9.2: Account for Uncollectible Accounts Using the Balance Sheet and Income Statement Approaches (2024)

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You lend a friend $500 with the agreement that you will berepaid in two months. At the end of two months, your friend has notrepaid the money. You continue to request the money each month, butthe friend has yet to repay the debt. How does this affect yourfinances?

Think of this on a larger scale. A bank lends money to a couplepurchasing a home (mortgage). The understanding is that the couplewill make payments each month toward the principal borrowed, plusinterest. As time passes, the loan goes unpaid. What happens when aloan that was supposed to be paid is not paid? How does this affectthe financial statements for the bank? The bank may need toconsider ways to recognize this bad debt.

Fundamentals of Bad Debt Expenses and Allowances for DoubtfulAccounts

Bad debts are uncollectible amounts fromcustomer accounts. Bad debt negatively affects accounts receivable(see Figure 9.2). When future collection of receivables cannot bereasonably assumed, recognizing this potential nonpayment isrequired. There are two methods a company may use to recognize baddebt: the direct write-off method and the allowance method.

9.2: Account for Uncollectible Accounts Using the Balance Sheet and Income Statement Approaches (2)

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

Under generally accepted accounting principles (GAAP), thedirect write-off method is not an acceptable method of recordingbad debts, because it violates the matching principle. For example,assume that a credit transaction occurs in September 2018 and isdetermined to be uncollectible in February 2019. The directwrite-off method would record the bad debt expense in 2019, whilethe matching principle requires that it be associated with a 2018transaction, which will better reflect the relationship betweenrevenues and the accompanying expenses. This matching issue is thereason accountants will typically use one of the two accrual-basedaccounting methods introduced to account for bad debt expenses.

It is important to consider other issues in the treatment of baddebts. For example, when companies account for bad debt expenses intheir financial statements, they will use an accrual-based method;however, they are required to use the direct write-off method ontheir income tax returns. This variance in treatment addressestaxpayers’ potential to manipulate when a bad debt is recognized.Because of this potential manipulation, the Internal RevenueService (IRS) requires that the direct write-off method must beused when the debt is determined to be uncollectible, while GAAPstill requires that an accrual-based method be used for financialaccounting statements.

For the taxpayer, this means that if a company sells an item oncredit in October 2018 and determines that it is uncollectible inJune 2019, it must show the effects of the bad debt when it filesits 2019 tax return. This application probably violates thematching principle, but if the IRS did not have this policy, therewould typically be a significant amount of manipulation on companytax returns. For example, if the company wanted the deduction forthe write-off in 2018, it might claim that it was actuallyuncollectible in 2018, instead of in 2019.

The final point relates to companies with very little exposureto the possibility of bad debts, typically, entities that rarelyoffer credit to its customers. Assuming that credit is not asignificant component of its sales, these sellers can also use thedirect write-off method. The companies that qualify for thisexemption, however, are typically small and not major participantsin the credit market. Thus, virtually all of the remaining bad debtexpense material discussed here will be based on an allowancemethod that uses accrual accounting, the matching principle, andthe revenue recognition rules under GAAP.

For example, a customer takes out a $15,000 car loan on August1, 2018 and is expected to pay the amount in full before December1, 2018. For the sake of this example, assume that there was nointerest charged to the buyer because of the short-term nature orlife of the loan. When the account defaults for nonpayment onDecember 1, the company would record the following journal entry torecognize bad debt.

Bad Debt Expense increases (debit), and Accounts Receivabledecreases (credit) for $15,000. If, in the future, any part of thedebt is recovered, a reversal of the previously written-off baddebt, and the collection recognition is required. Let’s say thiscustomer unexpectedly pays in full on May 1, 2019, the companywould record the following journal entries (note that the company’sfiscal year ends on June 30)

The first entry reverses the bad debt write-off by increasingAccounts Receivable (debit) and decreasing Bad Debt Expense(credit) for the amount recovered. The second entry records thepayment in full with Cash increasing (debit) and AccountsReceivable decreasing (credit) for the amount received of$15,000.

As you’ve learned, the delayed recognition of bad debt violatesGAAP, specifically the matching principle. Therefore, the directwrite-off method is not used for publicly traded company reporting;the allowance method is used instead.

The allowance method is the more widely used method because itsatisfies the matching principle. The allowancemethodestimates bad debt during a period, based oncertain computational approaches. The calculation matches bad debtwith related sales during the period. The estimation is made frompast experience and industry standards. When the estimation isrecorded at the end of a period, the following entry occurs.

