To match the cost of uncollectible accounts and the related revenue, uncollectible accounts, more commonly referred to as bad debts, must be estimated. Bad debts are accounted for using the allowance approach, applied using either the income statement method or balance sheet method. When uncollectible accounts are specifically identified, they are written off. Write-offs can be subsequently recovered. The journalizing of short-term notes receivable and related interest revenue is also discussed in this chapter.

7.1 Accounts Receivable

The revenue portion of the operating cycle, as copied in Figure 7.1, begins with a sale on credit and is completed with the collection of cash. Unfortunately, not all receivables are collected. This section discusses issues related to accounts receivable and their collection:

Uncollectible Accounts Receivable

Extending credit to customers results in increased sales and therefore profits. However, there is a risk that some accounts receivable will not be collected. A good internal control system is designed to minimize bad debt losses. One such control is to permit sales on account only to credit-worthy customers; this can be difficult to determine in advance. Companies with credit sales realize that some of these amounts may never be collected. Uncollectible accounts, commonly known as bad debts, are an expense associated with selling on credit.

Bad debt expenses must be matched to the credit sales of the same period. For example, assume BDCC recorded a $1,000 credit sale to XYA Company in April, 2015. Assume further that in 2016 it was determined that the $1,000 receivable from XYA Company would never be collected. The bad debt arising from the credit sale to XYA Company should be matched to the period in which the sale occurred, namely, April, 2015. But how can that be done if it is not known which receivables will become uncollectible? A means of estimating and recording the amount of sales that will not be collected in cash is needed. This is done by establishing a contra current asset account called Allowance for Doubtful Accounts (AFDA) in the general ledger to record estimated uncollectible receivables. This account is a contra account to accounts receivable and is disclosed on the balance sheet as shown below using assumed values.

The Allowance for Doubtful Accounts contra account reduces accounts receivable to the amount that is expected to be collected — in this case, $23,600.

Estimating Uncollectible Accounts Receivable

The AFDA account is used to reflect how much of the total Accounts Receivable is estimated to be uncollectible. To record estimated uncollectible accounts, the following adjusting entry is made:

The bad debt expense is shown on the income statement. AFDA appears on the balance sheet and is subtracted from accounts receivable resulting in the estimated net realizable accounts receivable.

Two different methods can be used to estimate uncollectible accounts. One method focuses on estimating Bad Debt Expense on the income statement, while the other focuses on estimating the desired balance in AFDA on the balance sheet.

The Income Statement Method

The objective of the income statement method is to estimate bad debt expense based on credit sales. Bad debt expense is calculated by applying an estimated loss percentage to credit sales for the period. The percentage is typically based on actual losses experienced in prior years. For instance, a company may have the following history of uncollected sales on account:

The average loss over these years is , or of 1%. If management anticipates that similar losses can be expected in 2015 and credit sales for 2015 amount to $300,000, bad debts expense would be estimated as $1,500 ($300,000 x 0.005). Under the income statement method, the $1,500 represents estimated bad debt expense and is recorded as noted below.

This estimated bad debt expense is calculated without considering any existing balance in the AFDA account:

The Balance Sheet Method

Estimated uncollectible accounts can also be calculated by using the balance sheet method where a process called aging of accounts receivable is used. At the end of the period, the total of estimated uncollectible accounts is calculated by analyzing accounts receivable according to how long each account has been outstanding. An aging analysis approach assumes that the longer a receivable is outstanding, the less chance there is of collecting it. This process is illustrated in the following schedule.

In this example, accounts receivable total $25,000 at the end of the period. These are classified into six time periods: those receivables that are not yet due; 1–30 days past due; 31–60 days past due; 61–90 days past due; 91–120 days past due; and over 120 days past due.

Based on past experience, assume management estimates a bad debt percentage, or rate of uncollectibility, for each time period as follows:

The calculation of expected uncollectible accounts receivable at December 31, 2015 would be as follows:

A total of $1,450 of accounts receivable is estimated to be uncollectible at December 31, 2015.

Under the balance sheet method, the estimated bad debt expense consists of the difference between the opening AFDA balance ($250, as in the prior example) and the estimated uncollectible receivables ($1,450) required at year-end:

As an alternative to using an aging analysis to estimate uncollectible accounts, a simplified balance sheet method can be used. The simplified balance sheet method calculates the total estimated uncollectible accounts as a percentage of the outstanding accounts receivables balance. For example, assume an unadjusted balance in AFDA of $250 as in the preceding example. Also assume the accounts receivable balance at the end of the period was $25,000 as in the previous illustration. If it was estimated that 6% of these would be uncollectible based on historical data, the adjustment would be:

The total estimated uncollectible accounts was $1,500 ($25,000 0.06). Given an unadjusted balance in AFDA of $250, the adjustment to AFDA must be a credit of $1,250 ($1,500 – $250).

