Accounting: The Language of Business (Part 44)

“I am no weakling, I deal with accounting.”

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Receivables (Part C)

by

Charles Lamson

Allowance Method of Accounting for Uncollectible Accounts

Most large businesses use the allowance method to estimate for the uncollectible portion of their trade receivables. To illustrate this method, we will use assumed data for Richards Company. This new business began in August and chose to use the calendar year as its fiscal year. The accounts receivable account has a balance of $105,000 at the end of December.

The customer accounts making up the $105,000 balance in Accounts Receivable include some that are past due. However, Richards doesn't know which specific accounts will be uncollectible at this time. It is likely that some accounts will be collected only in part and that others will become worthless. Based on a careful study, Richards estimates that a total of $4,000 will eventually be uncollectible. The following adjusting entry at the end of the fiscal period records this estimate:

Because the $4,000 reduction in accounts receivable is an estimate, it cannot be credited to specific customer accounts or to the accounts receivable controlling account. Instead, a contra asset account entitled Allowance for Doubtful Accounts is credited.

As with all periodic adjustments, the entry above serves two purposes. First, it reduces the value of the receivables to the amount of cash expected to be realized in the future. This amount, which is $101,000 ($105,000 - $4,000), is called the net realizable value of the receivables. Second, the adjusting entry matches the $4,000 expense of uncollectible accounts with the related revenues of the period.

After the adjusting entry has been posted, as shown in the following T accounts, Accounts Receivable still has a debit balance of $105,000. This balance is the amount of the total claims against customers on account. The credit balance of $4,000 in allowance for doubtful accounts is the amount to be deducted from accounts receivable to determine the net realizable value. The balance of the uncollectible accounts expense is reported in the current period income statement, normally as an administrative expense. This classification is used because the credit granting and collection duties are the responsibilities of departments within the administrative area.

Write-Offs to the Allowance Account

When a customer's account is identified as uncollectible, it is written off against the allowance account as follows:

The authorization to support this entry should come from a designated manager. It should normally be in writing.

The total amount written off against the allowance account during a period will rarely be equal to the amount in the account at the beginning of the period. The allowance account will have a credit balance at the end of the period if the write-offs during the period are less than the beginning balance. It will have a debit balance if the write-offs exceed the beginning balance. However, after the year-end adjusting entry is recorded, the allowance account should have a credit balance.

An account receivable that has been written off against the allowance account may later be collected. In such cases, the account should be reinstated by an entry that reverses the write-off entry. The cash received in payment should then be recorded as a receipt on account. For example, assume that the account of $610 written off in the preceding entry is later collected on June 10. The entry to reinstate the account and the entry to record its collection are as follows:

The two preceding entries can be combined. However, recording two separate entries in the customer's account, with proper notation of the write-off and reinstatement, provides useful credit information.

Estimating Uncollectibles

How is the amount of uncollectible accounts estimated? The estimate of uncollectibles at the end of a fiscal period is based on past experience and forecasts of the future. When the general economy is doing well, the amount of uncollectible expense is normally less than it would be when the economy is doing poorly. The estimate of uncollectibles is usually based on either (1) the amount of sales, as shown on the income statement for the period, or (2) the amount of the receivables, as shown on the balance sheet at the end of the period, and the age of the receivable accounts.

Estimate Based on Sales

Accounts receivable are created by credit sales. The amount of credit sales during the period may therefore be used to estimate the amount of uncollectible accounts expense. The amount of this estimate is added to whatever balance exists in Allowance for Doubtful Accounts. For example, assume that the allowance account has a credit balance of $700 before adjustment. It is estimated from past experience that 1% of credit sales will be uncollectible. If credit sales for the period are $300,000, the adjusting entry for uncollectible accounts at the end of the period is as follows: 

After the adjusting entry at has been posted, the balance of the allowance account is $3,700. If there had been a debit balance of $200 in the allowance account before the year-end adjustment, the amount of the adjustment would still have been $3,000. The balance in the allowance account would have been $2,800 ($3,000 - $200).

The estimate-based-on-sales method emphasizes the matching of uncollectible accounts expense with the related sales of the period. Thus, this method places more emphasis on the income statement than on the balance sheet.

Estimate Based on Analysis of Receivables

The longer an account receivable remains outstanding, the less likely that it will be collected. Thus, we can base the estimate of uncollectible accounts on how long the accounts have been outstanding. For this purpose, we can use a process called aging the receivables.

In aging the receivables, an aging schedule is prepared by classifying each receivable by its due date. The number of days an account is past due is determined from the due date of the account to the date the aging schedule is prepared. To illustrate, assume that Rodriguez Company is preparing an aging schedule as of August 31. Its account receivable for Saxon Woods company was due on May 29. As of August 31, Saxon's account is 94 days past due, as shown below.

After the number of days past due has been determined for each account, an aging schedule is prepared similar to the one shown in Exhibit 2.

EXHIBIT 2 Aging of Accounts Receivable

The aging schedule is completed by adding the columns to determine the total amount of receivables and each age class. A sliding scale of percentages, based on industry or company experience, is used to estimate the amount of uncollectibles in each age class, as shown in Exhibit 3.

EXHIBIT 3 Estimate of Uncollectible Accounts

Based on Exhibit 3, the desired balance for the allowance for doubtful accounts is estimated at $3,390. Comparing this estimate with the unadjusted balance of the allowance account determines the amount of the adjusting entry for uncollectible accounts expense. For example, assume that the unadjusted balance of the allowance account is a credit balance of $510. The amount to be added to this balance is therefore $2,880 ($3,390 - $510). The adjusting entry is as follows:

After the adjusting entry has been posted, the credit balance in the allowance account is $3,390, the desired amount. The net realizable value of the receivables is $82,910 ($86,300 - $3,390). If the unadjusted balance of the allowance account had been a debit balance of $300, the amount of the adjustment would have been $3,690 ($3,390 + $300).

Estimates of the uncollectible accounts expense based on the analysis of receivables emphasizes the current net realizable value of the receivables. Thus, this method places more emphasis on the balance sheet than on the income statement.

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 321-325* 

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