🔹 Writing Off Receivables
Bad Debts Expense 1,000 Accounts Receivable 1,000
- When using the Direct Write Off Method, you “directly” write off uncollectible amounts into Bad Debts Expense.
- The Allowance for Doubtful Accounts (ADA) is not used in this method; it's applicable only when using the Allowance Method.
- By crediting Accounts Receivable, its balance is reduced, reflecting that the amount is no longer expected to be collected from the customer.
Accounts Receivable 1,000 Bad Debts Expense 1,000
STEP 2: Receive the cash toward the customer’s Accounts Receivable.
Cash 1,000 Accounts Receivable 1,000
Allowance for Doubtful Accounts 1,000 Accounts Receivable 1,000
- When using the Allowance Method, you write off uncollectible amounts from Allowance for Doubtful Accounts (ADA).
- Allowance for Doubtful Accounts (ADA) is a “Contra-Asset” (-/+) that reduces the value of your Accounts Receivable.
- You are debiting ADA here to decrease (i.e. “use”) the available balance in the allowance — from the previous period’s year end adjusting entry to estimate bad debts.
- By crediting Accounts Receivable, its balance is reduced, reflecting that the amount is no longer expected to be collected from the customer.
Accounts Receivable 1,000 Allowance for Doubtful Accounts 1,000
STEP 2: Receive the cash toward the customer’s Accounts Receivable.
Cash 1,000 Accounts Receivable 1,000
🔹 Estimating Bad Debts
Bad Debts Expense ??? Allowance for Doubtful Accounts ???
However, how you’ll get the $ amount does change depending on which method you’re using!
Key Points:
- The specific dollar amount for the entry varies based on the estimation method asked for in your problem.
- The '% of Sales Method' calculates bad debts based on a predetermined percentage of sales.
- This method focuses on the income statement and matches bad debt expense to the sales they are associated with.
For a detailed explanation and example of how to calculate the dollar amount for the adjusting entry, refer to the video below.
Chapter 7 - % of Sales MethodBad Debts Expense ??? Allowance for Doubtful Accounts ???
However, how you’ll get the $ amount does change depending on which method you’re using!
Key Points:
- The specific dollar amount for the entry varies based on the estimation method asked for in your problem.
- The % of A/R method estimates bad debts based on a predetermined percentage applied to the total accounts receivable.
- It is a balance sheet approach, focusing on the expected uncollectibility of the current accounts receivable balance.
For a detailed explanation and example of how to calculate the dollar amount for the adjusting entry, refer to the video below.
Chapter 7 - % of A/R MethodBad Debts Expense ??? Allowance for Doubtful Accounts ???
However, how you’ll get the $ amount does change depending on which method you’re using!
Key Points:
- The specific dollar amount for the entry varies based on the estimation method asked for in your problem.
- The “Aging of A/R Method” involves classifying accounts receivable by their age, and applying different percentages to each category based on historical data to estimate bad debts.
- It provides a more accurate estimate of bad debts by considering the likelihood of receivables turning uncollectible increases with age.
- This approach emphasizes the assessment of each receivable's collectibility, making it a detailed balance sheet method.
For a detailed explanation and example of how to calculate the dollar amount for the adjusting entry, refer to the video below.
Chapter 7 - Aging of A/R Method
Also, here is an example table illustrating the Aging of Accounts Receivable concepts:
Age Category | Total A/R Amount | Estimated Bad Debt Percentage | Estimated Bad Debt Amount |
0-30 Days | $50,000 | 1% | $500 |
31-60 Days | $20,000 | 5% | $1,000 |
61-90 Days | $5,000 | 10% | $500 |
Over 90 Days | $1,000 | 20% | $200 |
In this table, each age category of receivables is associated with a specific percentage that reflects the increasing likelihood of non-collection as receivables get older. The estimated bad debt amount is calculated by applying the corresponding percentage to the total accounts receivable amount in each category. This method allows a company to make a more precise provision for bad debts in its financial statements.
🔹 Notes Receivable Entries
- The journal entry reflects the cash we’ve paid to the borrower and the note receivable the company expects to collect later.
