ACC 2201 chapter 5 (notes)
Common Mistake •Because Allowance for Uncollectible Accounts has a normal credit balance, students sometimes misclassify this account as a liability, which also has a normal credit balance. •Instead, a contra asset represents a reduction in a related asset. Key Point Establishing an allowance for uncollectible accounts correctly reports accounts receivable in the balance sheet at the amount expected to be collected. Bad debt expense is reported in the income statement.
Accounting for Uncollectible Accounts and the Accounts Receivable Portion of the Balance Sheet After we estimate uncollectible accounts to be $6 million, we reduce the $20 million balance of accounts receivable and report them at their estimated collectible amount of $14 million. But is this estimate correct? Only time will tell. Kimzey's prediction of $6 million for uncollectible accounts might be too high, or it might be too low. In either case, it's generally more informative than making no estimate at all. Earlier in the chapter, we discussed contra revenue accounts—sales discounts, returns, and allowances. Recall that these accounts provide a way to reduce revenue indirectly. In the same way, the allowance account provides a way to reduce accounts receivable indirectly, rather than decreasing the accounts receivable balance itself. We report the allowance for uncollectible accounts in the asset section of the balance sheet, but it represents a reduction in the balance of accounts receivable. The difference between total accounts receivable and the allowance for uncollectible accounts is referred to as net accounts receivable, which is net realizable value.
single estimated percentage (30%) to total accounts receivable: percentage-of-receivables method (balance sheet method ): the percentage may be estimated using current economic conditions, company history, and industry guidelines. A more accurate method is to consider the various ages of individual accounts receivable, using a higher percentage of uncollectible for "old" accounts than for "new" accounts. This is known as the aging method. For instance, accounts that are 120 days past due are older than accounts that are 60 days past due. The older the account, the less likely it is to be collected. Key Point Using the aging method to estimate uncollectible accounts is more accurate than applying a single percentage to all accounts receivable. The aging method recognizes that the longer accounts are past due, the less likely they are to be collected.
Aging Method: estimate of future bad debts on the various ages of individual accounts receivable, using a higher percentage for "old" accounts than for "new" accounts. The older the account, the less likely it is to be collected. The journal entry to estimate future bad debts is identical to the journal entry made using a single estimated percentage.
Accounts receivable we do not expect to collect have no benefit to the company. Thus, to avoid overstating the assets of the company, we need to reduce accounts receivable in the balance sheet by an estimate of the amount expected not to be collected. Using the allowance method, we account for events (customers' bad debts) that have not yet occurred but that are likely to occur. This is different from other transactions you've learned about up to this point. Those earlier transactions involved recording events that have already occurred, such as purchasing supplies, paying employees, and providing services to customers. Under the allowance method, companies are required to estimate future uncollectible accounts and report those estimates in the current year. Key Point Under the allowance method, accounts receivable are reported for the net amount expected to be collected. At the end of the current year, estimated future uncollectible accounts are reported in a contra asset account, reducing net accounts receivable.
Allowance Method (GAAP) •Generally accepted accounting principles (GAAP) require that we account for uncollectible accounts using the allowance method. •Companies must: #Estimate the amount of current accounts receivable that will prove to be uncollectible in the future. #Report this estimate as a contra asset to its accounts receivable. •Under the allowance method, companies are required to estimate future uncollectible accounts and report those estimates in the current year.
The allowance for uncollectible accounts is sometimes referred to as the allowance for doubtful accounts. The allowance account provides a way to reduce accounts receivable indirectly, rather than decreasing the accounts receivable balance itself.
Allowance for Uncollectible Accounts Companies report their estimate of future bad debts using an allowance for uncollectible accounts. Allowance for Uncollectible Accounts is a contra asset account that represents the amount of accounts receivable not expected to be collected. We report the allowance for uncollectible accounts in the asset section of the balance sheet, but it represents a reduction in the balance of accounts receivable. The difference between total accounts receivable and the allowance for uncollectible accounts equals net accounts receivable.
