Estimating Uncollectible Accounts

  • Compute and journalize bad debt expense as a percentage of receivables (balance sheet method)

 

The percentage-of-receivables method estimates uncollectible accounts by determining the estimated net realizable value of accounts receivable, so many accountants refer to this as the balance-sheet method.

There are two ways to do this method: a simple way that, of course, is not the best practice and a more complicated but more reliable way that uses an aging analysis that we’ll cover in the next section.

Here is Larkin Co.’s subsidiary ledger from year one before any adjustment for bad debt:

Customer Amount Owed
A 57,500
B 22,000
C 74,500
D 8,000
E 12,500
F 25,000
G 50,500Single line
250,000Double line

If Larkin estimates 3% of ending accounts receivable will be uncollectible, or conversely, estimates 97% of accounts receivable are collectible, then the allowance for doubtful accounts should be $7,500, calculated as follows:

Accounts Receivable, gross × estimated uncollectible = allowance

Or

Accounts Receivable, gross × estimated collectible = net realizable value

Accounts Receivable, gross $250,000
X % uncollectible 3.0%
Allowance $7,500
Accounts Receivable, gross $250,000
X % collectible 97.0%
Net realizable value $242,500
Accounts Receivable, gross $250,000
Allowance (7,500)
Net realizable value $242,500

Let’s look at Larkin Co. again. Remember they billed out $1 million in services during the year (a) and collected $750 thousand of that (b):

A T checking account. On the debit side, there is an entry for 750,000 dollars labeled (b).

Two T accounts side by side. On the left is the Accounts Receivable. There is a debit entry labeled (a) of 1,000,000 dollars. On the credit side, there is an entry for 750,000 dollars labeled (b). There is a total debit balance of 250,000 dollars. On the right side is the Allowance for Doubtful Accounts, which has no entries.

Two T accounts next to each other. On the left is Service Revenue. There is a credit entry of 1,000,000 labeled (a). On the right is Bad Debt Expense, which has no entries.

Now we have to book the allowance for doubtful accounts. Note: we did not calculate bad debt expense. We calculated the uncollectible accounts based on the accounts receivable we had outstanding at the end of the year.

JournalPage 1
Date Description Post. Ref. Debit Credit
20–
Dec 31 Bad Debt Expense 7,500.00
Dec 31       Allowance for Doubtful Accounts 7,500.00
Dec 31 To record bad debts as a percentage of accounts receivable

Notice, other than the amount and description, this is the same entry we made under the percentage of sales method.

However, there is a significant difference (other than the amount).

Let’s look at year two. Sales of $1,250,000 (d) and collections of $800,000 (e) and the write off of $8,000 (f).

Two T accounts side by side. On the left is a checking account. At the top of it, there is a debit balance of 750,000 dollars. There is also a debit entry of 800,000 dollars labeled (e). There is a total debit balance of 1,550,000 dollars. On the right is another checking account. There is a credit balance of 892,500 dollars.

Two T accounts side by side. On the left is the Accounts Receivable, with a balance at the top of 250,000 dollars. There is also a debit entry of 1,250,000 dollars labeled (d). There is a credit entry of 800,000 dollars labeled (e) and another credit entry for 8,000 dollars labeled (f). There is a total debit balance of 692,000 dollars. On the right side is Allowance for Doubtful Accounts, which has a credit balance at the top of 7,500 dollars. There is also a debit entry for 8,000 dollars. There is a total debit balance of 500 dollars.

Two T accounts next to each other. On the left is Service Revenue, which has a credit entry of 1,250,000 dollars that is labeled (d). On the right is Bad Debt Expenses, which has no entries.

Now it’s time to calculate the allowance for doubtful accounts:

Accounts Receivable, gross $692,000
% uncollectible 3.0%
Allowance $20,760
Accounts Receivable, gross $692,000
% collectible 97.0%
Net realizable value $671,240
Accounts Receivable, gross $692,000
Allowance (20,760)
Net realizable value $671,240

(Quick: Get out your calculator and check the math.)

The allowance for doubtful accounts, based on the percentage of sales, should be a credit balance of $20,760. Right now, it has a debit balance of $500 because last year we booked $7,500 but the actual write off was $8,000. Go back and look at the T account for the allowance.

What entry would you have to make to the allowance account to get the balance to be $20,760?

A T account for Allowance for Doubtful Accounts. At the top is a credit balance of 7,500 dollars. There is a debit entry of 8,000 dollars, as well as a credit adjusting journal entry of 21,260 dollars. The total credit balance is 20,760 dollars.

A T accounts for Bad Debt Expense. On the debit side, it has an adjusting journal entry of 21,260 dollars.

Notice that bad debt expense in this case is simply the other half of the entry to get the balance sheet account adjusted. The focus in this case is on the net realizable value of the receivables, and the income statement (bad debt expense) is relegated to second place.

JournalPage 1
Date Description Post. Ref. Debit Credit
20–
Dec 31 Bad Debt Expense 21,260.00
Dec 31       Allowance for Doubtful Accounts 21,260.00
Dec 31 To record bad debts as a percentage of receivables

This whole process is worth a review if you don’t have a clear understanding of it yet. Walk through it step-by-step:

  1. Calculate the balance you need to have in the account (allowance for doubtful accounts).
  2. Examine the current account balance.
  3. Determine what entry, debit or credit, and amount you need to have in order to get the balance where it needs to be.
  4. Test your hypothesis using T accounts.
  5. Write the entry, post it, and make sure it did what you wanted it to do.

This process works for all kinds of transaction analysis. For instance, let’s say you wrote off an account earlier in the year, but then the company paid unexpectedly. This doesn’t happen very often, but it’s possible.

JournalPage 1
Date Description Post. Ref. Debit Credit
20–
Dec 31 Allowance for Doubtful Accounts 2,000.00
Dec 31       Accounts Receivable 2,000.00
Dec 31 To write off bad account

And then, surprise, the company pays you $1,500 a few months later. You know you have to debit cash, but to what account do you post the credit?

You could just post the credit to allowance for doubtful accounts, but the proper way to handle this is to re-establish the receivable by reversing the write-off (partially) and then recording the payment against the account.

JournalPage 1
Date Description Post. Ref. Debit Credit
20–
Mar 17 Accounts Receivable 1,500.00
Mar 17       Allowance for Doubtful Accounts 1,500.00
Mar 17 To reverse prior write-off (partial)

 

JournalPage 1
Date Description Post. Ref. Debit Credit
20–
Mar 17 Checking Account 1,500.00
Mar 17       Accounts Receivable 1,500.00
Mar 17 To record payment on account

Hopefully, your accounting software has a process in place to accomplish this transaction, but it’s rare enough that you may have to figure out the result you want and then make it happen using the built-in systems.

Next, we’ll look at a more sophisticated way to calculate the net realizable value of accounts receivable and the allowance for doubtful accounts, but first check your understanding of the percentage of receivables method.

 

You can view the transcript for “Percentage of Receivables Method for Bad Debts Expense (Financial Accounting Tutorial #44)” here (opens in new window).