credit Card sales allow a company to receive cash quickly. Credit Card sales reduce bad debts. Credit Card companies charge a fee. LO4 Factoring Receivables