What is the aging method? – Explanation
The aging method is based on determining the desired balance in the account Allowance for Uncollectible Accounts. The accountant attempts to estimate what percentage of outstanding receivables at year-end will ultimately not be collected; ‘this amount becomes the desired ending balance in the Allowance for Uncollectible Accounts, and a credit entry to this account is made to adjust the previous balance to the new, desired balance.
The debit part of this entry is to the account Uncollectible Accounts Expense. The aging method is often referred to as the balance sheet approach because the accountant attempts to measure, as accurately as possible, the net realizable value of Accounts Receivable, a balance sheet figure.
The method to estimate the desired balance in the allowance account is called the aging of accounts receivable. This is done by dividing the balance in the Accounts Receivable account into age categories based on the length of time they have been outstanding. Categories such as current, 31—60 days, 61–90 days, and over 90 days are often used.
On the assumption that the longer an account is outstanding the less likely its ultimate collection is, an increasing percentage is applied to each of these categories. The total of these figures represents the desired balance in the account Allowance for Uncollectible Accounts.
To demonstrate the application of the aging method, we will use the data from the Porter Company.
At the end of 2019, the balance in Accounts Receivable was $200,000, and an aging schedule of the accounts is presented below. For the sake of simplicity, we are assuming that the entire $200,000 balance in Accounts Receivable consists of only 5 customers.
Based on the data in this exhibit, the Porter Company makes the following adjusting entry at December 31, 2019 to record the Unclooectible Accounts Expense:
After this entry is posted, the T accounts appear as follows:
A number of points need to be made about this illustration. First, the dollar amount of the required journal entry is the amount needed to bring the Allowance account to the desired balance of $19,700. Because the Allowance account had a $2,000 credit balance prior to adjustment, the required entry is for $17,700, or the difference between $19,700 and $2,000. In some situations, the Allowance account may have a debit balance before the adjustment. This may occur if during the year more accounts were written off as uncollectible than had been estimated for in the prior year.
In this situation, the debit balance should be added to the desired credit balance in the Allowance account to figure the correct amount of the entry. For example, if the Porter Company’s Allowance account had a $300 debit balance before the entry to record the uncollectible accounts expense was made, the Allowance account would require a credit entry of $20,000 in order to establish the necessary ending balance of $19,700.
The second issue is how the accountant determines the appropriate percentages to apply to each age category. Generally, these percentages are based on past experience adjusted for current. economic and credit conditions. These percentages should be evaluated on a regular basis and adjusted when necessary.
Finally, in some cases, the aging of the accounts receivable will indicate that a particular account has no possibility of collection. If this occurs, this account should be written off by debiting the Allowance account and crediting Accounts Receivable before figuring the desired ending balance in the Allowance account. In effect, this particular account is eliminated from the aging process, as it is already considered uncollectible.
Comparison between Percentage of net sales method and the aging method
Both the percentage-of-net-sales and the aging methods are generally accepted accounting methods, in that they both attempt to match revenues and expenses. The percentage-of-net-sales method is aimed at determining the
amount of uncollectible accounts expense, and the aging method is aimed at determining the balance in the account Allowance for Uncollectible Accounts. These methods thus will show different balances in both the expense and contra-asset accounts. This is illustrated below using the data from the Porter Company example.
These differences point out that management can choose among methods of applying generally accepted accounting principles and that these choices affect the firm’s financial statements. Once a method of estimating bad debts is chosen, it should be consistently followed. This will enhance the comparability of the financial statements.
Both the aging and the percentage-of-net-sales methods, as well as other methods, are found in practice. Although the percentage-of-net-sales method is easier to apply, the aging method forces management to analyze the status of their accounts receivable and credit policies annually. Some firms use both methods. The percentage-of-net-sales method is used to prepare monthly and quarterly statements, but the aging method is used to make the final adjustment at year-end.