Valuing Accounts Receivable
Once companies record receivables in the accounts, the next question is:
How should they report receivables in the financial statements?
Companies report accounts receivable on the balance sheet as an asset.
But determining the
to report is sometimes difficult because some
receivables will become uncollectible.
Each customer must satisfy the credit requirements of the seller before the
credit sale is approved. Inevitably, though, some accounts receivable become un-
collectible. For example, a customer may not be able to pay because of a decline in
its sales revenue due to a downturn in the economy. Similarly, individuals may be
laid off from their jobs or faced with unexpected hospital bills. Companies record
credit losses as debits to
Bad Debts Expense
(or Uncollectible Accounts Expense).
Such losses are a normal and necessary risk of doing business on a credit basis.
Two methods are used in accounting for uncollectible accounts: (1) the direct
write-off method and (2) the allowance method. The following sections explain
DIRECT WRITE-OFF METHOD FOR UNCOLLECTIBLE ACCOUNTS
direct write-off method
, when a company determines a particular
account to be uncollectible, it charges the loss to Bad Debts Expense. Assume, for
example, that on December 12 Warden Co. writes off as uncollectible M. E. Doran’s
$200 balance.The entry is:
Accounting for Receivables
Distinguish between the methods
and bases companies use to value
S T U D Y O B J E C T I V E 3
Bad Debts Expense
Accounts Receivable—M. E. Doran
(To record write-off of M. E. Doran
Under this method, Bad Debts Expense will show only
collectibles.The company will report accounts receivable at its gross amount.
Although this method is simple,its use can reduce the usefulness of both the in-
come statement and balance sheet. Consider the following example. Assume that
in 2011, Quick Buck Computer Company decided it could increase its revenues by
offering computers to college students without requiring any money down and
with no credit-approval process. On campuses across the country it distributed one
million computers with a selling price of $800 each. This increased Quick Buck’s
revenues and receivables by $800 million. The promotion was a huge success! The
2011 balance sheet and income statement looked great. Unfortunately, during
2012, nearly 40% of the customers defaulted on their loans.This made the 2012 in-
come statement and balance sheet look terrible. Illustration 8-1 shows the effect of
these events on the financial statements if the direct write-off method is used.