6.4 Accounting for Receivables and Bad Debts

Valuation of Receivables

• When a company extends credit to customers, sales revenues increase, but there's a risk not all customers will pay.
• Valuation is the dollar amount at which the company should report an asset on their balance sheet.
• GAAP requires companies to report receivables at their net realizable value (NRV).
• NRV is the amount the company expects to collect in cash after considering estimates for uncollectible amounts (bad debts).
• Bad debts represent the cost of doing business on credit.

Reporting Bad Debt Expense

• Bad Debt Expense (BDE) is reported on the income statement as an operating expense.
• Accounting theory suggests BDE must be reported in the same period as the credit sales at risk of not being collected to adhere to the matching principle.

Balance Sheet Reporting of Accounts Receivable

• Accounts receivables are reported as a current asset on the balance sheet.
• GAAP requires reporting at NRV to clearly indicate the probable future economic benefit.
• The probable future economic benefit of receivables is less than 100% due to the possibility of bad debts.

Example of Accounts Receivable Reporting

• Scenario: Accounts receivable as of December 31 are $100,000$.
• Assume 5% of receivables will not convert into cash.
• An allowance for doubtful accounts of $5,000$ is created.
• Accounts Receivable less the contra asset equals NRV (100,000 - $5,000 = $95,000).
• The company expects to convert $95,000$ into cash.
• Often, accounts receivable are reported as a single line item: "Accounts Receivable, net of $5,000$ allowance" = $95,000$ NRV.
• If accounts receivables are reported net, gross receivables can be found by adding back the allowance (95,000 + $5,000 = $100,000).

Methods for Recording Bad Debts

• FASB allows two methods:
  • Direct Write-Off Method.
  • Allowance Method (preferred).

Direct Write-Off Method

• The company waits until it can specifically identify the bad debt customer and then record bad debt expense.
• Used only when uncollectible accounts cannot be reasonably estimated or bad debts are immaterial, or not probable.
• Not preferred, as it can violate the matching principle.
• Examples of industries where direct write-off might be applicable:
  • Companies (e.g. Boeing) with contracts in foreign countries where defaults are improbable.
  • New companies in emerging industries lacking historical data for reasonable estimates.

Example of Direct Write-Off Method

• Scenario: April 1, Year 1: ABC performs services for Jones Company for $500$ on account.
• ABC's year-end: December 31.
• May 1, Year 2: Jones declares bankruptcy.
• Year 1:
  • Debit Accounts Receivable for Jones Company $500$.
  • Credit Sales Revenues $500$.
  • No entry for bad debt expense is made at year-end.
• Year 2 (May 1):
  • Debit Bad Debt Expense $500$.
  • Credit Accounts Receivable for Jones Company $500$.
• Why it's not preferred:
  • Revenue recognized in Year 1, but expense recorded in Year 2, violating the matching principle.

Allowance Method

• The preferred method by GAAP.
• Requires the company to estimate uncollectible accounts at year-end and record bad debt expense through an adjusting journal entry.
• Companies use past experience, industry averages, etc., to create the estimate (e.g., 3% to 5% of accounts receivable).
• FASB considers accounting for bad debts a loss contingency.

Loss Contingency Criteria

• Incurring the loss from non-collection depends on the probability that some customers will not pay in the future.
• The dollar amount of the loss is reasonably estimated based on past experience.

Requirements for Allowance Method

• Probable that the company will experience bad debts in the future.
• Reasonable to estimate a dollar amount.
• If both criteria are met, companies should follow the allowance method.
• The year-end adjusting journal entry is a debit to bad debt expense and a credit to the allowance for doubtful accounts.
• Accounts receivables are reported at their gross amount, and the allowance reduces receivables to their net realizable value.
• The balance sheet should not overstate the value of the asset.

Income Statement Impact

• Sales revenues are recorded in the period earned (e.g., $100,000$).
• Bad debt expense represents the cost of extending credit to customers and should be in the same period as credit sales to follow the matching principle.

Example of Allowance Method

• Scenario: April 1, Year 1: ABC performs services for Jones Company for a fee of $500$ on account.
• ABC's year-end: December 31.
• May 1, Year 2: Jones declares bankruptcy.
• At December 31 (Year 1):
  • Debit Bad Debt Expense.
  • Credit Allowance for Doubtful Accounts.
  • This entry is based on an estimate of future uncollectible accounts as of year-end.
• May 1 (Year 2):
  • Debit Allowance for Doubtful Accounts.
  • Credit Accounts Receivable for Jones Company.
• Notes:
  • At December 31, ABC company did not know it would be Jones' account specifically that would be uncollectible.
  • The allowance account is the best estimate for those customers who may not pay in the future.
  • Once the company identifies a specific account that is uncollectible, the company would debit the allowance for doubtful accounts and credit the specific accounts receivable.

