AMIS 212 – Introduction to Accounting II AMIS 212 – Marc Smith 1 Accounts Receivable: Module 5 Slide 1 Hi everyone. Let’s continue our discussion of bad debt expense.AMIS 212 – Introduction to Accounting II AMIS 212 – Marc Smith 2 Slide 2 And remember bad debt expense is an estimate. We have to estimate the amount of bad debt expense that we record in order to adhere to the matching concept. So the question then becomes, how do we do it? How do we come up with the estimate of bad debt expense? And companies really can use one of two methods. There are two acceptable methods that companies can use in coming up with the estimate of bad debt expense. We have what’s called the net credit sales method, or percentage of sales method. And we have what’s called the aging method, or percentage of receivables method. Please note, both methods are acceptable. Both methods are generally accepted accounting principles. So the choice in terms of do we use the aging method or do we use the net credit sales method, that choice is a management decision. Either one is fine, either one is acceptable as long as it’s applied consistently from one year to the next to the next.AMIS 212 – Introduction to Accounting II AMIS 212 – Marc Smith 3 Slide 3 Let’s start with the net credit sales method. This one’s a little bit easier to apply. When a company is using the net credit sales method to estimate their bad debt expense, they will simply take the credit sales for the year, take the net credit sales for the year, multiplied by some percentage expected to be uncollectable. So we’ll take the net credit sales times this percentage expected to be uncollectable and that gives us the bad debt expense estimate. Note that percentage expected to be uncollectable is based on some historical pattern. For example, let’s say for our company over the last four years we have averaged three and a half percent of our sales to be uncollectable. So 3.5% would be a very reasonable estimate to use in coming up with our bad debt expense. To illustrate how this is gonna work, let’s just assume that the company estimates that 1% of the year’s credit sales will be uncollectable and let’sAMIS 212 – Introduction to Accounting II AMIS 212 – Marc Smith 4 assume the credit sales for the year were 800,000. The bad debt expense that would be recorded would simply be $8,000 or 1% of the 800,000 of credit sales. That’s your net credit sales method.AMIS 212 – Introduction to Accounting II AMIS 212 – Marc Smith 5 Slide 4 The other acceptable method is called the aging method. And the aging method requires an analysis of your account receivable balance by determining how old or how long each receivable has been held by the company. How long has it been since that account receivable originated and has not yet been paid? The logic here, is that the older the account receivable is, the longer the account receivable has been outstanding, the less likely it is that that receivable will ever be collected. Now what we’re gonna do is we’re gonna have to take all of our accounts receivable and do that analysis. And then we’re gonna put the accounts receivable into different categories by age. And for each category we will assign a percentage expected to be uncollectable. And this is referred to as your aging schedule. This thing that we’re talking about, it’s called an aging schedule. And in fact, there is an aging schedule. In my aging schedule it looks like we have four categories of receivables: those receivables that areAMIS 212 – Introduction to Accounting II AMIS 212 – Marc Smith 6 not past due; those receivables that are 1 to 30 days past due; 31 to 90 days past due; and over 90 days past due. And for each of those categories you assign a percentage expected to be uncollectable and it makes sense. The older the accounts receivable is, the greater or higher that percentage will be. Because the older the receivable the greater the chance it will never be collected.AMIS 212 – Introduction to Accounting II AMIS 212 – Marc Smith 7 Slide 5 So we put together this aging schedule. We know what this aging schedule is and then what we’re gonna do is we’re gonna do this ugly looking equation right here. For each category in that aging schedule you will take the amount of your receivables times that percentage and then that symbol there to the left simply means add them up. So there is our aging schedule with that calculation. We’d seen the four categories. We had the amount of receivables in each category and we had assigned the percentage expected to be uncollectable for each category. So for each category take the amount of receivables times that percentage and then sum those four products. And that looks like $1,130.AMIS 212 – Introduction to Accounting II AMIS 212 – Marc Smith 8 Slide 6 So that calculation gave us 1130, 1,130. Key point, critical point when using the aging method. That 1130, that number from the aging schedule, does not represent your bad debt expense estimate. It is not your bad debt expense. Rather, that number from the aging schedule, again the 1130 in our example, represents the required ending credit balance in the allowance for doubtful accounts. In order to come up with our estimate we’re gonna need to force out the bad debt expense using the T-account for the allowance for doubtful accounts.AMIS 212 – Introduction to Accounting II AMIS 212 – Marc Smith 9 Slide 7 And in fact there is your T-account and we’ve seen it a couple of times. And we know what goes into that T-account. There’s your beginning balance, upper credit side. There’s the write-offs on the debit side. There’s the recoveries on the credit side. And what we were just able to do using that aging schedule that 1130, that comes or represents the ending credit balance in the allowance for doubtful accounts. So you take that number from the aging schedule and that comes over to the allowance for doubtful accounts T-account as the ending credit balance. And what you’re gonna need to do is force out the bad debt expense, make the bad debt expense an X. So to force out our bad debt expense simply setup an algebra equation using that T-account, using bad debt expense as X and we’re able to solve for X. Key thing about the