{"id":169,"date":"2024-09-06T16:47:07","date_gmt":"2024-09-06T16:47:07","guid":{"rendered":"https:\/\/content.one.lumenlearning.com\/financialaccounting\/chapter\/estimating-bad-debt-expense\/"},"modified":"2024-09-18T21:39:05","modified_gmt":"2024-09-18T21:39:05","slug":"estimating-bad-debt-expense","status":"publish","type":"chapter","link":"https:\/\/content.one.lumenlearning.com\/financialaccounting\/chapter\/estimating-bad-debt-expense\/","title":{"raw":"Estimating Bad Debt Expense","rendered":"Estimating Bad Debt Expense"},"content":{"raw":"<section class=\"textbox learningGoals\" aria-label=\"Learning Goals\">\r\n<ul>\r\n \t<li>Compute and journalize bad debt expense under the allowance method (percentage of sales)<\/li>\r\n<\/ul>\r\n<\/section>&nbsp;\r\n\r\nGAAP requires companies to match expenses to revenue as closely as possible. Under the direct write-off method of accounting for uncollectible accounts receivable, you could have revenue in October, finish the year, and report that revenue to investors and creditors, and then in the next year, find that account has gone bad. As accountants, we don\u2019t want to go back to the prior year, change it, restate it, and publish new financials. That would be time-consuming and the users of those financials would be frustrated if we were always going back and changing the financials. So, once a year is over, and the books are closed, it\u2019s done and we don\u2019t go back.\r\n\r\nWhat are the other alternatives? The FASB asked this question and the answer that came back was this: if we (accountants) could reasonably estimate bad debts in some way we could post an expense in the same year or other time period as the revenue\/receivable was booked.\r\n\r\nThe easiest, but least accurate way to do this is to simply take a percentage of sales, based on a historical average, and use it as an estimate, and then periodically make sure it is fairly accurate over time. We call this the percentage-of-sales method. Also, sometimes accountants refer to this method as the income statement method because the focus is on the expense account.\r\n\r\nThe formula to estimate bad debts expense is:\r\n\r\nBad debt expense = Net sales (total or credit) \u00d7 Percentage estimated as uncollectible\r\n\r\nTechnically, we should base bad debt expense on credit sales only, but if cash sales are small or make up a fairly constant percentage of total sales, bad debt expense could be based on total net sales. Since at least one of these conditions is usually met, companies commonly use total net sales rather than credit sales.\r\n\r\nHere\u2019s an example. Larkin Co. is a start-up accounting firm that billed out $1 million in services during the year (a) and collected $750 thousand of that revenue (b):\r\n\r\n<a href=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5107\/2020\/10\/09070837\/Screen-Shot-2020-11-08-at-11.04.40-PM.png\"><img class=\"alignnone size-medium wp-image-5391\" src=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5107\/2020\/10\/09070837\/Screen-Shot-2020-11-08-at-11.04.40-PM-300x278.png\" alt=\"A Checking T account. There is a debit entry for 750,000 dollars labeled (b).\" width=\"300\" height=\"278\" \/><\/a>\r\n\r\n<a href=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5107\/2020\/10\/09070948\/Screen-Shot-2020-11-08-at-11.04.54-PM.png\"><img class=\"alignnone size-medium wp-image-5392\" src=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5107\/2020\/10\/09070948\/Screen-Shot-2020-11-08-at-11.04.54-PM-300x247.png\" alt=\"An Accounts Receivable T account. It has a debit entry of 1,000,000 dollars labeled (a) and a credit entry of 750,000 dollars marked with a (b).\" width=\"300\" height=\"247\" \/><\/a>\r\n\r\n<a href=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5107\/2020\/10\/09071059\/Screen-Shot-2020-11-08-at-11.05.01-PM.png\"><img class=\"alignnone size-medium wp-image-5393\" src=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5107\/2020\/10\/09071059\/Screen-Shot-2020-11-08-at-11.05.01-PM-300x267.png\" alt=\"A Service Revenue T account. It has a credit entry labeled (a) for 1,000,000 dollars.\" width=\"300\" height=\"267\" \/><\/a>\r\n\r\nWhile preparing the year-end financial statements before the close of the year, Larkin Co. decides to use the percentage-of-sales method to estimate a reduction to sales that will closely approximate the revenue they have booked that they will never actually collect. They are using the same credit policies as other accounting firms and expect about the same amount of bad debt on a percentage basis. They use an industry standard (that one of the experienced partners in the firm has provided) of 1%.\r\n\r\nBased on this percentage, the amount of revenues that will never be collected is 1,000,000 \u00d7 .01 = $10,000.\r\n\r\nSo, they make this entry (c):\r\n<table class=\"fin-table gridded\"><caption class=\"u-clearfix\"><span style=\"text-transform: uppercase;\">Journal<\/span><span style=\"float: right;\">Page 1<\/span><\/caption>\r\n<thead>\r\n<tr aria-hidden=\"true\">\r\n<td colspan=\"5\"><\/td>\r\n<\/tr>\r\n<tr>\r\n<th scope=\"col\">Date<\/th>\r\n<th scope=\"col\">Description<\/th>\r\n<th scope=\"col\">Post. Ref.