Applying the Allowance Method - Balance Sheet Approach

• Companies use the balance sheet approach to estimate uncollectible accounts.
• The estimate is based on a percentage of accounts receivable at year-end that, based on past experience, might prove uncollectible.
• Also referred to as an aging of accounts receivable.
• Aging categorizes receivables by time periods (e.g., 0-30 days, 31-60 days, 90+ days).
• Older receivables have a higher risk of uncollectibility.

Example of Balance Sheet Approach

• Scenario: ABC company has $200,000$ of accounts receivables as of year-end.
• Based on experience, ABC estimates 5% will prove uncollectible.
• ABC has a $2,000$ credit balance in their allowance for doubtful accounts before adjustment.
• The allowance for doubtful accounts is a permanent balance sheet account to reduce accounts receivables to their net realizable value.

Steps:

1. Calculate the Estimated Uncollectible Amount:
   • $200,000 * 5$
2. Report on the Balance Sheet:
   • Accounts Receivable: $200,000$
   • Allowance for Doubtful Accounts: $10,000$
   • Net Realizable Value: $190,000$

• A more common way to report this on your year end balance sheet would be to take these accounts receivables and save net of my $10,000$ allowance, and it would be reported at a hundred and $90,000$ net realizable value.

1. Adjust the Allowance Account:
   • Current balance before adjustment is $2,000$ (credit).
   • The goal is to have an ending balance of $10,000$.
   • Therefore, we need a credit adjustment of $8,000$ (10,000 - $2,000 = $8,000).
2. Record the Adjusting Journal Entry:
   • Debit Bad Debt Expense: $8,000$
   • Credit Allowance for Doubtful Accounts: $8,000$

• This brings the ending balance of the allowance account to equal $10,000$, or 5% of the ending accounts receivables.

Reconciling Accounts Receivable and Allowance Accounts

• Accounts Receivable Reconciliation:
  • Beginning Balance (Debit).
  • Add: Credit Sales (debit to AR).
  • Less: Cash Collections (credit to AR).
  • Less: Write-Offs (credit to AR).
  • = Ending Balance.
  • Formula Approach:
    • Ending Balance = Beginning Balance + Credit Sales - Cash Collections - Write-Offs
• Allowance for Doubtful Accounts Reconciliation:
  • Beginning Balance (Credit).
  • Less: Write-Offs (debit to allowance).
  • Add: Reinstatement of Previous Write-Off (credit to allowance).
  • =Balance Before Adjustment (debit or credit).
  • Year End Adjusting Journal Entry (credit to allowance).
  • Ending Balance (Credit).

Example 1: Reconciling the Allowance for Doubtful Accounts

• Accounts Receivable at Year-End: $100,000$
• Allowance Account Credit Balance: $1,000$
• Estimated Uncollectible: 4% of AR

1. To determine the adjusting entry needed to achieve an ending balance equal to 4% of accounts receivable we must calculate the product of accounts receivable and the estimated uncollectable percentage
   • $100,000 * 0.04 = 4,000$.
2. So the goal is to get an ending balance of $4,000$.
3. To do this, an adjusting journal entry is created
   • Credit Allowance Account: $3,000$ (4,000 - $1,000 = $3,000 also the amount needed to make the credit entry)
   • Debit Bad Debt Expense: $3,000$

Example 2: Reconciling the Allowance for Doubtful Accounts (with a debit initial balance)

• Accounts Receivable at Year-End: $100,000$
• Estimated Uncollectible: 4% of AR
• This time The allowance Account Debit Balance: $1,000$

1. To determine the adjusting entry needed to achieve an ending balance equal to 4% of accounts receivable we must calculate the product of accounts receivable and the estimated uncollectable percentage
   • $100,000 * 0.04 = 4,000$.
2. The Journal adjustment need to eliminate debit balance and arrive at $4,000$ credit balance that is equivalent to 4%.
3. So the goal is to make an adjustment of $5,000$ (4,000 + $1,000 = $5,000).

• Debit Bad Debt Expense: $5,000$
• Credit Allowance Account: $5,000$

Helpful Journal Entries for Bad Debts

1. Writing off an Account Receivable:

   • Debit Allowance for Doubtful Accounts.
   • Credit Accounts Receivable.

2. Customer Restores Credit:

   • Debit Accounts Receivable
   • Credit Allowance for Doubtful Accounts.
   • Debit Cash and Credit Accounts Receivable. (collect the money)

3. Recording Bad Debts at Year End:

   • Debit: Bad debt expense.
   • Credit: Allowance for doubtful accounts.