BASIC ACCOUNTING

WORKS LEVEL II
Unit of Competence:
Develop Understanding of Debt and
Consumer Credit

By Endale Tizazu
2013E.C
 LEARNING OUTCOMES:
At the end of the course the trainees must be able to:
LO1. Identify and discuss the role of credit in society
LO2 . Identify and discuss the range of credit options
available
Lo3. Identify and discuss costs of using credit
LO4. Analyze and discuss the effective use of consumer
credit
LO5. Manage personal credit rating and history
Key words
Credit :- the ability of a customer to obtain goods or
services before payment, based on the trust that payment
will be made in the future.
Debt :- it refers to an amount of money that is borrowed and
meant to be repaid
Loan:- a thing that is borrowed, especially a sum of money
that is expected to be paid back with interest
 LO1. Identify and discuss the role of credit in society

 The role of consumer credit includes:

 A consumer credit system allows consumers to borrow
money or incur debt, and to defer repayment of that money
over time. Having credit enables consumers to buy goods or
assets without having to pay for them in cash at the time of
purchase.
 Identify the Different Types of Receivables
 The term receivables refers to amounts due from individuals
and companies.
 Receivables are claims that are expected to be collected in
cash.
 Receivables represent one of a company’s most liquid assets.
Receivables are frequently classified as:
 Accounts receivable:
– Are amounts owed by customers on account.
– Result from the sale of goods and services (often called trade
receivables).
– Are expected to be collected within 30 to 60 days.
– Are usually the most significant type of claim held by a company.
 Notes receivable:
– Represent claims for which formal instruments of credit are issued
as evidence of debt.
– Are credit instruments that normally require payment of interest
and extend for time periods of 60-90 days or longer.
– May result from sale of goods and services (often called trade
receivables).
.
 Other receivables:
– Nontrade receivables including interest receivable,
loans to company officers, advances to employees, and
income taxes refundable.
– Generally classified and reported as separate items in
the balance sheet
 Explain how Accounts Receivable are Recognized in
the Accounts
Two accounting problems associated with accounts
receivable are:
A. Recognizing accounts receivable
B. Valuing accounts receivable
A. Recognizing accounts receivable
 Service organizations -A receivable is recorded when
service is provided on account.
– Debit accounts receivable and credit service revenue
 Merchandisers – A receivable is recorded at the point of
sale of merchandise on account.
– Debit accounts receivable and credit sales
– Receivable may be reduced by sales discount and/or sales
return
Advantages and disadvantages of credit may include:
advantages:
 obtain and can use purchased item immediately
 minimizes the need to carry cash or write cheques
 cont.…
 allows for installment payments on expensive items
 convenient form of payment when travelling, especially
overseas
Disadvantages:
 may increase cost of items purchased due to interest
accrued
 usually attracts other fees such as account servicing fees
 can lead to compulsive buying habits
 creates a false sense of wealth
B. Valuing accounts receivable
 Determining the amount of accounts receivable to report is
difficult because some receivables will become
uncollectible.
 This creates bad debt expense – a normal and necessary
risk of doing business on credit.
Two methods are used in accounting for uncollectible
accounts:
1. Direct Write-off Method
2. Allowance Method
1. Direct Write-Off Method
When a specific account is determined to be uncollectible, the loss is
charged to Bad Debt Expense
For example, assume that Warden Co. writes off M. E. Doran’s
$200 balance as uncollectible on December 12. The entry is:
Dec. 12 Bad Debts Expense 200
Accounts Receivable--M. E. Doran 200
(To record write-off of M. E. Doran account)
 Bad debts expense will show only actual losses from
uncollectibles.Bad debts expense is often recorded in a period
different from that in which the revenue was recorded.
 Under this method, no attempt is made to: show accounts
receivable in the balance sheet at the amount actually expected
to be received; and Match bad debts expenses to sales revenue
in the income statement.
 Use of the direct write-off method can reduce the usefulness of
both the income statement and balance sheet.Unless bad debt
losses are insignificant, the direct write-off method is not
2. Allowance Method
– The allowance method of accounting for bad debts
involves estimating uncollectible accounts at the end of
each period.
 It provides better matching of expenses and revenues on
the income statement and ensures that receivables are
stated at their cash (net) realizable value on the balance
sheet.
 Cash (net) realizable value is the net amount of cash
expected to be received. It excludes amounts that the
company estimates it will not collect.
 Receivables are therefore reduced by estimated
uncollectible amounts on the balance sheet through use of
the allowance method.
 Cont...
 The allowance method is required for financial reporting
purposes when bad debts are material.
Three essential features of the allowance method are:
1. Uncollectible accounts receivable are estimated and
matched against revenues in the same accounting period
in which the revenues occurred.
2. Estimated uncollectibles are recorded as an increase to
Bad Debts Expense and an increase to Allowance for
Doubtful Accounts (a contra asset account) through an
adjusting entry at the end of each period.
3. Actual uncollectibles are debited to Allowance for
Doubtful Accounts and credited to Accounts Receivable
at the time the specific account is written off as
uncollectible.
Recording Estimated Uncollectibles
 Allowance for Doubtful Accounts shows the estimated amount of
claims on customers that are expected to become uncollectible in
the future.
 The credit balance in the allowance account will absorb the specific
write-offs when they occur.