<\/th>\r\n<th scope=\"col\">Debit<\/th>\r\n<th scope=\"col\">Credit<\/th>\r\n<\/tr>\r\n<\/thead>\r\n<tbody>\r\n<tr>\r\n<td>20--<\/td>\r\n<td><\/td>\r\n<td><\/td>\r\n<td><\/td>\r\n<td><\/td>\r\n<\/tr>\r\n<tr>\r\n<th scope=\"row\">Dec 31<\/th>\r\n<td>Bad Debt Expense<\/td>\r\n<td class=\"r\"><\/td>\r\n<td class=\"r\">10,000.00<\/td>\r\n<td><\/td>\r\n<\/tr>\r\n<tr>\r\n<th><span class=\"u-sr-only\">Dec 31<\/span><\/th>\r\n<td>\u00a0 \u00a0 \u00a0 Allowance for Doubtful Accounts<\/td>\r\n<td><\/td>\r\n<td><\/td>\r\n<td>10,000.00<\/td>\r\n<\/tr>\r\n<tr>\r\n<th><span class=\"u-sr-only\">Dec 31<\/span><\/th>\r\n<td>To record bad debts as a percentage of sales<\/td>\r\n<td><\/td>\r\n<td><\/td>\r\n<td><\/td>\r\n<\/tr>\r\n<\/tbody>\r\n<\/table>\r\nWe post this entry to the GL:\r\n\r\n<a href=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5107\/2020\/10\/09071305\/Screen-Shot-2020-11-08-at-11.05.06-PM.png\"><img class=\"alignnone size-medium wp-image-5394\" src=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5107\/2020\/10\/09071305\/Screen-Shot-2020-11-08-at-11.05.06-PM-300x247.png\" alt=\"A T account for Allowance for Doubtful Accounts. There is a credit entry of 10,000 dollars marked with a (c).\" width=\"300\" height=\"247\" \/><\/a>\r\n\r\n<a href=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5107\/2020\/10\/09071434\/Screen-Shot-2020-11-08-at-11.05.11-PM.png\"><img class=\"alignnone size-medium wp-image-5395\" src=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5107\/2020\/10\/09071434\/Screen-Shot-2020-11-08-at-11.05.11-PM-300x237.png\" alt=\"A T account for Bad Debt Expense. It has a debit entry of 10,000 dollars labeled with a (c).\" width=\"300\" height=\"237\" \/><\/a>\r\n\r\nNotice they did not post the credit side of the entry to Accounts Receivable because the subsidiary account always, always, always has to agree with the control account. They could create a fictitious customer in the subsidiary ledger and then post the credit to the fictitious customer\u2019s account, but it\u2019s not common practice to do that. Instead, we create a separate GL account called Allowance for Doubtful Accounts. It\u2019s a companion account to Accounts Receivable, and since it has a credit balance, it is called a \u201ccontra account.\u201d We\u2019ll see more of these acoounts as we go on.\r\n\r\nHere is what the GL looks like now:\r\n\r\n<a href=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5107\/2020\/10\/09071701\/Screen-Shot-2020-11-08-at-11.05.16-PM.png\"><img class=\"alignnone size-medium wp-image-5396\" src=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5107\/2020\/10\/09071701\/Screen-Shot-2020-11-08-at-11.05.16-PM-300x274.png\" alt=\"A T Checking account. There is a debit entry of 750,000 dollars labeled with a (b).\" width=\"300\" height=\"274\" \/><\/a>\r\n\r\n<a href=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5107\/2020\/10\/09072005\/Screen-Shot-2020-11-08-at-11.05.21-PM.png\"><img class=\"alignnone wp-image-5397\" src=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5107\/2020\/10\/09072005\/Screen-Shot-2020-11-08-at-11.05.21-PM-300x114.png\" alt=\"Two T accounts side by side. On the left is Accounts Receivable, which has a debit entry labeled (a) of 1,000,000 dollars. On the credit side, there is an entry labeled (b) worth 750,000 dollars. On the right side is the Allowance for Dutiful Accounts. It has a credit entry of 10,000 dollars labeled (c).\" width=\"658\" height=\"250\" \/><\/a>\r\n\r\n<a href=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5107\/2020\/10\/09072242\/Screen-Shot-2020-11-08-at-11.05.29-PM.png\"><img class=\"alignnone wp-image-5398\" src=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5107\/2020\/10\/09072242\/Screen-Shot-2020-11-08-at-11.05.29-PM-300x132.png\" alt=\"Two T accounts side by side. On the left is the Service Revenue account, which has a credit entry of 1,000,000 dollars and is labeled with an (a). On the right is the Bad Debt Expense account, which has a credit entry of 10,000 dollars labeled with a (c).\" width=\"623\" height=\"274\" \/><\/a>\r\n\r\nBad Debt Expense is not considered a contra account to Revenue. It\u2019s a stand-alone account usually classified as a selling expense (which you will see in the module on Merchandising Operations). However, Allowance for Doubtful Accounts is attached to Accounts Receivable. It holds the amount we have determined is uncollectible until we actually identify the accounts that go bad.\r\n\r\nYou can see from these few T accounts that although total gross revenues are $1 million, we have created a matching expense that records the estimated amount that will be uncollectible. The matching principle requires us to book expenses in the same period as the revenues to which they are related to the best of our ability.\r\n\r\nAlso, we now have a net number for accounts receivable. The net receivable, adjusted for the estimated uncollectible accounts is $750,000 (gross receivables) minus the allowance of $10,000. That means that we expect to collect in cash $740,000 once all the payments and non-payments are accounted for. Accountants call this collection the net realizable value. Remember, to recognize a revenue or an expense means to record it, and to realize it means it actually happens. In this case, to realize a revenue recorded \u201con account\u201d means to collect the cash.\r\n\r\nIf you wanted to sell all your receivables to me (called \u201cfactoring\u201d), I would not buy them from you based on the gross amount, which is both the control account and the detailed list of customers from whom I will collect (the subsidiary ledger). I would buy them from you based on the net realizable value\u2014the cash I would expect to ultimately collect. We\u2019ll cover factoring in slightly more detail a bit later.