Explanation of the Topic...
|Part 1||Introduction to Accounts Receivable and Bad Debts Expense, Recording Services Provided on Credit|
|Part 2||Recording Sales of Goods on Credit, Credit Terms with Discounts|
|Part 3||Credit Risk, Allowance Method for Reporting Credit Losses|
|Part 4||Writing Off an Account under the Allowance Method, Recovery of Account under Allowance Method, Bad Debts Expense as a Percent of Sales|
|Part 5||Difference between Expense and Allowance, Aging of Accounts Receivable, Mailing Statements to Customers|
|Part 6||Pledging or Selling Accounts Receivable, Accounts Receivable Ratios, Direct Write-off Method|
Under the allowance method, if a specific customer's accounts receivable is identified as uncollectible, it is written off by removing the amount from Accounts Receivable. The entry to write off a bad account affects only balance sheet accounts: a debit to Allowance for Doubtful Accounts and a credit to Accounts Receivable. No expense or loss is reported on the income statement because this write-off is "covered" under the earlier adjusting entries for estimated bad debts expense.
Let's illustrate the write-off with the following example. On June 3, a customer purchases $1,400 of goods on credit from Gem Merchandise Co. On August 24, that same customer informs Gem Merchandise Co. that it has filed for bankruptcy. The customer states that its bank has a lien on all of its assets. It also states that the liquidation value of those assets is less than the amount it owes the bank, and as a result Gem will receive nothing toward its $1,400 accounts receivable. After confirming this information, Gem concludes that it should remove, or write off, the customer's account balance of $1,400.
Under the allowance method of recording credit losses, Gem's entry to write off the customer's account balance is as follows:
|Aug 24||Allowance for Doubtful Accounts||1,400|
The two accounts affected by this entry contain this information:
|Accounts Receivable||Allowance for Doubtful Accounts|
|June 1 Balance||–||–||June 1 Balance|
|June Sales||105,000||5,000||June Collections||2,000||June 30 Adjust|
|June 30 Balance||100,000||2,000||June 30 Balance|
|July Sales||225,000||95,000||July Collections||8,000||July 31 Adjust|
|July 31 Balance||230,000||10,000||July 31 Balance|
|Aug Sales||204,000||194,000||Aug Collections|
|Aug 23 Balance||240,000||10,000||Aug 23 Balance|
|1,400||Aug 24 W-Off||Aug 24 W-Off||1,400|
|Aug 24 Balance||238,600||8,600||Aug 24 Balance|
Note that prior to the August 24 entry of $1,400 to write off the uncollectible amount, the net realizable value of the accounts receivables was $230,000 ($240,000 debit balance in Accounts Receivable and $10,000 credit balance in Allowance for Doubtful Accounts). After writing off the bad account on August 24, the net realizable value of the accounts receivable is still $230,000 ($238,600 debit balance in Accounts Receivable and $8,600 credit balance in Allowance for Doubtful Accounts).
The Bad Debts Expense remains at $10,000; it is not directly affected by the journal entry write-off. The bad debts expense recorded on June 30 and July 31 had anticipated a credit loss such as this. It would be double counting for Gem to record both an anticipated estimate of a credit loss and the actual credit loss.
After a seller has written off an accounts receivable, it is possible that the seller is paid part or all of the account balance that was written off. Under the allowance method, if such a payment is received (whether directly from the customer or as a result of a court action) the seller will take the following two steps:
Reinstate the account that was written off by reversing the write-off entry. If we assume that the $1,400 written off on Aug 24 is collected on October 10, the reinstatement of the account looks like this:
|Oct 10||Accounts Receivable||1,400|
|Allowance for Doubtful Accounts||1,400|
Process the $1,400 received on October 10:
The seller's accounting records now show that the account receivable was paid, making it more likely that the seller might do future business with this customer.
Another way sellers apply the allowance method of recording bad debts expense is by using the percentage of credit sales approach. This approach automatically expenses a percentage of its credit sales based on past history.
For example, let's assume that a company prepares weekly financial statements. Past experience indicates that 0.3% of its sales on credit will never be collected. Using the percentage of credit sales approach, this company automatically debits Bad Debts Expense and credits Allowance for Doubtful Accounts for 0.3% of each week's credit sales. Let's assume that in the current week this company sells $500,000 of goods on credit. It estimates its bad debts expense to be $1,500 (0.003 x $500,000) and records the following journal entry:
|Oct 10||Bad Debts Expense||1,500|
|Allowance for Doubtful Accounts||1,500|
The percentage of credit sales approach focuses on the income statement and the matching principle. Sales revenues of $500,000 are immediately matched with $1,500 of bad debts expense. The balance in the account Allowance for Doubtful Accounts is ignored at the time of the weekly entries. However, at some later date, the balance in the allowance account must be reviewed and perhaps further adjusted, so that the balance sheet will report the correct net realizable value. If the seller is a new company, it might calculate its bad debts expense by using an industry average until it develops its own experience rate.
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