Accounts Receivable and Bad Debts Expense(Quick Test #3 with Coaching)

An aging (also spelled ageing) of accounts receivable is an internal report (not a financial statement) that lists each customer having a balance in a company’s Accounts Receivable account. The amount owed by each customer is then sorted into columns such as current, 1-30 days past due, 31-60 days past due, and so on.

The following image is a condensed example:

Typically, the older the receivable, the more likely it will not be collected in full. Therefore, the aging of accounts receivable is an important tool for helping the company collect the money it is owed.

The aging of accounts receivable is also useful for determining whether the credit balance in the Allowance for Doubtful Accounts is realistic.

The following image shows the calculation of UXL’s net credit sales and its net sales.

Purchases Discounts, Freight In, and Freight Out are not used in the calculation of sales and net sales. Purchases Discounts and Freight In are included in the cost of goods sold. Freight Out is the expense of delivery products to customers.

The balance in Accounts Receivable is the amount of the company’s sales on credit that are not yet collected. The balance in the Allowance for Doubtful Accounts is an estimate of the accounts receivable amounts that will not be collected.

Accounts receivable, net is often a line item in the current asset section of a company’s balance sheet. It represents the combination of the debit balance in Accounts Receivable and the credit balance in the related contra asset account Allowance for Doubtful Accounts. For JBCO the net amount of accounts receivable is $482,000 ($500,000 minus $18,000).

The net realizable value (NRV) of accounts receivable is the amount that is expected to turn to cash, which is also the combination of the debit balance in Accounts Receivable and the credit balance in Allowance for Doubtful Accounts. For JBCO the NRV of accounts receivable is $482,000 ($500,000 minus $18,000).

The accounting profession generally requires that the allowance method be used for the company’s financial statements for the following reasons:

• The balance sheet line-item Accounts receivable – net will report a more realistic amount that will be turning to cash.
• The income statement line-item Bad debts expense will report the losses from credit sales closer to the time when the credit sales were made.

On the other hand, the U.S. income tax rules require that the bad debts expense be claimed only when an account receivable is written off. This prevents companies from arbitrarily claiming bad debts expense before the loss is known with certainty.

Since a U.S. company must comply with both the accounting principles and the income tax regulations, it ends up that:

• The financial statements must use the allowance method, and
• The income tax return must use the direct write-off method.

Below is a summary/review of the allowance method and the direct write-off method:

Summary of Reporting Losses from Sales on Credit

Allowance Method anticipates that some sales on credit and the related accounts receivable will not be collected in full. Rather than waiting until specific receivables are identified, an estimated amount is debited to Bad Debts Expense and is credited to a contra asset account Allowance for Doubtful Accounts. When an account is identified as uncollectible and is written off, the Allowance account is debited and Accounts Receivable is credited.

Methods or approaches used when anticipating the bad debts expense under the allowance method:

• Percentage of sales focuses on the income statement line item bad debts expense, which will be a consistent percentage of net credit sales.
• Percentage of accounts receivable is focused on the balance sheet line-item accounts receivable - net. Under this approach the credit balance in the Allowance for Doubtful Accounts is adjusted so that the balance sheet reports a realistic amount of the receivables that will be turning to cash.

In reality, both the percentage of sales and the percentage of accounts receivable are useful. For example, if the company uses the percentage of sales throughout the year, but the credit balance in the Allowance account is not sufficient at the end of the year, the percentage of accounts receivable will aid in determining the amount of the additional adjustment needed in the Allowance account balance and to the bad debts expense.

Direct Write-off Method does not use the account Allowance for Doubtful Accounts. Under this method, there is no anticipating any bad debts expense. A loss from sales on credit is reported only when a specific account receivable is determined to be uncollectible. At that point, the bad account is removed (written off) from the Accounts Receivable account and the amount is debited to Bad Debts Expense.

The percentage of sales method seeks to have the bad debts expense (reported on the period’s income statement) be a specified percentage of the net credit sales. This amount is debited to the income statement account Bad Debts Expense and credited to the balance sheet account Allowance for Doubtful Accounts.

When the percentage of sales method is used, the previous credit balance in the Allowance account is not relevant/not considered. The reason is that the previous credit balance in the Allowance account pertains to the unpaid credit sales that occurred in earlier months.

In Question 5, the Bad Debts Expense for January is debited for $5,000 (0.005 X $1,000,000 of net credit sales) and the account Allowance for Doubtful Accounts is credited for $5,000.

