Estimating Bad Debts Unit 8 Companies use either of two methods in the estimation of uncollectible...

Estimating Bad DebtsEstimating Bad Debts

UnitUnit

88

• Companies use either of two methods in the estimation of uncollectible accounts:

1. Percentage of sales

2. Percentage of receivables

• Both bases are GAAP; the choice is a management decision.

BASES USED FOR THE BASES USED FOR THE ALLOWANCE METHODALLOWANCE METHODBASES USED FOR THE BASES USED FOR THE ALLOWANCE METHODALLOWANCE METHOD

ILLUSTRATION ILLUSTRATION 9-49-4 COMPARISON OF BASES OF COMPARISON OF BASES OF

ESTIMATING UNCOLLECTIBLESESTIMATING UNCOLLECTIBLES

ILLUSTRATION ILLUSTRATION 9-49-4 COMPARISON OF BASES OF COMPARISON OF BASES OF

ESTIMATING UNCOLLECTIBLESESTIMATING UNCOLLECTIBLES

Percentage of Sales Percentage of ReceivablesNet Realizable Value

AllowanceAccounts for

Receivable DoubtfulAccounts

Emphasis on Income Statement Relationships

Emphasis on Balance Sheet Relationships

• In the percentage of sales basis, management establishes a percentage relationship between the amount of credit sales and expected losses from uncollectible accounts.

• Expected bad debt losses are determined by applying the percentage to the sales base of the current period.

• This basis better matches expenses with revenues.

PERCENTAGE OF SALES BASISPERCENTAGE OF SALES BASISPERCENTAGE OF SALES BASISPERCENTAGE OF SALES BASIS

PERCENTAGE OF SALES BASISPERCENTAGE OF SALES BASIS

Example 1Example 1


Example 1Example 1

Situation A: Pereira Company determines that 1% of net credit sales will become uncollectible. If net credit sales are $170,000 the estimated bad debt expense is $1700 (170,000*1%). The general journal entry is;

Date Account Title and Explanation Debit CreditDec. 31 Bad Debts Expense 1,700

Allowance for Doubtful Accounts 1,700 To record estimate of uncollectible accounts.

GENERAL JOURNAL


Example 2 Balance In Doubtful AccountsExample 2 Balance In Doubtful Accounts


Example 2 Balance In Doubtful AccountsExample 2 Balance In Doubtful Accounts

Situation B: Pereira Company determines that 1% of net credit sales will become uncollectible. If net credit sales are $170,000 the estimated bad debt expense is $1700 (170,000*1%). However the allowance for doubtful accounts still has a credit balance of $1500. How much is journalized? Answer: the same as in situation A. Balances in doubtful accounts are ignored.



GENERAL JOURNAL

• Under the percentage of receivables basis, management establishes a percentage relationship between the amount of accounts receivable and the required balance in the allowance account.

• This percentage can be applied to the total accounts receivable balance, or to individual accounts receivable balances stratified by age.

PERCENTAGE OF PERCENTAGE OF RECEIVABLES BASISRECEIVABLES BASIS


• The required balance in the allowance account is determined by applying the percentage to the accounts receivable balance at the end of the current period.

• The amount of the adjusting entry to record expected bad debt losses for the current period is the difference between the required balance and the existing balance in the allowance account.

• This basis produces the better estimate of net realizable value of receivables.



PERCENTAGE OF RECEIVABLES BASISPERCENTAGE OF RECEIVABLES BASIS

EXAMPLE 1 Net ReceivablesEXAMPLE 1 Net Receivables


EXAMPLE 1 Net ReceivablesEXAMPLE 1 Net Receivables

Pereira Company decides to use the percentage of receivables method to estimate bad debts. It determines that 3% of total accounts receivables will become uncollectibe. If the accounts receivables total is $40,000 the estimated bad debt expense is $1,200. (40,000*3%)



GENERAL JOURNAL


EXAMPLE 2 Credit Balance in Allowance EXAMPLE 2 Credit Balance in Allowance for Doubtful Accountsfor Doubtful Accounts


EXAMPLE 2 Credit Balance in Allowance EXAMPLE 2 Credit Balance in Allowance for Doubtful Accountsfor Doubtful Accounts

Pereira Company decides to use the percentage of receivables method to estimate bad debts. It determines that 3% of total accounts receivables will become uncollectibe. If the accounts receivables total is $40,000 the estimated bad debt expense is $1,200. (40,000*3%). However there is still a credit balance of $500 in the allowance for doubtful accounts remaining from last year’s adjusting entry. Therefore bad debt expense is only $700. (1,200-500)

Date Account Title and Explanation Debit CreditDec. 31 Bad Debts Expense 700

Allowance for Doubtful Accounts 700 To record estimate of uncollectible accounts.

GENERAL JOURNAL


EXAMPLE 3 Debit Balance in Allowance EXAMPLE 3 Debit Balance in Allowance for Doubtful Accountsfor Doubtful Accounts


EXAMPLE 3 Debit Balance in Allowance EXAMPLE 3 Debit Balance in Allowance for Doubtful Accountsfor Doubtful Accounts

Pereira Company decides to use the percentage of receivables method to estimate bad debts. It determines that 3% of total accounts receivables will become uncollectibe. If the accounts receivables total is $40,000 the estimated bad debt expense is $1,200. (40,000*3%). However there is debit balance of $300 in the allowance for doubtful accounts. In other words Pereira had more bad debts than estimated. Therefore bad debt expense is $1,500. (1,200+300)



GENERAL JOURNAL

PERCENTAGE OF RECEIVABLES PERCENTAGE OF RECEIVABLES BASISBASIS

EXAMPLE 4 Aging of AccountsEXAMPLE 4 Aging of Accounts

PERCENTAGE OF RECEIVABLES PERCENTAGE OF RECEIVABLES BASISBASIS

EXAMPLE 4 Aging of AccountsEXAMPLE 4 Aging of AccountsPereira Company decides to use the percentage of receivables method to estimate bad debts. However it wants to use the aging of accounts receivables as a basis.

Days 0-30 days 31-60 days 61-90 days 91-120 over 120

Amount $27,000 5,700 3,000 2,400 1,900

Percent 2% 4% 10% 50% 75%

Bad Debt $540 228 300 1200 1425

Total Bad Debt Expense = $3,693



GENERAL JOURNAL


EXAMPLE 5EXAMPLE 5


EXAMPLE 5EXAMPLE 5



GENERAL JOURNAL

Pereira Company decides to use the percentage of receivables method to estimate bad debts. In using the aging of accounts receivables as a basis the company determines that $3,693 of receivables will become uncollectible. However there is still a credit balance of $500 in the allowance for doubtful accounts remaining from last year’s adjusting entry. Therefore bad debt expense is only $3,193 (3,693-500)

SUMMARY OF UNCOLLECTIBLE ACCOUNTS

Methods of Write-Off

DIRECT ALLOWANCE

PERCENTAGE OF ACCOUNTS

RECEIVABLES

PERCENTAGE OF SALES

TOTAL RECEIVABLES

AGING OF RECEIVABLES

To accelerate the receipt of cash from receivables, owners frequently:

1. sell to a factor, such as a finance company or a bank, and

2. make credit card sales.

DISPOSING OF DISPOSING OF ACCOUNTS RECEIVABLEACCOUNTS RECEIVABLE


• A factor buys receivables from businesses for a fee and collects the payments directly from customers.

• Credit cards are frequently used by retailers who wish to avoid the paperwork of issuing credit.

• Retailers can receive cash more quickly from the credit card issuer.



Estimating Bad Debts Unit 8 Companies use either of two methods in the estimation of uncollectible...

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