ACCT Chapter 8 Terms

Allowance Method

A method of accounting for uncollectible receivables in which the company estimates bad debts expense instead of waiting to see which customers the company will not collect from.

Notes Receivable (also called promissory notes)

A written promise that a customer will pay a fixed amount of principal plus interest by a certain date in the future... called the maturity date. The date when a note is due. Notes receivable usually have longer terms than accounts receivable.

Computing interest when the period is stated for one year EXAMPLE SMART TOUCH

Exhibit 8-4: Smart Touch Learning is lending Lauren Holland $1,000 on September 30, 2019, for one year at an annual interest rate of 6%. The accounting clerk for Smart Touch Learning would record the following journal entry: Sep. 30 DR: Notes Receivable—Holland 1,000 CR: Cash 1,000 Accepted note in exchange for cash. Maturity Date is September 30, 2020 Using the data, Smart Touch Learning computes interest revenue for one year as follows: Amount of interest = Principal * Interest rate * Time = $1,000 * 0.06 * 12/12 = $60 • The maturity value of the note is $1,060 ($1,000 principal + $60 interest). • The time element is 12/12 or 1 because the note's term is one year.

Comparison of Percent-of-Sales, Percent-of-Receivables, and Aging-of- Receivables Methods

INCOME STATEMENT APPROACH: Percent-of-Sales Method Bad Debts Expense = Net credit sales × % BALANCE SHEET APPROACHES: Percent-of-Receivables Method and Aging-of-Receivables Method Step 1: Target balance = Ending balance of Accounts Receivable × % Step 2:Bad debts expense = Target balance − Unadj. credit balance in Allowance for Bad Debts OR Bad debts expense = Target balance + Unadj. debit balance in Allowance for Bad Debts

How are notes receivable accounted for?

The debtor signs a promissory note as evidence of the transaction. •Promissory note—A written promise to pay a specified amount of money at a particular future date, usually with interest. • Maker of the note (debtor)—The entity that signs the note and promises to pay the required amount; the maker of the note is the debtor. -the maker of the note is the debtor. • Payee of the note (creditor)—The entity to whom the maker promises future payment; the payee of the note is the creditor. The creditor is the company that loans the money. -the creditor is the company that loans the money. (SEE NOTES FOR PROMISSORY NOTE EX)

Net Realizable Value

The net value a company expects to collect from its accounts receivable. Accounts Receivable less Allowance for Bad Debts.

Recovery of Accounts Previously Written Off—Direct Write-off Method EXAMPLE

To account for a recovery, the company must reverse the earlier write-off. EX: on September 10, Smart Touch Learning unexpectedly receives $200 cash from Dan King. The company will reverse the earlier write-off and then record the cash collection as follows: Sept. 10 DR: Accounts Receivable—King 200 CR: Bad Debts Expense 200 Reinstated previously written off account. Sept. 10 DR: Cash 200 CR: Accounts Receivable—King 200 Collected cash on account.

Identifying Maturity Date

When the period is given in months, the note's maturity date falls on the same day of the month as the date the note was issued. When the period is given in days, the maturity date is determined by counting the actual days from the date of issue. In counting the number of days in a note term, remember to: • Count the maturity date. • Omit the date the note was issued.

Bad debts expense arises from

failure to collect from some customers who purchase on account.

A Receivable

occurs when a business sells goods or services to another party on account (on credit). It is a monetary claim against a business or an individual.

The three major types of receivables are:

• Accounts receivable • Notes receivable • Other receivables

Limitations of the Direct Write-off Method (often used only by small, nonpublic companies)

•the direct write-off method violates the matching principle. -For example, when using the direct write-off method, a company might record sales revenue in 2017 but not record the bad debts expense until 2018. This results in: •Overstated net income in 2017 •Understated net income in 2018. •In addition, on the balance sheet at December 31, 2017, Accounts Receivable will be overstated because the company will have some receivables that will be uncollectible but are not yet written off. •The direct write-off method is only acceptable for companies that have very few uncollectible receivables.

Accounts receivable (also called trade receivables)

represent the right to receive cash in the future from customers for goods sold or for services performed. Accounts receivable are usually collected within a short period of time, such as 30 or 60 days, and are therefore reported as a current asset on the balance sheet.

