Subject: Subject: Financial Analysis and Reporting

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 Module 5: Estimation of Doubtful Accounts

Intended Learning Outcomes (ILO)

By the end of the module, the students are expected to:

1. To Identify the methods of estimating doubtful accounts expense.

2. To understand the argument for and against the aging of accounts receivable method.
3. To understand the argument for and against the percentage of accounts receivable method.
4. To understand the argument for and against the percentage of sales method.

Lecture Proper and Discussion

What Is an Allowance for Doubtful Accounts?

An allowance for doubtful accounts is a contra account that nets against the total receivables
presented on the balance sheet to reflect only the amounts expected to be paid. The allowance for
doubtful accounts estimates the percentage of accounts receivable that are expected to be
uncollectible. However, the actual payment behavior of customers may differ substantially from the
estimate.

KEY TAKEAWAYS

• The allowance for doubtful accounts is a contra account that records the percentage of
receivables expected to be uncollectible.
• The allowance is established in the same accounting period as the original sale, with an offset
to bad debt expense.
• The percentage of sales method and the accounts receivable aging method are the two most
common ways to estimate uncollectible accounts.

Understanding the Allowance for Doubtful Accounts

Regardless of company policies and procedures for credit collections, the risk of the failure to receive
payment is always present in a transaction utilizing credit. Thus, a company is required to realize this
risk through the establishment of the allowance for doubtful accounts and offsetting bad
debt expense. In accordance with the matching principle of accounting, this ensures that expenses
related to the sale are recorded in the same accounting period as the revenue is earned. The
allowance for doubtful accounts also helps companies more accurately estimate the actual value of
their account receivables.

Because the allowance for doubtful accounts is established in the same accounting period as the
original sale, an entity does not know for certain which exact receivables will be paid and which will
default. Therefore, generally accepted accounting principles (GAAP) dictate that the allowance must
be established in the same accounting period as the sale, but can be based on an anticipated or
estimated figure. The allowance can accumulate across accounting periods and may be adjusted
based on the balance in the account.

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Recording the Allowance for Doubtful Accounts
Two primary methods exist for estimating the dollar amount of accounts receivables not expected to
be collected.

What Is Accounts Receivable Aging?

Accounts receivable aging (tabulated via an aged receivables report) is a periodic report that
categorizes a company's accounts receivable according to the length of time an invoice has been
outstanding. It is used as a gauge to determine the financial health of a company's customers. If the
accounts receivable aging shows a company's receivables are being collected much slower than
normal, this is a warning sign that business may be slowing down or that the company is taking
greater credit risk in its sales practices.

KEY TAKEAWAYS

• Accounts receivable aging is the process of distinguishing open accounts receivables based
on the length of time an invoice has been outstanding.
• Accounts receivable aging is useful in determining the allowance for doubtful accounts.
• The aged receivables report tabulates those invoices owed by length, often in 30-day
segments, for quick reference.

How Accounts Receivable Aging Works

Accounts receivable aging, as a management tool, can indicate that certain customers are becoming
credit risks, and may reveal whether the company should keep doing business with customers that
are chronically late payers. Accounts receivable aging has columns that are typically broken into date
ranges of 30 days, and shows total receivables that are currently due, as well as receivables that are
past due.

Allowance for Doubtful Accounts

Accounts receivable aging is useful in determining the allowance for doubtful accounts. When
estimating the amount of bad debt to report on a company’s financial statements, the accounts
receivable aging report is useful to estimate the total amount to be written off. The primary useful
feature is the aggregation of receivables based on the length of time the invoice has been past due.

A company applies a fixed percentage of default to each date range. Invoices that have been past
due for longer periods of time are given a higher percentage due to increasing default risk and
decreasing collectibility. The sum of the products from each outstanding date range provides an
estimate regarding the amount of uncollectible receivables.

Aged Receivables Report

The aged receivables report, or table, depicting accounts receivable aging provides details of specific
receivables based on age. The specific receivables are aggregated at the bottom of the table to
display the total receivables of a company, based on the number of days the invoice is past due. The
typical column headers include 30-day windows of time, and the rows represent the receivables of
each customer. Here's an example of an accounts receivable aging report.

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Benefits of Accounts Receivable Aging
The findings from accounts receivable aging reports may be improved in various ways. First,
accounts receivable are derivations of the extension of credit. If a company experiences difficulty
collecting accounts, as evidenced by the accounts receivable aging report, specific customers may be
extended business on a cash-only basis. Therefore, the aging report is helpful in laying out credit and
selling practices.

