CHAPTER 8
RECEIVABLES, BAD DEBT EXPENSE,
AND INTEREST REVENUE
Student Learning Objectives and Related Assignment Materials
Student Learning
Objectives
Mini–
Exercises
Exercises
Coached
Problems
Problems
(Groups
A & B)
Compre–
hensive
Problems
Skills
Develop–
ment
Cases
Continuing
Cases
LO 8-1 Describe the
trade-offs of
extending credit.
1, 2
6
LO 8-2 Estimate and
report the effects
of uncollectible
accounts.
3, 4, 5,
6, 7, 8,
9, 13
1, 2, 3,
4, 5, 6,
7*, 8*,
9*, 13,
14, 15
1, 2, 4*^
A1, A2,
A4^, B1,
B2, B4^
1*^+, 3^+
1, 2, 3,
4, 5^, 7
1†
LO 8-3 Compute and
report interest on
notes receivable.
10*, 11,
12, 13
10, 11,
12
2, 3, 4*^
A3, A4^,
B3, B4^
3^+
4
2^£
LO 8-4 Compute and
interpret the
receivables
turnover ratio.
14, 15
13, 15,
16
5
A5, B5
2^+
1, 2, 3, 6
1†
2^£
LO 8-S1 Record bad
debts using the
direct write-off
method.
16
17
* Animated solution included in the PowerPoint Slides.
^ Particularly challenging; requires students to combine multiple concepts in order to advance to the
next level of accounting knowledge.
+ The Comprehensive Problems are comprised of CP8-1, which also covers LO 6-6, CP8-2, which also
covers LO 6-4, and CP8-3, which also covers LO 3-3, 4-2, 4-3, 4-4, 6-3, 6-4, 6-5, and 7-3.
† Continuing Case 8-1 builds on the story of Nicole’s Getaway Spa, introduced in earlier chapters. This
case focuses on analyzing transactions and preparing journal entries for Sales, estimating the
Allowance for Doubtful Accounts required, analyzing and preparing the journal entry for Bad Debt
Expense, and calculating and interpreting the accounts receivable turnover ratio. This case will be
extended in future chapters.
£ Continuing Case 8-2 builds on the story of Wiki Art Gallery (WAG), an instructional case in Connect.
This case focuses on the methods to record bad debts, the adequacy of the allowance for bad debts,
determining write-offs given information set forth in the financial statements, and calculation and
interpretation of the number of days to collect. The case will be extended in future chapters.
Overview
The challenging job of monitoring and managing receivables, especially during difficult economic times,
is explained.
Students learn how to estimate and report the effects of uncollectible accounts, charge interest on
outstanding balances, and evaluate accounts receivable collection performance. Chapter supplement A
illustrates the non-GAAP direct write-off method.
Synopsis of Chapter Revisions
• Updated focus company illustrations with VF Corp.—the maker of North Face jackets, JanSport
backpacks, Wrangler jeans, and Vans shoes
• Updated Spotlight on Financial Reporting showing credit card costs at Target
• New numbers in aging method illustration
• Updated receivables turnover analysis in Exhibit 8.7, involving VF Corp, Kellogg’s, and Skechers
• Updated demonstration case featuring Rocky Mountain Chocolate Factory
• Reviewed, updated, and introduced new end-of-chapter material, including comprehensive problem
with automatic posting from journal entries to T-accounts and trial balance preparation
PowerPoint Slides
Student Learning Objective
PowerPoint® Slides
LO 8-1 Describe the trade-offs of extending credit.
8-2 through 8-3
LO 8-2 Estimate and report the effects of uncollectible accounts.
8-4 through 8-23
LO 8-3 Compute and report interest on notes receivable.
8-24 through 8-33
LO 8-4 Compute and interpret the receivables turnover ratio.
8-34 through 8-38
LO 8-S1 Record bad debts using the direct write-off method.