\r\n\r\nAccounts Receivable and its companion account, Allowance for Doubtful Accounts, are permanent accounts and are not closed at the end of the accounting cycle. Revenues and Bad Debt Expense are temporary accounts and are closed to capital at the end of the cycle. So, in year two, the beginning balances of Larkin Co. look like this:\r\n\r\n<a href=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5107\/2020\/10\/09073702\/Screen-Shot-2020-11-08-at-11.05.47-PM.png\"><img class=\"alignnone wp-image-5399\" src=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5107\/2020\/10\/09073702\/Screen-Shot-2020-11-08-at-11.05.47-PM-300x121.png\" alt=\"Two T accounts next to each other. On the left is a checking account with a debit balance of 750,000 dollars. On the right is a Capital account with a credit balance of 900,000 dollars.\" width=\"580\" height=\"234\" \/><\/a>\r\n\r\n<a href=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5107\/2020\/10\/09075228\/Screen-Shot-2020-11-08-at-11.05.55-PM.png\"><img class=\"alignnone wp-image-5400\" src=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5107\/2020\/10\/09075228\/Screen-Shot-2020-11-08-at-11.05.55-PM-300x120.png\" alt=\"Two T accounts side by side. On the left is Accounts Receivable, with a debit balance of 250,000. On the right side is Allowance for Dutiful Accounts, with a credit balance of 10,000 dollars.\" width=\"578\" height=\"231\" \/><\/a>\r\n\r\n<a href=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5107\/2020\/10\/09075427\/Screen-Shot-2020-11-08-at-11.06.10-PM.png\"><img class=\"alignnone wp-image-5401\" src=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5107\/2020\/10\/09075427\/Screen-Shot-2020-11-08-at-11.06.10-PM-300x111.png\" alt=\"Two T accounts next to each other. On the left is Service Revenue and on the right is Bad Debt Expense.\" width=\"586\" height=\"217\" \/><\/a>\r\n\r\n<span style=\"font-size: 1rem; text-align: initial;\">Assume the subsidiary receivables ledger looks something like this (simplified):<\/span>\r\n<div align=\"left\">\r\n<table class=\"fin-table acctstatement\">\r\n<tbody>\r\n<tr>\r\n<th scope=\"col\">Customer<\/th>\r\n<th scope=\"col\">Amount Owed<\/th>\r\n<\/tr>\r\n<tr>\r\n<td>A<\/td>\r\n<td>57,500<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>B<\/td>\r\n<td>22,000<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>C<\/td>\r\n<td>74,500<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>D<\/td>\r\n<td>8,000<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>E<\/td>\r\n<td>12,500<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>F<\/td>\r\n<td>25,000<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>G<\/td>\r\n<td>50,500<span class=\"u-sr-only\">Single line<\/span><\/td>\r\n<\/tr>\r\n<tr>\r\n<td><\/td>\r\n<td>250,000<span class=\"u-sr-only\">Double line<\/span><\/td>\r\n<\/tr>\r\n<tr>\r\n<td><\/td>\r\n<td><\/td>\r\n<\/tr>\r\n<\/tbody>\r\n<\/table>\r\n<\/div>\r\nNotice how the subsidiary ledger agrees to the GL control account and does not include our estimated $10,000 of bad debt.\r\n\r\nNow, in year 2, client D refuses to pay and then disappears. All efforts to collect fail. In February, we decide to write off the account as a loss.\r\n<table class=\"fin-table gridded\"><caption class=\"u-clearfix\"><span style=\"text-transform: uppercase;\">Journal<\/span><span style=\"float: right;\">Page 1<\/span><\/caption>\r\n<thead>\r\n<tr aria-hidden=\"true\">\r\n<td colspan=\"5\"><\/td>\r\n<\/tr>\r\n<tr>\r\n<th scope=\"col\">Date<\/th>\r\n<th scope=\"col\">Description<\/th>\r\n<th scope=\"col\">Post. Ref.<\/th>\r\n<th scope=\"col\">Debit<\/th>\r\n<th scope=\"col\">Credit<\/th>\r\n<\/tr>\r\n<\/thead>\r\n<tbody>\r\n<tr>\r\n<td>20--<\/td>\r\n<td><\/td>\r\n<td><\/td>\r\n<td><\/td>\r\n<td><\/td>\r\n<\/tr>\r\n<tr>\r\n<th scope=\"row\">Feb 28<\/th>\r\n<td>Allowance for Doubtful Accounts<\/td>\r\n<td class=\"r\"><\/td>\r\n<td class=\"r\">8,000.00<\/td>\r\n<td><\/td>\r\n<\/tr>\r\n<tr>\r\n<th><span class=\"u-sr-only\">Feb 28<\/span><\/th>\r\n<td>\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0Accounts Receivable<\/td>\r\n<td><\/td>\r\n<td class=\"r\"><\/td>\r\n<td class=\"r\">8,000.00<\/td>\r\n<\/tr>\r\n<tr>\r\n<th><span class=\"u-sr-only\">Feb 28<\/span><\/th>\r\n<td>To write off bad account from client D<\/td>\r\n<td><\/td>\r\n<td><\/td>\r\n<td><\/td>\r\n<\/tr>\r\n<\/tbody>\r\n<\/table>\r\nWe post this entry to both the GL and the subsidiary ledger:\r\n\r\n<a href=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5107\/2020\/10\/09075643\/Screen-Shot-2020-11-08-at-11.06.18-PM.png\"><img class=\"alignnone wp-image-5402\" src=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5107\/2020\/10\/09075643\/Screen-Shot-2020-11-08-at-11.06.18-PM-300x122.png\" alt=\"Two T accounts next to each other. On the left is the Checking Account, which has a debit balance of 750,000 dollars. On the right is Capital, which has a credit entry of 900,000 dollars.