Common Mistake •Some students erroneously think firms should reduce total assets and record bad debt expense at the time the bad debt actually occurs. •However, companies anticipate future bad debts and establish an allowance for those estimates. Key Point The direct write-off method waits to reduce accounts receivable and record bad debt expense until accounts receivable prove uncollectible in the future. This leads to accounts receivable being overstated in the current year. The direct write-off method generally is not acceptable for financial reporting.
Allowance method vs direct write off method Assume that at the end of Year 1, a company estimates that $10,000 of accounts receivable won't be collected. For simplicity, also assume that this estimate of future bad debts turns out to be correct, and actual bad debts in Year 2 total $10,000.
Also at the time of cash collection on March 10, F.Y.Eye credits Accounts Receivable for the full $2,000, even though it receives cash of only $1,960. The reason is that the $2,000 balance in Accounts Receivable is "received in full" by the combination of the $1,960 cash collection and the $40 sales discount. The balance of Accounts Receivable now equals $0. Note that if the customer did not pay within the discount period, F.Y.Eye would reduce accounts receivable and increase cash by the gross amount of the receivable, or $2,000 in this case.
Balance of Accounts Receivable after Credit Sales, Sales Return, Sales Allowance, and Collection on Account after Sales Discount
Later in 2025, on September 8, Bruce's bankruptcy proceedings are complete. Kimzey had expected to receive none of the $4,000 Bruce owed. However, after liquidating all assets, Bruce is able to pay each of his creditors 25% of the amount due them. So, when Kimzey receives payment of $1,000 (= $4,000 × 25%), it makes the following two entries. The first entry simply reverses a portion of the previous entry that Kimzey made on February 23 to write off the account. The second entry records the collection of the account receivable. Notice that in both entries the amounts have offsetting effects on total assets. Therefore, collecting cash on an account previously written off also has no effect on total assets and no effect on net income.
Collecting on Accounts Previously Written Off (2 entries) Later in 2025, on September 8, Kimzey receives a payment from the customer whose account had been written off of $1,000. The company records the collection using two entries:
Key Point Revenues are reported for the amount the company is entitled to receive. This amount equals total revenues minus trade discounts, sales returns, sales allowances, and sales discounts. Trade discounts reduce revenue directly, while sales returns, sales allowances, and sales discounts are recorded in separate contra revenue accounts and subtracted when calculating net revenues.
Collection After the Discount Period F.Y.Eye typically provides laser eye surgery for $3,000. The company offers laser eye surgery in the month of March for only $2,400. F.Y.Eye provides laser eye surgery to a customer on March 1 for $2,400 on account with terms of 2/10, n/30. Cash is collected from the customer on March 31, which is not within the 10-day discount period. The company records the following:
Notice that F.Y.Eye receives only $1,960 cash, the $2,000 amount owed less the $40 sales discount. Similar to sales returns and sales allowances, we record sales discounts in a contra revenue account—Sales Discounts. The reason we use a contra revenue account is to be able to keep the total revenue separate from the reduction in that revenue due to quick payment. The effect of this transaction is to reduce assets and net revenues of the company by $40. Also at the time of cash collection on March 10, F.Y.Eye credits Accounts Receivable for the full $2,000, even though it receives cash of only $1,960. The reason is that the $2,000 balance in Accounts Receivable is "received in full" by the combination of the $1,960 cash collection and the $40 sales discount.
Collection During the Discount Period F.Y.Eye typically provides laser eye surgery for $3,000. The company offers laser eye surgery in the month of March for only $2,400. F.Y.Eye provides laser eye surgery to a customer on March 1 for $2,400 on account with terms of 2/10, n/30. Cash is collected from the customer on March 10, which is within the 10-day discount period. The company records the following:
Companies sometimes provide goods or services to customers, not for cash, but on account. Credit sales typically include an informal credit agreement supported by an invoice. An invoice is a source document that identifies the date of sale, the customer, the specific items sold, the dollar amount of the sale, and the payment terms. Payment terms typically require the customer to pay within 30 to 60 days after the sale.
