Estimating the Amount of
Bad Debts Expense
pp. 411-417
Three Approaches
• I) Using the Income Statement
• II)Using the Balance Sheet
• III)Aging Accounts Receivable Approach
I) Estimating Bad Debts Using the Income
Statement
Example: Credit sales = $400,000 in 2006. Based on past experience,
the company estimates that 0.6% of credit sales will be uncollectible.
400000 x 0.6% = 2400 will be uncollectible
DR Bad Debts Expense 2400
CR Allowance for Doubtful Accounts 2400
• This entry does not mean that the fiscal year end balance in the
“Allowance for Doubtful Accounts” will be $2400. It would only be
$2400 if the account had a zero balance prior to.
Never expect the Allowance for Doubtful Accounts to have an
unadjusted balance of 0 at the end of the year
1) Past entries would have accumulated in the account
2) Bad debts must estimated every year and these do not equal the
amounts written off
3) Amounts written off probably relate to credit sales made during the
year. These debits affect the unadjusted Allowance for Doubtful
Accounts
Expressing bad debts expense as a percentage of sales is an estimate
based on past experience.
Different rates may be used in other periods.
II) Estimating Bad Debts Using the Balance
Sheet
• Based on the assumption that a portion of the end-of-period
accounts receivable will not be collected
• Done in two ways
• The simplified balance sheet approach
• Aging the Accounts Receivable approach
See HANDOUT called “ESTIMATING BAD DEBTS USING THE BALANCE SHEET”
III) Aging Accounts Receivable Approach
• Produces a more refined estimate based on past experience and also
based on present information
• Each a/r is examined to estimate the amount that is uncollectible
• Amounts are classified based on how long they have been outstanding
• Estimates that are uncollectible are made based on the assumption that the
longer an amount has been outstanding, the more likely it will be
uncollectible
III) cont’d
• To age a/r outstanding, you must examine each account and classify
the outstanding amount by how much time has passed since they
were created
• The classes are based on 30 day periods
• Past experience is used to estimate the % of each class that will become
uncollectible
• These % are applied to the amounts in the classes to determine the balance
of “Allowance for Doubtful Accounts”
• SEE HANDOUT # 2 FOR DAY 6
Which Method is more reliable?
The income statement approach the bad debts expense was estimated
to be $2400
The balance sheet approach estimated the bad debts expense to be
$2300
The aging of accounts receivable estimated the bad debts expense to
be $2090
• All three approaches produced different numbers for the bad debts
estimate.
• However, the aging of accounts receivable is based on a more
detailed look at specific outstanding accounts and is usually the most
reliable.
DIRECT WRITE-OFF METHOD OF
ACCOUNTING FOR BAD DEBTS
• This method does not estimate uncollectible accounts or bad debts
expense
• No adjusting entries are made
• Accounts are written off:
• DR Bad Debts Expense
• CR Accounts Receivable
• This approach mismatches revenues and expenses because bad debts
expense is not recorded until an account becomes uncollectible
• Useful when the amounts to be written off are small – materiality
principle
• If payment is received after an account has been written off:
First:
DR A/R
CR Bad Debts Expense
To reinstate the account
Second:
DR Cash
CR A/R
For full payment of account
The Materiality Principle
• States that the requirement of accounting principles may be ignored
if the effect on the financial statements is unimportant to the uses.
The work to be done
• Progress Check 8-10 to 8-11
• Exercise 8-5 to 8-7
• Problem 8-3 to 8-5