The journal entry for the Bad Debt Expense increases (debit) theexpense’s balance, and the Allowance for Doubtful Accountsincreases (credit) the balance in the Allowance. Theallowance for doubtful accounts is a contra assetaccount and is subtracted from Accounts Receivable to determine theNet Realizable Value of the Accounts Receivableaccount on the balance sheet. A contra account hasan opposite normal balance to its paired account, thereby reducingor increasing the balance in the paired account at the end of aperiod; the adjustment can be an addition or a subtraction from acontrolling account. In the case of the allowance for doubtfulaccounts, it is a contra account that is used to reduce theControlling account, Accounts Receivable.

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

THINK IT THROUGH

Bad Debt Estimation

As the accountant for a large publicly traded food company, youare considering whether or not you need to change your bad debtestimation method. You currently use the income statement method toestimate bad debt at 4.5% of credit sales. You are consideringswitching to the balance sheet aging of receivables method. Thiswould split accounts receivable into three past- due categories andassign a percentage to each group.

While you know that the balance sheet aging of receivablesmethod is more accurate, it does require more company resources(e.g., time and money) that are currently applied elsewhere in thebusiness. Using the income statement method is acceptable undergenerally accepted accounting principles (GAAP), but should youswitch to the more accurate method even if your resources areconstrained? Do you have a responsibility to the public to changemethods if you know one is a better estimation?

Income Statement Method for Calculating Bad Debt Expenses

The income statement method (also known as thepercentage of sales method) estimates bad debt expenses based onthe assumption that at the end of the period, a certain percentageof sales during the period will not be collected. The estimation istypically based on credit sales only, not total sales (whichinclude cash sales). In this example, assume that any credit cardsales that are uncollectible are the responsibility of the creditcard company. It may be obvious intuitively, but, by definition, acash sale cannot become a bad debt, assuming that the cash paymentdid not entail counterfeit currency. The income statement method isa simple method for calculating bad debt, but it may be moreimprecise than other measures because it does not consider how longa debt has been outstanding and the role that plays in debtrecovery.

To illustrate, let’s continue to use Billie’s WatercraftWarehouse (BWW) as the example. Billie’s end-of-year credit salestotaled $458,230. BWW estimates that 5% of its overall credit saleswill result in bad debt. The following adjusting journal entry forbad debt occurs.

Bad Debt Expense increases (debit), and Allowance for DoubtfulAccounts increases (credit) for $22,911.50 ($458,230 × 5%). Thismeans that BWW believes $22,911.50 will be uncollectible debt.Let’s say that on April 8, it was determined that Customer RobertCraft’s account was uncollectible in the amount of $5,000. Thefollowing entry occurs.

In this case, Allowance for Doubtful Accounts decreases (debit)and Accounts Receivable: Craft decreases (credit) for the knownuncollectible amount of $5,000. On June 5, Craft unexpectedly makesa partial payment on his account in the amount of $3,000. Thefollowing journal entries show the reinstatement of bad debt andthe subsequent payment.

The outstanding balance of $2,000 that Craft did not repay willremain as bad debt.

YOUR TURN

Heating and Air Company

You run a successful heating and air conditioning company. Yournet credit sales, accounts receivable, and allowance for doubtfulaccounts figures for year-end 2018, follow.

Compute bad debt estimation using the income statement method,where the percentage uncollectible is 5%.
Prepare the journal entry for the income statement method ofbad debt estimation.
Compute bad debt estimation using the balance sheet method ofpercentage of receivables, where the percentage uncollectible is9%.
Prepare the journal entry for the balance sheet method bad debtestimation.

Solution

$41,570; $831,400 × 5%
$20,056.50; $222,850 × 9%

Balance Sheet Method for Calculating Bad Debt Expenses

The balance sheet method (also known as thepercentage of accounts receivable method) estimates bad debtexpenses based on the balance in accounts receivable. The methodlooks at the balance of accounts receivable at the end of theperiod and assumes that a certain amount will not be collected.Accounts receivable is reported on the balance sheet; thus, it iscalled the balance sheet method. The balance sheet method isanother simple method for calculating bad debt, but it too does notconsider how long a debt has been outstanding and the role thatplays in debt recovery. There is a variation on the balance sheetmethod, however, called the aging method that does consider howlong accounts receivable have been owed, and it assigns a greaterpotential for default to those debts that have been owed for thelongest period of time.

Continuing our examination of the balance sheet method, assumethat BWW’s end-of-year accounts receivable balance totaled$324,850. This entry assumes a zero balance in Allowance forDoubtful Accounts from the prior period. BWW estimates 15% of itsoverall accounts receivable will result in bad debt. The followingadjusting journal entry for bad debt occurs.