Credit Sales and Accounts Receivable Credit sales transfer goods or services to a customer today while bearing the risk of collecting payment from that customer in the future. •At the time of a credit sale, a company will record: #Accounts receivable. Accounts receivable represent amounts owed to a company by its customers from the sale of goods or services on account. #Revenue. Even though no cash is received at the time of the credit sale, the seller records revenue immediately once goods or services are provided to the customer, and future collection from the customer is probable.
1.Revenues are reported for the amount of cash a company expects to be entitled to receive from customers for providing goods and services. 2.Total revenues are reduced by sales returns, sales allowances, and sales discounts that occur during the year. 3.Total revenues are further reduced by an adjusting entry at the end of the year for the estimate of additional sales returns, sales allowances, and sales discounts expected to occur in the future but that relate to the current year. Key Point Customers' accounts receivable we no longer expect to collect are referred to as uncollectible accounts, or bad debts.
End-of-Period Adjustment For Contra Revenues •The previous discussion deals with how companies record contra revenues—sales returns, sales allowances, and sales discounts—during the year. •However, companies also must adjust for these amounts at the end of the year using adjusting entries. •The revenue recognition standard requires a company to report revenues equal to the amount of cash the company "expects to be entitled to receive."
The receivables not expected to be collected should not be counted in assets of the company. The entry to establish an allowance for uncollectible accounts affects the reported financial position of the company by reducing assets and increasing expenses.
Estimating Uncollectible Accounts In 2024, its first year of operations, Kimzey Medical Clinic bills customers $50 million for emergency care services provided. At the end of 2024, Kimzey is owed $20 million from customers and estimates that 30% will not be collected. The company records the following:
we increase the Allowance when we do not know which specific accounts will be written off. Then, once we know the specific patients who won't pay, we reduce the Allowance and reduce the Accounts Receivable for the specific patient. Overall, the write-off of the account receivable has no effect on total amounts reported in the balance sheet or in the income statement. There is no decrease in total assets and no decrease in net income with the write-off. Why? •We have already recorded the negative effects of the bad news. Kimzey recorded those effects when it estimated future bad debts at the end of 2025 by recording bad debt expense and the allowance account. •So, when Bruce declares bankruptcy in the following year, 2025, we had already allowed for this bad debt. •The write-off on February 23, 2025, reduces both an asset account (Accounts Receivable) and its contra asset account (Allowance for Uncollectible Accounts), leaving the net receivable unaffected. •Thus, the entry to record the actual write-off results in no change to total assets and no change to net income.
Example of Writing Off Accounts Receivable On February 23, based on information about a former patient, Kimzey believes it is unlikely the patient will pay his account of $4,000. The company will adjust the allowance and reduce the accounts receivable balance itself as follows: Overall, the write-off of the account receivable has no effect on total amounts reported in the balance sheet or in the income statement.
•Even though F.Y.Eye normally charges $3,000 for this service, the company can record revenue for only $2,400, because that's the amount the company is entitled to receive from this customer. •The trade discount of $600 is recorded indirectly by simply recording revenue equal to the discounted price. We don't keep track in a separate account of trade discounts given to customers.
Example of a Trade Discount F.Y.Eye typically provides laser eye surgery for $3,000. The company offers laser eye surgery in the month of March for only $2,400. The company records the following at the time of service:
The offsetting debit in the entry to establish the allowance account is bad debt expense. Bad debt expense represents the cost of estimated future bad debts that is reported as an expense in the current year's income statement, along with other expenses. Bad debt expense sometimes is referred to as uncollectible accounts expense or provision for doubtful accounts.
