Question

GAAP requires receivables be reported on the balance sheet net of uncollectible amounts (bad debt). This means the allowance method must be used to record uncollectible accounts. The allowance method includes making an adjusting entry. In your own words, explain this procedure to a new accounting student. Address these topics:

the two accounts used in the adjusting entry

two methods of estimating the bad debt expense amount for the adjusting entry

how each estimating method could result in a different amount of bad debt expense

how a different amount of estimated bad debt expense would affect the income statement and the balance sheet numbers

specific examples/numbers could be used to demonstrate the effect on the financial statements

Answer 1

the two accounts used in the adjusting entry

Allowance for Doubtful Accounts

Bad debts

two methods of estimating the bad debt expense amount for the adjusting entry

Estimating uncollectible accounts Accountants use two basic methods to estimate uncollectible accounts for a period.

The first method—percentage-of-sales method—focuses on the income statement and the relationship of uncollectible accounts to sales.

The second method—percentage-of-receivables method—focuses on the balance sheet and the relationship of the allowance for uncollectible accounts to accounts receivable.

how each estimating method could result in a different amount of bad debt expense

• The percentage-of-sales method estimates uncollectible accounts from the credit sales of a given period. In theory, the method is based on a percentage of prior years’ actual uncollectible accounts to prior years’ credit sales.

Bad Debt Expense = Net sales (total or credit) x Percentage estimated as uncollectible

• The percentage-of-receivables method estimates uncollectible accounts by determining the desired size of the Allowance for Uncollectible Accounts. Rankin would multiply the ending balance in Accounts Receivable by a rate (or rates) based on its uncollectible accounts experience.

Bad Debt Expense = (Accounts receivable ending balance x percentage estimated as uncollectible) – Existing credit balance in allowance for doubtful accounts or + existing debit balance in allowance for doubtful accounts

how a different amount of estimated bad debt expense would affect the income statement and the balance sheet numbers

To illustrate, assume that Rankin Company’s estimates uncollectible accounts at 1% of total net sales. Total net sales for the year were $500,000; receivables at year-end were $100,000, and the Allowance for Doubtful Accounts had a zero balance. Rankin would make the following adjusting entry at year-end:

Dec.	31	Bad Debt Expense	Debit 5,000	Credit
		Allowance for Doubtful Accounts		5,000
		To record estimated uncollectible accounts
		($500,000 X 1%).

Rankin reports Bad Debt Expense on the income statement. It reports the accounts receivable less the allowance among current assets in the balance sheet as follows:

Accounts receivable	$100,000
Less: Allowance for doubtful accounts	(5,000)
Accounts receivable, net	$95,000

On the income statement, Rankin would match the bad debt expense against sales revenues in the period. We would classify this expense as a selling expense since it is a normal consequence of selling on credit.

The Allowance for Doubtful Accounts account can have either a debit or credit balance before the year-end adjustment. Under the percentage-of-sales method, the company ignores any existing balance in the allowance when calculating the amount of the year-end adjustment

Using the same information as before, under the percentage of sale method: adjusting entry would be

Dec.	31	Bad Debt Expense	Debit 6,000	Credit
		Allowance for Doubtful Accounts		6,000
		($ 100,000 x 6%) – 0

Accounts Receivable would be reported on the balance sheet as (notice how the allowance for doubtful accounts equals 6% of accounts receivable):

Accounts receivable	$100,000
Less: Allowance for doubtful accounts	(6,000)
Accounts receivable, Net	$94,000