AC 210 Lecture Notes - Lecture 35: Internal Revenue Service, Accounts Receivable, Subledger
5 Jun 2018
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Evaluating Accounts Receivable
Business owners know that some customers who receive credit will never pay their
account balances. These uncollectible accounts are also called bad debts. Companies
use two methods to account for bad debts: the direct write‐off method and the
allowance method.
Direct write‐off method. For tax purposes, companies must use the direct write‐off
method, under which bad debts are recognized only after the company is certain the
debt will not be paid. Before determining that an account balance is uncollectible, a
company generally makes several attempts to collect the debt from the customer.
Recognizing the bad debt requires a journal entry that increases a bad debts expense
account and decreases accounts receivable. If a customer named J. Smith fails to pay a
$225 balance, for example, the company records the write‐off by debiting bad debts
expense and crediting accounts receivable from J. Smith.
The Internal Revenue Service permits companies to take a tax deduction for bad debts
only after specific uncollectible accounts have been identified. Unless a company's
uncollectible accounts represent an insignificant percentage of their sales, however,
they may not use the direct write‐off method for financial reporting purposes. Since
several months may pass between the time that a sale occurs and the time that a
company realizes that a customer's account is uncollectible, the matching principle,
which requires that revenues and related expenses be matched in the same accounting
period, would often be violated if the direct write‐off method were used. Therefore, most
companies use the direct write‐off method on their tax returns but use the allowance
method on financial statements.
Allowance method. Under the allowance method, an adjustment is made at the end of
each accounting period to estimate bad debts based on the business activity from that
accounting period. Established companies rely on past experience to estimate
unrealized bad debts, but new companies must rely on published industry averages
until they have sufficient experience to make their own estimates.
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The adjusting entry to estimate the expected value of bad debts does not reduce
accounts receivable directly. Accounts receivable is a control account that must have
the same balance as the combined balance of every individual account in the accounts
receivable subsidiary ledger. Since the specific customer accounts that will become
uncollectible are not yet known when the adjusting entry is made, a contra‐asset
account named allowance for bad debts, which is sometimes called allowance for
doubtful accounts, is subtracted from accounts receivable to show the net realizable
value of accounts receivable on the balance sheet.
If at the end of its first accounting period a company estimates that $5,000 in accounts
receivable will become uncollectible, the necessary adjusting entry debits bad debts
expense for $5,000 and credits allowance for bad debts for $5,000.
After the entry shown above is made, the accounts receivable subsidiary ledger still
shows the full amount each customer owes, the balance of the control account
(accounts receivable) agrees with the total balance in the subsidiary ledger, the credit
balance in the contra asset account (allowance for bad debts) can be subtracted from
the debit balance in accounts receivable to show the net realizable value of accounts
receivable, and a reasonable estimate of bad debts expense is recognized in the
appropriate accounting period.
When a specific customer's account is identified as uncollectible, it is written off against
the balance in the allowance for bad debts account. For example, J. Smith's
uncollectible balance of $225 is removed from the books by debiting allowance for bad
debts and crediting accounts receivable. Remember, general journal entries that affect
a control account must be posted to both the control account and the specific account in
the subsidiary ledger.
find more resources at oneclass.com
find more resources at oneclass.com
Document Summary
Business owners know that some customers who receive credit will never pay their account balances. These uncollectible accounts are also called bad debts. Companies use two methods to account for bad debts: the direct write off method and the. For tax purposes, companies must use the direct write off. balance, for example, the company records the write off by debiting bad debts method, under which bad debts are recognized only after the company is certain the debt will not be paid. Before determining that an account balance is uncollectible, a company generally makes several attempts to collect the debt from the customer. Recognizing the bad debt requires a journal entry that increases a bad debts expense account and decreases accounts receivable. If a customer named j. smith fails to pay a expense and crediting accounts receivable from j. smith.