Recording and Writing Off Uncollectible Accounts—Direct Write-off Method EXAMPLE

let's assume that on August 9 Smart Touch Learning determines that it will not be able to collect $200 from customer Dan King for a sale of merchandise inventory made on May 5. The company would write off the customer's account receivable by debiting Bad Debts Expense and crediting the customer's Accounts Receivable as follows: DR: Bad Debts Expense 200 CR: Accounts Receivable-King 200 Once an account receivable is written off, the company stops pursuing the collection.

Recording Sales on Credit

selling on account (on credit) creates an account receivable. Businesses must maintain a separate accounts receivable account for each customer in order to account for payments received from the customer and amounts still owed.

How are uncollectibles accounted for when using the Direct Wire- Off method?

the company must record an expense associated with the cost of the uncollectible account. -record a debit to Bad Debts Expensehe company will record a debit to Allowance for Bad Debts. Bad Debts Expense is not debited when a company writes off an account receivable when using the allowance method because the company has already recorded the Bad Debts Expense as an adjusting entry.

Suppose Rubinstein Jewelers has a six-month, 10% note receivable for $1,200 from Mark Adair that was signed on March 3, 2019, and Adair defaults. Rubinstein Jewelers will record the default on September 3, 2019, as follows:

2019 Sep. 3 DR: Accounts Receivable—Adair 1,260 CR: Notes Receivable—Adair 1,200 Interest Revenue ($1,200 × 0.10 × 6/12) 60 Rubinstein will then bill Adair for the account receivable. This allows Rubinstein to eventually write off the receivable using either the direct write-off method or the allow- ance method if at a later date Rubinstein can still not collect the account receivable.

ROSA EXAMPLE Some companies sell merchandise in exchange for notes receivable. Assume that on July 1, 2019, Rosa Electric sells household appliances for $2,000 to Dorman Builders. Dorman signs a nine-month promissory note at 10% annual interest. Rosa's entries to record the sale (ignore Cost of Goods Sold), interest accrual, and collection from Dorman are as follows:

2019 Jul. 1 DR: Notes Receivable—Dorman Builders 2,000 CR: Sales Revenue 2,000 Dec. 31 DR: Interest Receivable ($2,000 × 0.10 × 6/12) 100 CR: Interest Revenue 100 2020 Apr. 1 DR: Cash ($2,000 + ($2,000 × 0.10 × 9/12)) 2,150 CR: Notes Receivable—Dorman Builders 2,000 Interest Receivable 100 Interest Revenue ($2,000 × 0.10 × 3/12) 50

SPORTS CLUB EX A company may accept a note receivable from a credit customer who fails to pay an account receivable. The customer signs a promissory note and gives it to the creditor. Suppose Sports Club cannot pay Blanding Services the amount due on accounts receivable of $5,000. Blanding may accept a 60-day, $5,000 note receivable, with 12% interest, from Sports Club on November 19, 2019. Blanding's entries are as follows:

2019 Nov. 19 DR: Notes Receivable— Sports Club 5,000 CR: Accounts Receivable—Sports Club 5,000 Dec. 31 DR: Interest Receivable ($5,000 × 0.12 × 42/365) 69 CR: Interest Revenue 69 2020 Jan. 18 DR: Cash ($5,000 + ($5,000 × 0.12 × 60/365)) 5,099 CR: Notes Receivable—Sports Club 5,000 Interest Receivable 69 Interest Revenue ($5,000 × 0.12 × 18/365)* 30

Aging-of-Receivables Method (aka balance sheet approach)

A method of estimating uncollectible receivables by determining the balance of the Allowance for Bad Debts account based on the age of individual accounts receivable. -The procedure for recording the year-end adjusting entry is similar to the percent-of-receivables method. However this method, businesses group individual accounts according to how long the receivable has been outstanding. -different percentage are applied to each category. Step 1: Determine the target balance of Allowance for Bad Debts by using the age of each account. Step 2: Determine the amount of bad debts expense by evaluating the allowance account. Bad debts expense = Target balance -Unadjusted credit balance of Allowance for Bad Debts OR Bad debts expense = Target balance + Unadjusted debit balance of Allowance for Bad Debts

The formula for computing Interest on a Note

Amount of Interest = Principal * Interest Rate * Time • In the formula, time (period) represents the portion of a year that interest has accrued on the note. -It may be expressed as a fraction of a year in months (number of months/12) -or a fraction of a year in days (number of days/365).

