5.2 Review Assignment: Bad Debts

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Accounting for Receivables

Chapter 9

Wild and Shaw

Fundamental Accounting Principles

24th Edition

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Valuing Accounts Receivable

A receivable is an amount due from another party.

A company must also maintain a separate account for each customer that tracks how much that customer purchases, has already paid, and still owes.

This graph shows recent dollar amounts of receivables and their percent of total assets for four well-known companies.

Learning Objective C1: Describe accounts receivable and how they occur and are recorded.

Exhibit 9.1

A receivable is an amount due from another party. The two most common receivables are accounts receivable and notes receivable. Other receivables include interest receivable, rent receivable, tax refund receivable, and receivables from employees.

Accounts receivable are amounts due from customers for credit sales.

The graph on this slide shows recent dollar amounts of receivables and their percent of total assets for four well-known companies.

Credit sales are recorded by increasing (debiting) Accounts Receivable. A company must maintains a separate account for each customer that tracks how much that customer purchases, has already paid, and still owes.

The general ledger has a single Accounts Receivable account (called a control account). A supplementary record has a separate account for each customer called the accounts receivable ledger (or accounts receivable subsidiary ledger).

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Sales on Credit

On July 1, TechCom had a credit sale of $950 to CompStore and a collection of $720 from RDA Electronics from a prior credit sale.

Learning Objective C1: Describe accounts receivable and how they occur and are recorded.

To see how accounts receivable from credit sales are recognized in the accounting records, we look at two transactions on July 1 between TechCom and its credit customer.

The first is a credit sale of $950 to CompStore.

The second transaction is a collection of $720 from RDA Electronics from a prior credit sale.

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Sales on Credit: Accounts Receivable Ledger

Learning Objective C1: Describe accounts receivable and how they occur and are recorded.

Exhibit 9.4

This slide shows the general ledger and the accounts receivable ledger after recording the two July 1 transactions. The general ledger shows the effects of the sale, the collection, and the resulting balance of $3,230. These transactions are also shown in the individual customer accounts: RDA Electronics balance is $280, and CompStore’s ending balance is $2,950. The $3,230 total of customer accounts equals the balance of the Accounts Receivable account in the general ledger.

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Direct Write-Off Method

There are two methods of accounting for bad debts:

Direct Write-Off Method

Allowance Method

Some customers may not pay their account. Uncollectible amounts are referred to as bad debts.

Learning Objective P1: Apply the direct write-off method to accounts receivable.

When a company directly grants credit to customers, it expects some customers to not pay what they promised. The accounts of these customers are uncollectible accounts, commonly called bad debts. The total of uncollectible accounts is an expense of selling on credit. Why do companies sell on credit if they expect some accounts to be uncollectible? The answer is that companies believe that granting credit will increase total sales and net income enough to offset bad debts. Companies use two methods to account for uncollectible accounts: (1) direct write-off method and (2) allowance method.

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Direct Write-Off Method - Recording and Writing Off Bad Debts

TechCom determines on January 23 that it cannot collect $520 owed to it by its customer J. Kent.

Notice that the specific customer is noted in the transaction so we can make the proper entry in the customer’s Accounts Receivable subsidiary ledger.

Learning Objective P1: Apply the direct write-off method to accounts receivable.

The direct write-off method records the loss from an uncollectible account receivable when it is determined to be uncollectible. No attempt is made to predict bad debts expense.

If TechCom determines on January 23 that it cannot collect $520 owed to it by its customer J. Kent, it records the loss using the direct write-off method as shown in this slide.

The debit in this entry charges the uncollectible amount directly to the current period’s Bad Debts Expense account. The credit removes its balance from the Accounts Receivable account in the general ledger (and its subsidiary ledger).

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Direct Write-Off Method – Recovering a Bad Debt

On March 11, J. Kent was able to make full payment to TechCom for the amount previously written-off.

Learning Objective P1: Apply the direct write-off method to accounts receivable.