\" width=\"590\" height=\"240\" \/><\/a>\r\n\r\n<a href=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5107\/2020\/10\/09075810\/Screen-Shot-2020-11-08-at-11.06.22-PM.png\"><img class=\"alignnone wp-image-5403\" src=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5107\/2020\/10\/09075810\/Screen-Shot-2020-11-08-at-11.06.22-PM-300x123.png\" alt=\"Two T accounts side by side. On the left is Accounts Receivable, with a debit balance of 250,000 and a credit entry of 8,000 dollars on February 28th. There is a total debit balance of 242,000 dollars. On the right side is Allowance for Dutiful Accounts, which has a credit entry of 10,000 dollars and a debit entry of 8,000 dollars. It has a total credit balance of 2,000 dollars.\" width=\"588\" height=\"241\" \/><\/a>\r\n\r\n<a href=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5107\/2020\/10\/09080135\/Screen-Shot-2020-11-08-at-11.06.26-PM.png\"><img class=\"alignnone wp-image-5404\" src=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5107\/2020\/10\/09080135\/Screen-Shot-2020-11-08-at-11.06.26-PM-300x114.png\" alt=\"Two T accounts side by side. On the left is Service Revenue and on the right is Bad Debt Expense.\" width=\"611\" height=\"232\" \/><\/a>\r\n\r\n<span style=\"font-size: 1em;\">The subsidiary ledger agrees with the control account.<\/span>\r\n<table class=\"fin-table acctstatement\">\r\n<tbody>\r\n<tr>\r\n<th scope=\"col\">Customer<\/th>\r\n<th scope=\"col\">Amount Owed<\/th>\r\n<\/tr>\r\n<tr>\r\n<td>A<\/td>\r\n<td>57,500<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>B<\/td>\r\n<td>22,000<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>C<\/td>\r\n<td>74,500<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>D<\/td>\r\n<td><\/td>\r\n<\/tr>\r\n<tr>\r\n<td>E<\/td>\r\n<td>12,500<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>F<\/td>\r\n<td>25,000<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>G<\/td>\r\n<td>50,500<span class=\"u-sr-only\">Single line<\/span><\/td>\r\n<\/tr>\r\n<tr>\r\n<td><\/td>\r\n<td>242,000<span class=\"u-sr-only\">Double line<\/span><\/td>\r\n<\/tr>\r\n<\/tbody>\r\n<\/table>\r\nWe haven\u2019t posted any other transactions, but you can see we didn\u2019t record the write off of the prior year\u2019s sale as an expense in this year. We already \u201crecognized\u201d the expense in year one when we recognized the revenue from all that work we did. This year, we are simply recognizing the actual account that went bad. (Assume all those others are paying or have paid. Now there are new revenues and new accounts receivable, but right now we\u2019re just trying to isolate this one issue).\r\n\r\nThink of the allowance for doubtful accounts as a place to hold \u201caccounts that will go bad in the future, we just don\u2019t know which account that is yet.\u201d When we actually identify the account(s) that go bad, we remove that account from the subsidiary ledger and the GL by moving from the \u201cunidentified\u201d bad accounts to the actual lists (control and subsidiary).\r\n\r\nNotice three things:\r\n<ul>\r\n \t<li style=\"font-weight: 400;\">Bad Debt Expense is recognized in the same period that the revenue is recognized.<\/li>\r\n \t<li style=\"font-weight: 400;\">The estimate ($10,000 in this case) may not be exact. We are balancing the matching principle and usefulness against perfection. We don\u2019t need to be perfectly accurate. We need to provide a reasonable picture of the company\u2019s financial position at the end of the year, and that includes an estimate of accounts that will never materialize into cash.<\/li>\r\n<\/ul>\r\nIn applying the percentage-of-sales method, companies annually review the percentage of uncollectible accounts that resulted from the previous year\u2019s sales. If the percentage rate is still valid, the company makes no change. However, if the situation has changed significantly, the company increases or decreases the percentage rate to reflect the changed condition. For example, in periods of recession and high unemployment, a firm may increase the percentage rate to reflect the customers\u2019 decreased ability to pay. However, if the company adopts a more stringent credit policy, it may have to decrease the percentage rate because the company would expect fewer uncollectible accounts.\r\n\r\nAgain, this \u201cincome statement method\u201d is the easiest to apply, but not the most accurate. In fact, it is not considered GAAP, so public companies who file audited financial statements with the SEC cannot use this method. We\u2019ll cover a better method, the one used by most companies for year end financials, in the next section.\r\n\r\n&nbsp;\r\n\r\n<section class=\"textbox watchIt\" aria-label=\"Watch It\"><iframe src=\"\/\/plugin.3playmedia.com\/show?mf=5475491&amp;p3sdk_version=1.10.1&amp;p=20361&amp;pt=375&amp;video_id=uE-umnuyRzQ&amp;video_target=tpm-plugin-aq3m3rfz-uE-umnuyRzQ\" width=\"800px\" height=\"450px\" frameborder=\"0\" marginwidth=\"0px\" marginheight=\"0px\" data-mce-fragment=\"1\"><\/iframe>You can view the <a href=\"https:\/\/course-building.s3-us-west-2.amazonaws.com\/Financial+Accounting\/Transcripts\/SalesMethodOrIncomeApproach_transcript.txt\" target=\"_blank\" rel=\"noopener\">transcript for \"Sales Method or Income Approach for Bad Debts Expense (Financial Accounting Tutorial #43)\" here (opens in new window)<\/a>.