Recording uncollectible accounts expense and bad debts

The risk of extending credit arises from the possibility that the customer will not pay. This risk impacts both the measurement of income and the description of the receivables held by the seller. The accountant’s task involves consideration of these three issues:

1. What is the nature of the loss?
2. When does the loss occur?
3. What is the size of the loss?

Each of these questions is discussed below, as well as the practical aspects of disclosing the impact of non-collection and the entries that are made for dealing with these bad debts.

What is the nature of the loss?

Most accounting theorists have endorsed the position that the bad debt loss is an expense. They rely on the accrual approach which calls for recognizing revenue when the seller performs. The fact that the buyer fails to perform is properly described, they conclude, as an expense. This view has been persuasive in the development of GAAP.

When does the loss occur?

Accountants also have debated the question of the time period in which to recognize the loss on non-collection. Some have supported the point of view that it should not be recorded until it is known for certain that the debtor will not pay. The reliability of this approach is potentially high because it does not rely on estimates, but it has the potential for income manipulation by allowing management to determine when to record the expense.

Another weakness of this approach is that the recognition of the expense is dependent upon observing its effects instead of matching it with its related revenues. For these reasons, this approach is not generally accepted. Small firms and large firms with small losses may use this approach on the basis of simplicity and lack of materiality. It is otherwise an unacceptable practice.

Most accountants take the position that the expense is incurred in order to increase sales and thus should be reported in the same time period as those sales if cause and effect are to be related. Essentially, it is believed that the expense is incurred at the time that the sale takes place. This approach had been generally accepted by common practice for many years. When implemented, this approach results in an annual adjusting entry of this form, assuming an expense of $16,000:

Recording uncollectible accounts expense and bad debts journal entry

This system is often referred to as the allowance method. The allowance is a contra account and is credited instead of the Accounts Receivable control account because it is not known which individual accounts are uncollectible. If the control account were to be credited, its balance would not equal the sum of the subsidiary account balances.

Also Check:  Accounts Receivable

What is the size of the loss?

When the nature and the timing of the loss have been determined, our attention can be focused on a dollar measurement of the amount to be recorded. Some accountants prefer to use a direct approach to estimating the expense. That is, the first result of the analysis is the amount of bad debt expense for the period. This approach is income statement oriented in that it is designed to match the main expense of extending credit with the revenue produced by that activity.

Typically, the calculation is based on an assumption of a relationship between the expense and credit sales for the year. The greater the credit sales, the greater we expect the expense to be. In practice, the estimate should be made using the prediction basis that works best. That is, if other factors can make one prediction better (such as total sales, general economic conditions, or geographic region), we should use them if they are easily included. For example, the Sample Company estimates that its bad debt expense for 20×1 will be 1.2 percent of its credit sales of $17,530,000. This journal entry would be recorded:

Recording uncollectible accounts expense and bad debts journal entry

Under this direct approach to estimating the expense, the increase in the allowance is computed indirectly. It also should be noted that this entry is the only one made during the year to the Bad Debt Expense account.

Other accountants prefer an indirect approach to estimating the amount of the expense. That is, the first result of their analysis is the desired year-end balance of the allowance account. This approach is balance sheet oriented in that its primary goal is accurate description of the net collectible amount of receivables. When the appropriate year-end balance is computed, it is compared with the preadjustment balance and the needed change is determined, Thus, the bad debt expense is estimated indirectly as the change in the allowance.

For example, suppose instead that the Sample Company accountant estimates that the Allowance for Uncollectibles should be $375,000 after it is adjusted. The unadjusted balance is only $114,550. Therefore, the account needs to be credited for the difference of $260,450. This journal entry would be recorded:

Recording uncollectible accounts expense and bad debts journal entry

Again, this entry would be the only one made during the year that would affect the expense account. There are a variety of ways of estimating the balance of the allowance. All involve an analysis of the existing accounts and application of one or more percentage factors. The accountant for Sample Company may have estimated that 5 percent of its $7,500,000 of receivables were uncollectible in arriving at the desired balance of $375,000 used in the entry above.

