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Friday, February 19, 2010

Accounting for Bad Debts

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The two methods for accounting for bad debts are the Direct Write-off method and the Allowance method.

Direct write-off does not properly match, nor does it conform to conservatism, hence the method is not GAAP. It is, however, the method that must be used for income tax reporting.

The Allowance method (is GAAP) does properly match expenses with revenues and is in conformity with conservatism and can be applied in two different, yet similar ways:
Income statement method—relies on an estimate based on a percentage of net credit sales. The balance in the allowance account at the end of the period is not taken into consideration. The percentage of net credit sales is debited to Bad debt expense and credited to the Allowance for bad debts accounts, no matter the balance in the allowance account. (The Kimmel, et al. text does not present this method)

Balance sheet method—relies on an estimate of uncollectible accounts made during an analysis of the Accounts receivable account. The balance in the Allowance account is taken into consideration and the adjusting entry brings the Allowance account up to the desired amount. If the allowance account has a debit balance, it is “overdrawn”. In other words, there have been more write-offs than planned. If the allowance account has a credit balance, it has a positive balance and has not been utilized as fully as was expected.

Accounting for bad debts expense is done only at the end of the accounting period and is done as an adjusting entry. The Bad debt expense account is not used at the time individual accounts are written off. The adjusting entry looks identical under either the Income Statement method or the Balance Sheet method (since Direct Write-off is not GAAP, we won’t do the journal entries related to the method). The adjusting journal entry replenishes the allowance account, which is a contra-asset account and is in effect a reserve for uncollectible accounts, in order to provide for the write-offs that will surely occur as a result of past credit sales. The only difference between the income statement method and the balance sheet method would be the amount in question:

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12/31 Bad debt expense X,XXX
Allowance for bad debts X,XXX

Net realizable value:

Since we know that we probably won’t be able to collect the entire amount of our receivables, we must present the amount that we reasonably believe that we can collect on the balance sheet (remember that conservatism tells us to avoid overstating our assets). This net amount is often referred to as the net realizable value (NRV) of accounts receivable. This amount is the difference between the amount in accounts receivable and the amount in the allowance account.

Writing off an account:

When a reasonable effort has been made to collect from a customer and it has become evident that our efforts are to be unsuccessful, it is time to write off the account. This is accomplished by the following entry:

Date Allowance for bad debts X,XXX
Accounts receivable—Deadbeat customer X,XXX

Recovery of an account:

On rare occasions customers can return from apparent oblivion and pay us for a debt that seemed hopelessly uncollectible. If we have written them off, we must reinstate their account and journalize the receipt of their payment. This is usually done with two journal entries:

Date Accounts receivable—Deadbeat customer X,XXX
Allowance for bad debts X,XXX

Cash X,XXX
Accounts receivable—Deadbeat customer X,XXX

Notice that the first entry is the reverse of the entry to write off the account and the second is the standard entry to record the receipt of cash on account.


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