8-39 through 8-42
Animated Builds and Animated Solutions
PowerPoint® Slides
Mini-Exercise 8-10
8-44
Exercise 8-7
8-45 through 8-46
Exercise 8-8
8-47 through 8-49
Exercise 8-9
8-50 through 8-52
Coached Problem 8-4
8-52 through 8-61
Comprehensive Problem 8-1
8-62 through 8-65
Summary of Related Video Program
Spotlight Video Series
Chapter 8 – Resetting the Clock (approximately 4:00)
This video describes how a credit manager at MCI used his knowledge of the allowance method to avoid
recording $70 million in bad debts. The video shows students how small initial missteps led the credit
manager to redirect his genuine ambition into criminal actions, which ended in a prison sentence and
personal ruin.
Chapter Summary
LO 8-1 Describe the trade-offs of extending credit.
• By extending credit to customers, a company is likely to attract a greater number of customers
willing to buy from it.
• The additional costs of extending credit include increased wage costs, bad debt costs, and delayed
receipt of cash.
LO 8-2 Estimate and report the effects of uncollectible accounts.
• Under generally accepted accounting principles, companies must use the allowance method to
account for uncollectibles. This method involves the following steps:
1. Estimate and record uncollectibles with an end-of-period adjusting journal entry that increases
Bad Debt Expense (debit) and increases the Allowance for Doubtful Accounts (credit).
2. Identify and write off specific customer balances in the period that they are determined to be
uncollectible.
• The adjusting entry (in 1) reduces Net Income as well as Net Accounts Receivable. The write-off
(in 2) has offsetting effects on Accounts Receivable and the Allowance for Doubtful Accounts,
ultimately yielding no net effect on Net Accounts Receivable or on Net Income.
LO 8-3 Compute and report interest on notes receivable.
• Interest is calculated by multiplying the principal, interest rate, and time period (number of months
out of 12). As time passes and interest is earned on the note, accountants must record an adjusting
journal entry that accrues the interest revenue that is receivable on the note.
LO 8-4 Compute and interpret the receivables turnover ratio.
• The receivables turnover ratio measures the effectiveness of credit-granting and collection
activities. It reflects how many times average trade receivables were recorded and collected during
the period.
• Analysts and creditors watch this ratio because a sudden decline may mean that a company is
extending payment deadlines in an attempt to prop up lagging sales. Or it may mean that a
company is recording sales of merchandise that customers are likely to return later.
Accounting Decision Tools
1. Receivables Turnover Ratio = Net Sales Revenue ÷ Average Net Receivables
• It tells you the number of times receivables turn over during the period
• A higher ratio means faster (better) turnover
2. Days to Collect = 365 ÷ Receivables Turnover Ratio
• It tells you the average number of days from sale on account to collection
• A higher number means a longer (worse) time to collect
Chapter Outline
Teaching Notes
I. Understand the Business
LO 8–1 Describe the trade-offs of extending credit.
A. Pros and Cons of Extending Credit
1. The advantage of extending credit is that it allows the
company to remain competitive with its competitors who
also extend credit to business customers.
2. Disadvantages of Extending Credit
a. Increased wage costs—If credit is extended, the
company will have to hire people to (a) evaluate
whether each customer is creditworthy, (b) track how
much each customer owes, and (c) follow up to collect
the receivable from each customer.
b. Bad debt costs—Inevitably, some customers dispute
what they owe and pay only a portion of the total
amount that they’ve been charged; these “bad debts”
can be a significant additional cost of extending credit.
c. Delayed receipt of cash—Even if the company was to
collect in full from customers, it will likely have to
wait 30–60 days before receiving the cash. During this
time, the company may need to take out a short-term
bank loan to pay for other business activities; the
interest on such a loan is another cost of extending
credit to customers.
The “Spotlight on Business
Decisions” feature addresses
deciding whether to grant
credit.
3. Most managers find that the additional revenue (i.e., gross
profit) gained from selling on account exceeds the
additional costs listed above.