- You will only recognize this for the principal amount, the interest amount will come into play later with the journal entry on the maturity date.
- Start date of the note: January 5th.
- Maturity date calculation:
- January has 31 days; since the note starts on the 5th, count 26 days remaining in January.
- Add 28 days for February.
- 31 days are in March.
- The remaining 5 days carry over into April, making the maturity date April 5th.
- Total days counted: 90.
Knowing the number of days in each month is useful for calculating maturity dates:
- January: 31 days
- February: 28 days (29 in leap years)
- March: 31 days
- April: 30 days
- May: 31 days
- June: 30 days
- July: 31 days
- August: 31 days
- September: 30 days
- October: 31 days
- November: 30 days
- December: 31 days
- Use the formula: Interest = Principal (P) x Rate (R) x Time (T).
- For a $10,000 note at 5% annual interest over 90 days using the 360-day year convention:
- Interest = $10,000 x 0.05 x (90/360).
- Interest = $10,000 x 0.05 x 0.25.
- Interest = $125.
- At maturity, the entry reflects the repayment of the principal and the recognition of interest revenue. Cash is debited for the total amount received.
- Notes Receivable is credited for the principal amount to remove the receivable.
- Interest Revenue is credited for the interest earned over the 90 day period.
- The journal entry records the issuance of a loan (debit to Notes Receivable) and the outflow of cash (credit to Cash).
- The entry recognizes the principal amount; interest will be accounted for when it accrues.
Interest Accrual Over Periods
- If the note spans multiple accounting periods, you must accrue the earned interest at the period's end that has not been paid by the borrower.
- Start date of the note: November 1st.
- Maturity date calculation:
- November has 30 days; since the note starts on the 1st, count 29 days remaining in November.
- Add 31 days for December.
- Add 30 days for January; making the maturity date January 30th.
- Total days counted: 90.
Knowing the number of days in each month is useful for calculating maturity dates:
- January: 31 days
- February: 28 days (29 in leap years)
- March: 31 days
- April: 30 days
- May: 31 days
- June: 30 days
- July: 31 days
- August: 31 days
- September: 30 days
- October: 31 days
- November: 30 days
- December: 31 days
- Use the formula: Interest = Principal (P) x Rate (R) x Time (T).
- For a $10,000 note at 5% annual interest over 90 days using the 360-day year convention:
- Interest = $10,000 x 0.05 x (90/360).
- Interest = $10,000 x 0.05 x 0.25.
- Interest = $125.
- As the accounting period ends, if the note has not yet matured, interest earned to date is recognized.
- Interest Receivable is debited for the amount of interest that has accrued on the note receivable, increasing assets.
- Interest Revenue is credited to record the earned income, reflecting the company's right to this income, which will be received in the future.
Maturity Date Example
- From November 5th:
- November has 25 days remaining after the 5th.
- December adds another 31 days, reaching 56 days in total.
- January contributes 31 more days, resulting in 87 days by the end of January.
- The remaining 3 days carry over into February, making the maturity date February 3rd.
- The cumulative total is 90 days.
Knowing the number of days in each month is useful for calculating maturity dates:
- January: 31 days
- February: 28 days (29 in leap years)
- March: 31 days
- April: 30 days
- May: 31 days
- June: 30 days
- July: 31 days
- August: 31 days
- September: 30 days
- October: 31 days
- November: 30 days
- December: 31 days
- Use the formula: Interest = Principal (P) x Rate (R) x Time (T).
For the 56 days from November 1st to December 31st on a $10,000 note at 5% interest:
- Interest = $10,000 x 0.05 x 56/360
- Interest = $78 (rounded)
- The final maturity entry accounts for the cash received (debit to Cash), the principal amount of the note (credit to Notes Receivable), and all interest accrued.
- The Interest Receivable is credited to clear the receivable, and Interest Revenue is credited for the additional interest accrued from January 1st to January 30th.
- The total interest revenue recognized over the 90 days is $125, with $78 accrued at the end of the previous year and an additional $47 recognized in the new year.