Companies will use the information on an accounts receivable aging report to create collection letters
to send to customers with overdue balances. Accounts receivable aging reports mailed to customers
along with the month-end statement or collection letter provides a detailed account of outstanding
items. Therefore, an accounts receivable aging report may be utilized by internal as well as external
individuals.

Percent of Sales Method

The Percent of Sales Method uses one income statement account, Sales, to estimate the change in
another income statement account, Bad Debt Expense, for the period. This is the amount of the
required adjusting entry. This method is typically used by businesses with a large number of
customers with relatively uniform accounts receivable balances. The balance in the Allowance
account is the balance in the ledger before adjustment plus the adjusting entry for bad debt expense.
The bad debt expense for the period is calculated by multiplying the uncollectible percentage times
the credit sales in the period to determine the uncollectible accounts expense for the period. This will
be the amount of the adjusting entry.

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Percent of Accounts Receivable Method

The Percent of Receivables Method uses the balance in one balance sheet account, Accounts
Receivable, to estimate the balance in another balance sheet account, Allowance for Uncollectible
Accounts, at the end of the period. The adjusting entry for bad debt expense is the difference
between the balance in the ledger for the allowance account before adjustment and the estimated
balance in the allowance account.

The current balance of accounts receivable is analyzed by use of an aging schedule to determine the
desired ending balance for the Allowance for Doubtful Accounts. The uncollectible accounts expense
for the period is determined based on the current (unadjusted) balance in the Allowance, the desired
ending balance in the Allowance account and any write-offs of uncollectible accounts during the
period.

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Suggested Teaching Activities (TAs)

• https://youtu.be/zwPhZGM9vIs

Assessment Tasks / Output (ATOs)

Multiple choice and True or False:

1. The Allowance for Doubtful Accounts has a debit balance of $1,000 at the end of the year (before
adjustment), and uncollectible accounts expense is estimated at 2% of net sales. If net sales are
$600,000, the amount of the adjusting entry to record the provision for doubtful accounts is:

a) $1,000
b) $13,000
c) $11,000
d) $12,000

Answer: D

2. The Allowance for Doubtful Accounts has a debit balance of $1,000 at the end of the year (before
adjustment), and uncollectible accounts estimate based on an aging schedule is $10,000. If accounts
receivable are $600,000 the amount of the adjusting entry to record the provision for doubtful
accounts is:

a) $10,000
b) $11,000
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c) $9,000
d) $16,000

Answer: B

3. Allowance for Doubtful Accounts has a credit balance of $500 at the end of the year (before
adjustment), and an analysis of customers’ accounts indicates doubtful accounts of $11,500. Which
of the following entries records the proper provision for doubtful accounts?

a) Debit Uncollectible Accounts Expense, $11,000; credit Allowance for Doubtful Accounts, $11,000.
b) Debit Uncollectible Accounts Expense, $12,000; credit Allowance for Doubtful Accounts, $12,000.
c) Debit Allowance for Doubtful Accounts, $12,000; credit Uncollectible Accounts Expense, $12,000.
d) Debit Allowance for Doubtful Accounts, $11,000; credit Uncollectible Accounts Expense, $11,000.

Answer: C

4. Accounts Receivable Turnover measures

a) Number of days outstanding

b) Fair market value of Accounts Receivables
c) The efficiency of the accounts payable function
d) How frequently during the year the Accounts Receivable are converted to cash

Answer: D

5. Accounts receivable are reported on the balance sheet at their

a) Fair market value

b) Present value
c) Net realizable value
d) Maturity value

Answer: C

6. The adjustment for uncollectible accounts involves a credit to Bad Debt Expense and a debit to the
Allowance for Uncollectible Accounts.

Answer: False

7. The Allowance for Uncollectible Accounts is a contra asset account representing the amount of
accounts receivable that the company does not expect to collect.

Answer: True

8. Bad debt expense is the amount of the adjustment to the allowance for uncollectible accounts that
represents the cost of the estimated future bad debts.

Answer: True

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9. Notes receivable only arise from sales to customers.

Answer: False

10. Notes receivable typically earn interest revenue for the lender and interest expense for the
borrower.

Answer: True

Readings and Other References

1. Intermediate accounting volume 1; Conrado T. Valix, Jose F. Peralta, Christian Aris M. Valix
2. https://youtu.be/zwPhZGM9vIs

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