4. Note Receivable—Promise that requires another party to
pay the business according to a written agreement.
a. Differ from accounts receivable in that notes generally
charge interest.
b. Stronger legal claim than accounts receivable.
c. New note needs to be created for each transaction so
they are used less frequently.
Chapter Outline
Teaching Notes
II. Accounting for Accounts Receivable
A. Accounts Receivable and Bad Debts
LO 8–2 Estimate and report the effects of uncollectible accounts.
1. Accounts Receivable—Amounts owed to a business by
its customers.
✓ Supplemental Enrichment
Activity (Activity) #1
2. The two objectives in accounting for accounts receivable
and bad debts relate to the need to:
a. Report accounts receivable on the balance sheet at the
amount the company expects to collect (“net realizable
value”).
❖ Video Spotlight Series –
Chapter 8
b. Match the cost of bad debts to the accounting period in
which the related credit sales are made.
3. Allowance Method—Method of accounting that reduces
accounts receivable (as well as net income) for an
estimate of uncollectible accounts (bad debts) following a
two-step process:
a. Make an end-of-period adjustment to record the
estimated bad debts in the period credit sales occur.
b. Remove (“write off”) specific customer balances when
they are known to be uncollectible.
4. Adjust for Estimated Bad Debts
a. Credit sales, when first recorded, affect both balance
sheet (increase in Accounts Receivable) and the
income statement (increase in Sales Revenue).
b. To account for any bad credit sales, an adjustment is
made at the end of each accounting period to reduce
accounts receivable (using a contra-asset account
called Allowance for Doubtful Accounts) and reduce
net income (using an expense account called Bad Debt
Expense).
c. Bad Debt Expense—Estimated amount of this
period’s credit sales that customers will fail to pay.
d. The company estimates $900 of bad debts this period.
Recording and reporting
i. Analyze:
Assets = Liabilities + Stockholders’ Equity
Allowance for Doubtful Accounts (xA) –900; Bad
Debt Expense (E) –900
estimated bad debts
illustrated in Exhibit 8.2
ii. Record:
Bad Debt Expense
900
Allowance for Doubtful Accounts
900
e. The Allowance for Doubtful Accounts, a contra-asset
account, is a permanent account, so its balance carries
forward from one accounting period to the next.
f. Bad Debt Expense, which is a temporary account, will
have its balance zeroed out at the end of each year.
g. The two account balances will be equal only during
the first accounting period.
Chapter Outline
Teaching Notes
h. For billing and collection, a separate accounts
receivable account (called a subsidiary account) is
maintained for each customer; total of these accounts
is reported as Accounts Receivable on balance sheet.
i. At the time the estimate is made, there is no way to
know which particular customers’ accounts receivable
are uncollectible. If the company were to remove the
customer accounts believed to be uncollectible, it
would lose track of which customers still owed
money.
j. Accounts Receivable, Net of Allowance is a subtotal
on the balance sheet that is computed by subtracting
the contra-asset account Allowance for Doubtful
Accounts from the asset account Accounts Receivable.
5. Remove (Write Off) Specific Customer Balances
a. Write-Off—The act of removing an uncollectible
account and its corresponding allowance from the
accounting records.
b. When it becomes clear that a particular customer will
not pay its balance, the company will remove that
customer’s account from its accounts receivable
records.
i. With the receivable removed, there’s no longer a
need to include an allowance for it, so the
corresponding amount also is removed from the
allowance for doubtful accounts.
ii. A write-off does not affect income statement
accounts; the estimated bad debt expense relating
to these uncollectible accounts was already
recorded with an adjusting journal entry in the
period the sale was recorded.
c. The company writes off an $800 receivable from one
of its customers.
i. Analyze:
Assets = Liabilities + Stockholders’ Equity
Accounts Receivable (A) –800; Allowance for
Doubtful Accounts (xA) –800
ii. Record:
Allowance for Doubtful Accounts
800
Accounts Receivable
800
d. The write-off decreased both total Accounts
Receivable and Allowance for Doubtful Accounts by
the same amount ($800).
e. Consequently, the net accounts receivable balance
after the write-off is unchanged from the net accounts
receivable balance before the write-off.