Other Receivables (make up a miscellaneous category)

Any other type of receivable where there is a right to receive cash in the future. Common examples include dividends receivable, interest receivable, and taxes receivable. These other receivables may be either current or long-term assets, depending on whether they will be received within one year or the normal operating cycle if the cycle is longer than a year (current asset) or received more than a year in the future (long-term asset).

Percent-of-Receivables Method Example

On December 31, 2020, Smart Touch Learning's unadjusted Accounts Receivable balance is $6,375, and 4% of accounts receivable is estimated to be uncollectible. Step 1: Calculate the target balance. It is always reported as a credit balance. $6,375 × 0.04 = $255 Step 2: The bad debts expense adjustment must be calculated based on the target balance. $255 - $55 = $200 Smart Touch Learning records the following adjusting entry on December 31 to recognize bad debts expense for the year: Dec. 31 DR: Bad Debts Expense 200 ---------CR: Allowance for Bad Debts 200 Recorded bad debts expense for the period. After posting the adjusting entry, Smart Touch Learning has the following balances in its Recorded bad debts expense for the period. balance sheet and income statement accounts: SEE NOTES FOR T CHARTS

Aging-of-Receivables Method EXAMPLE

Smart Touch Learning knows the target balance of the Allowance for Bad Debts account is $185. Smart Touch Learning will determine its bad debts expense by subtracting the $55 unadjusted credit balance in the allowance account from the target balance, $185. Step 1: Calculate the target balance using the aging schedule. It is always reported as a credit balance Step 2: The bad debts expense adjustment must be calculated based on the target balance. $185-$55=$130 __Allowance_for_Bad_Debts__ ____________________|_80_Jan._1,_2020,_Bal. _Write-offs 25_| ____________________|_55_Unadj._Bal._______ ____________________|_130_Adj.____________(St.2) ____________________|_185 Dec. 31, 2020, Bal. (st. 1) Smart Touch Learning will record the following adjusting entry on December 31 to recognize bad debts expense for the year: Dec. 31 DR: Bad Debts Expense 130 ---------CR: Allowance for Bad Debts 130 Recorded bad debts expense for the period. After posting the adjusting entry, Smart Touch Learning has the following balances in its Recorded bad debts expense for the period. balance sheet and income statement accounts: SEE NOTES FOR TCHARTS/REST

Accruing Interest Revenue (Refer back to Exhibit 8-4)

Smart Touch Learning lending Lauren Holland $1,000 on September 30, 2019, for one year at an annual interest rate of 6%. On December 31, interest should be accrued. How much of the total interest revenue does Smart Touch Learning earn in 2019 (from September 30 through December 31)? $1,000 * 0.06 * 3/12 = $15 The accounting clerk makes the following adjusting entry at December 31, 2019: Dec. 31 DR: Interest Receivable 15 CR: Interest Revenue 15 Accrued interest revenue. How much interest revenue does Smart Touch Learning earn in 2020? $1,000 * 0.06 * 9/12 = $45 On the maturity date of the note, Smart Touch Learning will receive cash for the principal amount plus interest. The company considers the note honored and makes the following entry: Sep. 30 DR: Cash ($1,000 + ($1,000 × 0.06 × 12/12)) $1,060 CR: Notes Receivable—Holland $1,000 Interest Receivable $15 Interest Revenue $45 Collected note receivable plus interest.

Percent-of-Sales Method EXAMPLE

Smart Touch Learning uses the percent-of-sales method to account for uncollectibles. Past experience suggests that 0.5% of credit sales will be uncollectible, which amounted to $60,000 Percent-of-Sales Method: Bad Debts Expense = Net credit sales * % = $60,000 * 0.005 = $300 At December 31, Smart Touch Learning records the following adjusting entry to recognize bad debts expense for the year: DR: Bad Debts Expense 300 CR: Allowance for Bad Debts 300 Recorded bad debts expense for the period. (When using the allowance method, the only time Bad Debts Expense is recorded is as an adjusting entry) After posting the adjusting entry, Smart Touch Learning has the following balances in its balance sheet and income statement accounts. Ignore the previously recorded reversal of the write-off and assume collections on account during the year are $58,000: SEE NOTES FOR T CHARTS

Recording Bad Debts Expense—Allowance Method EXAMPLE

Suppose that as of December 31, 2019, Smart Touch Learning estimates that $80 of its $4,400 accounts receivable are uncollectible. The accounting clerk will record the following adjusting entry: Dec. 31 DR: Bad debts expense $80 CR:Allowance for bad debts $80 Recorded bad debts expense for the period. Accounts Receivable will be reported on the balance sheet, but it will now be shown at the net realizable value. (Accounts Receivable less Allowance for Bad Debts) Smart Touch Learning would report the following on its balance sheet: Current Assets: Accounts Receivable $4,400 Less: Allowance for Bad Debts (80) Total assets: $4,320 The contra account, Allowance for Bad Debts, is subtracted from Accounts Receivable showing that although $4,400 is owed to Smart Touch Learning, the company estimates that $80 of accounts receivable will be uncollectible.