Sometimes an account written off is later collected. If the account of J. Kent that was written off directly to Bad Debts Expense is later collected in full, the two journal entries in this slide record this recovery.

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Assessing the Direct Write-off Method

The direct write-off method usually does not best match sales and expenses.

Expense recognition principle requires expenses to be reported in the same accounting period as the sales they helped produce.

Materiality constraint permits direct write-off method if results are similar to allowance method.

Learning Objective P1: Apply the direct write-off method to accounts receivable.

Companies weigh at least two concepts when considering use of the direct write-off method.

Expense recognition requires expenses be reported in the same period as the sales they helped produce. The direct write-off method usually does not best match sales and expenses because bad debts expense is not recorded until an account becomes uncollectible, which often occurs in a period after the credit sale.

The materiality constraint permits use of the direct write-off method when its results are similar to using the allowance method.

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Allowance Method

Two advantages to the allowance method:

It records estimated bad debts expense in the period when the related sales are recorded.

It reports accounts receivable on the balance sheet at the estimated amount of cash to be collected.

At the end of each period, estimate total bad debts expected to be realized from that period’s sales.

Learning Objective P2: Apply the allowance method to accounts receivable.

The allowance method for bad debts matches the estimated loss from uncollectible accounts receivable against the sales they helped produce. We use estimated losses because when sales occur, sellers do not know which customers will not pay. This means that at the end of each period, the allowance method requires an estimate of the total bad debts expected from that period’s sales. This method has two advantages over the direct write-off method:

it records estimated bad debts expense in the period when the related sales are recorded and

it reports accounts receivable on the balance sheet at the estimated amount to be collected.

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Allowance Method - Recording Bad Debts Expense

TechCom had credit sales of $300,000 during its first year of operations. At the end of the first year, $20,000 of credit sales remained uncollected. Based on the experience of similar businesses, TechCom estimated that $1,500 of its accounts receivable would be uncollectible.

Learning Objective P2: Apply the allowance method to accounts receivable.

The allowance method estimates bad debts expense at the end of each accounting period and records it with an adjusting entry. TechCom, had credit sales of $300,000 during its first year of operations. At the end of the first year, $20,000 of credit sales remained uncollected. Based on the experience of similar businesses, TechCom estimated that $1,500 of its accounts receivable would be uncollectible and made the adjusting entry shown in this slide.

The estimated bad debts expense of $1,500 is reported on the income statement (as either a selling expense or an administrative expense). The Allowance for Doubtful Accounts is a contra asset account. A contra account is used instead of reducing accounts receivable directly because at the time of the adjusting entry, the company does not know which customers will not pay. After the bad debts adjusting entry is posted, TechCom’s account balances for Accounts Receivable and its Allowance for Doubtful Accounts are as shown at the bottom of this slide.

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Balance Sheet Presentation

Learning Objective P2: Apply the allowance method to accounts receivable.

The Allowance for Doubtful Accounts credit balance of $1,500 has the effect of reducing accounts receivable to its realizable value. Although credit customers owe $20,000 to TechCom, only $18,500 is expected to be realized in cash collections from these customers. (TechCom continues to bill its customers a total of $20,000). In the balance sheet, the Allowance for Doubtful Accounts is subtracted from Accounts Receivable and is often reported as shown here.

Sometimes the Allowance for Doubtful Accounts is not reported separately in the Balance Sheet where Accounts receivable is to be reported by its realized value (net of the doubtful account balance).

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Allowance Method – Writing Off a Bad Debt

TechCom has determined that J. Kent’s $520 account is uncollectible.

Learning Objective P2: Apply the allowance method to accounts receivable.

When specific accounts become uncollectible, they are written off against the Allowance for Doubtful Accounts.

TechCom decides that J. Kent’s $520 account is uncollectible and makes the above entry to write it off.

This entry removes $520 from the Accounts Receivable account (and the subsidiary ledger). The general ledger accounts now appear as shown (assuming no other transactions affecting these accounts).

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Writing Off a Bad Debt

The write-off does not affect the realizable value of accounts receivable.

