Tutorial

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1 Learning Objectives 8 Estimating Uncollectible Accounts 2 Overview 9  Percentage of Sales Method: Estimating Uncollectible Accounts Expense 3 Recognizing Uncollectible Accounts Expense 10 Accounts Receivable Aging Method: Estimating Allowance for Uncollectible Accounts 4 Allowance Method 11 Accounts Receivable Aging Method: Calculating Uncollectible Accounts Expense 5 Example 12 Accounts Receivable Aging Method: Journal Entries 6 Writing-off an Uncollectible Account 13 Summary 7 Review Question 1 14  Key Terms

Learning Objectives
After completing this tutorial you should be able to:

• Calculate uncollectible accounts expense using the Percentage of Sales method and the Aging Method.
• Record uncollectible accounts expense using the Allowance method.
• Prepare a journal entry to write-off a customer account under the Allowance method.

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Overview

Previous tutorials discussed the recording of credit sales. Recall that when goods or services are sold on credit, Accounts Receivable is debited and Revenue is credited.
Selling on credit enables a company to increase revenues and net income since customers unable to pay immediately may make a credit purchase. However, the business may fail to collect from some credit customers. The amounts that cannot be collected are called uncollectible accounts. Uncollectible accounts expense is an expense of selling on credit.

This tutorial extends the discussion of accounts receivable in prior tutorials by explaining how information about uncollectible accounts is recorded in the accounting system.

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Recognizing Uncollectible Accounts Expense

As discussed on the previous screen, the amount not collectible from customers is an expense. A key question related to recognizing this expense is: When should uncollectible accounts expense be recognized?

For example, assume that a company makes a credit sale in November 2000. After making several collection efforts, the company decides that the customer's account is uncollectible in July 2001. One option is to record an expense when a customer's account becomes uncollectible. Thus in this example, the company could record the expense in 2001. Since the revenue from these credit sales was recognized in 2000, this approach does not match the uncollectible accounts expense with the revenue it helped produce.

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Allowance Method

An alternative approach is to recognize the uncollectible accounts expense in the same accounting period as the revenues it helped produce. Thus, in the previous example, the uncollectible accounts resulting from sales in the year 2000 should be recognized in the year 2000. This approach is called the allowance method. The allowance method is used by companies with large credit sales because it provides better matching of the uncollectible accounts expense and revenues.

Since the business may not know which accounts are uncollectible until a later period, uncollectible accounts must be estimated and recorded at the end of the accounting period. The recording of uncollectible accounts has two effects. First, Uncollectible Accounts Expense is debited. This expense is subtracted from revenues on the income statement and reduces net income.

In addition to the expense, uncollectible accounts also effectively decrease accounts receivable. However, instead of directly crediting Accounts Receivable, a contra asset called Allowance for Uncollectible Accounts is credited.

The Accounts Receivable account, the Allowance account and the net realizable value of accounts receivable are shown on the balance sheet. The net realizable value is an estimate of the amount management expects to collect on the total accounts receivable.

Net Realizable value = Accounts Receivable - Allowance for Uncollectible Accounts

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Example

Johnson Manufacturing had credit sales of $30,000 in 2000. Based on prior experience, the management expects that $1,500 of the accounts receivable will be uncollectible. Uncollectible Accounts Expense is debited by $1,500. Allowance for Uncollectible Accounts is credited by the same amount.

DATE	ACCOUNT	DEBIT	CREDIT
2000
Dec. 31	Uncollectible Accounts Expense   Allowance for Uncollectible Accounts	1,500	1,500

In the above example, the Uncollectible Accounts Expense of $1,500 is shown on the income statement with other expenses. Thus net income is reduced by $1,500 because of the uncollectible accounts.

A partial balance sheet given below shows how information related to uncollectible accounts is shown on the balance sheet.

Balance Sheet
December 31, 2000

Accounts Receivable	$30,000
Less: Allowance for Uncollectible Accounts	1,500
Net Accounts Receivable	28,500

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Writing-off an Uncollectible Account

As explained previously, under the Allowance method, an Allowance for Uncollectible Accounts is credited for the amount of estimated uncollectible accounts at the end of every period. The Accounts Receivable balance is reduced only when specific accounts are identified as uncollectible. When a specific customer account is identified as uncollectible, it is written off against the Allowance for Uncollectible Accounts. Thus a specific account is written off by debiting Allowance for Uncollectible Accounts and crediting Accounts Receivable.

