College Accounting, by Heintz and Parry

Chapter 16:

Accounting for

Accounts Receivable

Eddie called “Diss Jockey” Dan Miller in late January to ask him about a $137 bill that was 60 days overdue. The number was disconnected, and further efforts to contact him only uncovered the information that he had moved out of town and left no forwarding address. The store had been “dissed” by the “Diss Jockey.” Eddie was “diss”-gusted by the whole event, but it led to an important discussion between Nick and Eddie about how to account for bad debts (also known as uncollectible accounts): people or companies who aren’t going to pay what they owe you. Eddie told Nick, “Since we made no adjusting entry at the end of 2000, we should probably just use the direct write-off method during this year.” In response, Nick had this . . .

Question: What accounts would get debited and credited when we find out about an uncollectible account under this method?

Eddie told him, “The credit is to accounts receivable, because that asset is no longer worth anything. The debit is to bad debt expense, because we lose money when this happens.”

Date Description P. R. Debit Credit 2001 Jan. 22 Bad Debt Expense 137.00 Accounts Receivable-Dan Miller 137.00

Nick asked, “What if the bum has an attack of conscience later on and sends us the money?”

“No problem. We would just make the write-off entry in reverse to put him back onto our books, and then we’ll make the normal entry for a collection on account. Here is what it would look like.”

Date Description P. R. Debit Credit 2001 Feb. 26 Accounts Receivable-Dan Miller 137.00 Bad Debt Expense 137.00

26 Cash 137.00 Accounts Receivable-Dan Miller 137.00

“Of course, at the end of this year I think we should switch to the allowance method.”

Nick was perplexed. “What? Do you want me to give them three dollars a week if they do chores around my house and pay their bills on time?”

“No, it’s not that kind of an allowance, Nick. At the end of the year we make an allowance for the fact that we’re not likely to get all of the money people owe us. It’s an adjusting entry with a credit to Allowance for Doubtful Accounts, a contra asset. We subtract it from Accounts Receivable on our Balance Sheet to get the net realizable value of our receivables. That’s the amount we actually expect to collect. Here is a sample of the adjusting entry.” Date Description P. R. Debit Credit Adjusting Entry 2001 Dec. 31 Bad Debt Expense XXX.00 Allowance for Bad Debts XXX.00

“Accounts Receivable on the balance sheet would look something like this.” The CD Side of Town

Balance Sheet For Year Ended Dec. 31, 2001 Cash 8,133Accounts Receivable 12,200Less Allow. For Bad Debts 450 11,750

Nick asked, “Does the entry to write people off change under the allowance method?”

“Good question,” responded Eddie (Eddie loved feeling like an expert). “When you write someone off, your debit would now be to the allowance account, because your allowance account is for non-payers who have not been identified, and this non-payer has now been identified. Under the allowance method, our entry for Dan Miller would look like this.”

Date Description P. R. Debit Credit 2001 Jan. 22 Allowance for Bad Debts 137.00 Accounts Receivable-Dan Miller 137.00

Nick asked, “What about the entries we make if Dan sends the money later? Do those change?”

“Yes, in a similar way. The credit to bad debt expense would be replaced with a credit to allowance for bad debts.”

Date Description P. R. Debit Credit 2001 Feb. 26 Accounts Receivable-Dan Miller 137.00 Allowance for Bad Debts 137.00

26 Cash 137.00 Accounts Receivable-Dan Miller 137.00

“Okay, let’s go back to the adjusting entry. How do we figure out how much money we won’t receive? If we knew how much it was, wouldn’t we have written those accounts off already?”

“Most companies use one of two methods to guess how much they won’t collect. One is the percentage of sales method, where you multiply sales times a percentage that’s normally based on your past history of write-offs. Here’s an example.”

Sales $400,000 Estimated Uncollectible Percentage X 0.5% Adjusting Entry Amount $ 2,000

Eddie added, “This is the easier of the two methods.”

Date Description P. R. Debit Credit Adjusting Entry 2001 Dec. 31 Bad Debt Expense 2000.00 Allowance for Bad Debts 2000.00

“However, the percentage of receivables method may be more accurate, especially with an aging of receivables. Your entry is for a percentage of your accounts receivable. Aging the receivables means that you categorize your receivables by how long you’ve been owed, and use higher percentages of uncollectibility for older receivables. Here is an example.”Age of $ Amount of Estimated % Estimated $Receivables Receivables Uncollectible Uncollectiblenot yet due $8,000 X 1% = $801-30 days late 3,000 X 2.5% = 7531-60 days late 1,000 X 6% = 6061-90 days late 400 X 8% = 32>90 days late 600 X 35% = 210 Total estimated uncollectibles $457 Date Description P. R. Debit Credit Adjusting Entry 2001 Dec. 31 Bad Debt Expense 457.00 Allowance for Bad Debts 457.00

“Of course, there’s one complication with the percentage of receivables method. After this year, we will have to alter our adjustment based on the balance that is already in the Allowance for Doubtful Accounts, because our write-offs this year are unlikely to be exactly equal to the allowance amount we put in last year. For example, if our allowance was $457 at Dec. 31, 2001 but we only wrote off $300 in 2002, we’d have a $157 credit balance at Dec. 31, 2002. That means that if we estimated $527 in uncollectibles, we’d calculate our entry like this.”

Estimated Uncollectible Accounts $527 Existing Allowance Account Balance - 157 Adjusting Entry Amount $370

Date Description P. R. Debit Credit Adjusting Entry 2001 Dec. 31 Bad Debt Expense 370.00 Allowance for Bad Debts 370.00

“Sometimes, of course, we will write off more than the balance in the Allowance for Doubtful Accounts. For example, if our allowance was $457 at Dec. 31, 2001 but we wrote off $600 in 2002, we’d have a $143 debit balance at Dec. 31, 2002. That means that if we estimated $527 in uncollectibles, we’d calculate our entry like this.”

Estimated Uncollectible Accounts $527 Existing Allowance Account Balance +143 Adjusting Entry Amount $670

“Don’t forget: subtract a credit balance, add a debit balance.”

Date Description P. R. Debit Credit Adjusting Entry 2001 Dec. 31 Bad Debt Expense 670.00 Allowance for Bad Debts 670.00

“Based on what you’ve told me,” Nick concluded, “I want to use the allowance method next year. I also think we should age our receivables to come up with an adjusting entry.”

“Nick, I agree with you. In fact, the direct write-off method is generally not acceptable for financial reporting purposes. We will have to use it for taxes, though.”

“It’s settled, then. Any tips on how I can keep the entries straight using the allowance method?”

“Yes, I try to always keep two things in mind:

1) don’t touch the Bad Debt Expense account until December 31, when we adjust it and close it, and

2) when reinstating a customer who paid after being written off, just reverse the write-off entry and then make the standard entry to collect an account receivable.”