Accounts receivable
When a business sells on credit, the amount customers owe is accounts receivable, a current asset. Some customers will never pay. The cost of those uncollectible accounts is bad debt expense.
Two methods
- Direct write-off: expense is recorded only when a specific account is judged uncollectible. Simple, but it breaks the matching principle, because the expense may land in a later period than the sale. It is not acceptable for most companies under GAAP.
- Allowance method: estimate bad debts at the end of each period and set up a contra-asset account, Allowance for Doubtful Accounts. This matches the expense to the period of the sales.
Balance sheet presentation:
Accounts receivable − Allowance = Net realisable value (the amount expected to be collected)
Estimating: two approaches
Percentage of credit sales (income statement approach). Apply an estimated percentage to the period's credit sales. The result is the expense for the period.
Aging of receivables (balance sheet approach). Group receivables by how overdue they are and apply a higher percentage to older groups. The result is the required ending balance of the allowance, so the expense is whatever is needed to reach that balance.
Entries
- Adjusting entry: Dr Bad Debt Expense / Cr Allowance for Doubtful Accounts.
- Writing off a specific account: Dr Allowance for Doubtful Accounts / Cr Accounts Receivable. This has no effect on net realisable value and no effect on net income, because the expense was already recorded when estimated.
Worked examples
Percentage of sales. Credit sales are $200,000 and 2 percent is expected to be uncollectible: expense = 200,000 × 0.02 = $4,000.
Aging. Receivables total $50,000 and the aging analysis says $5,000 will be uncollectible. The allowance currently has a $1,200 credit balance.
- Required ending balance = $5,000 (credit).
- Existing balance = $1,200 (credit).
- Adjustment needed = 5,000 − 1,200 = $3,800 expense.
Write-off. A $800 account is written off. Receivables fall by 800 and the allowance falls by 800. If receivables were $60,000 and the allowance $3,500, net realisable value was 56,500; afterwards receivables are 59,200 and the allowance 2,700, so it is still 56,500.
Notes receivable
A note receivable is a written promise to pay, usually with interest. Interest = principal × rate × time. On a $12,000 note at 5 percent for 6 months: 12,000 × 0.05 × 6/12 = $300.
Receivables turnover
Turnover = net credit sales ÷ average accounts receivable. With $900,000 of credit sales and average receivables of $100,000, turnover is 9 times a year. Dividing 365 by 9 gives about 41 days to collect, a measure of collection speed.
Common mistakes
- Debiting bad debt expense when writing off a specific account under the allowance method.
- Forgetting to consider the existing allowance balance in the aging method.
- Showing the allowance as a liability; it is a contra-asset.