Chapter 8 Accounts receivable and further record-keeping

Discussion questions

At the end of the financial year, companies estimate the percentage of accounts receivable that
they do not believe are likely to be collected (doubtful debts); these are normally recorded as
‘DR bad debts’ or ‘CR allowance’ for doubtful debts. Sometimes an organization finds out that
an account is definitely a bad debt (i.e. it will not be collected). As the expense has already been
recognized, this amount is then written out of the accounts receivable balance (‘DR Allowance
for Doubtful Debts CR Accounts receivable’).

Accounts receivable need to be recorded at net realizable value. The allowance for doubtful
debts is an estimate of the amount of the accounts receivable that are likely not to be collected. It
is deducted from gross accounts receivable to get net accounts receivable. This figure is shown
on the face of the balance sheet.

The income statement approach calculates the balance of the bad debts expense account. The
income statement approach relies on the historical relationship (or an estimate of the current
relationship) between credit sales and the amount of those sales unlikely to be collected. For
example, past experience might suggest that bad debts are about 1.5 per cent of net credit sales
each year. This percentage is then multiplied by net credit sales to estimate the bad debts
expense. Once the bad debts expense is calculated the following journal entry would be created:
DR Bad debts expense (1.5% of net credit sales)
CR Allowance for doubtful debts (1.5% of net credit sales)

The balance sheet approach calculates the balance of the allowance for doubtful debts account.
The balance sheet approach is based on the belief that the older the account receivable, the
greater the probability that the amount will not be collected. The important step to remember in
this approach is that the allowance for doubtful debts is a balance sheet account and will have an
opening balance that will need to be considered in the determination of the amount of the journal
entry. The amount of the increase required to move the allowance for doubtful debts to the
calculated amount will be the bad debts expense for the period. For example, the allowance for
doubtful debts, calculated based on the aging of account receivable and the probability of
collection, is to be $2 900. The opening balance of the allowance for doubtful debts is $2 500,
therefore the allowance needs to increase by $400 and the journal entry would be:
DR Bad debts expense 400
 CR Allowance for doubtful debts 400

Problem
PROBLEM 8.4
Calculate bad debt expense and allowance for doubtful debts
Windjammer Technologies Ltd has been having difficulty collecting its accounts receivable. For
the year 2019, the company increased the allowance for doubtful accounts by $53 000, bringing
the balance to $74 000. At the end of 2019, accounts receivable equaled $425 000. When the
year-end audit was being done, it was decided to provide a further $45 000 of accounts
receivable that were doubtful and write off $30 000 of accounts receivable previously deemed
doubtful.
Calculate the following:
1. bad debts expense for 2019
2. allowance for doubtful debts at the end of 2019
3. estimated collectable value of accounts receivable at the end of 2019.

PROBLEM 8.7
Doubtful debts
On 1 July 2018, Morton Limited had accounts receivable of $53 000 and an allowance for
doubtful debts of $3100. During the year ended 30 June 2019, credit sales amounted to $432 500
and cash collected from customers was $417 400. At the end of the financial year, the credit
manager decided that accounts totalling $1200 should be written off as bad debts and the
allowance for doubtful debts increased to $4200.
1. What was the estimated collectable value of accounts receivable as at 30 June 2019?
2. What was the amount of the bad debts expense for the year ended 30 June 2019?
3. What are the main reasons for using the allowance method of accounting for bad debts
rather than the direct write-off method?