Cash sales were omitted from the calculation since there is no credit risk with cash sales. Since the $30,000 credit balance in the Allowance account must remain in the Allowance account for the unpaid credit sales made in the previous months, the credit balance in the Allowance account at the end of January will be $35,000 ($30,000 + $5,000 added in January). This is shown in the following image.

The aging of accounts receivable is associated with getting the proper ending balance in the balance sheet account Allowance for Doubtful Accounts. In other words, the company's focus is reporting the correct amount on the balance sheet’s current asset line accounts receivable – net. The amount ending up on the income statement as bad debts expense is not a concern. This approach is referred to as the percentage of accounts receivable method, the balance sheet method, and/or the aging method.

As the following image indicates, the credit balance in the Allowance account prior to the company’s adjusting entries was $40,000. Since JEBCO’s aging of accounts receivable indicates that the credit balance in the Allowance account should be $47,000, JEBCO must:

• Credit the Allowance for Doubtful Accounts for $7,000, and
• Debit Bad Debts Expense for $7,000.

Recap: Under the balance sheet method, the focus is getting the correct ending balance in the Allowance account without regard to the effect on the income statement line-item bad debts expense.

The $4,000 that AXCO had debited to Bad Debts Expense during the 5-month period was 0.002 times the net credit sales. At the time of the sales, AXCO did not know which of its credit customers would not be paying. (If AXCO knew, it would not make the sales.) With the allowance method, AXCO anticipates an estimated amount of its net credit sales that will not be collected.

Since the Allowance account had a $4,000 credit balance on June 30, we assume that none of the receivables had been written off (removed from the Accounts Receivable account).

On July 15, AXCO learned the identity of a specific customer that will not pay the $2,100 that it owes to AXCO from April transactions. Since the specific customer and the amount owed are known, AXCO must remove the customer’s balance from its Accounts Receivable account. This is done with a credit of $2,100 to Accounts Receivable.

Since AXCO had been recording/reporting bad debts expense when it was selling goods on credit, AXCO should not debit Bad Debt Expense again when the bad account is identified. Instead, AXCO should reduce the credit balance it had been accumulating in the Allowance account. This is done with a debit to Allowance for Doubtful Accounts for $2,100 as shown in the following image:

Note that the Bad Debts Expense T-account was not involved in writing off the $2,100 customer’s balance.

When the allowance method is used for recording losses on credit sales, Bad Debts Expense is debited, and the Allowance for Doubtful Accounts is credited in advance of knowing the specific customers that will not pay the amount owed.

As we saw in Question 7, when an account receivable is identified as uncollectible, it is written off with a credit to Accounts Receivable and a debit to the Allowance for Doubtful Accounts. (Under the allowance method, there is no entry to Bad Debts Expense when the customer’s account is written off.)

In Question 8, five months after writing off a bad account receivable, the company received/recovered $400 of the amount written off. Under the allowance method, two entries are made:

1. Reverse $400 of the write-off entry of July 15, since only $400 is being recovered. This is done with an entry that debits Accounts Receivable and credits Allowance for Doubtful Accounts.
2. Record the $400 received with a debit to Cash and a credit to Accounts Receivable.

These two entries are shown in T-accounts in the following image:

Under the direct write-off method, there is no general ledger account entitled Allowance for Doubtful Accounts. Under the direct write-off method, TELCO does not debit Bad Debts Expense until a specific account is identified as uncollectible and is removed from its Accounts Receivable account with a credit entry.

Therefore, when JELCO writes off its customer’s account balance of $5,000, JELCO will:

• Debit Bad Debts Expense for $5,000, and
• Credit Accounts Receivable for $5,000

For every $1.00 of sales, LAXCO incurs $0.70 of variable expenses ($0.60 for the cost of goods sold + $0.10 for other variable expenses). This leaves $0.30 or 30% of each sales dollar available for LAXCO to cover the $5,000 loss from extending credit to customers.

Algebraically we have: 0.30 of Sales = $5,000
Dividing each side of the equation by 0.3, we have: 0.3 Sales/0.3 = $5,000/0.3
After dividing, we have: Sales = $16,667

The following verifies our calculation:
Additional sales needed: $16,667
Additional variable expenses (70% of $16,667): $11,667
Amount remaining to cover the loss from the bad account: $5,000

Review of terms
With credit terms of net 30 days, MARCO’s customers are to pay sales invoice amounts (minus any returns and/or allowances) within 30 days of the sales.

