{"id":136,"date":"2015-03-18T23:51:45","date_gmt":"2015-03-18T23:51:45","guid":{"rendered":"https:\/\/courses.candelalearning.com\/finacct2x10xmaster\/?post_type=chapter&p=136"},"modified":"2017-08-22T16:38:47","modified_gmt":"2017-08-22T16:38:47","slug":"direct-write-off-and-allowance-methods","status":"web-only","type":"chapter","link":"https:\/\/courses.lumenlearning.com\/tcc-financialaccounting\/chapter\/direct-write-off-and-allowance-methods\/","title":{"raw":"Direct Write-Off and Allowance Methods","rendered":"Direct Write-Off and Allowance Methods"},"content":{"raw":"Because customers do not always keep their promises to pay, companies must provide for these uncollectible accounts in their records. Companies use two methods for handling uncollectible accounts. The direct write-off method recognizes bad accounts as an expense at the point when judged to be uncollectible and is the required method for federal income tax purposes.\u00a0 The allowance method provides in advance for uncollectible accounts think of as setting aside money in a reserve account.\u00a0 The allowance method represents the accrual basis of accounting and is the accepted method to record uncollectible accounts for financial accounting purposes.\r\n\r\nhttps:\/\/youtu.be\/BltYFDV18Wc\r\n\r\nDirect Write-off<\/strong>\r\n\r\nThe direct write-off method is used only when we decide a customer will not pay.\u00a0 We do not record any estimates or use the Allowance for Doubtful Accounts under the direct write-off method.\u00a0 We record Bad Debt Expense for the amount we determine will not be paid.\u00a0 This method violates the GAAP matching principle of revenues and expenses recorded in the same period.\r\n\r\nWhen we write-off an account under this method, the entry would be:\r\n\r\n\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 Debit\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 Credit<\/strong>\r\n\r\nBad Debt Expense\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 X<\/strong>\r\n\r\n\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 Accounts Receivable\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 X<\/strong>\r\n\r\nThe amount used will be the amount the customer owes that we will not be able to collect.\r\n\r\n \r\n\r\nAllowance Method<\/strong>\r\n\r\nThe allowance method follows GAAP matching principle since we estimate uncollectible accounts at the end of the year.\u00a0 We use this estimate to record Bad Debt Expense and to setup a reserve account called Allowance for Doubtful Accounts (also called Allowance for Uncollectible Accounts) based on previous experience with past due accounts.\u00a0 We can calculate this estimates based on Sales (income statement approach) for the year or based on Accounts Receivable balance at the time of the estimate (balance sheet approach).\r\n\r\nAs a contra asset account to the Accounts Receivable account, the Allowance for\u00a0Doubtful Accounts<\/strong><\/span> (also called Allowance for\u00a0uncollectible accounts or Allowance for bad debts) reduces accounts receivable to their net realizable value. Net realizable value<\/strong><\/span> is the amount the company expects to collect from accounts receivable. When the firm makes the bad debts adjusting entry, it does not know which specific accounts will become uncollectible. Thus, the company cannot enter credits in either the Accounts Receivable control account or the customers\u2019 accounts receivable subsidiary ledger accounts. If only one or the other were credited, the Accounts Receivable control account balance would not agree with the total of the balances in the accounts receivable subsidiary ledger. Without crediting the Accounts Receivable control account, the allowance account lets the company show that some of its accounts receivable are probably uncollectible.\r\n\r\nWhen we decide a customer will not pay the amount owed, we use the Allowance for Doubtful accounts to offset this loss instead of Bad Debt Expense.\r\n\r\nAt the end of each year, we ESTIMATE bad debts expense and make the following entry:\r\n\r\n\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 Debit\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 Credit<\/strong>\r\n\r\nBad Debt Expense\u00a0\u00a0\u00a0\u00a0\u00a0 X<\/strong>\r\n\r\n\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 Allowance for Doubtful Accounts\u00a0\u00a0\u00a0\u00a0 X<\/strong>\r\n\r\nThe amount used will be the ESTIMATED amount calculated using sales or accounts receivable.<\/em>\r\n\r\n \r\n\r\nWhen we write-off a customer account under the allowance method, the entry would be:\r\n\r\n\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0Debit\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 Credit<\/strong>\r\n\r\nAllowance for Doubtful Accounts\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 X<\/strong>\r\n\r\n\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 \u00a0Accounts Receivable\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 X<\/strong>\r\n\r\nNotice how we do not use bad debts expense in a write-off under the allowance method.<\/em>\r\n\r\n \r\n

\u00a0Accounting in the Headlines<\/strong><\/h1>\r\nLet's try and make accounts receivable more relevant or understandable using an actual company.\r\n

What does Coca-Cola\u2019s Form 10-k communicate about its accounts\u00a0receivable?<\/h3>\r\n

\"Picture<\/a>The Coca-Cola Company (KO<\/a>), like other U.S. publicly-held companies, files its financial statements in an annual filing called a Form 10-K with the Securities & Exchange Commission (SEC).<\/p>\r\n\r\n

\r\n\r\nCoca-Cola has several assets that are listed on its balance sheet.\u00a0 Let\u2019s look at what is reported on Coca-Cola\u2019s Form 10-K regarding its accounts receivable. A\u00a010-K is another name for a company's annual report.\u00a0Additionally,\u00a0\u00a0a 10-Q is a company's quarterly report.\r\n\r\nSee the following excerpts from Coca-Cola\u2019s 2013 Form 10-K<\/a>:\r\n
    \r\n \t
  1. Partial Consolidated Balance Sheets containing current assets (page 76);<\/li>\r\n \t
  2. Trade Accounts Receivable note (page 89); and<\/li>\r\n \t
  3. Partial Statements of Income (page 74).<\/li>\r\n<\/ol>\r\nQuestions<\/strong>\r\n
      \r\n \t
    1. What is the total (gross) value of Coca-Cola\u2019s accounts receivable (before deduction for its allowance for doubtful accounts) as of December 31, 2013? As of December 31, 2012?<\/li>\r\n \t
    2. What is \u201cnet realizable value\u201d?<\/li>\r\n \t
    3. What factors does Coca-Cola use to determine the amount of its allowance for doubtful accounts?<\/li>\r\n \t
    4. In what line item on the income statement would bad debt expense be included?<\/li>\r\n<\/ol>\r\n<\/div>\r\nhttp:\/\/www.openassessments.org\/assessments\/1179","rendered":"

      Because customers do not always keep their promises to pay, companies must provide for these uncollectible accounts in their records. Companies use two methods for handling uncollectible accounts. The direct write-off method recognizes bad accounts as an expense at the point when judged to be uncollectible and is the required method for federal income tax purposes.\u00a0 The allowance method provides in advance for uncollectible accounts think of as setting aside money in a reserve account.\u00a0 The allowance method represents the accrual basis of accounting and is the accepted method to record uncollectible accounts for financial accounting purposes.<\/p>\n