Guided Readings for Financial Accounting, Lesson 7.2 – Mastery Level

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SUGGESTION: Read the fourth section of Chapter Seven (“The Actual Estimation of Uncollectible Accounts”). Only one aspect of the recording of bad debts remains to be studied. That is the method by which the actual estimation is made. In practice, there are two ways to determine that amount. This section demonstrates both although the percentage of receivables method is now preferred by FASB.

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(7Q17) – A company estimated its bad debts in Year One and then wrote off individual receivables during Year Two as they became uncollectible. At the end of the Year Two before new adjusting entries are made, the allowance for doubtful accounts retains a credit balance. What does that indicate? If the ending allowance for doubtful accounts were a debit balance instead, what would that mean?

(7A17) – At the end of any year, the allowance account might well have a credit balance remaining. That indicates the previous year’s estimate of bad accounts was too high. In making the current year adjusting entry for uncollectible accounts, a smaller estimate might be warranted. If the allowance ends the year with a debit balance, the prior year estimate was too low. Thus, a larger expense might be appropriate for the new year.

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(7Q18) – At the end of the current year, a company has a $1,000 credit balance in its allowance for doubtful accounts. In recognizing the expense for this new year, the company debits bad debt expense and credits the allowance for doubtful accounts. What are the two basic methods of determining the dollar amount to be recognized in this adjusting entry?

(7A18) – The amount to be recognized through a debit to bad debt expense and a credit to the allowance for doubtful accounts can be determined by (1) the percentage of sales method or (2) the percentage of receivables method (or a variation known as the aging method). The first method ignores any balance in the allowance account. The estimate is recorded directly as the new expense. In the second method, the expense is the amount needed to adjust the allowance account up to the estimated balance.

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(7Q19) – The percentage of sales method of estimating bad debts is referred to as an income statement approach. What is being estimated in this method? The percentage of receivables method of estimating bad debts is referred to as a balance sheet approach. What is being estimated?

(7A19) – In the percentage of sales method, the company estimates bad debt expense (a figure reported on the income statement). In the percentage of receivables method, the company estimates the allowance for doubtful accounts (a figure reported on the balance sheet as a contra account).

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(7A19-Continued) – You should always be able to tell if your answers are correct in doing bad debts. If the percentage of sales method estimates $7,000, then the reported bad debt expense must be $7,000. If the percentage of receivables method estimates $7,000, then the reported allowance for doubtful accounts must be $7,000. If the numbers do not match properly, something is wrong.

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(7Q20) – At the end of the current year, a company has a $1,000 credit balance in its allowance for doubtful accounts. There is no balance in bad debt expense because the estimate has not yet been recorded. The company is now making its adjusting entry to debit bad debt expense and credit the allowance for doubtful accounts. Assume the company has sales for the year of $800,000 and estimates that 4 percent of all sales will prove uncollectible. What amounts are recorded in this adjusting entry?

(7A20) – Sales are $800,000. If the estimated amount of uncollectible accounts is 4 percent of sales, then the expense is $32,000. In the percentage of sales method, the $1,000 credit balance in the allowance account does not directly influence the adjusting entry. The expense is $32,000 (as estimated) and the allowance rises from a $1,000 credit to a $33,000 credit.

The entry: debit (increase) bad debt expense by $32,000 and credit (increase) the allowance for doubtful accounts by the same $32,000.

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(7Q21) – At the end of the current year, a company has a $1,000 credit balance in its allowance for doubtful accounts. The company is now making an adjusting entry to debit bad debt expense and credit the allowance for doubtful accounts. Assume the company has sales for the year of $600,000 and estimates that 3 percent of all sales will prove uncollectible. What does the company report as its bad debt expense? What does the company report as its allowance for doubtful accounts?

(7A21) – The percentage of sales method is being used. Bad debt expense is 3 percent of $600,000 or $18,000. The allowance for doubtful accounts is the $1,000 credit in the T-account plus the $18,000 amount recognized in the adjusting entry for a total of $19,000. The balances reflect two different things and will rarely be the same.

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(7Q22) – At the end of the current year, a company has a $1,000 debit balance in its allowance for doubtful accounts. The company is now making an adjusting entry to debit bad debt expense and credit the allowance for doubtful accounts. Assume the company has sales for the year of $800,000 and estimates that 4 percent of all sales will prove uncollectible. What does the company report as bad debt expense? What does the company report as its allowance for doubtful accounts?

(7A22) – The percentage of sales method is being used. Bad debt expense is 4 percent of $800,000 or $32,000. The allowance for doubtful accounts has a $1,000 debit in the T-account. The $32,000 amount recognized as the estimated bad debts is a credit to the allowance. The previous $1,000 debit is netted with the $32,000 credit so that the allowance account has a $31,000 credit balance.

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(7Q23) – In all of the previous examples, the bad debt expense and the allowance for doubtful accounts had different balances after the adjusting entry was made. Why are those two balances different?