<\/section><section class=\"textbox tryIt\" aria-label=\"Try It\">[ohm2_question]25339[\/ohm2_question]\r\n[ohm_question]204392-204397[\/ohm_question]<\/section>","rendered":"<section class=\"textbox learningGoals\" aria-label=\"Learning Goals\">\n<ul>\n<li>Compute and journalize bad debt expense under the allowance method (percentage of sales)<\/li>\n<\/ul>\n<\/section>\n<p>&nbsp;<\/p>\n<p>GAAP requires companies to match expenses to revenue as closely as possible. Under the direct write-off method of accounting for uncollectible accounts receivable, you could have revenue in October, finish the year, and report that revenue to investors and creditors, and then in the next year, find that account has gone bad. As accountants, we don\u2019t want to go back to the prior year, change it, restate it, and publish new financials. That would be time-consuming and the users of those financials would be frustrated if we were always going back and changing the financials. So, once a year is over, and the books are closed, it\u2019s done and we don\u2019t go back.<\/p>\n<p>What are the other alternatives? The FASB asked this question and the answer that came back was this: if we (accountants) could reasonably estimate bad debts in some way we could post an expense in the same year or other time period as the revenue\/receivable was booked.<\/p>\n<p>The easiest, but least accurate way to do this is to simply take a percentage of sales, based on a historical average, and use it as an estimate, and then periodically make sure it is fairly accurate over time. We call this the percentage-of-sales method. Also, sometimes accountants refer to this method as the income statement method because the focus is on the expense account.<\/p>\n<p>The formula to estimate bad debts expense is:<\/p>\n<p>Bad debt expense = Net sales (total or credit) \u00d7 Percentage estimated as uncollectible<\/p>\n<p>Technically, we should base bad debt expense on credit sales only, but if cash sales are small or make up a fairly constant percentage of total sales, bad debt expense could be based on total net sales. Since at least one of these conditions is usually met, companies commonly use total net sales rather than credit sales.<\/p>\n<p>Here\u2019s an example. Larkin Co. is a start-up accounting firm that billed out $1 million in services during the year (a) and collected $750 thousand of that revenue (b):<\/p>\n<p><a href=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5107\/2020\/10\/09070837\/Screen-Shot-2020-11-08-at-11.04.40-PM.png\"><img loading=\"lazy\" decoding=\"async\" class=\"alignnone size-medium wp-image-5391\" src=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5107\/2020\/10\/09070837\/Screen-Shot-2020-11-08-at-11.04.40-PM-300x278.png\" alt=\"A Checking T account. There is a debit entry for 750,000 dollars labeled (b).\" width=\"300\" height=\"278\" \/><\/a><\/p>\n<p><a href=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5107\/2020\/10\/09070948\/Screen-Shot-2020-11-08-at-11.04.54-PM.png\"><img loading=\"lazy\" decoding=\"async\" class=\"alignnone size-medium wp-image-5392\" src=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5107\/2020\/10\/09070948\/Screen-Shot-2020-11-08-at-11.04.54-PM-300x247.png\" alt=\"An Accounts Receivable T account. It has a debit entry of 1,000,000 dollars labeled (a) and a credit entry of 750,000 dollars marked with a (b).\" width=\"300\" height=\"247\" \/><\/a><\/p>\n<p><a href=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5107\/2020\/10\/09071059\/Screen-Shot-2020-11-08-at-11.05.01-PM.png\"><img loading=\"lazy\" decoding=\"async\" class=\"alignnone size-medium wp-image-5393\" src=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5107\/2020\/10\/09071059\/Screen-Shot-2020-11-08-at-11.05.01-PM-300x267.png\" alt=\"A Service Revenue T account. It has a credit entry labeled (a) for 1,000,000 dollars.\" width=\"300\" height=\"267\" \/><\/a><\/p>\n<p>While preparing the year-end financial statements before the close of the year, Larkin Co. decides to use the percentage-of-sales method to estimate a reduction to sales that will closely approximate the revenue they have booked that they will never actually collect. They are using the same credit policies as other accounting firms and expect about the same amount of bad debt on a percentage basis. They use an industry standard (that one of the experienced partners in the firm has provided) of 1%.<\/p>\n<p>Based on this percentage, the amount of revenues that will never be collected is 1,000,000 \u00d7 .01 = $10,000.<\/p>\n<p>So, they make this entry (c):<\/p>\n<table class=\"fin-table gridded\">\n<caption class=\"u-clearfix\"><span style=\"text-transform: uppercase;\">Journal<\/span><span style=\"float: right;\">Page 1<\/span><\/caption>\n<thead>\n<tr aria-hidden=\"true\">\n<td colspan=\"5\"><\/td>\n<\/tr>\n<tr>\n<th scope=\"col\">Date<\/th>\n<th scope=\"col\">Description<\/th>\n<th scope=\"col\">Post. Ref.<\/th>\n<th scope=\"col\">Debit<\/th>\n<th scope=\"col\">Credit<\/th>\n<\/tr>\n<\/thead>\n<tbody>\n<tr>\n<td>20&#8211;<\/td>\n<td><\/td>\n<td><\/td>\n<td><\/td>\n<td><\/td>\n<\/tr>\n<tr>\n<th scope=\"row\">Dec 31<\/th>\n<td>Bad Debt Expense<\/td>\n<td class=\"r\"><\/td>\n<td class=\"r\">10,000.00<\/td>\n<td><\/td>\n<\/tr>\n<tr>\n<th><span class=\"u-sr-only\">Dec 31<\/span><\/th>\n<td>\u00a0 \u00a0 \u00a0 Allowance for Doubtful Accounts<\/td>\n<td><\/td>\n<td><\/td>\n<td>10,000.00<\/td>\n<\/tr>\n<tr>\n<th><span class=\"u-sr-only\">Dec 31<\/span><\/th>\n<td>To record bad debts as a percentage of sales<\/td>\n<td><\/td>\n<td><\/td>\n<td><\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<p>We post this entry to the GL:<\/p>\n<p><a href=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5107\/2020\/10\/09071305\/Screen-Shot-2020-11-08-at-11.05.06-PM.png\"><img loading=\"lazy\" decoding=\"async\" class=\"alignnone size-medium wp-image-5394\" src=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5107\/2020\/10\/09071305\/Screen-Shot-2020-11-08-at-11.05.06-PM-300x247.png\" alt=\"A T account for Allowance for Doubtful Accounts. There is a credit entry of 10,000 dollars marked with a (c).