Accounts receivable
And now for something completely different...Accounts Receivable:
When you sell on account, you debit accounts receivable and credit sales. When you get paid, you debit cash and credit accounts receivable.
But, what if you don’t get paid? After exhausting all your collection efforts (“The number you have reached is no longer in service, and there is no new number!”), you no longer have an asset that is expected to provide future benefit, and therefore has no value. To put it simply, you need to write-off (or charge-off, or eliminate the value of) the account receivable. One way is to simply debit bad-debt expense, and credit accounts receivable for the amount owed. That approach is known as the direct method of accounting for uncollectible accounts, and it violates both the revenue recognition rules and the matching rules. If your sale is recorded in one fiscal period, and the write-off is recorded in the next period, then net income is overstated in the first period and understated in the next period. Somehow, we need to match the bad debts to the credit sales, and hence the need to estimate bad debts and establish an allowance for bad debts as a contra account to accounts receivable.
(A short note: I use the term “bad debt”, whereas Needles uses “uncollectible accounts”. The terms refer to the same thing; money owed you that you don’t ever expect to get.)
Under the allowance method, when you write off the bad debt, you debit the allowance for bad debts, and credit accounts receivable. At fiscal period end, as part of the adjustment process, bad debt expense is recorded for an estimated amount as follows:
Debit Bad Debt Expense (estimated amount)
Credit Allowance for Bad Debts (estimated amount)
Then, as bad debts are incurred, the allowance is debited for the actual write-off amount.
Debit Allowance for Bad Debts (actual amount)
Credit Accounts Receivable (actual amount)
Under GAAP, there are two methods to estimate bad debt expense. The first approach focuses on the income statement and is called the Percent of Sales Method. Using this approach, Bad Debt Expense equals Net Sales multiplied by a percentage of estimated uncollectible accounts. For instance, if sales in a period total $1 million, and, based on past experience, current economic conditions, and the company’s present credit policies, management believes that an estimate of uncollectibility of 1.5% of sales is appropriate, then the adjustment transaction is:
Debit Bad Debt Expense $15,000
Credit Allowance for Bad Debts $15,000
The Percent of Sales method ignores the beginning balance in the allowance account in determining bad debt expense. Instead, the focus of the analysis is on the amount of sales that are anticipated to be uncollected.
The other method of estimating bad debt expense is called the Accounts Receivable Aging Method, and focuses on the quality of assets, not the volume of sales. Using this approach, management analyzes the individual assets comprising the total accounts receivable, and determines a dollar amount of assets deemed to be uncollectible. Then, using the adjustment transaction, the balance of the Allowance for Bad Debts is adjusted to equal the estimate of uncollectible accounts. For example, let’s assume a credit balance in the allowance of $2,000, prior to the adjustment. Management ages the accounts and determines that $15,000 will probably not be collected. The adjustment transaction is as follows:
Debit Bad Debt Expense $13,000
Credit Allowance for Bad Debts $13,000
If, on the other hand, we assume a debit balance in the allowance of $2,000, meaning that more accounts had been written off in a prior fiscal period than had been anticipated, the adjustment transaction is as follows:
Debit Bad Debt Expense $17,000
Credit Allowance for Bad Debts $17,000
Using the Aging Method, again, the allowance is credited to reflect a balance equal to management’s estimated of bad debts. The focus is on asset quality, not bad debt expense. No, the Aging Method is not designed to make you feel old. And, unlike the FIFO/LIFO controversy, the two methods are not mutually exclusive. The Percent of Sales Method is “quick and dirty”, and appropriate for interim reporting or when a company has relatively a large number of accounts, none of which represent a significant amount of the total. The Aging Method requires an in-depth analysis of the asset quality, and may be more appropriate for year-end reporting, or when a company has relatively few accounts in relationship to the total accounts receivable.
Hang in there people, we’re almost done for the quarter!
Clifford