Exhibit 9.5

Learning Objective P2: Apply the allowance method to accounts receivable.

The write-off does not affect the realizable value of accounts receivable as shown in this slide. Neither total assets nor net income is affected by the write-off of a specific account. Instead, both assets and net income are affected in the period when bad debts expense is predicted and recorded with an adjusting entry.

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Allowance Method - Recovering a Bad Debt

On March 11, Kent pays in full his $520 account previously written off.

To help restore credit standing, a customer sometimes pays all or part of the amount owed on an account even after it has been written off.

Learning Objective P2: Apply the allowance method to accounts receivable.

If an account that was written off is later collected, two entries are made. The first is to reverse the write-off and reinstate the customer’s account. The second is to record the collection of the reinstated account as illustrated here.

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Estimating Bad Debts Expense

Two Methods

Percent of Sales Method

Accounts Receivable Methods

Percent of Accounts Receivable

Aging of Accounts Receivable

Learning Objective P3: Estimate uncollectibles based on sales and accounts receivable.

Bad debts expense is estimated under the allowance method. There are two common methods. One is based on the income statement relation between bad debts expense and sales. The second is based on the balance sheet relation between accounts receivable and the allowance for doubtful accounts.

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Percent of Sales Method

Bad debts expense is computed as follows:

Learning Objective P3: Estimate uncollectibles based on sales and accounts receivable.

The percent of sales method, also called the income statement method, assumes that a percent of credit sales for the period is uncollectible.

When using the Percent of Sales Method, the estimate at the end of the period is determined by taking current period sales and multiplying by an established bad debt percentage. The bad debt percentage is determined based on past history of the company and current economic trends. Also, the sales transactions included in this computation are typically only the credit sales. There are no collection issues to consider for cash sales transactions.

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Musicland’s accountant computes estimated Bad Debts Expense of $2,400.

Percent of Sales Method: Example

Musicland has credit sales of $400,000 in 2017. It is estimated that 0.6% of credit sales will eventually prove uncollectible.

Let’s look at recording Bad Debts Expense for 2017.

Learning Objective P3: Estimate uncollectibles based on sales and accounts receivable.

The percent of sales method, also referred to as the income statement method, is based on the idea that a given percent of a company’s credit sales for the period is uncollectible. To illustrate, assume that Musicland has credit sales of $400,000 in year 2016. Based on past experience, Musicland estimates 0.6% of credit sales to be uncollectible. This implies that Musicland expects $2,400 of bad debts expense from its sales (computed as $400,000 x 0.006). The adjusting entry to record this estimated expense is shown here.

The allowance account ending balance on the balance sheet for this method would rarely equal the bad debts expense on the income statement. This is because unless a company is in its first period of operations, its allowance account has a zero balance only if the prior amounts written off as uncollectible exactly equal the prior estimated bad debts expenses. (When computing bad debts expense as a percent of sales, managers monitor and adjust the percent so it is not too high or too low.)

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Percent of Receivables Method

Compute the estimate of the Allowance for Doubtful Accounts.

Year-end Accounts Receivable x Bad Debt % Bad Debts Expense is computed as:

Total Estimated Bad Debts Expense
– Previous Balance in Allowance Account
= Current Bad Debts Expense

Learning Objective P3: Estimate uncollectibles based on sales and accounts receivable.

The percent of accounts receivable method, also called a balance sheet method, assumes that a percent of a company’s receivables is uncollectible. This percent is based on experience and economic trends. Total receivables is multiplied by this percent to get the estimated uncollectible amount as reported in the balance sheet as Allowance for Doubtful Accounts.

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Musicland has $50,000 in accounts receivable and $200 credit balance in Allowance for Doubtful Accounts. 5% of receivables are uncollectible. $50,000 x 5% = $2,500 ending balance.

Percent of Receivables Method: Example

Exhibit 9.7

Learning Objective P3: Estimate uncollectibles based on sales and accounts receivable.

