Lesson Objectives:- Sales method rules
- How bad debts are estimated and recorded.
- Example of the adjustment process
- Advantage of the sales method
We just talked about the fact that there are two different methods used to calculate the allowance for doubtful accounts. The first method that we will review in this lesson is the percentage of sales method.
Let's start with the rules that apply to using the sales method, as these rules best demonstrate how the method works.
Always use a T-account to record the Allowance for Doubtful Accounts. Use the abbreviation AFDA.
Bad debts adjustment should always be recorded with a debit for the bad debt account and credit for the AFDA.
Only the adjustment for the estimate of the bad debts expense and AFDA should be journalized in the entry. There can be other values such as beginning, ending, write-offs and recovery of receivables, but these will not be recorded on the same journal entry.
Find the ending AFDA for the balance sheet. This will be deducted from the accounts receivable to come up with the net receivables.
Keep these rules in mind as we review a real-world example of how the sales method of estimating the bad debts expense is applied.
Let's go ahead and take a look at a step-by-step example of how this method is applied. We will use the account values listed above; these values are for the year 2015.
When we start 2015, we will use the T-account format to record the beginning balance of $3,000 for AFDA.
For the purpose of this example, management estimates that 2 percent of all sales will be uncollectible. This percentage is multiplied by net sales because the net sales factors in any returns or discounts. This calculation would be 0.02 x 800,000 = $16,000, which would then be recorded on the AFDA T-account as the adjustment amount.
The ending balance for AFDA would be $19,000 which is the total of the beginning balance and adjustment amount.
Now that we have the estimate of the bad debts expense, we will go ahead and record the journal entry. Above, the estimate figure of $16,000 is listed as a debit for the bad debts expense and a credit for AFDA.
Finally, we would look at the gross accounts receivable and subtract the ending AFDA value to come up with the net receivables value of $481,000.
We've come up with the bad debts expense and AFDA adjustment as well as the net receivables amount using the percentage of sales method. We will take a look at the receivables method in the next lesson.
Each method has its own advantage when it comes to accounting principles. The sales method best demonstrates the matching principle because the bad debts expense is being matched directly to the sales. The estimated bad debt amount is multiplied by the sales, therefore matching the expenses to the revenues earned in the given accounting period.