9 Accounts Receivable

How should A/R should be measured on the Statement of Financial Position? We know that not all customers will pay their accounts in full. For example, some customers will go bankrupt, or may be dissatisfied with us or our product and choose not to pay. So the total amount owed by all customers is higher than what we expect to actually get paid. Should the A/R balance reflect the amount customers owe or the amount the company expects to receive? And why is this important? Well, if you are reading financial statements, would you rather know (1) how much the company is owed by its customers or (2) how much the company expects to collect? The amount the company will collect is likely most useful to answer questions like how much cash will the company have for investing? or does the company have enough current assets to pay their liabilities as they come due?

Net Realizable Value (NRV)Net Realizable Value (NRV):
The amount at which a company expects to settle an account. In the context of A/R this means the estimated amount of cash a company expects to receive from its customers in payment of past sales on accounts. For inventory, NRV is the amount for which inventory can be sold. is the amount at which a company expects to settle an account. In the context of A/R this means the estimated amount of cash a company expects to receive from its customers in payment of past sales on account.

We have worked with A/R (gross)—the total amount owed by customers. Next we will calculate A/R (net): the amount a company expects to collect from customers. In the process, a handy contra-account called Allowance for Doubtful AccountsAllowance for Doubtful Accounts (AFDA):
The amount of A/R that is not expected to be collected. This contra-account reduces the balance of A/R from the total amount owed to the estimated amount collectible. will be introduced. This allowance account will reflect the amount of A/R that we don’t expect to be paid back, and is calculated as gross A/R less net A/R. To illustrate, a company is owed $25,000 from its customers but expects that only $22,000 will be received from customers. The calculation of Allowance for Doubtful Accounts is $25,000 – $22,000 = $3,000. And the presentation of A/R on the Statement of Financial Position looks like this:

Importantly, A/R (gross) and Allowance for Doubtful Accounts show up as accounts in a bookkeeping system: you can debit and credit them. A/R (net) is a calculated account that only appears on the Statement of Financial Position.

Let’s take a closer look at this contra-account. How does Allowance for Doubtful Accounts work? Buckle up, because this account is different from other accounts we’ve learned. Here are the basics:

1. Allowance for Doubtful Accounts is naturally a credit balance because it is a contra-account. So even though it is an asset account, this contra-account reduces the balance of A/R (gross) from the amount owed less the estimated amount collectible. Only a credit will bring down the balance of a debit asset account.
2. This account is calculated as the uncollectible amount of A/R owing. In practice, depending on the information given to you, you will either calculate the uncollectible as a percentage of gross A/R, or calculate it as gross A/R less net A/R.
3. You will prepare a journal entry to make Allowance for Doubtful Accounts equal to this ending balance. If the opening balance of Allowance for Doubtful Accounts is $500 and the amount you calculated in part (2) is $3,000, then the adjustment needed is a credit of $2,500 ($3,000 – $500).

Let’s work through this short example:

My Turn:

It’s 31 December and time to prepare financial statements. The company expects that $22,000 of gross A/R will be collected (as above). Further, trial balance shows a current balance in Allowance for Doubtful Accounts of $500 (CR). If the company estimates that $22,000 of A/R owing will be received, we can calculate the ending balance of Allowance for Doubtful Accounts as $3,000 ($25,000 – $22,000). In this case, we want the balance of Allowance for Doubtful Accounts to be $3,000 (CR), but it’s only $500 (CR) right now. We need to make a credit adjustment for $2,500 ($3,000 – $500). Let’s look at this adjustment using a T-account:

Let’s make this T-account balance with a $2,500 credit. We’ll need to change the balance with a journal entry:

But what should the debit be? Being a debit, it’s likely an asset or expense. Hmmm… I can’t think of an asset that would fit, but how about an expense. Bad Debt Expense is an operating expense on the Income Statement. Bad Debt Expense answers the question: what amount of credit sales made in the period is expected to be uncollectible? In this case, the answer to that question is $2,500.

Let’s try another example. Still Co. has a balance in their Allowance for Doubtful Accounts of $5,700 DR on 31 December. Still is preparing their annual financial statements and estimated that $10,300 of A/R is uncollectible. Prepare a journal entry to adjust Allowance for Doubtful Accounts.

Notice that the balance in the allowance account is a debit. This can happen if a company underestimated uncollectible A/R in the past. Let’s construct the T-account:

$10,300 is the desired amount in Allowance for Doubtful Accounts at the end of the period. To make this T-account work we need a credit of $16,000 (10,300 + 5,700). Let’s change the balance of Allowance for Doubtful Accounts with a journal entry:

And let’s double check that our math works by posting the journal entry to the allowance account:

Yes, it works! Well done! We’ll get more practice toward the end of this chapter, but for now let’s take a look at how we might calculate amounts uncollectible from an A/R Aging Summary.