Income Statement Showing Estimated Bad Debt Expense the income statement for Kimzey Medical Clinic after estimating bad debt expense. In the 2024 income statement, we reduce the $50 million of revenue from credit sales by total expenses of $40 million, of which $6 million is for estimated future bad debts.
d.A debit to Bad Debt Expense = $20,000 The adjustment equals $500,000 × 4% = $20,000. The adjusting entry includes a debit to Bad Debt Expense and a credit to Allowance for Uncollectible Accounts.
On December 31 before adjusting entries, a company reports the following balances: Accounts Receivable $100,000 Allowance for Uncoll. Accts. $2,000 (credit) Credit Sales $500,000 The company estimates bad debts to be 4% of credit sales. The adjusting entry would include: a.A debit to Bad Debt Expense = $18,000 b.A credit to Allowance for Uncoll. Accts. = $24,000 c.A credit to Allowance for Uncoll. Accts. = $22,000 d.A debit to Bad Debt Expense = $20,000
a.A debit to Bad Debt Expense for $22,000 Bad debts are estimated to be $20,000 (= $100,000 × 20%). The current $2,000 debit balance of the Allowance needs a credit adjustment of $22,000 to be equal to $20,000 credit. (Debit balance of $2,000 + Credit of $22,000 = Credit balance of $20,000.) The adjustment of $22,000 is recorded as a debit to Bad Debt Expense and a credit to Allowance for Uncollectible Accounts.
On December 31 before adjusting entries, a company reports the following balances: •Accounts Receivable $100,000 •Allowance for Uncollectible Accounts $2,000 (debit) The company estimates bad debts to be 20% of accounts receivable. The adjusting entry would include: a.A debit to Bad Debt Expense for $22,000 b.A credit to Allow. for Uncollectible Accts for $18,000 c.A credit to Allow. for Uncollectible Accts. for $20,000 d.A debit to Bad Debt Expense for $20,000
d.Last year's estimate of bad debts was too high. The Allowance for Uncollectible Accounts is a contra account with a credit balance. The balance is reduced (debited) for actual bad debts. If the account balance at the end of the year is a credit, then estimated bad debts for this year are greater than this year's actual bad debts.
On December 31 before adjusting entries, a company's balance of Allowance for Uncollectible Accounts is a credit of $2,000. What does a "credit" balance prior to adjusting entries indicate? a.The company did not estimate bad debts last year. b.Last year's estimate of bad debts was too low. c.The company's estimate equals actual bad debts. d.Last year's estimate of bad debts was too high.
In our example for Kimzey, we previously established an allowance for uncollectible accounts in 2024 by applying a single estimated percentage (30%) to total accounts receivable. This is known as the percentage-of-receivables method. This method sometimes is referred to as a balance sheet method because we base the estimate of bad debts on a balance sheet account—accounts receivable. For this method, the percentage may be estimated using current economic conditions, company history, and industry guidelines. At the end of 2025, we could once again multiply total accounts receivable by a single percentage to get an estimate of future uncollectible accounts.
Percentage-of-Receivables Method: method of estimating uncollectible accounts based on the percentage of accounts receivable expected not to be collected. •This method sometimes is referred to as a balance sheet method because we base the estimate of bad debts on a balance sheet account—accounts receivable. •For this method, the percentage may be estimated using current economic conditions, company history, and industry guidelines.
The more frequently a business is able to "turn over" its average accounts receivable, the more effective a company is at granting credit to and collecting cash from its customers. Key Point The receivables turnover ratio and average collection period can provide an indication of management's ability to collect cash from customers in a timely manner.
Receivables Turnover Ratio: Number of times during a year the average accounts receivable balance is collected #net credit sales = Sales on credit - Sales returns - Sales allowances. Average Collection Period: Number of days the average accounts receivable balance is outstanding
Notice that instead of debiting Cash, as in a cash sale, the company debits another asset—Accounts Receivable—for the credit sale. Later, when $500 cash is received from the customer, the company then records the increase to Cash. Also, Service Revenue is increased because the company has provided services to the customer.