Musicland has $50,000 of accounts receivable on December 31, 2019. 5% of its receivables is estimated to be uncollectible. This means that after the adjusting entry is posted, we want the Allowance for Doubtful Accounts to show a $2,500 credit balance (5% of $50,000). Musicland’s beginning balance is $2,200 on December 31, 2018.

During 2019, accounts of customers are written off on July 10 and November 20. Thus, the account has a $200 credit balance before the December 31, 2019, adjustment. The adjusting entry of $2,300 will give the allowance account the estimated $2,500 balance is shown on this slide.

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Each age group is multiplied by its estimated bad debts percentage.

Estimated bad debts for each group are totaled.

Aging of Receivables Method

Classify each receivable by how long it is past due.

Learning Objective P3: Estimate uncollectibles based on sales and accounts receivable.

The aging of accounts receivable method, also called a balances sheet method, uses both past and current receivables information to estimate the allowance amount.

Each receivable is classified by how long it is past its due date. Then estimates of uncollectible amounts are made assuming that the longer an amount is past due, the more likely it is to be uncollectible.. After the amounts are classified (or aged), experience is used to estimate the percent of each uncollectible class. These percents are applied to the amounts in each class and then totaled to get the estimated balance of the Allowance for Doubtful Accounts.

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Aging of Accounts Receivable: Musicland

Exhibit9.8

Learning Objective P3: Estimate uncollectibles based on sales and accounts receivable.

This aging of accounts lists each customer’s individual balances assigned to one of five classes based on its days past due. The amounts in each class are totaled and multiplied by the estimated percent of uncollectible accounts for each class. The percents used are regularly reviewed to reflect changes in the company and economy.

Musicland has $3,700 in accounts receivable that are 31 to 60 days past due. Its management estimates 10% of the amounts in this age class are uncollectible, or a total of $370 ($3,700 x 10%). Similar analysis is done for each of the other four classes. The final total of $2,270 ($740 + $325 + 370 + $475 + $360) shown in the first column is the estimated balance for the Allowance for Doubtful Accounts.

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Step 1: Determine current balance: $200 credit.

Step 2: Determine what the account balance should be: $2,270.

Step 3: Make adjusting entry to get from step 1 to step 2: $2,270 - 200 = $2,070.

Aging of Accounts Receivable: Adjusting Entry with Credit Balance

Learning Objective P3: Estimate uncollectibles based on sales and accounts receivable.

Notice that the allowance account has an unadjusted credit balance of $200, the required adjustment to the Allowance for Doubtful Accounts is $2,070. (We could also use a T-account for this analysis as shown in the slide.) This yields the following end-of-period adjusting entry shown above.

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Step 1: Determine what current balance equals: $500 debit.

Step 2: Determine what the account balance should be: $2,270.

Step 3: Make adjusting entry to get from step 1 to step 2: $2,270 + 500 = $2,770.

Aging of Accounts Receivable: Adjusting Entry with Debit Balance

Learning Objective P3: Estimate uncollectibles based on sales and accounts receivable.

Notice that if the allowance account has an unadjusted debit balance of $500, the required adjustment to the Allowance for Doubtful Accounts is $2,770 because we need to add the $500 debit balance to the desired ending balance. (We can use a T-account for this analysis as shown in the slide.) This yields the following end-of-period adjusting entry of $2,770 as shown on this slide.

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Summary of Methods

Exhibit 9.10

Learning Objective P3: Estimate uncollectibles based on sales and accounts receivable.

This diagram summarizes the three estimation methods and their focus of analysis.

The aging of accounts receivable method focuses on specific accounts and is usually the most reliable of the estimation methods.

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End of Chapter 9

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Sheet1


		Current Period Sales
	×	Bad Debt %
	=	Estimated Bad Debts Expense

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Sheet1


		$ 400,000
	×	0.6%
	=	$ 2,400

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Sheet1

	Allowance for Doubtful Accounts
		200
		2,070
		2,270
		30,000

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Sheet1

	Allowance for Doubtful Accounts
	500
		2,770
		2,270
		30,000

Page &P