Chapter Outline
Teaching Notes
B. Methods for Estimating Bad Debts—Uncollectibles can be
estimated using one of two methods:
1. Percentage of Credit Sales Method (also called the
income statement approach)
✓ Activity #3
a. Simpler to apply.
Simpler for the company
b. Estimates bad debts based on the historical percentage
of sales that lead to bad debt losses.
and for students!
b. Focus is on estimating Bad Debt Expense for the
period.
2. Aging of Accounts Receivable Method (also called the
balance sheet approach)
✓ Activity #2
a. Harder to apply but generally more accurate.
Harder for the company
b. Focuses on estimated the ending balance in the
Allowance for Doubtful Accounts.
and for students!
c. Gets its name because it is based on the “age” of each
amount in Accounts Receivable.
d. Follows three steps:
i. Step 1—Prepare an aged listing of accounts
receivable with totals for each aging category.
Illustrated in Exhibit 8.3
ii. Step 2—Estimate bad debt loss percentages for
each category; generally, higher percentages are
applied to increasingly old receivables.
iii. Step 3—Compute the total estimate by multiplying
the totals in Step 1 by the percentages in Step 2 and
then summing across all aging categories; the total
across all aging categories represents the balance to
which the Allowance for Doubtful Accounts will
need to be adjusted at the end of the period.
3. The amount is Step 3 is the desired balance in the
Allowance for Doubtful Accounts, not the amount of the
adjustment. To compute the amount of the adjustment,
subtract the existing unadjusted balance from the desired
adjusted balance computed above in Step 3.
The “Spotlight on Business
Decisions” feature addresses
collection efforts based on
the aged listing of accounts
receivable.
4. Although the Allowance for Doubtful Accounts normally
has a credit balance, it might have a debit balance prior to
adjusting for uncollectible accounts.
a. A debit balance occurs when a company has recorded
write-offs that exceed its previous estimates of
uncollectible accounts.
A debit balance means that
last year’s estimate was
simply too low.
b. The amount of the adjustment needed to reach the
desired balance still needs to be calculated under the
aging of accounts receivable method.
c. The only difference is that to reach the desired
balance, an amount equal to the desired balance plus
the existing debit balance must be recorded.
d. After the adjustment is recorded, the Allowance for
Doubtful Accounts will return to a credit balance.
Chapter Outline
Teaching Notes
5. Other Issues
a. Revising Estimates
i. Bad debt estimates will always differ somewhat
from the amount that is later written off.
ii. To ensure bad debts and the allowance for doubtful
accounts do not become materially misstated over
time, companies revise overestimates of prior
periods by lowering estimates in the current period,
or they raise estimates in the current period to
correct underestimates of prior periods.
b. Account Recoveries
i. 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.
ii. The company collects the $800 previously written
off from one of its customers.
• i. Analyze:
Assets = Liabilities + Stockholders’ Equity
Accounts Receivable (A) +800; Allowance for
Doubtful Accounts (xA) +800; Cash (A)
+800; Accounts Receivable (A) –800
• ii. Record:
Accounts Receivable
800
Allowance for Doubtful Accounts
800
Cash
800
Accounts Receivable
800
iii. In the two entries above, Accounts Receivable is
debited and then credited for the same amount. It’s
tempting to cancel these two out; however, doing
so would create an inaccurate credit history for the
customer.
c. Alternative Methods
i. An alternative approach, the direct write-off
method, is easier to use, but it overstates the value
of Accounts Receivable and violates the expense
recognition principle; as such, it is not considered a
generally accepted accounting method.
Covered in Supplement 8A
ii. However, the Internal Revenue Service (IRS)
requires the use of this method for tax purposes.
