Accounting for Debt
Accounting for Debt
Accounting for Debt
In 2007, Americans racked up a whopping $972 billion in credit card debt, up from $555 billion in 1997 (Federal Reserve). This increase clearly shows that credit card usage, as well as the amount of credit card debt have increased over the past decade. With this being said, most companies today accept credit cards as a form of payment for merchandise or a service, despite the risk of not receiving payment.
Since cash payment is not received during a credit transaction, the amount of money owed to the company from the sale is applied to the balance sheet under Accounts Receivable. All companies who accept credit as a form of payment recognize that a percentage of customers will not pay their debts, and therefore, must account for these debts on their financial statements.
During the current accounting period, a company cannot immediately account for specific customers' accounts that will become uncollected in the future, so they must develop an estimate of the amount that may not be received. This amount is based on the company's past business experience and the current industry. The estimated amount of accounts receivable that will be uncollected is called the Allowance for Bad Debts account, or Allowance of Uncollectible Accounts. This estimated amount is then reflected in the Bad Debt Expense account. Once this amount is estimated, a valuation adjustment is made, which reports an asset at a net realizable value that is less than cost. This reduces the carrying value, recognizing the bad debt expense. The transaction would be shown as a debit to the Bad Debt Expense account and a credit to the Allowance for Bad Debt account in the same amount. This transaction would appear in the journal as follows:
Dr. Bad Debt Expense XX
Cr. Allowance for Bad Debts XX
Over time, a specific amount of uncollectible debts can be determined from customer accounts. When this amount is determined, the company can then "write-off" that amount from Accounts Receivable. When the amount is "written off", it is removed from Accounts Receivable. Therefore, the Allowance for Bad Debts account would be debited and the Accounts Receivable would be credited. This would be recorded in the journal as follows:
Dr. Allowance for Bad Debts XX
Cr. Accounts Receivable XX
Let's say a company has $8,300 in Accounts Receivable, and has determined that currently, $300 will not be collected. The transaction would appear on the balance sheet as:
Accounts Receivable..$8,300
Less: Allowance for Bad Debts (300)
Net Accounts Receivable.$8,000
It is important to understand that "write offs" do not affect the net accounts receivable on the balance sheet because Accounts Receivable and Allowance for Bad Debts balance each other. The Allowance for Bad Debts account is a valuation account; therefore, its credit balance is subtracted from the debit balance of Accounts Receivable to determine the amount of net receivables that were reported on the balance sheet.
Even though companies accept credit as payment for merchandise or services rendered, they acknowledge that not all payment will be collected. Until a specific amount of uncollected accounts can be determined, a company must estimate an amount they believe may not be received based on past experiences and the current industry which is called the Allowance for Bad Debts. When the expense from the current year in which the revenue from the transaction with the customer is determined uncollectible, it can "written off" the Accounts Receivable.
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