Estimating and Recording Bad Debts Expense—Allowance Method

Under the allowance method of accounting for uncollectibles, businesses must estimate the amount of the bad debts expense at the end of the accounting period. This is done using one of three methods: -Percent-Of-Sales -Percent-Of-Receivables -Aging -Of-Receivables

Computing Interest when period is stated in months, EXAMPLE ROSA

When the term of a note is stated in months, we compute the interest based on the 12-month year. • Interest on a $2,000 note at 10% for nine months is computed as follows: Amount of interest = Principal * Interest rate * Time = $2,000 * 0.10 * 9/12 = $150

Comparison of Accounting for Uncollectibles (Direct Write-off Method Versus Allowance Method)

Write-off of an uncollectible account: DIRECT WRITE-OFF METHOD DR: Bad Debts Expense $ CR: Accounts Receivable—Customer $ Wrote off an uncollectible account. ALLOWANCE METHOD DR: Allowance for Bad Debts $ CR: Accounts Receivable—Customer $ Wrote off an uncollectible account. Recovery of accounts previously written off: DIRECT WRITE-OFF METHOD DR: Accounts Receivable—Customer $ CR: Bad Debts Expense $ Reinstated previously written off account. DR: Cash $ CR: Accounts Receivable—Customer $ Collected cash on account ALLOWANCE METHOD DR: Accounts Receivable—Customer $ CR: Allowance for Bad Debts $ Reinstated previously written off account. DR: Cash $ CR: Accounts Receivable—Customer $ Collected cash on account. Adjusting entry to recognize bad debts: DIRECT WRITE-OFF METHOD No adjusting entry recorded. ALLOWANCE METHOD DR: Bad Debts Expense $ CR: Allowance for Bad Debts $ Recorded bad debts expense for the period.

ACCURATE Recovery of Accounts Previously Written Off—Direct Write-off Method

to keep accurate records about the collection of cash for a previously written off account, the business should reestablish the Accounts Receivable by debiting the receivable account. Then the business can record the receipt of cash for the receivable by debiting Cash and crediting Accounts Receivable.

Maturity date

• Date when final payment of the note is due. -Also called the due date.

There are two methods of accounting for uncollectible receivables and recording the related bad debts expense:

• Direct write-off method • Allowance method

Accruing interest revenue

• Some notes receivable may be outstanding at the end of an accounting period. The interest revenue earned on the note up to year-end is part of that year's earnings -Recall that interest revenue is earned over time, not just when cash is received. Because of the revenue recognition principle, we want to record the earnings from the note in the year in which they were earned.

Principal

• The amount loaned out by the payee and borrowed by the maker of the note.

Computing Interest when period is stated in days, EXAMPLE Sports Club

• The interest on a $5,000 note at 12% for 60 days can be computed as follows: Amount of interest = Principal * Interest rate * Time = $5,000 * 0.12 * 60/365 = $98.63 (rounded) -Keep in mind that interest rates are stated as an annual rate. Therefore, the time in the interest formula should also be expressed in terms of a fraction of one year.

Interest rate

• The percentage rate of interest specified by the note. -Interest rates are almost always stated for a period of one year.

Interest period

• The period of time during which interest is computed. -It extends from the original date of the note to the maturity date. -Also called the note term.

Interest

• The revenue to the payee for loaning money -Interest is an expense to the debtor and revenue to the creditor.

Maturity value

• The sum of the principal plus interest due at maturity. -Maturity value is the total amount that will be paid back.

Recording Dishonored Notes Receivable

• When a maker dishonors a note, the dishonored note and the unpaid interest are transferred to Accounts Receivable. •Later, the Accounts Receivable can be written off under the direct write-off method or the allowance method

Allowance for Bad Debts

•A contra asset account, related to accounts receivable, that holds the estimated amount of uncollectible accounts.

