Question

You have just been hired as the new controller of Slytherin Inc., replacing the previous controller who was apparently turned into a weasel.

Slytherin’s accounts receivable balance at the end of December, 2015, was $800,000. Slytherin had net sales of $9,540,000, of which $1,200,000 were for cash and the remainder were on credit. Slytherin’s allowance for doubtful accounts had a debit balance of $4,000 on December 31, before any year-end adjustment was made. In prior years, Slytherin had used the percentage-of-credit-sales approach to estimating bad debts expense (at 0.4%). However, for the 2015 year, Slytherin decided to accept the recommendation of its auditors (Cornelius & Fudge) and switch to the aging-of-receivables approach. Accordingly, before his transformation, the prior controller had prepared the following table:

Amount	Age	Estimated % Uncollectible
650,000	Under 30 days	1%
100,000	31-60	10%
50,000	61+ days	30%

The CEO of Slytherin would like to know what bad debts expense would be under both approaches.   Calculate:

1. Bad debts expense using the percentage-of-sales approach
2. Bad debts expense using the aging-of-receivables approach

The CEO also believes that there has been a mistake, because allowance of doubtful account (AFDA) currently has a debit balance. Explain what a debit balance in AFDA could indicate.

Answer 1

1. Bad debt expense using the percentage of sales approach

Bad debt is the amount of debt which are irrecoverble from the debtors. As it is a loss, it must be written off from the income statement. By following the conservative concept (which says provide for all possible losses and not to account any probable income), we can create an allowance for doubtful debt from the current years profit to cover the next years bad debt expenses.

Under this approach bad debt is calculated as a percentage of credit sales. First we have to calculate credit sales. No need to estimate any bad debt expense on cash sales as the amount is already received. So bad debt expense is to be calculated only on credit sales.

Net sales	9540000
Less Cash sales	(1200000)
Credit sales	8340000

Bad debt expense = 8340000 x 0.4% = 33360

and the double entry to record this is

	Dr. $	Cr. $
Bad debt expense Acc Dr.	33360
Allowance for doubtful debts		33360

2. Bad debts expense using the aging-of-receivables approach

Under this approach, bad debt expense is calculated by charging specific percentage of bad debt to different group of accounts receivables, who are grouped by age. The total of all groups amount is the allowance for doubtful debt account balance.

Under this method bad debt expense for the current year is decided by looking at the present balance of Allowance for doubtful debt account. If it shows a credit balance, it is subtracted from the calculated amount. On the otherhand if the account shows a debit balance, the calculated amount is added with the balance to get the amount to be debited to bad debt expense account.

Age	Receivables	% of Bad debt		Bad debt
Under 30days	650000	1%	= 650000 x 1/100	6500
30- 60 Days	100000	10%	= 100000 x 10 /100	10000
60 + days	50000	30%	= 50000 x 30/100	15000
	Total Allowance for dountful debt account balance		31500

In this case the allowance for doubtful debt account shows a debit balance of $4000. So this amount should be added back to get the bad debt expense.

Bad debt = 31500 +4000 = 35500

And the journal entry will be

	Dr. $	Cr. $
Bad debt expense Acc Dr.	35500
Allowance for doubtful debts		35500

to make it more clear, it would be better to prepare a T account

Allowance for doubtful debts
Date	Details	$	Date	Details	$
	Balance b/d	4000
	Balance c/d	31500		Bad debt expense	35500
		35500			35500

3. Debit balance in Allowance for doubtfel debt account

Debit balance in this account is just like an overdrawn amount from our bank account. We are estimating bad debt expense based on our historical experience. If the amount of actual bad debt expense is greater than the estimated amount, it would result into a debit balance. It may be due to under estimation of expesnses or unexpected increase in bad debt expense in the current year.

There was only a mistake with the estimation of bad debt expense that was the reason for a debit balance in the allowance for doubtful debt account.