Accounting Lecture February 22: Bad Debt Flashcard

Companies accept credit cards for several reasons
-To increase sales
When customers purchase on open account, they may be offered a sales discount to encourage early payment
2/10, n/30

2% discount
10 days in discount period
n (net total sales less returns)
30 is the maximum credit period of 30 days

Read as “Two, ten, net thirty”

Put the discount terms in relation to the annual interest rate to see if it is actually a good deal
365 days/ 20 days X (the %) = xx%

*Will not have to calculate on an exam

Interest rate for 20 days =
Amount saved/ Amount paid
Reporting Net Sales
Companies record credit card discounts, sales discounts, and sales returns and allow
1. Merchandise invoiced at $9,500 is sold on terms 1/10, n/30

If the buyer pays within the discount period, what amount will be reported on the income statement as net sales

If they pay early they will receive a 1% discount
Sales returns related to sales on account were $650. All returns were made BEFORE the payment. ONE HALF of the remaining sales on account were paid WITHIN the discount period. What amount will be reported on the income statement as net sales?
Credit Card sales (discount 3%) $9,400
Sales on account (2/15, n/60) $12,000

*Will not have to calculate this on the exam

*People use these estimates a lot to inflate and manipulate their income

Credit Card Discount = $9,4000 *3% = $282.00

Do not apply the 2% to all of the credit card sales: Look at the dates when it applies

Only subtract the sales returns, if it says to do that specfically

Reporting Net Sales with Discounts, Returns, and Bad Debts

The folloowing data is provided for ABC Company for the year ended Dec 31, 2014

Balances Jan 1:
Accounts receivable: $116,000
Allowance for doubtful accounts $5,200

d. Karen paid her invoice early from the discount period

Until she pays for the goods early, then there will be a discount stated

f. Two days after paying the account in full,

*Because she already received the full discount for paying the amount due in full, then you need to make sure to remove the $500 return by 2% for the period

G. $88,200 cash from customer sales on credit in prior year, all within the discount periods

88,200/98% X (0.2) = $1,800 (post 2% discount)

Accounts Receieveable

Transacting goods and services

Are created when companies have sales to customers on open accounts
Notes Receivable

If you loan money to other people

Are written promises to another party to pay with specfied
Nontrade receivables

Anything else that you transact that is not goods or services

*Will not be on the exam

are amounts owed to the business for other than business transactions
Trade receivables
Are amounts owed to the business for credit sales of goods
Accouting for Bad Debts
Bad Debts: result from credit customers who will not pay the amount they owe, regardless of collection efforts
Matching principle for bad debts
Bad debt expense

record in same accounting period

Sales Revenue

Will affect income statement and balance sheet
Bad debts
Importance of Analyzing Credit Risk

*Will not have to calculate on the exam

A business could be driven into bankruptcy asa result of customers not paying their bills on time

Example: General Motors
They had 82% of Bad Debt (coming from their net sales)

If GM’s bad debt expense increased by less than 0.5% points, it would have wiped out GM’s pre-tax income (jump to 3.2 billion)

*.82% is driven by the companies MANAGEMENT (potential to manipulate it)
-Want to make it lower, as it would increase their net income, and have a higher EPS

Earnings Management

Detecting potential earnings manipulation includes

Cash that does not follow earnings
-Operational cash flow should not lag behind sales for an extended period
-If receivables rise significantly faster than cash sales, or than the % of total sales, it may indicate aggressive revenue recognition
Example

Deferred Revenue (cash first, deliver good or service on a later date)

Cash (+A) 1000
Unearned Revenue (+L) (1000)

Accrued Revenue (No cash yet)

Accounts receivable (+A) 1000
Revenues (+R/+E) 1000

Which is easier to manipulate? Accrued is

*Because Deferred is with cash, which can easily be proved

If they want to inflate their revenue, they can say that they are going to receive the higher amount of cash, and receive it next period
*Auditors will then look at the cash flow statement

*Want to look out for big variances if a consistent company like Target or Walmart

How to Mitigate Credit Risk
Companies can take several steps to manage credit risk:
-Screening customers before extending credit
-Setting credit limits
-Monitoring receivables and refusing to sell additional products to customers who do not pay their current balances in a reasonable amount of time
Target Example
They sold their Credit portfolio to Toronto Dominion Bank – they will now have the risk instead of Target
About 6 billion

Why do this? Isolates this risk to a company who is better suited to handle this

Target also got 6 billion right away, vs. waiting a few years for the people to pay back their debt to target

Recording Bad Debt Expense Estimate
Decrease net income

Bad Debt expense 75, 995
Allowance for doubtful accounts 75,995 (contra-asset account)

Bad debt expense is normally classified
as a selling expense and is closed at year end
Contra-asset Account example

*Amount that varies over time

Gross PPE 1,000,000
Accumulated depreciation (+XA, -A) 100,000
Net PPE 900,000 (what the total assets is affected by)

Gross Accounts receivable Recorded 1,000,000
Allowance for doubtful accounts (+XA, -A) 100,000
Net accounts receivable 900,000

Debt expense
Take in as an expense,
decrease net income
decrease gross accounts receivable
Writing Off Specific Uncollectible Accounts
When it is clear that a specfic customer’s account receieveable will be uncollectable, the amount should be removed from the accounts reeceievable account and charged to the allowance for doubtful accounts
Decker’s total write-off’s for 2011 were $68,075
Bad debt expense
Allowance for doubtful accounts 75,995 (contra-asset)

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