What is the proper accounting treatment for dealing with accounts receivable defaults which exceed the balance in the allowance for doubtful accounts? For example, if I only have a $200 credit balance in the allowance for doubtful accounts and a $500 account receivable becomes uncollectible, what is to be done? An offsetting debit to bad debt expense?
Bad Debt Expense
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Counterofbeans
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You got it. You need to Dr Bad Debt Expense and Cr A/R allowance.
Two things to note:
(1) This technically means you didn't correctly estimate your bad debt expense correctly in the first place (you have a cutoff issue) &
(2) Don't just take your AR allowance to $500. You'll need more than that, for there are certainly some amounts in A/R that won't be collected in cash above and beyond this identified item that need an allowance for, you just don't know about them yet.
Two things to note:
(1) This technically means you didn't correctly estimate your bad debt expense correctly in the first place (you have a cutoff issue) &
(2) Don't just take your AR allowance to $500. You'll need more than that, for there are certainly some amounts in A/R that won't be collected in cash above and beyond this identified item that need an allowance for, you just don't know about them yet.
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The reason I pose this question is because the textbook I am studying is confusing when it comes to the topic of bad debt expense. The textbook presents an example relating to using the credit of sales method to estimate bad debt expense. I understand the reason behind having to use the allowance methods in order to report bad debt expense (so expenses can be matched with the revenues of the period). I understand that these expenses are estimations. However, the application of the procedure is confusing me.
In the aforementioned example, a company has credit sales of $620,000 during 2009 and estimates at the end of 2009 that 1.43% of these credit sales will eventually default. No problems here; the adjusting entry on December 31, 2009 would be a debit to Bad Debt Expense for $8,866 and a credit to Allowance for Doubtful Accounts for $8,866. The example also states that during 2009, a customer defaults on a $524 balance related to goods purchased in 2008. Prior to the adjusting entries, the company's Accounts Receivable and Allowance for Doubtful Accounts balances were $304,000 and $134 (credit), respectively.
The book's solution to the problem is to debit Allowance for Doubtful Accounts for $524 and credit Accounts Receivable for $524, in order to write-off the defaulted receivable related to 2008. I have no problems here. Next, the book debits Bad Debt Expense for $8,866 and credits Allowance for Doubtful Accounts for $8,866. No problems here. Here is where I become confused: since only $134 of the $524 write-off is reflected in the Allowance account prior to adjusting entries, the remaining $390 reduces the balance in the Allowance account to $8,476 (the credit of $8,866 - $390). So, even though the correct Bad Debt Expense is recorded for the income statement, the amount in the Allowance account that is associated with 2009 credit sales is $390 less than what management believes will eventually become uncollected. For example, if the Bad Debt Expense of $8,866 is debited and the Allowance account is credited for this same amount before the write-off of the defaulted $524 balance, than the Allowance account has a credit balance of $9,000 ($134 + $8,866). Net realizable value is $304,000 - $9,000 = $295,000. Now, the write-off of $524 is made, which does not affect net realizable value of Accounts Receivable because the $304,000 is reduced by $524, as is the number being subtracted from it ( $304,000 - $524 = $303,476 ) and ( $9,000 - $524 = $8,476); $303,476 - $8,476 = $295,000. In reality however, isn't the net realizable value understated if $390 of the Allowance account was used up in order to write off a 2008 receivable?
In the aforementioned example, a company has credit sales of $620,000 during 2009 and estimates at the end of 2009 that 1.43% of these credit sales will eventually default. No problems here; the adjusting entry on December 31, 2009 would be a debit to Bad Debt Expense for $8,866 and a credit to Allowance for Doubtful Accounts for $8,866. The example also states that during 2009, a customer defaults on a $524 balance related to goods purchased in 2008. Prior to the adjusting entries, the company's Accounts Receivable and Allowance for Doubtful Accounts balances were $304,000 and $134 (credit), respectively.