With credit terms of 2/10, net 30, MARCO’s customers have two options:

• Pay MARCO’s sales invoice amounts (net of any returns and/or allowances) with 30 days of the invoice date, or
• Pay MARCO’s sales invoices (net of any returns and/or allowances) minus a 2% discount within 10 days of the invoice date.

The 2% discount is also known as a sales discount, cash discount, or early payment discount.

Comparison #1

If customers pay within 10 days, MARCO is being paid 20 days sooner than if they are paid in 30 days. The cost of receiving the money 20 days sooner is 2% of the invoice amount.

Expressing the 2% discount as a rate per year (interest rate per annum), the 2% for 20 days becomes approximately 36% per annum. We arrived at the annual rate by multiplying both the 2% and the 20 days by 18 = 36% for 360 days.

Recall that the bank loan has an interest rate of 12% per year.

Therefore, MARCO’s less costly option is with credit terms of net 30 days.

Comparison #2

1. If MARCO offers credit terms of 2/10, net 30 and there were $100,000 of credit sales that pay within the discount period of 10 days, MARCO will receive $98,000. The cost of getting the $98,000 twenty days early is $2,000.
2. If MARCO offers only credit terms of net 30 days, MARCO will receive the $100,000 in 30 days instead of 10 days. If MARCO borrows $98,000 for 20 days (from days 11 - 30), the interest cost would be $644.38 ($98,000 X 12% X 20/365 days).

Conclusion
The early payment discount of $2,000 vs. the bank loan interest of $644.38 means the lesser cost for MARCO is to have credit terms of net 30 days.

When a company using the allowance method collects one of its accounts receivable, it affects two current asset accounts:

• Accounts Receivable (which decreases), and
• Cash (which increases)

As a result:

• The total amount of current assets does not change.
• Current liabilities are not involved (therefore no change).
• Working capital does not change, since working capital = current assets minus current liabilities.
• Net income does not change since revenues (and the related receivables) were recorded when the sale or service was earned (not when cash is received).

Therefore, neither the company’s working capital nor its net income increases when an account receivable is collected.

The accounts receivable turnover ratio is calculated as follows:

Net credit sales for the year are divided by the average balance in Accounts Receivable during the year.

The accounts receivable turnover ratio indicates how many times the average balance in Accounts Receivable turned over during the year. The greater/higher the ratio (the greater the number of turns during the year). This means the receivables were collected faster.

Keep in mind that the accounts receivable turnover ratio is an average of all the customers’ accounts. Some customers’ account balances may turn to cash quickly, while some customers’ balances may be past due.

To quickly see which customers’ receivables are past due, companies can easily generate an aging of accounts receivable.

The calculation of XYZ’s accounts receivable turnover ratio is shown in the following image:

The collection period is the number of days it took (on average) during the past year for a company to convert its accounts receivable to cash.

The collection period depends on the company’s credit terms. If a company’s credit terms are net 10 days, the collection period should be much shorter than credit terms of net 30 days.

Similarly, a collection period of 35 days may be acceptable for a company with credit terms of net 30 days. However, it is not acceptable if the terms are net 10 days.

One way to calculate the collection period is:
365 (the number of days in a year) divided by the accounts receivable turnover ratio.

XYZ’s collection period is shown in the following image:

Companies that make significant sales with credit terms may need cash prior to the date when the receivables are scheduled to be collected.

Two of the ways a company may be able obtain cash sooner than the date when the receivables are to be collected are:

• Obtaining a loan from a bank or an asset-based lender. The terms assigning and pledging are used when the company gives the lender a claim to its receivables as collateral for a loan.

  For example, a company may assign or pledge $100,000 of its accounts receivable as collateral for a loan of $80,000. Under this arrangement, the company continues to report the accounts receivable on its balance sheet as a current asset and reports the loan balance as a current liability on its balance sheet. The company’s notes to its financial statements should disclose the details of the loan including the assigning or pledging of receivables.

• Selling some of its receivables to a factor. A factor is a business that buys a company’s receivables for less than the invoiced amounts and then collects the receivables from the company’s customers.

  Factoring could be done with recourse or without recourse. With recourse means the company is liable if the customers fail to pay the factor the full amount. Without recourse means the company is not liable if the customers fail to pay the factor the full amount.

  When certain conditions have been met, there will be a true sale of accounts receivable. In this situation, the company selling its receivables will record the cash received and removes the receivables from its balance sheet. Since this is not a loan, no liability account is involved. (The factor reports the receivables as current assets until the receivables are collected.)

Generally, the assigning, pledging, and factoring of receivables is expensive due to the lender’s or factor’s additional work of tracking and collecting the receivables.