Regardless of whether the income statement method or balance sheet method is used, the amount estimated as an allowance for doubtful accounts seldom agrees with the amounts that actually prove uncollectible. A credit balance remains in the allowance account if fewer bad debts occur during the year than are estimated. There is a debit balance in the allowance account if more bad debts occur during the year than are estimated. By monitoring the balance in the Allowance for Doubtful Accounts general ledger account at each year-end, though, management can determine whether the estimates of uncollectible amounts are accurate. If not, they can adjust these estimates going forward.

Writing Off Accounts Receivable

When recording the adjusting entry to estimate uncollectible accounts receivable at the end of the period, it is not known which specific receivables will become uncollectible. When an account is determined to be uncollectible, it must be removed from the accounts receivable account. This process is known as a write-off. To demonstrate the write-off of an account receivable, assume that on January 15, 2016 the $1,000 credit account for customer Bendix Inc. is identified as uncollectible because of the company’s bankruptcy. The receivable is removed by:

The $1,000 write-off reduces both the accounts receivable and AFDA accounts. The write-off does not affect net realizable accounts receivable as demonstrated below.

Additionally, a write-off does not affect bad debt expense. This can be a challenge to understand. To help clarify, recall that the adjusting entry to estimate uncollectibles was:

This adjustment was recorded because GAAP requires that the bad debt expense be matched to the period in which the sales occurred even though it is not known which receivables will become uncollectible. Later, when an uncollectible receivable is identified, it is written off as:

Notice that the AFDA entries cancel each other out so that the net effect is a debit to bad debt expense and a credit to accounts receivable. The use of the AFDA contra account allows us to estimate uncollectible accounts in one period and record the write-off of bad receivables as they become known in a later period.

Recovery of a Write-Off

When Bendix Inc. went bankrupt, its debt to Big Dog Carworks Corp. was written off in anticipation that there would be no recovery of the amount owed. Assume that later, an announcement was made that 25% of amounts owed by Bendix would be paid. This new information indicates that BDCC will be able to recover a portion of the receivable previously written off. A recovery requires two journal entries. The first entry reinstates the amount expected to be collected by BDCC—$250

($1,000 25%) in this case and is recorded as:

This entry reverses the collectible part of the receivable previously written off. The effect of the reversal is shown below.

The second entry records the collection of the reinstated amount as:

The various journal entries related to accounts receivable are summarized below:

7.2 Short-Term Notes Receivable

LO2 – Explain and record a short-term notes receivable as well as calculate related interest.

Short-term notes receivable are current assets, since they are due within the greater of 12 months or the business’s operating cycle. A note receivable is a promissory note. A promissory note is a signed document where the debtor, the person who owes the money, promises to pay the creditor the principal and interest on the due date. The principal is the amount owed. The creditor, or payee, is the entity owed the principal and interest. Interest is the fee for using the principal and is calculated as: Principal Annual Interest Rate Time. The time or term of the note is the period from the date of the note to the due date. The due date, also known as the maturity date, is the date on which the principal and interest must be paid. The date of the note is the date the note begins accruing interest.

Short-term notes receivable can arise at the time of sale or when a customer’s account receivable becomes overdue. To demonstrate the conversion of a customer’s account to a short-term receivable, assume that BDCC’s customer Bendix Inc. is unable to pay its $5,000 account within the normal 30-day period. The receivable is converted to a 5%, 60-day note dated December 5, 2015 with the following entry:

Assuming a December 31, year-end for BDCC, the adjusting entry to accrue interest on December 31 would be:

The interest of $17.81 was calculated as: $5,000 5% 26/3652 = $17.80822 rounded to $17.81. All interest calculations in this textbook are rounded to two decimal places.

At maturity, February 3, 2016, BDCC collects the note plus interest and records:

The total interest realized on the note was $41.10 ($5,000 5% 60/365 = $41.0959 rounded to $41.10). Part of the $41.10 total interest revenue was realized in 2015 ($17.81) and the rest in 2016 ($41.10 – $17.81 = $23.29). Therefore, care must be taken to correctly allocate the interest between periods. The total cash received by BDCC on February 3 was the sum of the principal and interest: $5,000.00 + $41.10 = $5,041.10.

When the term of a note is expressed in months, the calculations are less complex. For example, assume that BDCC sold customer Woodlow a $4,000 service on August 1, 2015. On that date, the customer signed a 4%, 3-month note. The term of the note is based on months and not days therefore the maturity date is October 31, 2015. BDCC would record the collection on October 31 as:

The total interest realized on the note was $40 ($4,000 4% 3/123 = $40.00)