Valuing Accounts Receivable

• Some receivables will become uncollectible– Not reported as assets if no future benefit– Net realizable value: the collectible amount

• Receivables are written down to their collectible amount– By recording bad debt expense– In the same period as related revenues are

recorded: matching of revenues and expenses

The Allowance Method

Three features of allowance method:1. Amount of uncollectible receivables is estimated

and recorded at end of period2. Specific amounts determined uncollectible are

written off against the allowance3. Specific amounts that are recovered are reversed

out of allowance and the collection recorded

1. Recording Estimated Uncollectibles

Dec. 31 Bad Debts Expense 24,000 Allowance for Doubtful Accounts 24,000

To record estimate of bad debts expense

Assume that $24 000 of receivables are assumed to be uncollectible. The journal entry is as follows:

Allowance for Doubtful Accounts • Deducted from Accounts Receivable in the current

assets section of balance sheet – contra asset account• Net Realizable value = Accounts Receivable less

Allowance for Doubtful Accounts• Look at p.415 for presentation in financial statements

Two Methods for Estimating the Allowance:A. Percentage of Sales

• Calculates bad debt expense as a percentage of net credit sales– Based on past experience and company’s credit policy– Example: 2% of credit sales of $1,200,000 = $24,000– The adjusting entry would be:

Bad Debts Expense 24 000Allowance for Doubtful Accounts 24 000

• Better matches revenues and expenses• When calculating the adjusting entry the existing balance in the Allowance

for Doubtful Accounts is ignored• The amount should be compared to what is actually written off, if it is

significantly different than a different percentage should be used.• Also called the income statement method

B. Percentage of Receivables• Calculates the percentage of receivables that are estimated to be

uncollectible• Based on past experience and credit policy

• Can be applied to total receivables balance or amounts grouped by age• Requires an aging schedule to be prepared – this is easy to do in a

computerized system• Better estimate of net realizable value – therefore the one usually used• See page 416 for an example of an aging schedule• The balance in the allowance for doubtful accounts must be taken into

account.• For example, if a company has a balance of $5 000 and needs an allowance

of $20 000, an adjusting entry of $15 000 (20 000 – 5 000) would be madeBad debts expense 15 000

Allowance for Doubtful Accounts 15 000• Also called the balance sheet method

Comparison of Approaches

Income Statement Approach

Percentage of Sales

Matching

SalesBad Debts Expense

Percentage of Receivables

Net Realizable Value

Allowance for Doubtful Accounts

Accounts Receivable

Balance Sheet Approach

2. Recording Write-Off of an Uncollectible Account

Mar. 1 Allowance for Doubtful Accounts 4,500 Accounts Receivable - Kids Online 4,500

Write-off of uncollectible account

• When collection has been tried and it appears impossible, the receivable needs to be written off

• To keep good internal control write-offs should be approved by management

• Assume that the accounts receivable from Kids Online of $4500 has been deemed uncollectible, the journal entry for the write-off would be as follows:

• Only Balance Sheet accounts are affected for a write-off – the Net Realizable Value is not affected.

J uly 1 Accounts Receivable - Kids Online 4,500 Allowance for Doubtful Accounts 4,500

To reverse write-off of Kids Online account

J uly 1 Cash 4,500 Accounts Receivable - Kids Online 4,500

To record collection from Kids Online

3. Recovery of an Uncollectible Account• If a company ends up collecting cash from a customer that had

previously been written off, two entries need to be made.• The entry to write off the account needs to be reversed to restore

the customer’s account• The collection is recorded in the normal way

• Assume the Kids Online account was subsequently collected, the journal entries would be as follows.

Homework

• BE8-5,6,7,8,9