\" width=\"300\" height=\"247\" \/><\/a><\/p>\n<p><a href=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5107\/2020\/10\/09071434\/Screen-Shot-2020-11-08-at-11.05.11-PM.png\"><img loading=\"lazy\" decoding=\"async\" class=\"alignnone size-medium wp-image-5395\" src=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5107\/2020\/10\/09071434\/Screen-Shot-2020-11-08-at-11.05.11-PM-300x237.png\" alt=\"A T account for Bad Debt Expense. It has a debit entry of 10,000 dollars labeled with a (c).\" width=\"300\" height=\"237\" \/><\/a><\/p>\n<p>Notice they did not post the credit side of the entry to Accounts Receivable because the subsidiary account always, always, always has to agree with the control account. They could create a fictitious customer in the subsidiary ledger and then post the credit to the fictitious customer\u2019s account, but it\u2019s not common practice to do that. Instead, we create a separate GL account called Allowance for Doubtful Accounts. It\u2019s a companion account to Accounts Receivable, and since it has a credit balance, it is called a \u201ccontra account.\u201d We\u2019ll see more of these acoounts as we go on.<\/p>\n<p>Here is what the GL looks like now:<\/p>\n<p><a href=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5107\/2020\/10\/09071701\/Screen-Shot-2020-11-08-at-11.05.16-PM.png\"><img loading=\"lazy\" decoding=\"async\" class=\"alignnone size-medium wp-image-5396\" src=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5107\/2020\/10\/09071701\/Screen-Shot-2020-11-08-at-11.05.16-PM-300x274.png\" alt=\"A T Checking account. There is a debit entry of 750,000 dollars labeled with a (b).\" width=\"300\" height=\"274\" \/><\/a><\/p>\n<p><a href=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5107\/2020\/10\/09072005\/Screen-Shot-2020-11-08-at-11.05.21-PM.png\"><img loading=\"lazy\" decoding=\"async\" class=\"alignnone wp-image-5397\" src=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5107\/2020\/10\/09072005\/Screen-Shot-2020-11-08-at-11.05.21-PM-300x114.png\" alt=\"Two T accounts side by side. On the left is Accounts Receivable, which has a debit entry labeled (a) of 1,000,000 dollars. On the credit side, there is an entry labeled (b) worth 750,000 dollars. On the right side is the Allowance for Dutiful Accounts. It has a credit entry of 10,000 dollars labeled (c).\" width=\"658\" height=\"250\" \/><\/a><\/p>\n<p><a href=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5107\/2020\/10\/09072242\/Screen-Shot-2020-11-08-at-11.05.29-PM.png\"><img loading=\"lazy\" decoding=\"async\" class=\"alignnone wp-image-5398\" src=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5107\/2020\/10\/09072242\/Screen-Shot-2020-11-08-at-11.05.29-PM-300x132.png\" alt=\"Two T accounts side by side. On the left is the Service Revenue account, which has a credit entry of 1,000,000 dollars and is labeled with an (a). On the right is the Bad Debt Expense account, which has a credit entry of 10,000 dollars labeled with a (c).\" width=\"623\" height=\"274\" \/><\/a><\/p>\n<p>Bad Debt Expense is not considered a contra account to Revenue. It\u2019s a stand-alone account usually classified as a selling expense (which you will see in the module on Merchandising Operations). However, Allowance for Doubtful Accounts is attached to Accounts Receivable. It holds the amount we have determined is uncollectible until we actually identify the accounts that go bad.<\/p>\n<p>You can see from these few T accounts that although total gross revenues are $1 million, we have created a matching expense that records the estimated amount that will be uncollectible. The matching principle requires us to book expenses in the same period as the revenues to which they are related to the best of our ability.<\/p>\n<p>Also, we now have a net number for accounts receivable. The net receivable, adjusted for the estimated uncollectible accounts is $750,000 (gross receivables) minus the allowance of $10,000. That means that we expect to collect in cash $740,000 once all the payments and non-payments are accounted for. Accountants call this collection the net realizable value. Remember, to recognize a revenue or an expense means to record it, and to realize it means it actually happens. In this case, to realize a revenue recorded \u201con account\u201d means to collect the cash.<\/p>\n<p>If you wanted to sell all your receivables to me (called \u201cfactoring\u201d), I would not buy them from you based on the gross amount, which is both the control account and the detailed list of customers from whom I will collect (the subsidiary ledger). I would buy them from you based on the net realizable value\u2014the cash I would expect to ultimately collect. We\u2019ll cover factoring in slightly more detail a bit later.