The IRS does not like
estimates.
Chapter Outline
Teaching Notes
LO 8–3 Compute and report interest on notes receivable.
III. Notes Receivable and Interest Revenue
A. A company reports Notes Receivable in three situations:
✓ Activity #4
1. It loans money to employee or businesses.
2. It sells expensive items for which customers require an
extended payment period.
3. It converts an existing accounts receivable to a note
receivable to allow an extended payment period.
4. The accounting issues are similar to those for accounts
receivable except that notes receivable charged interest
from the day they are created to the day they are due
(maturity date).
B. Calculating Interest
Interest (I) = Principal (P) × Interest Rate (R) × Time (T)
Illustrated in Exhibit 8.4
1. Principal—The amount of the note receivable.
2. Interest rates are always stated as an annual percentage
even if the note is for less than a year.
3. The time period is the portion of a year for which interest
is calculated.
Homework assignments
assume that the time is
4. Most financial institutions use the number of days out of
365 to compute interest.
measured in terms of the
number of months out of 12.
C. Recording Notes Receivable and Interest Revenue
1. Establishing a Note Receivable
The company loans $100,000 to another company.
a. Analyze: Assets = Liabilities + Stockholders’ Equity
Notes Receivable (A) +100,000; Cash (A) –100,000
b. Record:
Notes Receivable
100,000
Cash
100,000
2. Accruing Interest Earned
a. Under accrual basis accounting, interest revenue is
recorded when it is earned (at the end of each
accounting period).
Timeline illustrated in
Exhibit 8.5
b. At the end of each accounting period, a company must
make an adjusting journal entry to accrue the interest
earned but not yet received by debiting Interest
Receivable and crediting Interest Revenue.
c. The company earned two months of interest revenue
during the accounting period.
i. Interest = Principal × Interest Rate × Time
$1,000 = $100,000 × 6% × 2/12
ii. Analyze:
Assets = Liabilities + Stockholders’ Equity
Interest Receivable (A) +1,000; Interest Revenue
(R) +1,000
Chapter Outline
Teaching Notes
iii. Record:
Interest Receivable
1,000
Interest Revenue
1,000
3. Recording Interest Received
At maturity, the company receives a cash interest
payment of $6,000 (= $100,000 × 6% × 12/12) earned two
months of interest revenue during the accounting period.
a. Analyze: Assets = Liabilities + Stockholders’ Equity
Cash (A) +6,000, Interest Receivable (A) –1,000;
Interest Revenue (R) +5,000
b. Record:
Cash
6,000
Interest Receivable
1,000
Interest Revenue
5,000
4. Recording Principal Received
The company receives the $100,000 principal due at
maturity.
a. Analyze: Assets = Liabilities + Stockholders’ Equity
Cash (A) +100,000, Notes Receivable (A) –100,000
b. Record:
Cash
100,000
Notes Receivable
100,000
5. Accounting for Uncollectible Notes
a. Companies might not collect the full principal and
interest that they are owed on a note receivable.
The “Spotlight on Ethics”
b. When collection is in doubt, company should record
an Allowance for Doubtful Accounts against the Notes
Receivable, just as is records an Allowance for
Doubtful Accounts against Accounts Receivable.
feature addresses the
avoidance of recording bad
debts by replacing accounts
receivable with notes.
LO 8–4 Compute and interpret the receivables turnover ratio.
III. Evaluate Receivables Management
A. Receivables Turnover Analysis
1. Receivables Turnover—The process of selling and
collecting on account.
a. The receivables turnover ratio determines the average
number of times this process occurs during the period.
b. Receivables Turnover Ratio = Net Sales Revenue ÷
Average Net Receivables.
c. The receivables turnover ratio measures the number of
times receivables turn over during the period.
d. A higher receivables turnover ratio means faster
(better) turnover.
e. Channel stuffing—Company allows customers more
time to pay their accounts to entice them to buy as
much as possible.