Describe the trade-offs of extending credit.

1. Chapter 8: Reporting and Interpreting Receivables, Bad Debt Expense, and Interest RevenueLearning Objective 1 Describe the trade-offs of extending credit.

2. Pros and Cons of Extending Credit Advantage Increases the seller’s revenues. • Disadvantages • Increased wage costs. • Bad debt costs. • Delayed receipt of cash.

3. Learning Objective 2 Estimate and report the effects of uncollectible accounts.

4. Accounts Receivable and Bad Debts Jan. 1 Record sales on account Bad debt known drAccounts Receivable crSales Revenue Income Statement Sales Revenue Cost of Goods Sold Gross Profit … Balance Sheet Cash Accounts Receivable Inventory …

5. Accounts Receivable and Bad Debts Jan. 1 Jan. 31 Record sales on account Record estimate of bad debts Bad debt known drBad Debt Expense (+E, -SE) crAllowance for Doubtful Accounts (+xA, -A) drAccounts Receivable crSales Revenue Balance Sheet Cash Accounts Receivable Less: Allowance for Doubtful Accounts Accounts Receivable, Net Inventory … Balance Sheet Cash Accounts Receivable Inventory … Income Statement Sales Revenue Cost of Goods Sold Gross Profit … Income Statement Sales Revenue Cost of Goods Sold Gross Profit Bad Debt Expense …

6. Accounts Receivable and Bad Debts Jan. 1 Jan. 31 Record sales on account Record estimate of bad debts Bad debt known dr Bad Debt Expense (+E, -SE) cr Allowance for Doubtful Accounts (+xA, -A) dr Accounts Receivable cr Sales Revenue Balance Sheet Cash Accounts Receivable Less: Allowance for Doubtful Accounts Accounts Receivable, Net Inventory … Balance Sheet Cash Accounts Receivable Inventory … dr Allowance for Doubtful Accounts (-xA) cr Accounts Receivable(-A)

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

8. 1. Adjust for Estimated Bad Debts Assume that Skechers estimates $900 in bad debts at the end of the accounting period. Analyze Record 1 2

9. 1. Adjust for Estimated Bad Debts

10. 2. Remove (Write-off) Specific Customer Balances Skechers writes off $800 receivable from Fast Footwear because the company could not pay its account. Analyze Record 1 2

11. 2. Remove (Write-off) Specific Customer Balances

12. Methods for Estimating Bad Debts There are two acceptable methods of estimating the bad debts in a given period. Percentage of Credit Sales Method. Aging of Accounts Receivable. Simpler to apply. More accurate

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

14. Percentage of Credit Sales Method Skechers has experienced bad debt losses of ¾ of 1 percent of credit sales in prior periods. Credit sales in January total $120,000, Record 2

15. 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.

16. 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 Age Accounts Receivable.

17. Aging of Accounts Receivable Step 2 Estimate bad debt loss percentages for each category.

18. Aging of Accounts Receivable Step 3 Compute the total estimated bad debts.

19. Aging of Accounts Receivable AJE = ($17,240 - $15,000) = $2,240

20. Aging of Accounts Receivable Prepare the AJE for Bad Debt Expense at March 31. Record Analyze Summarize 1 3 2

21. 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 recoveryand 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.

22. Other Issues 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.

23. Learning Objective 3 Compute and report interest on notes receivable.

24. 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 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).

25. Calculating Interest Interest (I) = Principal (P) × Interest Rate (R) × Time (T) The annual interest ratecharged on the note The amount of thenote receivable See if you can calculate the interest below using your calculator. The time period forinterest calculation

26. Recording Notes Receivable and Interest Revenue The four key events that occur with any note receivable are: 1 3 2 4 Date of Note Receivable November 1, 2009 Annual Interest Rate 6% Amount of the Note $100,000 Maturity Date of Note October 31, 2010 Year End of Company December 31, 2009

27. (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. Record Analyze 1 2

28. (2) Accruing Interest Earned Accrue the interest earned at year-end, December 31, 2009. 2 Principal (P) × Interest Rate (R) × Time (T) = Interest (I) $100,000 × 6% × 2/12 = $1,000

29. (2) Accruing Interest Earned Accrue the interest earned at year-end, December 31, 2009. Record Analyze 1 2

30. (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

31. (3) Record Interest Received Record interest received at maturity, October 31, 2010. Record Analyze $5,000 = $100,000 × 6% × 10/12 1 2

32. (4) Recording Principal Received The principal amount of the note is received on October 31, 2010. Record Analyze 1 2

33. Learning Objective 4 Compute and interpret the receivables turnover ratio.

34. 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 receivables (called days to collect).

35. Receivables Turnover Analysis ReceivableTurnover Ratio Net Sales Revenue Average Net Receivables $500,000 $ 50,000 = = 10 times (Beginning net receivables + Ending net receivables) ÷ 2 Days toCollect 365Receivable Turnover Ratio = 365 10 = 36.5 days

36. 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.

37. 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 seller’s cash collection, but also reduces losses from customers writing bad checks. Credit card company charges a fee.