<\/p>\n<p>Accounts Receivable and its companion account, Allowance for Doubtful Accounts, are permanent accounts and are not closed at the end of the accounting cycle. Revenues and Bad Debt Expense are temporary accounts and are closed to capital at the end of the cycle. So, in year two, the beginning balances of Larkin Co. look like this:<\/p>\n<p><a href=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5107\/2020\/10\/09073702\/Screen-Shot-2020-11-08-at-11.05.47-PM.png\"><img loading=\"lazy\" decoding=\"async\" class=\"alignnone wp-image-5399\" src=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5107\/2020\/10\/09073702\/Screen-Shot-2020-11-08-at-11.05.47-PM-300x121.png\" alt=\"Two T accounts next to each other. On the left is a checking account with a debit balance of 750,000 dollars. On the right is a Capital account with a credit balance of 900,000 dollars.\" width=\"580\" height=\"234\" \/><\/a><\/p>\n<p><a href=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5107\/2020\/10\/09075228\/Screen-Shot-2020-11-08-at-11.05.55-PM.png\"><img loading=\"lazy\" decoding=\"async\" class=\"alignnone wp-image-5400\" src=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5107\/2020\/10\/09075228\/Screen-Shot-2020-11-08-at-11.05.55-PM-300x120.png\" alt=\"Two T accounts side by side. On the left is Accounts Receivable, with a debit balance of 250,000. On the right side is Allowance for Dutiful Accounts, with a credit balance of 10,000 dollars.\" width=\"578\" height=\"231\" \/><\/a><\/p>\n<p><a href=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5107\/2020\/10\/09075427\/Screen-Shot-2020-11-08-at-11.06.10-PM.png\"><img loading=\"lazy\" decoding=\"async\" class=\"alignnone wp-image-5401\" src=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5107\/2020\/10\/09075427\/Screen-Shot-2020-11-08-at-11.06.10-PM-300x111.png\" alt=\"Two T accounts next to each other. On the left is Service Revenue and on the right is Bad Debt Expense.\" width=\"586\" height=\"217\" \/><\/a><\/p>\n<p><span style=\"font-size: 1rem; text-align: initial;\">Assume the subsidiary receivables ledger looks something like this (simplified):<\/span><\/p>\n<div style=\"text-align: left;\">\n<table class=\"fin-table acctstatement\">\n<tbody>\n<tr>\n<th scope=\"col\">Customer<\/th>\n<th scope=\"col\">Amount Owed<\/th>\n<\/tr>\n<tr>\n<td>A<\/td>\n<td>57,500<\/td>\n<\/tr>\n<tr>\n<td>B<\/td>\n<td>22,000<\/td>\n<\/tr>\n<tr>\n<td>C<\/td>\n<td>74,500<\/td>\n<\/tr>\n<tr>\n<td>D<\/td>\n<td>8,000<\/td>\n<\/tr>\n<tr>\n<td>E<\/td>\n<td>12,500<\/td>\n<\/tr>\n<tr>\n<td>F<\/td>\n<td>25,000<\/td>\n<\/tr>\n<tr>\n<td>G<\/td>\n<td>50,500<span class=\"u-sr-only\">Single line<\/span><\/td>\n<\/tr>\n<tr>\n<td><\/td>\n<td>250,000<span class=\"u-sr-only\">Double line<\/span><\/td>\n<\/tr>\n<tr>\n<td><\/td>\n<td><\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<\/div>\n<p>Notice how the subsidiary ledger agrees to the GL control account and does not include our estimated $10,000 of bad debt.<\/p>\n<p>Now, in year 2, client D refuses to pay and then disappears. All efforts to collect fail. In February, we decide to write off the account as a loss.<\/p>\n<table class=\"fin-table gridded\">\n<caption class=\"u-clearfix\"><span style=\"text-transform: uppercase;\">Journal<\/span><span style=\"float: right;\">Page 1<\/span><\/caption>\n<thead>\n<tr aria-hidden=\"true\">\n<td colspan=\"5\"><\/td>\n<\/tr>\n<tr>\n<th scope=\"col\">Date<\/th>\n<th scope=\"col\">Description<\/th>\n<th scope=\"col\">Post. Ref.<\/th>\n<th scope=\"col\">Debit<\/th>\n<th scope=\"col\">Credit<\/th>\n<\/tr>\n<\/thead>\n<tbody>\n<tr>\n<td>20&#8211;<\/td>\n<td><\/td>\n<td><\/td>\n<td><\/td>\n<td><\/td>\n<\/tr>\n<tr>\n<th scope=\"row\">Feb 28<\/th>\n<td>Allowance for Doubtful Accounts<\/td>\n<td class=\"r\"><\/td>\n<td class=\"r\">8,000.00<\/td>\n<td><\/td>\n<\/tr>\n<tr>\n<th><span class=\"u-sr-only\">Feb 28<\/span><\/th>\n<td>\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0Accounts Receivable<\/td>\n<td><\/td>\n<td class=\"r\"><\/td>\n<td class=\"r\">8,000.00<\/td>\n<\/tr>\n<tr>\n<th><span class=\"u-sr-only\">Feb 28<\/span><\/th>\n<td>To write off bad account from client D<\/td>\n<td><\/td>\n<td><\/td>\n<td><\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<p>We post this entry to both the GL and the subsidiary ledger:<\/p>\n<p><a href=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5107\/2020\/10\/09075643\/Screen-Shot-2020-11-08-at-11.06.18-PM.png\"><img loading=\"lazy\" decoding=\"async\" class=\"alignnone wp-image-5402\" src=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5107\/2020\/10\/09075643\/Screen-Shot-2020-11-08-at-11.06.18-PM-300x122.png\" alt=\"Two T accounts next to each other. On the left is the Checking Account, which has a debit balance of 750,000 dollars. On the right is Capital, which has a credit entry of 900,000 dollars.\" width=\"590\" height=\"240\" \/><\/a><\/p>\n<p><a href=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5107\/2020\/10\/09075810\/Screen-Shot-2020-11-08-at-11.06.22-PM.png\"><img loading=\"lazy\" decoding=\"async\" class=\"alignnone wp-image-5403\" src=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5107\/2020\/10\/09075810\/Screen-Shot-2020-11-08-at-11.06.22-PM-300x123.png\" alt=\"Two T accounts side by side. On the left is Accounts Receivable, with a debit balance of 250,000 and a credit entry of 8,000 dollars on February 28th. There is a total debit balance of 242,000 dollars. On the right side is Allowance for Dutiful Accounts, which has a credit entry of 10,000 dollars and a debit entry of 8,000 dollars. It has a total credit balance of 2,000 dollars.