Accounting for Bad Debts

and Receivables
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.
Valuing Accounts Receivable

Some customers may not pay their account.

Uncollectible amounts are referred to as bad debts.

There are two methods of Bad debts

accounting for bad debts:
Direct Write-Off Method
Allowance Method
Allowance for Doubtful debts
Direct Write-Off Method
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.
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.
 Direct Write-Off Method
• Used when a company cannot reasonably estimate bad debt expense
• Uncollectible accounts are directly written off to current year’s bad debt
expense
• The year sale was made does not matter
• Allowance for doubtful accounts is not used
Example: T. DeStadio’s account balance of $400 is deemed to be uncollectible
on May 15, 20X7.
Page 8
Date Account Titles and Description PR Dr. Cr.
20X7
May 15 Bad Debts Expense 400
Accounts Receivable, T DeStadio 400
Wrote off account
Matching vs. Materiality

The matching
Materiality states that
(expense recognition)
an amount can be
principle requires
ignored if its effect on
expenses to be
the financial
reported in the same
statements is
accounting period as
unimportant to users’
the sales they helped
business decisions.
produce.

The direct write-off method usually does not best

match sales and expenses.
 Two Methods
Summary of Methods
1. Percent of Sales Method
:Estimating Bad Debts 2. Accounts Receivable Methods
Expense Percent of Accounts Receivable
Aging of Accounts Receivable
 The Allowance Method of
Accounting for Bad Debts
▪ The purpose of the adjusting entry is to increase Bad Debts Expense
by the amount of the estimated loss and to produce a collectible figure
for the book value of Accounts Receivable.
▪ Allowance for Doubtful Accounts is classified as a deduction from
Accounts Receivable; it is a contra account.
▪ Bad Debts Expense appears on the income statement as an
operating expense.
▪ If a firm subdivides operating expenses into selling expenses and
general expenses, then they list Bad Debts Expense as a general
expense.
Aging of Accounts Receivable
Pivotal Issues When Managing Cash and Receivables

1. Cash needs
2. Credit policies
3. Level of accounts receivable
4. Financing receivables
5. Ethical estimates on credit sale losses
Percent of Sales Method

Bad debts expense is computed as follows:

Current Period Sales
× Bad Debt %
= Estimated Bad Debts Expense
 The Allowance Method of
Accounting for Bad Debts

On December 31, ExTone Company estimates that a total of $40,000 of the $1,000,000
balance in her company’s Accounts Receivable will eventually be uncollectible.

Dec. 31 Bad Debt Expense 40 000 00

Allowance for Doubtful Accounts 40 000 00
Uncollectible accounts
estimate.
13
On January 21, John Parker’s account totaling $6,000 is
written off because it is uncollectible.

Jan. 21 Allowance for Doubtful Accounts 6 000 00

Accounts Receivable—John Parker 6 000 00
To write off the uncollectible
account.

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Collecting a Written-Off Account
John Parker’s account of $6,000 which was written off on Jan 21is later
collected on June 10. Two entries are needed: one to reinstate John Parker’s
account and a second to record receipt of the cash.

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 Entry 1: Reinstate the account.

June 10 Accounts Receivable—John Parker 6 000 00

Allowance for Doubtful Accounts 6 000 00
To reinstate the account
written off on Jan. 21.

Entry 2: Record collection of cash.

June 10 Cash 6 000 00

Accounts Receivable—John Parker 6 000 00
Collection of written-off
account.

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 Estimate Based on Analysis of Receivables

If, based on analysis of receivables, it is estimated that $3,390 of the

receivables will be uncollectible and the Allowance for Uncollectible
Accounts currently has a balance of $510, the Bad Debt Expense must be
debited for $2,880 ($3,390 – $510).

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Estimate Based on Analysis of Receivables

Aug. 31 Bad Debt Expense 2 880 00

Allowance for Doubtful Accounts 2 880 00
Uncollectible accounts
($3,390 – $510).

BAD DEBT EXPENSE

Aug. 31 Adj. entry 2,880
Aug. 31 Adj. bal. 2,880

ALLOWANCE FOR DOUBTFUL ACCOUNTS

Aug. 31 Unadj. bal. 510
Aug. 31 Adj. entry 2,880
Aug. 31 Adj. bal. 3,390

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 If the unadjusted balance of Allowance
for Uncollectible Accounts had been a
debit balance of $300, the amount of the
adjustment would have been $3,690
($3,390 + $300).

BAD DEBT EXPENSE

Aug. 31 Adj. entry 3,690
Aug. 31 Adj. bal. 3,690

ALLOWANCE FOR DOUBTFUL ACCOUNTS

Aug. 31 Unadj. bal. 300 Aug. 31 Adj. entry 3,690
Aug. 31 Adj. bal. 3,390

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 The Allowance Method of
Accounting for Bad Debts

Three ways can be used to estimate the amount of bad debts expense:
1. Based on the aging of Accounts Receivable
2. Based on a percentage of Accounts Receivable
3. Based on a percentage of net sales or net credit sales
Allowance Method

At the end of each period, estimate total bad debts expected to

be realized from that period’s sales.

Two advantages to the allowance method:

1. It records estimated bad debts expense in the period when the related
sales are recorded.
2. It reports accounts receivable on the balance sheet at the estimated
amount of cash to be collected.
Recording Bad Debts Expenses: Allowance Method
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.
Balance Sheet Presentation
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.
Recovering a Bad Debt
To help restore credit standing, a customer sometimes volunteers
to pay all or part of the amount owed on an account even after it
has been written off.

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

written off.
Writing Off a Bad Debt

The write-off does not affect the realizable value of

accounts receivable.
 Percent of Receivables Method
1. Compute the estimate of the Allowance for Doubtful Accounts.

Year-end Accounts Receivable × Bad Debt %

2. Bad Debts Expense is computed as:

Total Estimated Bad Debts Expense

– Previous Balance in Allowance Account
= Current Bad Debts Expense
 Net Sales
Receivables turnover =
Average receivables 365
Number of days of receivables =
Receivables turnover
Reflects the relative size of a company’s accounts
receivable and the success of its credit and
collection policies
LIQUIDITY RATIOS
Current assets Ability to satisfy current
Current ratio = liabilities using current assets
Current liabilities
Short−term Ability to satisfy current
Cash + + Receivables
Quick ratio = investments liabilities using the most liquid of
Current liabilities current assets. Known as acid
test ratio.

RATIOS INDICATING MANAGEMENT OF CURRENT ASSETS

Net Sales How many times accounts
Receivables turnover = receivable are created and
Average receivables
collected during the period

Cost of goods sold How many times inventory is

Inventory turnover =
Average inventory created and sold during the
period
 Net operating cycle Number of days Number of days Number of days
or = + −
Cash conversion cycle of inventory of receivables of payables

The lower the number the better, a low number compared to peers within an
industry indicates strong cash flow creation from internal operations.
 Advantages of allowing customers to use credit
cards:
Customers’
credit is Sales increase by
evaluated by providing purchase
the credit card options to the customer.
issuer.

The risks of extending credit

are transferred to the credit
Cash collections
card issuer.
are quicker.