Recording a Credit Sale On March 1, a company provides services to a customer for $500. The customer doesn't pay cash at the time of service, but instead promises to pay the $500 by March 31. The company records the following at the time of the service:
To see how companies record subsequent receipts from customers, consider an example. On March 1, a company provides services to a customer for $500. The customer later pays the $500 by March 31. the company credits an asset—Accounts Receivable. This is because the company increased Service Revenue back on March 1 when the service was actually provided. Also, Accounts Receivable is reduced because the customer no longer owes money to the company. Key Point Companies record an asset (accounts receivable) and revenue when they sell goods or services to their customers on account, expecting collection in the future. Once the receivable is collected, the balance of accounts receivable is reduced.
Recording the Subsequent Receipt On March 1, a company provides services to a customer for $500. The customer later pays the $500 by March 31. The company records the following at the time of the service:
Sales Allowances: occur when the seller reduces the customer's balance owed or provides at least a partial refund because of some deficiency in the company's good or service. We record the sales allowance in a contra revenue account—Sales Allowances. Common Mistake Students sometimes misclassify contra revenue accounts—sales returns and sales allowances—as expenses. Like expenses, contra revenues have normal debit balances and reduce the reported amount of net income. However, contra revenues represent reductions of revenues, whereas expenses represent the separate costs of generating revenues.
Sales Allowances The customer having laser eye surgery on March 1 for $2,400 is not completely satisfied with the outcome of the surgery. On March 5, F.Y.Eye allows a $400 reduction in the amount owed by the customer. The company records the following:
We reduce revenue for sales returns using a contra revenue account—Sales Returns. A contra revenue account is an account with a balance that is opposite, or "contra," to that of its related revenue account. The reason we use a contra revenue account is to keep a record of the total revenue recognized separate from the reduction due to subsequent sales returns. Managers want to keep a record of not only how much their companies are selling, but also how much is being returned. High sales returns could be an indication of inventory problems, so it's important to keep track of both Sales Revenue and Sales Returns.
Sales Returns On March 2, F.Y.Eye sells sunglasses to one of its customers for $200 on account. On March 4, the customer decides she doesn't want eyeglasses and receives full credit from F.Y.Eye. The company records the following:
b.A decrease to net income The effect of a sales allowance is to decrease net income. A sales allowance decreases sales revenue in the income statement. A sales allowance also decreases assets by decreasing the balance of accounts receivable.
The effect of a sales allowance will result in which of the following: a.An increase to net income b.A decrease to net income c.An increase to accounts receivable d.An increase to sales revenue
Trade discounts represent a reduction in the listed price of a good or service. Companies typically use trade discounts to provide incentives to larger customers or consumer groups to purchase from the company. Trade discounts also can be a way to change prices without publishing a new price list or to disguise real prices from competitors. Because sellers are entitled to receive only the discounted amount, sale is recorded at this lower amount.
Trade Discounts •Reduction in list price of a product or service #Used to provide incentives to larger customers or consumer groups to purchase from the company •Because sellers are entitled to receive only the discounted amount, sale is recorded at this lower amount.
At the end of 2024 (previous year) Kimzey estimated future bad debts to be $6 million. This is the beginning balance of Allowance for Uncollectible Accounts in 2025. Let's assume, however, that only $4 million of accounts were actually written off in 2025. This means the balance of the allowance account at the end of 2025, prior to any year-end adjustment, has a leftover amount of $2 million. If we want the ending balance to be $7 million, by how much does the $5 million current balance need to be adjusted? $5 million. Key Point The year-end adjusting entry for future uncollectible accounts is affected by the current balance of Allowance for Uncollectible Accounts before adjustment. The current balance before adjustment equals the balance of the allowance account at the beginning of the current year (or end of last year) less actual write-offs in the current year.