The book's solution to the problem is to debit Allowance for Doubtful Accounts for $524 and credit Accounts Receivable for $524, in order to write-off the defaulted receivable related to 2008. I have no problems here. Next, the book debits Bad Debt Expense for $8,866 and credits Allowance for Doubtful Accounts for $8,866. No problems here. Here is where I become confused: since only $134 of the $524 write-off is reflected in the Allowance account prior to adjusting entries, the remaining $390 reduces the balance in the Allowance account to $8,476 (the credit of $8,866 - $390). So, even though the correct Bad Debt Expense is recorded for the income statement, the amount in the Allowance account that is associated with 2009 credit sales is $390 less than what management believes will eventually become uncollected. For example, if the Bad Debt Expense of $8,866 is debited and the Allowance account is credited for this same amount before the write-off of the defaulted $524 balance, than the Allowance account has a credit balance of $9,000 ($134 + $8,866). Net realizable value is $304,000 - $9,000 = $295,000. Now, the write-off of $524 is made, which does not affect net realizable value of Accounts Receivable because the $304,000 is reduced by $524, as is the number being subtracted from it ( $304,000 - $524 = $303,476 ) and ( $9,000 - $524 = $8,476); $303,476 - $8,476 = $295,000. In reality however, isn't the net realizable value understated if $390 of the Allowance account was used up in order to write off a 2008 receivable?
However, I don't know if this is simply the realities of estimating amounts. Now that I think about it, I cannot think of another way to treat the write-off the account related to 2008 in 2009 of $524. The fact that there is a $134 credit balance in the allowance account means that you can write of $134 and have the accounting equation still balance. However, the remaining $390 reduction in accounts receivable means that assets are $390 less than L + SE. You cannot simply debit bad debt expense because it is now 2009, and that account write-off is related to 2008. So, I guess there is no other way than to reduce the allowance account by this much?
Some comments;
One of the problems is caused because the book says the method to use to provide bad debt expense is: the calculation is based on credit sales. Given that, if the allowance becomes depleted thru losses (as in the example) then you will not increase the allowance thru bad debt provision until you have more credit sales. So - extreme example - what if there are no further credit sales for the year? Would the accountants leave the allowance at MINUS $390? No, unrealistic.
Also that Minus $390 is a debit which means you have more recorded as receivable per GL (the sum of the debit receivable balances PLUS the debit in the allowance) than you have receivables in reality - bad. So, in practice the calc is based on ending accts receivable and not credit sales for the period.
One of the problems is caused because the book says the method to use to provide bad debt expense is: the calculation is based on credit sales. Given that, if the allowance becomes depleted thru losses (as in the example) then you will not increase the allowance thru bad debt provision until you have more credit sales. So - extreme example - what if there are no further credit sales for the year? Would the accountants leave the allowance at MINUS $390? No, unrealistic.
Also that Minus $390 is a debit which means you have more recorded as receivable per GL (the sum of the debit receivable balances PLUS the debit in the allowance) than you have receivables in reality - bad. So, in practice the calc is based on ending accts receivable and not credit sales for the period.
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The book illustrates two methods of dealing with bad debt expense; the percentage of credit sales method and the aging method. According to the book, both are popular methods. Your extreme example is exactly what I was alluding to in my post; however, if the allowance account was reduced to zero, and accounts were written off after the allowance account was reduced to zero, would you not be able to simply credit the account receivable and debit bad debt expense (if that particular receivable was related to a sale in the current year?) The book did not mention this, so I'm not sure. My issue comes from the fact that an account related to 2008 that was written off in 2009 ate away at the allowance account that had a balance related to 2009 bad debt. Wouldn't it be smarter to use a combination of the direct write-off method (for accounts that are related to current year sales that are written off) and percentage of credit sales?
And, no, the accountants wouldn't leave the allowance account at minus $390, and they didn't; they simply used the bad debt expense for 2009 and the related allowance credit for the $390 to eat away at. My issue is that it eats away at the allowance account by 390, meaning that the net realizable value is overstated by 390.
And your last statement is true regarding the aging method; the textbook indicates that the percentage of credit sales method is primarily concerned with estimating bad debt expense, as it is an income statement approach; any balance in the allowance account is ignored when determining bad debt expense under this method.
You could do that but the problem is that if later you wanted to find ALL of the writedowns (so you could do an analysis) then you would look at the debits in the allowance account AND have to remember you did a direct writedown that was NOT recorded in the allowance account
In fact the actual methods used will vary by industry and even by individual companies within the same industry. So here you have "art more than science". At some point -though the company's accountants who determine the allowance amount and the outside CPA's who review it come to some sort of agreement on method.