For example, assume that after several collection efforts Johnson Manufacturing decided that $150 of accounts receivable would not be collectible from Tom Smith on February 21, 2001. The following journal entry is prepared to write off Tom Smith's account.

DATE	ACCOUNT	DEBIT	CREDIT
2001
Feb. 21	Allowance for Uncollectible Accounts    Accounts Receivable	150	150

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Review Question 1

Fill in the blanks. Use a term from the list given below.

Terms:

accounts receivable

allowance for uncollectible accounts

uncollectible accounts expense

allowance method

Under the   bad debts are estimated and recorded at the end of every period.

   is a contra asset account.

   is credited when a customer's account is written off.

   is debited when uncollectible accounts for a period are recognized.

   is debited when a customer's account is written off.

   is credited when uncollectible accounts for a period are recognized.

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Estimating Uncollectible Accounts

Previous screens discussed the recording of Uncollectible Accounts Expense and write-off of specific customer accounts. The remainder of this tutorial describes the methods used to estimate uncollectible accounts.

Two methods are used to estimate uncollectible accounts:
Percentage of Sales
Accounts Receivable Aging Method

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Percentage of Sales Method:
Estimating Uncollectible Accounts Expense

One approach used by businesses to estimate uncollectible accounts is to compute Uncollectible Accounts Expense as a percentage of total credit sales. The idea behind this approach is that Uncollectible Accounts Expense is directly related to the amount of credit sales.

Assume that Sanchez Company had credit sales of $40,000 in the year 2000. Based on prior experience, Sanchez Company estimates that 3% of its credit sales will be uncollectible.

Uncollectible Accounts Expense = .03 x $40,000
= $1,200

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Accounts Receivable Aging Method:
Estimating Allowance for Uncollectible Accounts

Recall that the percentage of sales method assumes that some portion of credit sales for the period will become uncollectible. The idea behind the Accounts Receivable Aging method is that some percentage of a company's ending accounts receivable balance will become uncollectible. This approach calculates the required balance in the Allowance for Uncollectible Accounts as a percentage of the ending Accounts Receivable balance. The current balance in the Allowance account is compared to the required balance to determine the amount of Uncollectible Accounts Expense.

To calculate the required balance in the allowance account, an analysis of the total accounts receivable by age is prepared. The aging analysis shows groups outstanding accounts receivable by due date. For example, accounts due for less than 30 days could be listed in one column of the aging report. Other columns could list balances due between 31-60 days, 61-90 days etc. Management estimates the probability that balances in each category will not be collected. These estimates are made under the assumption that the longer an amount is outstanding, the more likely it will be uncollectible.

For example, assume that Rockwell Company prepared the following aging report on December 31, 2000:

Customer	0-30 days	30-60days	60-90days	>90 days
M. Baker	$ 250			>
J. Perry		$450	$600
K. Santos	$1,000		$900
P. Thomas				$800
Estimated Percentage Uncollectible	1%	5%	10%	50%

The outstanding balance in each category (1-30 days, 61-90 days etc.) is multiplied by the corresponding estimated percentage uncollectible. These numbers are added to obtain the Allowance for Uncollectible Accounts

Estimated balance in Allowance for Uncollectible Accounts
= $1,250 x 0.01 + $450 x 0.05 + $1,500 x 0.1 + $800 x 0.5
= $12.50 + $22.50 + $150 + $400
= $585

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Accounts Receivable Aging Method:
Calculating Uncollectible Accounts Expense

Under the aging method, the aging report is used to estimate the balance in the Allowance for Uncollectible Accounts after recording the uncollectible accounts. This information is then used to calculate the Uncollectible Accounts Expense. In the previous example, the Allowance for Uncollectible Accounts was estimated to be $585.

The T-account below shows how Uncollectible Accounts Expense is calculated. In the previous section, the aging method was used to calculate the required balance of $585 in the Allowance accounts. Assume that the current balance in the Allowance account is $150 (credit). Since the Allowance account already has a credit balance of $150 it must be credited by $435 to get the required balance of $585. Thus the Uncollectible Accounts Expense is debited by $435 and Allowance for Uncollectible Accounts is credited by the same amount.