Unit
8
Estimating Bad Debts
BASES USED FOR THE
ALLOWANCE METHOD
• Companies use either of two methods in
the estimation of uncollectible accounts:
1. Percentage of sales
2. Percentage of receivables
• Both bases are GAAP; the choice is a
management decision.
ILLUSTRATION 9-4
COMPARISON OF BASES OF
ESTIMATING UNCOLLECTIBLES
Percentage of Sales
Matching
Sales
Percentage of Receivables
Net Realizable Value
Bad Debts
Expense
Emphasis on
Income Statement
Relationships
Accounts
Receivable
Allowance
for
Doubtful
Accounts
Emphasis on
Balance Sheet
Relationships
PERCENTAGE OF SALES BASIS
• In the percentage of sales basis, management
establishes a percentage relationship between
the amount of credit sales and expected losses
from uncollectible accounts.
• Expected bad debt losses are
determined by applying the
percentage to the sales base
of the current period.
• This basis better matches expenses
with revenues.
PERCENTAGE OF SALES BASIS
Example 1
Situation A: Pereira Company determines that 1% of net credit sales will
become uncollectible. If net credit sales are $170,000 the estimated bad debt
expense is $1700 (170,000*1%). The general journal entry is;
GENERAL JOURNAL
Date
Account Title and Explanation
Dec. 31 Bad Debts Expense
Allowance for Doubtful Accounts
To record estimate of uncollectible accounts.
Debit
Credit
1,700
1,700
PERCENTAGE OF SALES BASIS
Example 2 Balance In Doubtful Accounts
Situation B: Pereira Company determines that 1% of net credit sales will
become uncollectible. If net credit sales are $170,000 the estimated bad debt
expense is $1700 (170,000*1%). However the allowance for doubtful accounts
still has a credit balance of $1500. How much is journalized? Answer: the
same as in situation A. Balances in doubtful accounts are ignored.
GENERAL JOURNAL
Date
Account Title and Explanation
Dec. 31 Bad Debts Expense
Allowance for Doubtful Accounts
To record estimate of uncollectible accounts.
Debit
Credit
1,700
1,700
PERCENTAGE OF
RECEIVABLES BASIS
• Under the percentage of receivables
basis, management establishes a
percentage relationship between the
amount of accounts receivable and the
required balance in the allowance
account.
• This percentage can be applied to
the total accounts receivable balance,
or to individual accounts receivable
balances stratified by age.
PERCENTAGE OF
RECEIVABLES BASIS
• The required balance in the allowance account
is determined by applying the percentage to
the accounts receivable balance at the end of
the current period.
• The amount of the adjusting entry to record
expected bad debt losses for the current period
is the difference between the required balance
and the existing balance in the allowance
account.
• This basis produces the better estimate of net
realizable value of receivables.
PERCENTAGE OF RECEIVABLES BASIS
EXAMPLE 1 Net Receivables
Pereira Company decides to use the percentage of receivables method to estimate
bad debts. It determines that 3% of total accounts receivables will become
uncollectibe. If the accounts receivables total is $40,000 the estimated bad debt
expense is $1,200. (40,000*3%)
GENERAL JOURNAL
Date
Account Title and Explanation
Dec. 31 Bad Debts Expense
Allowance for Doubtful Accounts
To record estimate of uncollectible accounts.
Debit
Credit
1,200
1,200
PERCENTAGE OF RECEIVABLES BASIS
EXAMPLE 2 Credit Balance in Allowance
for Doubtful Accounts
Pereira Company decides to use the percentage of receivables method to estimate
bad debts. It determines that 3% of total accounts receivables will become
uncollectibe. If the accounts receivables total is $40,000 the estimated bad debt
expense is $1,200. (40,000*3%). However there is still a credit balance of $500 in the
allowance for doubtful accounts remaining from last year’s adjusting entry.
Therefore bad debt expense is only $700. (1,200-500)
GENERAL JOURNAL
Date
Account Title and Explanation
Dec. 31 Bad Debts Expense
Allowance for Doubtful Accounts
To record estimate of uncollectible accounts.
Debit
Credit
700
700
PERCENTAGE OF RECEIVABLES BASIS
EXAMPLE 3 Debit Balance in Allowance
for Doubtful Accounts
Pereira Company decides to use the percentage of receivables method to estimate
bad debts. It determines that 3% of total accounts receivables will become
uncollectibe. If the accounts receivables total is $40,000 the estimated bad debt
expense is $1,200. (40,000*3%). However there is debit balance of $300 in the
allowance for doubtful accounts. In other words Pereira had more bad debts than
estimated. Therefore bad debt expense is $1,500. (1,200+300)
GENERAL JOURNAL
Date
Account Title and Explanation
Dec. 31 Bad Debts Expense
Allowance for Doubtful Accounts
To record estimate of uncollectible accounts.
Debit
Credit
1,500
1,500
PERCENTAGE OF RECEIVABLES
BASIS
EXAMPLE 4 Aging of Accounts
Pereira Company decides to use the percentage of receivables method to estimate bad
debts. However it wants to use the aging of accounts receivables as a basis.
Days
0-30 days
31-60 days
61-90 days
91-120
over 120
Amount $27,000
5,700
3,000
2,400
1,900
Percent 2%
4%
10%
50%
75%
Bad Debt $540
228
300
1200
1425
Debit
Credit
Total Bad Debt Expense = $3,693
GENERAL JOURNAL
Date
Account Title and Explanation
Dec. 31 Bad Debts Expense
Allowance for Doubtful Accounts
To record estimate of uncollectible accounts.
3,693
3,693
PERCENTAGE OF
RECEIVABLES BASIS
EXAMPLE 5
Pereira Company decides to use the percentage of receivables method to
estimate bad debts. In using the aging of accounts receivables as a basis the
company determines that $3,693 of receivables will become uncollectible.
However there is still a credit balance of $500 in the allowance for doubtful
accounts remaining from last year’s adjusting entry. Therefore bad debt
expense is only $3,193 (3,693-500)
GENERAL JOURNAL
Date
Account Title and Explanation
Dec. 31 Bad Debts Expense
Allowance for Doubtful Accounts
To record estimate of uncollectible accounts.
Debit
Credit
3,193
3,193
SUMMARY OF UNCOLLECTIBLE ACCOUNTS
Methods of Write-Off
DIRECT
ALLOWANCE
PERCENTAGE OF
ACCOUNTS
RECEIVABLES
TOTAL
RECEIVABLES
AGING OF
RECEIVABLES
PERCENTAGE
OF SALES
DISPOSING OF
ACCOUNTS RECEIVABLE
To accelerate the receipt of cash from
receivables, owners frequently:
1. sell to a factor, such as a finance company
or a bank, and
2. make credit card sales.
DISPOSING OF
ACCOUNTS RECEIVABLE
• A factor buys receivables from businesses
for a fee and collects the payments
directly from customers.
• Credit cards are frequently used by retailers
who wish to avoid the paperwork of issuing
credit.
• Retailers can receive cash more quickly
from the credit card issuer.