Counterofbeans
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The issue you are having is because you are trying to reconcile an income statement methodology with the balance sheet and there isn't a connection between the two. At some point/certain points, the company must "true-up" their allowance for doubtful accounts with what shows up in the G/L (on the balance sheet) with reality (or estimated reality) & it is NOT uncommon to have out-of-cycle JEs that will adjust expense and the allowance account if the estimated % of bad debts isn't accurate. This is generally referred to as a change in estimate (it's possible to be an error if facts available at the time the estimate was made weren't considered).
Therein lies the key to the entire process: the estimated % used in the credit sales method is the single most important number, as that controls everything, including the expense that ends up in the P&L. This estimate is often so important, companies will disclose such as a Critical Accounting Estimate (we do). Outside of the aforementioned out-of-cycle JEs, nothing should touch the P&L, just the amount calculated from this %.
Note that the, "aging method" for estimating uncollectible accounts has the same weaknesses discussed above, it just generates the numbers differently.
In case you are interested, let me give you a real-life example.
Most of the time, the single most important item when evaluating uncollectible AR is a detailed review of the AR aging for balances outstanding much longer than the terms agreed to at the time of sale. For instance, if you are supposed to be paid within 30 days and a specific invoice is outstanding 90+ days, I'd say that's something your AR manager should specifically be looking at and informing you of. When an auditor comes out and audits the reserve for AR GL account, it's VERY common that they will closely examine old items and evaluate if it's reasonable that they are reserved for or not. This is much more of a "balance sheet" approach.
This is exactly how I do it, except I have a specific person in AR that follows up on each and every AR balance that goes over 40 days and, on a monthly basis, everything over 40 days outstanding is specificially identified and considered for reserve by my AR manager.
I'm not out of the woods yet though, as there's one thing that isn't being considered yet. Do you know what it is? If you guessed that there are balances in AR that are "current", but some are likely to get "old" and need a potential reserve, you're correct. Here, we use a percent of sales methodology.
What does this all mean? Well, we literally use both a balance sheet and an income statement approach to resolve our AR reserve challenges.
Therein lies the key to the entire process: the estimated % used in the credit sales method is the single most important number, as that controls everything, including the expense that ends up in the P&L. This estimate is often so important, companies will disclose such as a Critical Accounting Estimate (we do). Outside of the aforementioned out-of-cycle JEs, nothing should touch the P&L, just the amount calculated from this %.
Note that the, "aging method" for estimating uncollectible accounts has the same weaknesses discussed above, it just generates the numbers differently.
In case you are interested, let me give you a real-life example.
Most of the time, the single most important item when evaluating uncollectible AR is a detailed review of the AR aging for balances outstanding much longer than the terms agreed to at the time of sale. For instance, if you are supposed to be paid within 30 days and a specific invoice is outstanding 90+ days, I'd say that's something your AR manager should specifically be looking at and informing you of. When an auditor comes out and audits the reserve for AR GL account, it's VERY common that they will closely examine old items and evaluate if it's reasonable that they are reserved for or not. This is much more of a "balance sheet" approach.
This is exactly how I do it, except I have a specific person in AR that follows up on each and every AR balance that goes over 40 days and, on a monthly basis, everything over 40 days outstanding is specificially identified and considered for reserve by my AR manager.
I'm not out of the woods yet though, as there's one thing that isn't being considered yet. Do you know what it is? If you guessed that there are balances in AR that are "current", but some are likely to get "old" and need a potential reserve, you're correct. Here, we use a percent of sales methodology.
What does this all mean? Well, we literally use both a balance sheet and an income statement approach to resolve our AR reserve challenges.
Sure you can, especially since you now know your previous estimate wasn't correct. As stated above, this is generally a change in estimate or, perhaps, an error. In theory, it's a cutoff issue, which is exactly what's driving such change in estimate/error.
Yes, as stated above, but I wouldn't worry about whether or not the reserve is for current year sales or not. If you believe you are going to collect it, don't reserve it. When/if the facts change and you think you won't collect it, reserve it. I wouldn't worry about what fiscal year that lands in; it's simply a change in estimate.
This is correct. See discussion above for explanation
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Counterofbeans
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Mispost....
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