Question

COMMUNICATING IN PRACTICE O P2 @p3 BTN 9-2 As the accountant for Pure-Air Distributing, you attend a sales managers' meeting devoted to a discussion of credit policies. At the meeting, you report that bad debts expense is estimated to be $59,000 and accounts receivable at year-end amount to $1,750,000 less a $43,000 allowance for doubtful accounts. Sid Omar, a sales manager, expresses confusion over why bad debts expense and the allowance for doubtful accounts are different amounts. Write a one-page memorandum to him explaining why a difference in bad debts expense and the allowance for doubtful accounts is not unusual. The company estimates bad debts expense as 2% of sales.

Answer 1

Amount Reported as Bad Debts Expense

The amount reported in the income statement account Bad Debts Expense pertains to the estimated losses from extending credit during the period shown in the heading of the income statement. The estimated amount of Bad Debts Expense could be based on:

• A percentage of the company's credit sales during the period, or
• The change in the total amount needed in the Allowance for Doubtful Accounts based upon the amounts customers owe on the company's accounts receivable

Amount Reported as Allowance for Doubtful Accounts

The balance reported in the balance sheet account Allowance for Doubtful Accounts is the estimated amount of Accounts Receivable that will not be collected. The balance in Allowance for Doubtful Accounts could be based upon:

• An aging of the detailed amounts in Accounts Receivable
• The result of recording the credit part of the entries to Bad Debts Expense that were based on a percentage of credit sales

Example of Bad Debts Expense and Allowance for Doubtful Accounts

To illustrate, let's assume that on December 31 a company had $100,000 in Accounts Receivable and its balance in Allowance for Doubtful Accounts was a credit balance of $3,000. As a result, the December 31 balance sheet will be reporting that $97,000 will be turning to cash. During the first 30 days of January the company does not have any other information on bad accounts receivable. However, on January 31 the company learns that an additional $1,000 of its accounts receivable may not be collected. Therefore, on January 31 the company will make an adjusting entry to debit Bad Debts Expense for $1,000 and to credit Allowance for Doubtful Accounts for $1,000. After this entry is recorded, the company's income statement for the month of January will report Bad Debts Expense of $1,000 and its January 31 balance sheet will report a credit balance in Allowance for Doubtful Accounts in the amount of $4,000.

Estimating uncollectible accounts Accountants use two basic methods to estimate uncollectible accounts for a period. The first method—percentage-of-sales method—focuses on the income statement and the relationship of uncollectible accounts to sales. The second method—percentage-of-receivables method—focuses on the balance sheet and the relationship of the allowance for uncollectible accounts to accounts receivable.

In this question company has used percentage of sales method.

Bad Debt Expense = Net sales (total or credit) x Percentage estimated as uncollectible

In applying the percentage-of-sales method, companies annually review the percentage of uncollectible accounts that resulted from the previous year’s sales. If the percentage rate is still valid, the company makes no change. However, if the situation has changed significantly, the company increases or decreases the percentage rate to reflect the changed condition. For example, in periods of recession and high unemployment, a firm may increase the percentage rate to reflect the customers’ decreased ability to pay. However, if the company adopts a more stringent credit policy, it may have to decrease the percentage rate because the company would expect fewer uncollectible accounts.