Problem 7.3(Aging Accounts Receivable Write offs),
7.4(Accounting for Uncollectible Accounts)Assignment Questions:
2In this chapter, we will learn what is included in cash, how to
prepare a bank reconciliation, how to report accounts receivable
and account for uncollectible accounts, and how to account for
notes receivable.
Now, lets turn our attention to accounts receivable.Up to this
point in the course, we have unrealistically assumed that we would
collect all of our Accounts Receivable. We all know that in reality
we will not receive payment for some Accounts Receivable.Companies
must account for the fact that some customers may not be able to
pay the amounts they owe. At the end of the period, a company
estimates how much of its accounts receivable will not be
collected. This estimate is based on past collection history and
current economic information. Remember that when we make this
estimate, we do not know specifically WHO will not pay us. If we
knew WHO would not pay us, we would never have sold to them on
credit to begin in the first placeright?
The entry requires a debit to Uncollectible Accounts Expense and
a credit to Allowance for Doubtful Accounts for the estimated
amount. Why cant we just credit Accounts Receivable in this entry?
Remember, we are recording an estimate of uncollectible accounts
and we do not know WHO specifically will not pay us. If we tried to
credit Accounts Receivable, which customers account would we use?
The answer is we would not know which one to use. As a result, we
credit the Allowance for Doubtful Accounts account.
Uncollectible Accounts Expense is classified as a selling
expense on the Income Statement. Allowance for Doubtful Accounts is
a contra-asset account. It has a normal credit balance. It is
reported on the balance sheet as a subtraction from the Accounts
Receivable balance to arrive at the amount of accounts receivable
we actually think we will collect.
4949On the balance sheet, the Allowance for Doubtful Accounts is
subtracted from the Accounts Receivable balance. The reported value
is called net realizable value. It is the amount of Accounts
Receivable that we actually think we will collect.
Now, lets see what happens when we determine that a specific
customer will not be able to pay the amounts owed.
When using the allowance method, we write off an uncollectible
account to Allowance for Doubtful Accounts.
The company would debit Allowance for Doubtful Accounts and
credit Accounts Receivable. Now that we know the specific customer
involved, the customer is noted in the transaction so we can make
the proper entry in the customers Accounts Receivable ledger.
5151Assume that K-Max determines that Jason Clarkss five hundred
dollar account receivable is uncollectible. What entry would K-Max
make?
K-Max would debit Allowance for Doubtful Accounts and credit
Accounts Receivable for five hundred dollars.
5353Now assume that before the write off entry the balance in
Accounts Receivable was ten thousand dollars and the balance in
Allowance for Doubtful Accounts as two thousand five hundred
dollars.
Lets see what effect the write off had on these accounts.
5454After the five hundred dollar write off, the Accounts
Receivable balance is reduced to nine thousand five hundred dollars
and the Allowance for Doubtful Accounts balance is reduced to two
thousand dollars. Notice that the five hundred dollar write-off did
not change the net realizable value nor did it affect any income
statement accounts.
There are two methods to estimate of uncollectible accounts. One
method is the Balance Sheet Approach and the other method is the
Income Statement Approach. Lets look at the Balance Sheet Approach
first.When using the Balance Sheet Approach, first we classify the
Accounts Receivable by age. Second, for each age group we determine
the likelihood of being uncollectible. Third, for each age group we
calculate a separate allowance amount. Then, we add up all the
allowance amounts and that gives us the desired balance in the
Allowance for Doubtful Accounts.
Lets see an example of how the aging of accounts receivable
works. First, we broke East Companys accounts receivable up into
aged categories such as current, 1 to 30 days past due, 31 to 60
days past due, and so on. Then, for each of these age groups, we
determined how much we thought would be uncollectible. So, for the
current age group, one percent is expected to be uncollectible. For
the 1 to 30 days past due age group, three percent is expected to
be uncollectible, and so on. Notice that the older the age group
the higher the uncollectible percentage. Next, we multiplied the
balance of each age group by its uncollectible percentage. Then, we
added all the uncollectible amounts up to one thousand three
hundred fifty dollars. This is the balance we want in the Allowance
for Doubtful Accounts.
Assume East Company already had a five hundred dollar balance in
Allowance for Doubtful Accounts.
So, if we want the balance to be one thousand three hundred
fifty dollars, we only need to credit this account for eight
hundred fifty dollars.
The entry would be debit Uncollectible Accounts Expense and
credit Allowance for Doubtful Accounts for eight hundred fifty
dollars.
Now, lets look at the Income Statement Approach to estimate
credit losses. 6262When using the Income Statement Approach, 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 not any collection issues to consider for cash sales
transactions.
6262The credit loss estimate is calculated as net credit sales
times the estimated uncollectible percentage.6666East Company has
credit sales of sixty thousand dollars in the year two thousand and
five. Management estimates that one percent of credit sales will
eventually prove to be uncollectible. What is East Companys
adjusting entry for uncollectible accounts in two thousand and
five?
6767East Company would debit Uncollectible Accounts Expense and
credit Allowance for Doubtful Accounts for six hundred dollars,
which is one percent of sixty thousand dollars in credit sales.
Sometimes, after an account receivable has been written off, a
customer will send in a payment. If this happens, should the
customers payment be returned since the account has been written
off? Of course not.
When this happens, two entries are necessary. The first entry is
required to reverse the write off and re-establish the account
receivable. This entry includes a debit to Accounts Receivable an a
credit to Allowance for Doubtful Accounts.
The second entry records the receipt of cash with a debit to
Cash and a credit to Accounts Receivable.
Sometimes, after an account receivable has been written off, a
customer will send in a payment. If this happens, should the
customers payment be returned since the account has been written
off? Of course not.
When this happens, two entries are necessary. The first entry is
required to reverse the write off and re-establish the account
receivable. This entry includes a debit to Accounts Receivable an a
credit to Allowance for Doubtful Accounts.
The second entry records the receipt of cash with a debit to
Cash and a credit to Accounts Receivable.
When using the direct write-off method, customers accounts
receivable are written off to Uncollectible Accounts Expense at the
time the company becomes aware that the customer will not be able
to pay the amounts owed.
Under this method, no attempt is made to match revenues with the
uncollectible accounts expense. The Financial Accounting Standards
Board required disclosure of all significant concentrations of
credit risk in the notes to the financial statements.
Concentrations of credit risk are important for users to know so
they can assess the future viability of the company.
