Lecture-Bad_debts - Copy.docx - Handling bad debts is a...

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Handling bad debts is a necessary part of accounting and this chapter looks at how bad debts are handled in a business. It discusses how accounts receivable becomes uncollectible along with how these transactions are journalized. Accrual accounting matches earned revenue with expenses that occur in the same period. When a company has credit customers, one of the expenses incurred in earning the revenue is allowing for bad debts. The business accounts for bad debts in the period in which the sale was made and this is done by one of two methods: the sales percentage method or the aging of accounts receivable method. The estimated bad debts are recorded as an expense and as a contra-asset account called allowance for doubtful accounts. This account offsets accounts receivable to show the net realizable amount of accounts receivable. If these bad debts are subsequently repaid, the first journal entry reinstates accounts receivable; and a second entry records the receipt of cash. Accrual Accounting and Journalizing Bad Debts Transactions Summary: Generally accepted accounting principles (GAAP) require use of the allowance method, a method that estimates the amount of losses or unpaid receivables at the same time (month) that the sales (revenue) occur. At the time of the sales, it is extremely difficult to determine which customer will default. Therefore, we estimate, based on prior experience, a group or an amount that will not make payments by the end of the period. Bad Debts Expense is an expense account whose normal balance is a debit. It is a temporary account that is closed to Income Summary at year’s end. The bad debts expense account is the operating expense that estimates the amount of credit sales that will probably not be collectible in a given accounting period when the allowance method is used. The Allowance for Doubtful Accounts is a contra asset account to the accounts receivable account and is listed with the assets in the balance sheet. This account is permanent, functions opposite (increase by credit, decrease by debit) of assets, and is subtracted from the accounts receivable account to calculate the net realizable value of the receivables. The Net realizable value is the amount (Accounts Receivable – Allowance for Doubtful Accounts) that is expected to be collected. Under the allowance method, you can utilize one of two ways of calculating the estimate: the percentage-of-sales (income statement method) or the percentage of receivables (balance sheet method). Key Concepts: Bad debts expense, allowance for doubtful accounts, net realizable value Accrual accounting matches revenues earned and expenses incurred in the same period. Therefore, accrual accounting requires an approximate estimate amount that might be deemed uncollectible: Journal entry to record the estimate of future bad debts: Dr. Bad Debt Expense XX Cr. Allowance for Doubtful Accounts XX a) Bad debts expense is an operating expense account that estimates the amount of credit sales that will probably not be collected for that given time period.
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