Ok, so here's the deal. We want to make an entry to get bad debt expense recorded
this year (the year that the bad debts originated). This is easy enough, we will
simply debit bad debt expense in the adjusting entry. The question is, for what
amount? We have to estimate the amount, which means we guess. We can use any
method we want in going about making the guess, but it would probably be good if
we can defend the manner in which we come up with the amount.
Lets see if we can find a relationship (correlation, link, etc) between bad debts
expense and something else. If we have no credit sales, how much bad debt can we
have? Not much. Hey, what if we don't have any A/R at the end of the accounting
period, can we have any further bad debts? Not likely. These are the two items that
we have picked to analyze to determine if we can find a correlation to aid in the
estimation of the dollar amount of bad debts to estimate.
Here are some profound statements. If we have no credit sales, we will have no bad
debts. If we have a little credit sales, we will have a little bad debts. If we have a
few more credit sales, we will have a few more bad debts. And finally, if we have a
whole bunch of credit sales, we will have a whole bunch of bad debts. Now
obviously, this is not a dollar for dollar relationship, but over time we can observe
and calculate a relationship between the two. [You will not be asked to go thru past
information and attempt to draw out this calculated correlation. You just need to be
aware that this is a step in the process leading to the determination of the amount of
bad debt expense to report on the income statement and the effect that the
professional judgment of those involved in the preparation of financial statements
can influence the financial position of the reporting by the company.]
So, we really step into the game once a number of things have already taken place.
Assume that based upon an analysis of past A/R and bad debts, it is determined that
approximately 1% of sales ultimately end up being bad debts. No problem, if we
have sales this year of $100,000, we would estimate the bad debts expense associated
with this year to be $1,000 ($100,000 * 1%). Therefore, the adjusting entry is
Bad Debt Expense
Allowance for D/A
$1,000
$1,000
If next year sales are $200,000, we would make that year's entry for $2,000. We
simply make an adjusting entry debiting bad debt expense for an amount equal to the
sales for the year multiplied by the correlation percent determined by an analysis of
past sales and bad debts.
But what if the company made its estimate based not upon an analysis of sales but of
A/R. [Again before we enter the process] the analyst would evaluate all the
individual A/R that the company has listed in its records of people of owe us money
(lets say a total of $100,00,) and that analysis leads us to the conclusion that of the
total A/R, we do not expect to collect 3% of the A/R or $3,000. By default that
means that we do plan to collect $97,000 (this amount is referred to as the expected
realizable value). The function of the adjusting entry is to result in the account
"Allowance for D/A" to have a credit balance of $3,000. Therefore, if the Allowance
account has a zero balance prior to the adjusting entry, the adjusting entry will be for
$3,000; if the account has a $1,000 credit balance, the adjusting amount will be for
$2,000; if the account has a $2,000 debit balance, the adjusting amount will be for
$5,000. The bottom line is that after the adjusting entry has been recorded and
posted, the account Allowance for D/A will have a credit balance equal to the
amount calculated in the analysis.