(7A23) – The allowance for doubtful accounts ends virtually every year with a residual balance. It might be a debit (previous estimate was low) or a credit (previous estimate was high). Bad debt expense contains a zero until the estimate for the year is made. When the new estimation is made, bad debt expense is debited and the allowance for doubtful accounts is credited. The residual balance in the allowance keeps the two accounts from having the same total. All bad debt figures are estimates so differences do not cause concern.

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SUGGESTION: Work the first Test Yourself question in Section 7.4 of Chapter Seven (“The Travers Corporation starts operations …”) and the One Step Further question. They provide practice in using the percentage of sales method. Sales are $300,000 per year. The accounts written off total $15,000 each year. What is the balance in the allowance for doubtful accounts after Year One and after Year Two? Take your time. You can do this. Compute your answer and then read the explanation. Practice is the key to success.

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(7Q24) – At the end of the current year, a company has a $1,000 credit balance in its allowance for doubtful accounts. The company will now debit bad debt expense and credit the allowance for doubtful accounts. Assume that the company has accounts receivable of $600,000 and estimates that 6 percent of all accounts receivable are uncollectible. What amount is recognized in this adjusting entry?

(7A24) – Accounts receivable total $600,000. If 6 percent of these receivables are estimated as bad, the allowance for doubtful accounts needs to be raised to $36,000. The adjustment increases the $1,000 credit to a $36,000 credit so the expense is $35,000. With the percentage of receivables method, the balance left in the allowance account influences the amount recognized in the adjusting entry. Debit (increase) bad debt expense $35,000 and credit (increase) the allowance for doubtful accounts $35,000.

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(7Q25) – At the end of the current year, a company has a $1,000 debit balance in its allowance for doubtful accounts. The company will now debit bad debt expense and credit the allowance for doubtful accounts as the year-end adjustment. Assume that the company has accounts receivable of $600,000 and estimates that 6 percent of all accounts receivable are uncollectible. What amount is recognized in this adjusting entry?

(7A25) – Accounts receivable total $600,000. If 6 percent of these receivables are estimated as bad, the allowance for doubtful accounts needs to be raised to $36,000. The adjustment increases the $1,000 debit to a $36,000 credit so the expense is $37,000. It takes $37,000 to move the $1,000 debit balance to a $36,000 credit balance.

Debit (increase) bad debt expense $37,000 and credit (increase) the allowance for doubtful accounts $37,000.

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SUGGESTION: Work the second Test Yourself question in Section 7.4 of Chapter Seven (“The Yarrow Corporation starts operations …”) and the One Step Further question. Sales are $400,000 per year while annual cash collections are $300,000. The accounts written off total $12,000 each year. If 10 percent of ending accounts receivable are estimated to be uncollectible, what is the expense for Years One and Two? This is a great problem to practice your understanding of the percentage of receivables method.

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(7Q26) – The Cicero Corporation makes a sale to Ms. A on account for $3,000. The correct journal entry is made for this transaction and both the debit and credit are entered into the proper general ledger T-accounts (accounts receivable and sales revenue). At the same time, an entry is made into the accounts receivable subsidiary ledger. What is the purpose of a subsidiary ledger?

(7A26) – A subsidiary ledger maintains a record of all the individual balances that make up a general ledger account total. In this subsidiary ledger, Cicero keeps a record of each separate receivable balance included within its accounts receivable. Thousands of individual accounts might make up the total. Thus, a separate balance is established for Ms. A. When she makes this purchase, the amount she owes is increased in the subsidiary ledger by $3,000. The total for the company is listed in the general ledger balance.

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The following statement is included in the end-of-chapter material as a True or False question. “A company ends the current year with sales of $600,000, accounts receivable of $100,000, and an allowance for doubtful accounts with a $1,000 debit balance. Bad debts are estimated to be 3 percent of sales. On financial statements, the allowance for doubtful accounts will be reported as having an $18,000 credit balance.” That statement is False. Why is the statement False?

The previous statement is False. Sales are $600,000 during the year. Uncollectible accounts are estimated to be 3 percent of sales or $18,000. Bad debt expense is debited $18,000 and the allowance for doubtful accounts is credited $18,000. This $18,000 credit raises the allowance from the $1,000 debit that it currently holds to a $17,000 credit (and not $18,000). The statement is False.

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The following statement is included in the end-of-chapter material as a True or False question. “A company ends the current year with sales of $600,000, accounts receivable of $100,000, and an allowance for doubtful accounts with a $1,000 debit balance. Uncollectible accounts at the end of the year are estimated to be 6 percent of receivables. Bad debt expense will be reported on the income statement as $7,000.” That statement is True. Why is that statement True?

The previous statement is True. The company ends the year with $100,000 in accounts receivable. The company believes that 6 percent of this balance will prove to be uncollectible. The allowance for doubtful accounts should have a credit balance of $6,000. Prior to the adjusting entry, it holds a $1,000 debit balance. To move that $1,000 debit to a $6,000 credit balance, the bad debt expense entry must be $7,000. The more you practice, the easier accounting will become.

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Near the section of this chapter titled, “Applying the Percentage of Receivables Method,” there is a link for a video titled “Reporting Bad Debts.” Watch that video. Accounting for bad debts can be a bit complicated. This video overviews the process and provides tips on how to deepen your understanding.

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