Chapter 6: Bad Debt

Aging of Accounts Receivable

-Aged Accounts Receivable x Estimated Percentage Uncollectible=Estimated Amount Uncollectable -Add Estimated Amount Uncollectible -Estimated ending balance in Allowance for Doubtful Accounts Less: Balance in Allowance for Doubtful Accounts before Adjustment Bad Debt Expense for the Year

Subsidiary account:

-Companies keep separate accounts receivable account for each customer -The amount on the balance sheet represents the total of these individual customer accounts

Sales Discounts to Businesses

-Companies often sell to other businesses on open account (without a formal written promissory note). -Companies may offer a sales discount as an early payment incentive Benefits: 1. Prompt receipt of cash from customers reduces the necessity to borrow money to meet operating needs. 2. Because customers tend to pay bills providing discounts first, a sales discount also decreases the chances that the customer will run out of funds before the company's bill is paid. -2/10,n/30 -2=Discount Percentage -10=Number of days in the discount period -n=Net (total sales less returns) -30=Maximum credit period

Reporting Net Sales

-Companies record credit card discounts, sales discounts, and sales returns and allowances separately to allow management to monitor the magnitude of these transactions Sales revenue $6,000 Less: Credit card discounts (a contra-revenue) 90 Sales discounts (a contra-revenue) 20 Sales returns and allowances (a contra-revenue) 500 Net sales (the first line of the income statement) $5,390

Motivating Sales and Collections

-Companies use a variety of methods to motivate businesses and consumers to buy their products and make payments for their purchases, including: 1) Allowing consumers to use credit cards to pay for purchases. 2) Providing business customers direct credit and discounts for early payment. 3) Allowing returns from all customers under certain circumstances. *These methods affect the way companies compute net sales revenue*

Allowance for Doubtful Accounts

-Contra-asset account subtracted from the asset -Accounts Receivable on the balance sheet

Sales Returns and Allowances

-Customers have a right to return unsatisfactory or damaged merchandise and receive a refund or an adjustment to their bill. These returns are accumulated in a separate account called Sales Returns and Allowances Sales revenue $2,000 Less: Sales returns and allowances (10 pairs × $50) 500 Net sales (reported on the income statement) $1,500 -Cost of goods sold related to the returned sale would also be reduced.

Foreign Currency Receivables

-Export (international) sales are a growing part of the U.S. economy -Most export sales to businesses are on credit -When a buyer agrees to pay in its local currency, the resulting accounts receivable is denominated in a foreign currency -This amount cannot be added to other U.S. dollar accounts receivable -Companies must convert the amount to U.S. dollars using the end-of-period exchange rate between the two currencies

Comparison of the Two Methods

-Percentage of Credit Sales: Directly compute the amount of Bad Debt Expense on the income statement for the period -Aging of Accounts Receivable: Compute the estimated ending balance in the Allowance for Doubtful Accounts on the balance sheet after making the necessary adjusting entry. The difference between the current balance in the account and the estimated balance is recorded as the adjusting entry for Bad Debt Expense

Bad Debts

-Result from credit customers who will not pay the amount they owe, regardless of collection efforts -The Expense Recognition Principle requires recording of bad debt expense in the same accounting period in which the related sales are made -Problem: Company may not learn which particular customers will not pay until the next accounting period -Allowance Method: Companies use the allowance method to measure bad debt expense which is based on estimates of the expected amount of bad debts with two steps: 1) Make end-of-period adjusting entry to record bad debt expense. 2) Write off specific accounts determined to be uncollectible during the period -Adjusting journal entry at the end of the accounting period records the bad debt estimate

Credit Card Discount

-Retailers accept credit cards for several reasons: 1) To increase customer traffic. 2) To avoid the costs of providing credit directly to customers. 3)To lower risks due to bad checks. 4) To avoid losses due to fraudulent credit card sales. 5)To receive payment quicker -Credit Card Discount: When credit card sales are made, the company must pay the credit card company a fee for the service it provides Sales revenue $3,000 Less: Credit card discounts (0.03 × 3,000) 90 Net sales (reported on the income statement) $2,910

Estimating Bad Debt Expense

-The bad debt expense amount recorded in the end-of-period adjusting entry often is estimated based on either: 1) A percentage of total credit sales for the period 2) An aging of accounts receivable -The percentage of credit sales method is simpler to apply, but the aging method is generally more accurate -Many companies use the simpler method on a weekly or monthly basis and use the more accurate method on a monthly or quarterly basis to check the accuracy of the earlier estimates

Bad Debt Expense

-The expense associated with estimated uncollectible accounts receivable. It is included in the category "General and Administrative" expense on the income statement

Percentage of Credit Sales Method

-The percentage of credit sales method bases bad debt expense on the historical percentage of credit sales that result in bad debts Credit sales ($1,500,000) × Bad debt loss rate (1.0%) Bad debt expense $15,000

Writing Off Specific Uncollectible Accounts

-Throughout the year, when it is determined that a customer will not pay its debts (e.g., due to bankruptcy), the write-off of that individual bad debt is recorded through a journal entry

Receivables may be classified in three common ways

1) Accounts Receivable (created by a credit sale on an open account) or Notes Receivable (a written promise to pay principal and interest at one or more future dates) 2) Trade Receivable (Created in the normal course of business when a credit sale of merchandise or services occurs) or Nontrade Receivables (Arise from transactions other than the normal sale of merchandise or services) 3) Current (Short-term) or Noncurrent (Long-term)

Accounts Receivable

Accounts Receivable (Gross) $400,000 Allowance for Doubtful Accounts 50,000 Accounts Receivable (Net) $350,000