Also Check:  Using receivables to generate cash

A potentially more accurate approach is the analysis of an aged trial balance of the receivables. This schedule classifies the receivables on the basis of the length of time they have been outstanding. It is often prepared routinely for internal use and for auditing purposes.

Below example shows an excerpt of an aged trial balance for the Sample Company as of December 31, 20×1. When this information is available, it can be used to predict the uncollectible amount. Specifically, we can apply different percentages to each group. In effect, we act as if each age group is a different population of receivables with a unique percentage of uncollectible amounts. For Sample Company, this analysis was performed (the percentages are based on past experiences):

Recording uncollectible accounts expense and bad debts Example

This result is compared to the preadjustment balance in the allowance account, and the change is recorded in an adjusting entry.

Recording uncollectible accounts expense and bad debts example

There is little practical difference between the direct and indirect because they are only alternative ways of analyzing exactly the same data.

Subsequent entries

Entries made under the allowance method subsequent to recording the annual adjusting entry are the same under either the direct or indirect approach to estimating the expense.

Whenever a specific account is identified as being uncollectible, it should be removed from the ledger with an entry such as this one recorded by Sample Company for one of its receivables:

Recording uncollectible accounts expense and bad debts journal entry

This entry can be made because it is known which receivables account to remove from the subsidiary ledger. The action does not affect either the net amount of accounts receivable or the bad debt expense.

Some of these write-offs occur during the year when specific evidence of nonpayment is received. Others are postponed until the end of the year when the aged trial balance is prepared.

In the event that all or part of a previously written off account is actually collected, several alternative procedures are possible. If Sample Company collects $7,500 of the written off account, one approach would first reverse that amount of the write-off:

Recording uncollectible accounts expense and bad debts journal entry

Then, a normal cash receipt could be recorded:

Recording uncollectible accounts expense and bad debts journal entry

The same result could be achieved by recording one entry combining the effects of these two:

Recording uncollectible accounts expense and bad debts journal entry

Another approach that may be acceptable because of a lack of materiality records a credit to Miscellaneous Revenue.

Also Check:  Trade and nontrade receivables

Bad debt expense and the SCFP

When applying the working capital basis to preparing the SCFP, there is no need to adjust net income for bad debt expense in computing the amount of working capital generated from operations. Because the entry which recognizes expense also reduces current assets by an increase in the Allowance for Uncollectibles, it also reduces working capital.

When an uncollectible account is actually written off, there again is no change in working capital, and no disclosure should be made on the SCFP for this action. When an account which has been written off is collected, cash is increased and the net amount of accounts receivable is decreased. Because the change is confined within working capital, no disclosure is made in the SCFP.

Disclosure practices

Several possible ways exist for disclosing information about receivables and their uncollectible amounts. The most straightforward would be to provide it in this form:

Recording uncollectible accounts expense and bad debts journal entry

This approach allows the reader to calculate the proportion of the total group that is believed to be collectible or uncollectible. In order to simplify the presentation, however, many companies take this alternative to providing the same facts:

Recording uncollectible accounts expense and bad debts journal entry

In the event that the firm believes that information about the allowance is not material, this approach might be used:

Recording uncollectible accounts expense and bad debts journal entry

Other allowances. In addition to bad debts, there are several reasons that cause a company to fail to collect the face amount of its receivables. If the difference is material, one or more allowances might be created.

For example, if receivables are recorded gross, that is, before cash discounts, it may be appropriate to establish an allowance for the discounts that might be taken on the accounts that are eligible for them. Because the amount of discounts taken would be known early in the following year, there would be no need to estimate the amount. Once the number is known, this retroactive adjustment could be made:

Recording uncollectible accounts expense and bad debts journal entry

If receivables are recorded net of discounts, it may be necessary to establish a supplemental allowance to show the additional amount collectible because the discounts have been missed. Again, the timing may be such that the calculation can be made very precisely. This entry could be entered retroactively:

Recording uncollectible accounts expense and bad debts journal entry

The likelihood of either amount being material is so small that virtually all firms ignore this procedure. An allowance might also be set up to provide for possible returns of merchandise by customers. The entry would be written as follows:

Recording uncollectible accounts expense and bad debts journal entry

Leave a Comment