\" width=\"588\" height=\"241\" \/><\/a><\/p>\n<p><a href=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5107\/2020\/10\/09080135\/Screen-Shot-2020-11-08-at-11.06.26-PM.png\"><img loading=\"lazy\" decoding=\"async\" class=\"alignnone wp-image-5404\" src=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5107\/2020\/10\/09080135\/Screen-Shot-2020-11-08-at-11.06.26-PM-300x114.png\" alt=\"Two T accounts side by side. On the left is Service Revenue and on the right is Bad Debt Expense.\" width=\"611\" height=\"232\" \/><\/a><\/p>\n<p><span style=\"font-size: 1em;\">The subsidiary ledger agrees with the control account.<\/span><\/p>\n<table class=\"fin-table acctstatement\">\n<tbody>\n<tr>\n<th scope=\"col\">Customer<\/th>\n<th scope=\"col\">Amount Owed<\/th>\n<\/tr>\n<tr>\n<td>A<\/td>\n<td>57,500<\/td>\n<\/tr>\n<tr>\n<td>B<\/td>\n<td>22,000<\/td>\n<\/tr>\n<tr>\n<td>C<\/td>\n<td>74,500<\/td>\n<\/tr>\n<tr>\n<td>D<\/td>\n<td><\/td>\n<\/tr>\n<tr>\n<td>E<\/td>\n<td>12,500<\/td>\n<\/tr>\n<tr>\n<td>F<\/td>\n<td>25,000<\/td>\n<\/tr>\n<tr>\n<td>G<\/td>\n<td>50,500<span class=\"u-sr-only\">Single line<\/span><\/td>\n<\/tr>\n<tr>\n<td><\/td>\n<td>242,000<span class=\"u-sr-only\">Double line<\/span><\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<p>We haven\u2019t posted any other transactions, but you can see we didn\u2019t record the write off of the prior year\u2019s sale as an expense in this year. We already \u201crecognized\u201d the expense in year one when we recognized the revenue from all that work we did. This year, we are simply recognizing the actual account that went bad. (Assume all those others are paying or have paid. Now there are new revenues and new accounts receivable, but right now we\u2019re just trying to isolate this one issue).<\/p>\n<p>Think of the allowance for doubtful accounts as a place to hold \u201caccounts that will go bad in the future, we just don\u2019t know which account that is yet.\u201d When we actually identify the account(s) that go bad, we remove that account from the subsidiary ledger and the GL by moving from the \u201cunidentified\u201d bad accounts to the actual lists (control and subsidiary).<\/p>\n<p>Notice three things:<\/p>\n<ul>\n<li style=\"font-weight: 400;\">Bad Debt Expense is recognized in the same period that the revenue is recognized.<\/li>\n<li style=\"font-weight: 400;\">The estimate ($10,000 in this case) may not be exact. We are balancing the matching principle and usefulness against perfection. We don\u2019t need to be perfectly accurate. We need to provide a reasonable picture of the company\u2019s financial position at the end of the year, and that includes an estimate of accounts that will never materialize into cash.<\/li>\n<\/ul>\n<p>In applying the percentage-of-sales method, companies annually review the percentage of uncollectible accounts that resulted from the previous year\u2019s sales. If the percentage rate is still valid, the company makes no change. However, if the situation has changed significantly, the company increases or decreases the percentage rate to reflect the changed condition. For example, in periods of recession and high unemployment, a firm may increase the percentage rate to reflect the customers\u2019 decreased ability to pay. However, if the company adopts a more stringent credit policy, it may have to decrease the percentage rate because the company would expect fewer uncollectible accounts.<\/p>\n<p>Again, this \u201cincome statement method\u201d is the easiest to apply, but not the most accurate. In fact, it is not considered GAAP, so public companies who file audited financial statements with the SEC cannot use this method. We\u2019ll cover a better method, the one used by most companies for year end financials, in the next section.<\/p>\n<p>&nbsp;<\/p>\n<section class=\"textbox watchIt\" aria-label=\"Watch It\"><iframe loading=\"lazy\" src=\"\/\/plugin.3playmedia.com\/show?mf=5475491&amp;p3sdk_version=1.10.1&amp;p=20361&amp;pt=375&amp;video_id=uE-umnuyRzQ&amp;video_target=tpm-plugin-aq3m3rfz-uE-umnuyRzQ\" width=\"800px\" height=\"450px\" frameborder=\"0\" marginwidth=\"0px\" marginheight=\"0px\" data-mce-fragment=\"1\"><\/iframe>You can view the <a href=\"https:\/\/course-building.s3-us-west-2.amazonaws.com\/Financial+Accounting\/Transcripts\/SalesMethodOrIncomeApproach_transcript.txt\" target=\"_blank\" rel=\"noopener\">transcript for &#8220;Sales Method or Income Approach for Bad Debts Expense (Financial Accounting Tutorial #43)&#8221; here (opens in new window)<\/a>.<\/section>\n<section class=\"textbox tryIt\" aria-label=\"Try It\"><iframe loading=\"lazy\" id=\"ohm25339\" class=\"resizable\" src=\"https:\/\/ohm.one.lumenlearning.com\/multiembedq.php?id=25339&theme=lumen&iframe_resize_id=ohm25339&source=tnh&show_question_numbers\" width=\"100%\" height=\"150\"><\/iframe><br \/>\n<iframe loading=\"lazy\" id=\"ohm204392\" class=\"resizable\" src=\"https:\/\/ohm.lumenlearning.com\/multiembedq.php?id=204392-204397&theme=lumen&iframe_resize_id=ohm204392&source=tnh&show_question_numbers\" width=\"100%\" height=\"150\"><\/iframe><\/section>\n","protected":false},"author":6,"menu_order":7,"template":"","meta":{"_candela_citation":"[{\"type\":\"original\",\"description\":\"Estimating Bad Debt Expense\",\"author\":\"Joseph Cooke\",\"organization\":\"Lumen Learning\",\"url\":\"\",\"project\":\"\",\"license\":\"cc-by\",\"license_terms\":\"\"},{\"type\":\"cc\",\"description\":\"Accounting Principles: A Business Perspective\",\"author\":\"James Don Edwards, University of Georgia & Roger H. 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