Direct Write-off Method (primarily used by small, nonpublic companies.)

•A method of accounting for uncollectible receivables in which the company records bad debts expense when a customer's account receivable is uncollectible. -Accounts receivable are written off and bad debts expense is recorded when the business determines that it will never collect from a specific customer.

Percent of Receivables Method (aka balance sheet approach)

•A method of estimating uncollectible receivables by determining the balance of the Allowance for Bad Debts account based on a percentage of accounts receivable. •computes bad debts expense as a percentage of accounts receivable. The calculation for bad debts expense under the percent-of-receivables method is a two-step process. First, the company determines the target balance of Allowance for Bad Debts. Then, it uses the target balance to determine the amount of the bad debts expense. Step 1: Determine the target balance of Allowance for Bad Debts. Target balance = Ending balance of accounts receivable * % Step 2: Determine the amount of bad debts expense by evaluating the allowance account. Bad debts expense = Target balance - Unadjusted credit balance of Allowance for Bad Debts OR Bad debts expense = Target balance + Unadjusted debit balance of Allowance for Bad Debts

Percent-of-Sales Method (aka income-statement approach)

•A method of estimating uncollectible receivables that calculates bad debts expense based on a percentage of net credit sales. •Computes bad debts expense as a percentage of net credit sales. •(bc it focuses on the amount of expense that is reported on the income statement.)

Exercising Internal Control Over Receivables

•Businesses that sell goods or services on account receive cash by mail, usually in the form of a check, or online payments via electronic funds transfer (EFT), so internal control over collections is important. •a critical element of inter- nal control is the separation of cash-handling and cash-accounting duties. -The credit department should have no access to cash -Those who handle cash should not be in a position to grant credit to customers

Decreasing Collection Time and Credit Risk

•Companies must wait to receive cash from sales on account. •Some accounts are never collected. •Options to decrease collection time while transferring the risk of non-collection to a third party include: -Credit Card and Debit Card Sales -Factoring and Pledging Receivables •"When a business factors its receivables, it sells its receivables to a finance company or bank (often called a factor). The business immediately receives cash less an applicable fee from the factor for the receivables. The factor, instead of the business, now collects the cash on the receivables. The business no longer has to deal with the collection of the receivable from the customer. The business receives cash associated with the receivable from the factor instead of the customer." •"Pledging of receivables is another option for businesses that need cash immediately. In a pledging situation, a business uses its receivables as security for a loan. The business bor- rows money from a bank and offers its receivables as collateral. The business is still respon- sible for collecting on the receivables, but it uses this money to pay off the loan along with interest. In pledging, if the loan is not paid, the bank can collect on the receivables."

Recovery of Accounts Previously Written Off—Allowance Method

•Customers will occasionally make payment on receivables that have already been written off. A business will need to reverse the write-off to the Allowance for Bad Debts account and then record the receipt of cash. -In reversing the write-off, the business is reestablishing the receivable account and reversing the write-off from the Allowance for Bad Debts account. EXAMPLE Recall that Smart Touch Learning wrote off the $25 receivable from customer Shawn Clark on January 10, 2020. It is now March 4, 2020, and Smart Touch Learning unexpectedly receives $25 cash from Clark. The entries to reverse the write-off and record the receipt of cash are as follows: March 4. DR: Accounts Receivable—Clark 25 ------------CR: Allowance for Bad Debts 25 Reinstated previously written off account. 4.---- DR: Cash 25 -------CR: Accounts Receivable—Clark 25 Collected cash on account.

How are uncollectibles accounted for when using the Allowance Method? (Most companies use the allowance method to measure bad debts.)

•The allowance method is based on the matching principle. -It records bad debts expense in the same period as the sales revenue.

Writing Off Uncollectible Accounts—Allowance Method EXAMPLE

•The company will record a debit to Allowance for Bad Debts. Bad Debts Expense is not debited when a company writes off an account receivable when using the allowance method because the company has already recorded the Bad Debts Expense as an adjusting entry. On January 10, 2020, Smart Touch Learning determines that it cannot collect a total of $25 from its customer, Shawn Clark. The accounting clerk would record the following entry to write off the account: Jan. 10 DR: Allowance for Bad Debts 25 CR: Accounts Receivable—Clark 25 Wrote off an uncollectible account.