Bad Debt Expense increases (debit), and Allowance for DoubtfulAccounts increases (credit) for $48,727.50 ($324,850 × 15%). Thismeans that BWW believes $48,727.50 will be uncollectible debt.Let’s consider that BWW had a $23,000 credit balance from theprevious period. The adjusting journal entry would recognize thefollowing.

This is different from the last journal entry, where bad debtwas estimated at $48,727.50. That journal entry assumed a zerobalance in Allowance for Doubtful Accounts from the prior period.This journal entry takes into account a credit balance of $23,000and subtracts the prior period’s balance from the estimated balancein the current period of $48,727.50.

Balance Sheet Aging of Receivables Method for Calculating BadDebt Expenses

The balance sheet aging of receivables methodestimates bad debt expenses based on the balance in accountsreceivable, but it also considers the uncollectible time period foreach account. The longer the time passes with a receivable unpaid,the lower the probability that it will get collected. An accountthat is 90 days overdue is more likely to be unpaid than an accountthat is 30 days past due.

With this method, accounts receivable is organized intocategories by length of time outstanding, and an uncollectiblepercentage is assigned to each category. The length ofuncollectible time increases the percentage assigned. For example,a category might consist of accounts receivable that is 0–30 dayspast due and is assigned an uncollectible percentage of 6%. Anothercategory might be 31–60 days past due and is assigned anuncollectible percentage of 15%. All categories of estimateduncollectible amounts are summed to get a total estimateduncollectible balance. That total is reported in Bad Debt Expenseand Allowance for Doubtful Accounts, if there is no carryoverbalance from a prior period. If there is a carryover balance, thatmust be considered before recording Bad Debt Expense. The balancesheet aging of receivables method is more complicated than theother two methods, but it tends to produce more accurate results.This is because it considers the amount of time that accountsreceivable has been owed, and it assumes that the longer the timeowed, the greater the possibility that individual accountsreceivable will prove to be uncollectible.

Looking at BWW, it has an accounts receivable balance of$324,850 at the end of the year. The company splits its past-dueaccounts into three categories: 0–30 days past due, 31–90 days pastdue, and over 90 days past due. The uncollectible percentages andthe accounts receivable breakdown are shown here.

For each of the individual categories, the accountant multipliesthe uncollectible percentage by the accounts receivable total forthat category to get the total balance of estimated accounts thatwill prove to be uncollectible for that category. Then all of thecategory estimates are added together to get one total estimateduncollectible balance for the period. The entry for bad debt wouldbe as follows, if there was no carryover balance from the priorperiod.

Bad Debt Expense increases (debit) as does Allowance forDoubtful Accounts (credit) for $58,097. BWW believes that $58,097will be uncollectible debt.

Let’s consider a situation where BWW had a $20,000 debit balancefrom the previous period. The adjusting journal entry wouldrecognize the following.

This is different from the last journal entry, where bad debtwas estimated at $58,097. That journal entry assumed a zero balancein Allowance for Doubtful Accounts from the prior period. Thisjournal entry takes into account a debit balance of $20,000 andadds the prior period’s balance to the estimated balance of $58,097in the current period.

You may notice that all three methods use the same accounts forthe adjusting entry; only the method changes the financial outcome.Also note that it is a requirement that the estimation method bedisclosed in the notes of financial statements so stakeholders canmake informed decisions.

CONCEPTS IN PRACTICE

Generally Accepted Accounting Principles

As of January 1, 2018, GAAP requires a change in how health-careentities record bad debt expense. Before this change, theseentities would record revenues for billed services, even if theydid not expect to collect any payment from the patient. Thisuncollectible amount would then be reported in Bad Debt Expense.Under the new guidance, the bad debt amount may only be recorded ifthere is an unexpected circ*mstance that prevented the patient frompaying the bill, and it may only be calculated from the amount thatthe providing entity anticipated collecting.

For example, a patient receives medical services at a localhospital that cost $1,000. The hospital knows in advance that thepatient will pay only $100 of the amount owed. The previous GAAPrules would allow the company to write off $900 to bad debt. Underthe current rule, the company may only consider revenue to be theexpected amount of $100. For example, if the patient ran into anunexpected job loss and is able to pay only $20 of the $100expected, the hospital would record the $20 to revenue and the $80($100 – $20) as a write-off to bad debt. This is a significantchange in revenue reporting and bad debt expense. Health-careentities will more than likely see a decrease in bad debt expenseand revenues as a result of this change.³

Footnotes

3 Tara Bannow. “New Bad Debt Accounting Standards Likely toRemake Community Benefit Reporting.” Modern Healthcare. March 17, 2018. http://www.modernhealthcare.com/arti...NEWS/180319904