Lesson Objectives:- Defining the percentage of receivables method.
- What the aging schedule is.
- Using the T-account format to record the beginning, adjustment and ending values.
- Recording the bad debts expense.
In this lesson we will be talking about the percentage of receivables method for calculating the bad debts expense. The receivables method is slightly more complicated than the sales method that we reviewed in the previous lesson.
The difference is the receivables method does not use the net sales to calculate the uncollectible amount. Instead we will use the permanent account values for accounts receivable.
For the example, we are reviewing in this lesson, we will use the following values for receivables. We will also assume that the uncollectible amount will account for 1 percent of the receivables.
End 2014 receivables = 700,000
End 2015 receivables = 1,300,000
We will use the same format for the bad debts journal entry that we reviewed when talking about the sales method. The bad debts are listed as a debit and the contra asset account of AFDA as a credit. Hopefully you remember from the previous lesson that AFDA stands for allowance for doubtful accounts.
Normally, when talking about the receivables, we use the aging schedule to address receivables that have been outstanding for a certain amount of time (30 days, 3 months, 6 months and so on). The longer amount of time that the receivable has been outstanding, the less likely that it will be collected.
Let's forget about this concept for now, as I want to keep the receivables method as simple as possible. We will be revisiting this topic in the next lesson, so moving forward let's go ahead and take a look at the T-account for AFDA.
In order to come up with the adjustment entry for the bad debts expense, let's use the T-account format. We are looking for the adjustment value so we will need to find the beginning and ending amounts.
First, we will multiply the 2014 end receivables of $700,000 by the 1 percent uncollectible amount to come up with the beginning balance of $7,000. The ending balance will be calculated the same way using the 2015 end receivables multiplied by 1 percent or 0.01 to conclude with $13,000.
Now we just need to calculate the adjustment amount by subtracting the $7,000 beginning balance from the ending balance of $13,000 to come up with a $6,000 adjustment amount.
The difference between the ending and beginning amount is the adjustment value that we will be using to record the journal entry for the bad debts expense.
We have the $6,000 adjustment value that was calculated by finding the difference between the 2015 uncollectible end receivables and 2014 uncollectible end receivables. Now let's use the same journal entry format, to record the $6,000 as a debit to the bad debts expense account and a credit to the AFDA account.
Accounts receivable is a permanent account that is used in the receivables method, therefore the ending balance is calculated by multiplying the uncollectible percentage by the ending receivables. With this method, we are looking for the adjustment amount.
The sales method uses net sales to calculate the adjustment amount. Net sales is a temporary account that will be reset to zero at the end of every year, it is ultimately closed and transferred to a permanent account. In contrast to the receivables method, the sales method looks for the ending amount.
Keep in mind when we are needing to record the bad debts expense, we are always using the adjustment value and not the beginning or ending values.
Again, each bad debt expense method has its own benefits. We mentioned that the advantage of the sales method follows the matching principle to match the bad debt expense to the revenue earned in that particular accounting period.
The receivables method is not necessarily a good representation of the matching principle, but it gives a clear net realizable value of accounts receivable. This is simply the accounts receivable account less the AFDA amount.