Accounting: The Language of Business - Vol. 2 (Intermediate: Part 140)

Technology has changed accounting today. Bookkeeping is now automated. Since the first records were kept in America, bookkeepers have used a number of tools. William Seward Burroughs’ adding machine, created in 1887 and perfected for commercial sale in the 1890s, helped early accountants calculate receipts and quickly reconcile their books (Smithsonianmag.com).

 Short-Term Operating Assets: Cash and Receivables (Part E)

by

Charles Lamson

Accounting for Accounts Receivable: Subsequent Measurement

Managers understand that selling their products on credit increases total sales because customers prefer to buy on credit. However, there is the risk that the company will not collect the full amount of the receivables. The uncollectible portion of a company's receivables creates a measurement problem for accountants. Accounts receivable must be reported on the balance sheet at net realizable value. The term net realizable value (NRV) describes the estimated amount that a company reasonably expects to collect from its customers and is measured as the gross accounts receivable less an estimated allowance for uncollectible accounts (a contra-asset account). 

Firms report bad debt expense on the income statement to reflect the cost of uncollectible accounts. It is not possible to know which specific accounts will ultimately become uncollectible with certainty. Thus, at the end of each reporting period, management must estimate the NRV of accounts receivable and bad debt expense. 

The Allowance Message

We now focus on the allowance method, which estimates the NRV of accounts receivable and the current period's bad debt expense in your period of the sale. There are two key considerations related to uncollectible accounts. (An alternative is to report bad debt expense only during the period when an account is determined to be uncollectible. This approach, known as the direct write-off method, is generally not allowed under GAAP.):

1. The measurement of accounts receivable on the balance sheet at estimated NRV

2. The inclusion of bad debt expense related to the uncollectible account on the income statement in the appropriate period 

To illustrate, assume that a company sells a product on credit for $1,000, but it expects that the customer will ultimately pay only $900. As a result, the company will:

1. Report accounts receivable on the balance sheet at $900, computed as

follows:

     

2. Record revenue of $1,000 and bad debt expense of $100 in the same.

In this way, the allowance method measures the receivable at its NRV and reports the cost of selling on credit with the additional revenue generated from extending credit to customers in the same period.

As noted earlier, companies estimating bad debt expense also create an allowance for uncollectible accounts (We also refer to the allowance for uncollectible accounts as the allowance for bad debts or the allowance for doubtful accounts.) The allowance account is a contra-asset that reduces accounts receivable so that the NRV of accounts receivable is reported on the balance sheet. Example 9.4 illustrates the allowance for uncollectible accounts. In the year in which a company determines that a specific account is uncollectible, it writes off the account receivable against the allowance without a further reduction of earnings. We will discuss write-offs in a later post.

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 450-452*

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