Adjustment for Loss from Uncollectible Accounts (accrued expense)

Adjustment for Loss from Uncollectible Accounts (accrued expense)

Objective Explain and illustrate the allowance method of accounting for uncollectible accounts receivable. Cite the advantages and disadvantages of the allowance method. 2

Computer Systems Company ALLOWANCE METHOD Accounts Receivable Uncollectible Accounts Expense Allowance for Uncollectible Accounts Balance $100,000 $2,000 Balance NOTE: This page is provided in the In Class Booklet and is to be completed as we work through each Steps 1 and 2 in the next part of the illustration. 3

Allowance Method Two methods of accounting for uncollectible accounts receivable - Allowance Method - Direct Write-off Method Accounting for uncollectible accounts receivable for the Computer Systems Company (CSC): - Sales medium-size computer systems - Accounting period is the calendar year - Revenue is earned and recorded in 2008 - Accounts Receivable balance is $100,000 before adjustments - Allowance for Uncollectible Accounts balance is $2,000 before adjustments - Record the adjusting entries for uncollectible accounts at December 31, 2008 to T accounts Accounts receivable are used for selling merchandise and services on credit and normally are expected to be collected within a relatively short period of time, the initial entry to record the sale on credit is to debit Accounts Receivable and credit Sales 4

Allowance Method 1. An estimate is made of the accounts receivable that may be uncollectible in the accounting period. The estimate is expensed and a related allowance for doubtful accounts is recorded. The uncollectible accounts expense is classified as an operating expense, specifically as a selling or general and administrative expense. The Allowance for Doubtful Accounts is a contra asset account with a normal balance of credit. This account is reported on the balance sheet as a deduction from the accounts receivable in arriving at net realizable value. CSC: The Credit and Collections Department applies a percentage to the aged accounts receivable outstanding of $100,000 and estimates the uncollectible accounts as $5,000 at December 31, 2008. Since the beginning balance of the Allowance for Doubtful Accounts before the adjustment was $2,000, $3,000 must be added to bring the allowance up to $5,000. Dec 31 Uncollectible Accounts Expense $3,000 Allowance for Doubtful Accounts $3,000 5

Allowance Method (continued) 2. Accounts are written off after all appropriate measures have been taken and collection seems impossible such as the bankruptcy of the customer. The writeoffs are recorded to the allowance account provided in Item 1 and the specific account receivable is removed. CSC: On January 15, 2009, the account receivable of $1,000 for Alfred Smith was unable to be collected and the management authorized the write-off of this customer s account. Jan 15 Allowance for Doubtful Accounts $1,000 Accounts Receivable Alfred Smith $1,000 Observations: The write-off is not expensed, but recorded against the allowance account which was expensed in an earlier period when the sale was made and revenue was recognized. The write-off affects only balance sheet accounts which does not change the cash realizable value of the accounts receivable, total assets or net income. 6

Allowance Method (continued) Advantages The estimated uncollectible accounts are recorded in the same accounting period as the sale. The generation of revenue from the sale to the customer requires the incurrence of expenses such as the uncollectible accounts expense. As a result, the revenue and related expenses must be reported in the same period to appropriately determine net income. This fulfills the matching and expense recognition principles under Generally Accepted Accounting Principles where expenses incurred to generate revenue are matched and recorded in the same period. As a result, the allowance method is required for financial reporting purposes. The cash realizable value of the accounts receivable is appropriately reported in the current asset section of the balance sheet. The accounts receivable, net of the allowance for doubtful accounts, discloses the expected cash that can be collected from the receivables. Disadvantage The use of estimates can be under or over the actual write-offs of the accounts receivable. For example, if the estimate of uncollectible accounts is larger than the actual accounts written off then net income is understated in the period. Inaccurate and poorly prepared estimates can understate or overstate net income. 7

Computer Systems Company ALLOWANCE METHOD Accounts Receivable Uncollectible Accounts Expense Allowance for Uncollectible Accounts Balance $100,000 $2,000 Balance (1) $3,000 $3,000 (1) $1,000 (2) (2) $1,000 Balance $99,000 Balance $3,000 $4,000 Balance 8

Review ALLOWANCE METHOD December 31, 2008 1. Estimate of uncollectible accounts receivable Uncollectible Accounts Expense $3,000 Allowance for Doubtful Accounts $3,000 January 15, 2009 2. Write off of accounts receivable Allowance for Doubtful Accounts $1,000 Accounts Receivable A. Smith $1,000 A final review question: The cash realizable value, as discussed earlier, does not change as additional accounts receivable are written off in January 2009. Why? 9

Allowance Method (continued) 3. The Computer Systems Company reports their Allowance for Doubtful Accounts, after Items 1 and 2, on the balance sheet as follows: Current Assets Accounts Receivable $ 99,000 Allowance for Uncollectible Accounts - 4,000 Cash Realizable Value $ 95,000 4. Occasionally, there will be collection from a customer after the account has been written off. Two entries are required to record the recovery of a bad debt which include the reversal of the entry in Item 2 and then cash is debited and accounts receivable is credited for the amount received. 10

Estimating the Uncollectible Accounts One of the methods for estimating the expense for uncollectible accounts is the percentage of net credit sales method. The rate used is based on the: (1) company's past experience with uncollectible accounts and (2) management's assessment of current business conditions. The rate is multiplied by the sales on credit. Whiteside Antiques estimates that 0.80 percent of net credit sales will be uncollectible. Net credit sales for the year were $100,000. The estimated expense for uncollectible accounts = ($100,000 x 0.0080) or $800.

Journal Entries Allowance Method Date Dec. 31 Description Debit Credit Uncollectible Accts. Expense 800 Allowance for Doubtful Accts. 800 Estimated Whiteside Antiques AR anticipated to be uncollectible. The expense is recognized close to point of sale. Jan. 21 Allowance for Doubtful Accts. 600 Accounts Receivable - Simpson 600 Write off of Whiteside Antiques AR as uncollectible account. The expense was recognized earlier, not here when written off.