 Allowance for Doubtful Accounts is not closed at the end of the
fiscal year.
 Bad Debts Expense is reported in the income statement as an
operating expense (usually a selling expense).
Recording the Write-Off
 Each write-off should be approved in writing by authorized
management personnel.
 Under the allowance method, every bad debt write-off is
debited to the allowance account (not to Bad Debt Expense)
 Cont ...
 A write-off affects only balance sheet accounts. Cash realizable
value in the balance sheet, therefore, remains the same.
Recovery of an Uncollectible
 When a customer pays after the account has been written off, two
entries are required:
(1) The entry made in writing off the account is reversed to
reinstate the customer’s account.
(2) The collection is journalized in the usual manner.
 The recovery of a bad debt, like the write-off of a bad debt, affects
only balance sheet account.
In “real life,” companies must estimate the amount of
expected uncollectible accounts if they use the allowance
method.
 Frequently the allowance is estimated as a percentage of the
receivables.
 Management establishes a percentage relationship between the
amount of receivables and expected losses from uncollectible
accounts.
 A schedule is prepared in which customer balances are classified by
the length of time they have been unpaid.
 Because of its emphasis on time, this schedule is often called an
aging schedule and the analysis of it is often called aging the
accounts receivable.
 After the accounts are arranged by age, the expected bad debt
losses are determined by applying percentages, based on past
experience, to the totals of each category.
 The estimated bad debts represent the existing customer claims
expected to become uncollectible in the future.
 Occasionally the allowance account will have a debit
balance prior to adjustment because write-offs during the
year have exceeded previous provisions for bad debts.
– In such a case, the debit balance is added to the required
balance when the adjusting entry is made.
 Compute the Interest on Notes Receivable
 A promissory note is a written promise to pay a
specified amount of money on demand or at a definite
time.
 In a promissory note, the party making the promise to
pay is called the maker.
 The party to whom payment is to be made is called the
payee. The payee may be specifically identified by name
or may be designated simply as the bearer of the note.
 Notes receivable
 give the holder a stronger legal claim to assets than accounts
receivable.
 are frequently accepted from customers who need to extend the
payment of an outstanding account receivable, and they are
often required from high-risk customers.
 notes receivable, like accounts receivable, can be readily sold to
another party. Promissory notes are negotiable instruments
There are three basic issues in accounting for notes
receivable:
1. Recognizing notes receivable.
2. Valuing notes receivable.
3. Disposing of notes receivable
Computing Interest
The formula for computing interest is:
= Face Value of Note (principle) x Annual Interest Rate x
Time (in terms of one year)
 The interest rate specified on the note is an annual rate of
interest. The time factor in the computation expresses the
fraction of a year that the note is outstanding.
 When the maturity date is stated in days, the time factor is
frequently the number of days divided by 360.
For example, the maturity date of a 60-day note
dated July 17 is determined as follows:
Term of note 60 days
Days in July 31
Date of note 17
Note’s days in July 14
Days in August 31
Plus note’s days in July 14
Notes days to the end of August 45 45
Maturity date, September 15
 When the due date is stated in terms of months, the time
factor is the number of months divided by 12.
Recognizing Notes Receivable
 To illustrate the basic entry for notes receivable, the text
uses Brent Company’s $1,000, two-month, 8% promissory
note dated May 1. Assume that the note was written to
settle an open account. The entry for the receipt of the note
by Wilma Company is as follows:
May 1 Notes Receivable 1,000
Accounts Receivable—Brent Company 1,000
(To record acceptance of Brent Company note)
 The note receivable is recorded at its face value, the value
shown on the face of the note.
 No interest revenue is reported when the note is accepted
because the revenue recognition principle does not
recognize revenue until earned. Interest is earned (accrued)
 If a note is exchanged for cash, the entry is a debit to Notes
Receivable and a credit to Cash in the amount of the note.
Valuing Notes Receivable
 Like accounts receivable, short-term notes receivable are
reported at their cash (net) realizable value.
 The notes receivable allowance account is Allowance for
Doubtful Accounts.
 The computations and estimations are similar to the ones
related to accounts receivable.
Describe the Entries to Record the Disposition of Notes
Receivable
 Notes may be held to their maturity date, at which time the face value
plus accrued interest is due.
 In some situations, the maker of the note defaults, and appropriate
adjustment must be made.
 A note is honored when it is paid in full at maturity.
 A dishonored note is a note that is not paid in full at maturity.
 If the lender expects that it will eventually be able to collect, the
Notes Receivable account is transferred to an Account Receivable for
both the face value of the note and the interest due.
 If there is no hope of collection, the face value of the note should be
written off.
Explain the Statement Presentation of Receivables
 Each of the major types of receivables should be
identified in the balance sheet or in the notes to the
financial statements.
 Short-term receivables are reported in the current asset
section of the balance sheet below short-term
investments. These assets are nearer to cash and are thus
more liquid.
 Both the gross amount of receivables and the allowance
for doubtful accounts should be reported.
 Notes receivable are listed before accounts receivable
because notes are more easily converted to cash.
 Bad Debts Expense is reported under “Selling expenses”