1. Unit 8
Estimating Bad Debts

2. BASES USED FOR THE ALLOWANCE METHOD
Companies use either of two methods in the estimation of uncollectible accounts:
1. Percentage of sales
2. Percentage of receivables
Both bases are GAAP; the choice is a management decision.

3. ILLUSTRATION 9-4 COMPARISON OF BASES OF ESTIMATING UNCOLLECTIBLES
Percentage of Sales
Percentage of Receivables
Net Realizable Value
Allowance
Accounts
for
Receivable
Doubtful
Accounts
Emphasis on Income Statement Relationships
Emphasis on Balance Sheet Relationships

4. PERCENTAGE OF SALES BASIS
In the percentage of sales basis, management establishes a percentage relationship between the amount of credit sales and expected losses from uncollectible accounts.
Expected bad debt losses are determined by applying the percentage to the sales base of the current period.
This basis better matches expenses with revenues.

5. PERCENTAGE OF SALES BASIS
Example 1
Situation A: Pereira Company determines that 1% of net credit sales will become uncollectible. If net credit sales are $170,000 the estimated bad debt expense is $1700 (170,000*1%). The general journal entry is;

6. PERCENTAGE OF SALES BASIS Example 2 Balance In Doubtful Accounts
Situation B: Pereira Company determines that 1% of net credit sales will become uncollectible. If net credit sales are $170,000 the estimated bad debt expense is $1700 (170,000*1%). However the allowance for doubtful accounts still has a credit balance of $1500. How much is journalized? Answer: the same as in situation A. Balances in doubtful accounts are ignored.

7. PERCENTAGE OF RECEIVABLES BASIS
Under the percentage of receivables basis, management establishes a percentage relationship between the amount of accounts receivable and the required balance in the allowance account.
This percentage can be applied to the total accounts receivable balance, or to individual accounts receivable balances stratified by age.

8. PERCENTAGE OF RECEIVABLES BASIS
The required balance in the allowance account is determined by applying the percentage to the accounts receivable balance at the end of the current period.
The amount of the adjusting entry to record expected bad debt losses for the current period is the difference between the required balance and the existing balance in the allowance account.
This basis produces the better estimate of net realizable value of receivables.

9. PERCENTAGE OF RECEIVABLES BASIS EXAMPLE 1 Net Receivables
Pereira Company decides to use the percentage of receivables method to estimate bad debts. It determines that 3% of total accounts receivables will become uncollectibe. If the accounts receivables total is $40,000 the estimated bad debt expense is $1,200. (40,000*3%)

10. PERCENTAGE OF RECEIVABLES BASIS
EXAMPLE 2 Credit Balance in Allowance for Doubtful Accounts
Pereira Company decides to use the percentage of receivables method to estimate bad debts. It determines that 3% of total accounts receivables will become uncollectibe. If the accounts receivables total is $40,000 the estimated bad debt expense is $1,200. (40,000*3%). However there is still a credit balance of $500 in the allowance for doubtful accounts remaining from last year’s adjusting entry. Therefore bad debt expense is only $700. (1, )

11. PERCENTAGE OF RECEIVABLES BASIS
EXAMPLE 3 Debit Balance in Allowance for Doubtful Accounts
Pereira Company decides to use the percentage of receivables method to estimate bad debts. It determines that 3% of total accounts receivables will become uncollectibe. If the accounts receivables total is $40,000 the estimated bad debt expense is $1,200. (40,000*3%). However there is debit balance of $300 in the allowance for doubtful accounts. In other words Pereira had more bad debts than estimated. Therefore bad debt expense is $1,500. (1, )

12. PERCENTAGE OF RECEIVABLES BASIS EXAMPLE 4 Aging of Accounts
Pereira Company decides to use the percentage of receivables method to estimate bad debts. However it wants to use the aging of accounts receivables as a basis.
Days 0-30 days days days over 120
Amount $27,000 5,700 3,000 2,400 1,900
Percent 2% 4% 10% 50% 75%
Bad Debt $
Total Bad Debt Expense = $3,693

13. PERCENTAGE OF RECEIVABLES BASIS
EXAMPLE 5
Pereira Company decides to use the percentage of receivables method to estimate bad debts. In using the aging of accounts receivables as a basis the company determines that $3,693 of receivables will become uncollectible. However there is still a credit balance of $500 in the allowance for doubtful accounts remaining from last year’s adjusting entry. Therefore bad debt expense is only $3,193 (3, )

14. SUMMARY OF UNCOLLECTIBLE ACCOUNTS
Methods of Write-Off
DIRECT
ALLOWANCE
PERCENTAGE OF ACCOUNTS RECEIVABLES
PERCENTAGE OF SALES
TOTAL RECEIVABLES
AGING OF RECEIVABLES

15. DISPOSING OF ACCOUNTS RECEIVABLE
To accelerate the receipt of cash from receivables, owners frequently:
1. sell to a factor, such as a finance company or a bank, and
2. make credit card sales.

16. DISPOSING OF ACCOUNTS RECEIVABLE
A factor buys receivables from businesses for a fee and collects the payments directly from customers.
Credit cards are frequently used by retailers who wish to avoid the paperwork of issuing credit.
Retailers can receive cash more quickly from the credit card issuer.