Using the Aging Method to Adjust the Allowance in Subsequent Years If the estimated amount uncollectible is $7 million, then Allowance for Uncollectible Accounts needs to have an ending balance of $7 million. We need to: 1)Know the current balance of Allowance for Uncollectible Accounts and then 2)Determine the adjustment needed so that the ending balance will be $7 million.
c.Total assets are unchanged. The write-off of an account receivable has no effect on total amounts reported in the balance sheet or in the income statement. There is no decrease in total assets and no decrease in net income.
When writing off an uncollectible account: a.Bad debt expense is debited. b.Net income is decreased. c.Total assets are unchanged. d.The allowance account is credited.
b.Total Revenue - Sales Returns - Sales Allowances - Sales Discounts Net Revenues is equal to Total Revenue less Sales Returns, Sales Allowances, and Sales Discounts.
Which of the following computations would be used to compute Net Revenues? a.Total Revenue + Accounts Receivable - Sales Allowances - Sales Discounts b.Total Revenue - Sales Returns - Sales Allowances - Sales Discounts c.Total Revenue - Sales Allowances - Sales Discounts d.Net Income - Change in Accounts Receivable
a.Accounts receivable Accounts receivable represent cash owed to the company by its customers from sales or services on account. Nontrade receivables include tax refund claims, interest receivable, and loans by the company to other entities.
Which of the following generally is recorded at the time a company provides services to customers on account? a.Accounts receivable b.Interest receivable c.Notes receivable d.Tax refund claims
d.Older accounts are less likely to be collected. The aging method recognizes that the longer accounts are past due, the less likely they are to be collected. The aging method should provide a more accurate estimate of total uncollectible accounts compared to using a single percentage.
Which of the following is true about the aging method? a.No estimate for uncollectible accounts needs to be made. b.Older accounts are more likely to be collected. c.It is not acceptable for GAAP. d.Older accounts are less likely to be collected.
c.It is subtracted from the balance of Accounts Receivable in the balance sheet. The allowance account is a contra asset and is used to record estimated future uncollectible accounts. The balance is subtracted from Accounts Receivable in the balance sheet to arrive at Accounts Receivable's carrying value.
Which of the following is true regarding Allowance for Uncollectible Accounts? a.It is a liability account. b.It is added to the total of Sales Discounts, Sales Returns, and Sales Allowances. c.It is subtracted from the balance of Accounts Receivable in the balance sheet. d.It appears in the income statement as an expense.
b.The company would have an average collection period of 36.5 days. The average collection period is computed as 365 divided by the accounts receivable turnover of 10 (= 36.5 days).
Which of the following would be true for a company that has an accounts receivable turnover of 10? a.The company turns over their accounts receivable more than once a month. b.The company would have an average collection period of 36.5 days. c.The company would be considered as doing an efficient job of collecting receivables if the terms were net 30. d.The company would have an average collection period of 20 days.
The write-off of an account receivable occurs when the company identifies the specific account that has become uncollectible. The write-off has no effect on total amounts reported in the balance sheet or in the income statement. Because the write-off reduces both an asset account and a contra asset account, there is no decrease in total assets and no decrease in net income with the write-off. We have already recorded the negative effects of the bad news when we estimated those bad debts to occur. That estimate was recorded as an adjusting entry at the end of the previous year. Key Point Writing off a customer's account as uncollectible reduces the balance of accounts receivable but also reduces the contra asset—allowance for uncollectible accounts. The net effect is that there is no change in the net receivable (accounts receivable less the allowance) or in total assets.
Writing Off Accounts Receivable •When it becomes clear a customer will not pay, the company writes off the customer's account balance as uncollectible. •The write-off: #Reduces the balance of Accounts Receivable. #Reduces the balance of the contra account Allowance for Uncollectible Accounts. #The write-off has no effect on total assets (balance sheet) or total expenses (income statement).
