3.2 Accounts Receivable and Bad Debt

The main revenue recognition objective is to recognize revenue after the company’s performance obligation. This performance obligation is the performance of services or the delivery of goods being carried out in return for an amount of consideration the company expects to receive from the customer.  To keep track of what money is owed from customers in the future, Accounts Receivable is used.

Accounts Receivable

Accounts receivable is an outstanding customer debt on a credit sale. The company expects to receive payment on accounts receivable within the company’s operating period (less than a year). Accounts receivable is considered an asset, and it typically does not include an interest payment from the customer.

Sales Discount

Many companies give their customer credit terms or sales discounts to increase their cash flow.  This allows a company to receive money faster so they don’t have to take out a loan with a high interest rate. The customer knows the company’s term amount based on what is stated on the invoice or sales receipt.

To better illustrate merchandising activities, let’s continue to use California Business Solutions (CBS) who has $18,500 of inventory on hand. On August 1, a customer purchases 56 tablet computers at $300 on credit from XPS (vendor). The cost of goods sold is calculated at $56 per computer.  The payment terms are 2/10, n/30, and the invoice is dated August 1.  These credit terms include a discount opportunity (2/10), meaning the customer has 10 days from the invoice date to pay on their account to receive a 2% discount on their purchase.

In the first entry, both Accounts Receivable and Sales increase by $16,800 ($300 × 56).  In the second entry, COGS increases and Inventory decreases in the amount of $3,360 ($60 x 56).

On August 10, the customer pays their account in full.  Since the customer paid on August 10, they made the 10-day window and received a discount of 2%.

Cash increases for the amount paid to XPS, less the discount. Sales decreases for the amount of the discount ($16,800 × 2%), and Accounts Receivable decreases for the original amount owed, before discount.

Let’s take the same example sale with the same credit terms, but now assume the customer paid their account on August 25. The customer paid on their account outside of the discount window but within the total allotted timeframe for payment. The customer does not receive a discount in this case but does pay in full and on time.

Cash increases and Accounts Receivable decreases by $16,800.

Sales Returns and Allowance

Bad Debt

Bad debts are uncollectible amounts from customer accounts. Bad debt negatively affects accounts receivable. When future collection of receivables cannot be reasonably assumed, recognizing this potential nonpayment is required. There are two methods a company may use to recognize bad debt: the direct write-off method and the allowance method.

Direct Write-Off Method

The direct write-off method delays recognition of bad debt until the specific customer accounts receivable is identified. Once this account is identified as uncollectible, the company will record a reduction to the customer’s accounts receivable and an increase to bad debt expense for the exact amount uncollectible.

Under generally accepted accounting principles (GAAP), the direct write-off method is not an acceptable method of recording bad debts, because it violates the matching principle.  For this reason, we will not study this method.

Allowance Method

The allowance method is the more widely used method because it satisfies the matching principle. The allowance method estimates bad debt during a period, based on certain computational approaches. The calculation matches bad debt with related sales during the period by allowing you not to know which customer will not pay. The estimation is made from past experience and industry standards and recorded at the end of a period.

The allowance for doubtful accounts is a contra asset account and is subtracted from Accounts Receivable to determine the Net Realizable Value of the Accounts Receivable account on the balance sheet. A contra account has an opposite normal balance to its paired account, thereby reducing or increasing the balance in the paired account at the end of a period; the adjustment can be an addition or a subtraction from a controlling account. In the case of the Allowance for Doubtful Accounts it is a contra account that is used to reduce the Controlling account, Accounts Receivable.

At the end of an accounting period, the Allowance for Doubtful Accounts reduces the Accounts Receivable to produce Net Accounts Receivable. Note that allowance for doubtful accounts reduces the overall accounts receivable account, not a specific accounts receivable assigned to a customer. Because it is an estimation, it means the exact account that is (or will become) uncollectible is not yet known.

To demonstrate the treatment of the allowance for doubtful accounts on the balance sheet, assume that a company has reported an Accounts Receivable balance of $90,000 and a Balance in the Allowance of Doubtful Accounts  of $4,800. There is one more point about the use of the contra account, Allowance for Doubtful Accounts. In this example, the $85,200 total is the net realizable value, or the amount of accounts anticipated to be collected. However, the company is owed $90,000 and will still try to collect the entire $90,000 and not just the $85,200 The following table reflects how the relationship would be reflected in the current (short-term) section of the company’s Balance Sheet.

Income Statement Method

The income statement method (also known as the percentage of sales method) estimates bad debt expenses based on the assumption that at the end of the period, a certain percentage of sales during the period will not be collected. The estimation is typically based on credit sales only, not total sales (which include cash sales). In this example, assume that any credit card sales that are uncollectible are the responsibility of the credit card company. It may be obvious intuitively, but, by definition, a cash sale cannot become a bad debt, assuming that the cash payment did not entail counterfeit currency. The income statement method is a simple method for calculating bad debt, but it may be more imprecise than other measures because it does not consider how long a debt has been outstanding and the role that plays in debt recovery.

To illustrate, let’s use Billie’s Watercraft Warehouse (BWW) as the example. Assume that BWW’s end-of-year accounts receivable balance totaled $324,850. Billie’s end-of-year credit sales totaled $458,230. BWW estimates that 5% of its overall credit sales will result in bad debt. This means that BWW believes $22,911 (448,230 x .5%) will be uncollectible debt. The negative created by bad debt expense shows that Allowance for Doubtful Accounts has to be a negative.  This visual helps you understand contra accounts more clearly.

Both Allowance for Doubtful Accounts (Allowance for D/A) and Bad Debt Expense increase by $22,911.

Let’s say that on April 8, it was determined that Customer Robert Craft’s account was uncollectible in the amount of $5,000.  The Bad Debt was previously recorded and is waiting in Allowance for Doubtful Accounts to be used.

Allowance for Doubtful Accounts (Allowance for D/A) and Accounts Receivable will decrease by $5,000.

Balance Sheet Method

The balance sheet method (also known as the percentage of accounts receivable method) estimates bad debt expenses based on the balance in accounts receivable. The method looks at the balance of accounts receivable at the end of the period and assumes that a certain amount will not be collected. Accounts receivable is reported on the balance sheet; thus, it is called the balance sheet method. The balance sheet method is another simple method for calculating bad debt, but it too does not consider how long a debt has been outstanding and the role that plays in debt recovery.

Continuing our examination of the balance sheet method, assume that BWW’s end-of-year accounts receivable balance totaled $324,850. This entry assumes a zero balance in Allowance for Doubtful Accounts from the prior period. BWW estimates 15% of its overall accounts receivable will result in bad debt. This means that BWW believes $48,728 ($324,850 × 15%) will be uncollectible debt.

Bad Debt Expense increases and Allowance for Doubtful Accounts increases for $48,728.

Let’s consider that BWW had a $23,000 balance from the previous period.

This is different from the last entry, where bad debt was estimated at $48,728. That journal entry assumed a zero balance in Allowance for Doubtful Accounts from the prior period. This entry takes into account a balance of $23,000 and subtracts the prior period’s balance from the estimated balance in the current period of $48,728.  This means that BWW needs to $25,728 ($48,728 – $23,000) as uncollectible debt.

Bad Debt Expense increases and Allowance for Doubtful Accounts increases for $25,728.

Licensing and Attribution:

Content in this chapter was adapted from the following openly licensed resource(s):

Principles of Accounting, Volume 1: Financial Accounting by Mitchell Franklin, Patty Graybeal, and Dixon Cooper licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License

Principles of Accounting, Volume 2: Managerial Accounting by Mitchell Franklin, Patty Graybeal, and Dixon Cooper licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License