Accounting in a Nutshell 1
Accounts Receivable
Joel Shapiro has been an
Accounting instructor at Ryerson
University in Toronto, Canada for
20 years. Previously, he developed
an accounting and inventory
management software system for
small businesses. In his spare time,
he enjoys working on Kakuro and
cryptic crossword puzzles, and travels
throughout Ontario as a bridge
tournament director.
Joel Shapiro, MBA Accounting Instructor,
Ryerson University, Toronto
Abstract: This article will explain the generally accepted
methods of accounting for trade accounts receivable and
the related allowance for doubtful accounts and bad debt
expense. Three methods of estimating the allowance are
illustrated, with sample problems and solutions. In addi-
tion, guidance is provided with respect to the analysis and
interpretation of key financial ratios related to accounts
receivable.
Keywords: Accounts receivable, allowance for doubtful
accounts, bad debt expense.
Definitions
Trade accounts receivable are those which arise from
sales of goods or provision of services to customers.
They are almost always classified on a companys bal-
ance sheet (statement of financial position) as current
assets, as they are normally expected to be collected
in cash within one year. Those that are not collected
in cash become bad debt expense on the income state-
ment. This amount must be estimated in advance and
recorded as an allowance for doubtful accounts on the
balance sheet, deducted from the amount of accounts
receivable.
Introduction
Accounting requires that revenues be recorded in the
period when three conditions (performance, measure-
ment, and collectability) are met or at least reasonably
assured. Performance generally involves delivery of
goods to customers, or completion of agreed services.
The fact that this usually happens before cash is actually
collected is what gives rise to accounts receivable. Rev-
enue recognition does not depend on the receipt of cash!
Furthermore, all expenses that a company has incurred,
whether paid in cash or not, must also be recognized in
Expert Insights 1
 Accounting in a Nutshell 1
the same period as the revenues that those
expenses relate to. This is referred to as the
matching principlethe revenues earned,
and the expenses incurred to earn them,
must be matched together in the same
period.
Measurement is usually not a problem
because we know the selling price of the
goods or the agreed rate for the services.
Collectability, however, is often an issue,
because it is rare that a company will
ultimately collect every dollar owed to
it. Some customers (hopefully not very
many!) go bankrupt, refuse to pay, dispute
the amount, and so on. The seller wont
know in advance which those customers
arehe wouldnt have done business with
them in the first place if he did! But the
seller should be able to estimate, from his
own experience or perhaps industry statis-
tics, what percentage of his receivables or
his sales will ultimately prove worthless.
Because of the matching principle, this es-
timate must be made in the year the origi-
nal sale is madenot some time later when
it is known with certainty that a particular
account will not be collected. How this es-
timate is made, and how it is recorded in
the companys books and presented on its
financial statements, is the focus of this
article.
The Six Transactions That Affect
Accounts Receivable
There are only six basic types of transac-
tions that affect accounts receivable.
1. You sell goods or provide services
on account. (Cash sales do not affect re-
ceivables.) Revenue and receivables both
increase.
2. Your customer returns goods to you
and receives a credit on his account, not
a cash refund. Revenue and receivables
both decrease. In practice, revenue is
not decreased directly. A special account
called sales returns is used, which is sub-
tracted from revenues on the income
statement to arrive at net sales. It is im-
portant from a management perspective
2 Expert Insights
to know what, and how much, is being
returned.
3. You collect cash from your customers.
Cash increases and receivables decreases.
Those are easy. Here are the tricky ones,
which will be discussed individually below:
4. At year-end, you estimate how many
receivables (or sales) will not be collectable.
5. Some time later, you identify a partic-
ular bad debt and write it off.
6. Even later still, surprise! Out of the
blue, a previously written-off customer
pays you. Some bankruptcies take years to
finalize.
Transaction 4Estimating
Uncollectable Accounts
As explained above, this must be done in
the year the sale is made, not later when it
is known that an account is uncollectable.
An income statement account called Bad
Debt Expense is increased. This is an
ordinary operating expensea day-to-day
cost of doing business. The other half of
the entry, however, is not a decrease to
accounts receivable. This is because you
dont yet know which specific accounts are
uncollectable. You are only estimating the
total. Accounting is not an exact science
it is replete with estimations, educated
guesses, appraisals, opinions, and the like.
Thats perfectly acceptable. If an estimate
turns out to be too low, just make it larger
next time to compensate, or vice versa. As
long as your estimates are reasonable to
begin with, it will all work out in the long
run. So instead of directly reducing accounts
receivable, we increase a special account
called Allowance for Doubtful Accounts,
which is deducted directly from accounts
receivable in the current assets section of the
balance sheet. Suppose your company had
$1,000 in accounts receivable and estimated
that 5% of them would not be collected.
This is what your balance sheet would
look like:
Accounts receivable $1,000
Less Allowance for doubtful accounts 50
Net realizable value $ 950
 Accounting in a Nutshell 1
The net realizable value is the amount
that is ultimately expected to be collected.
It will probably turn out to be more or less,
as the $50 is only an estimate.
Transaction 5Identifying and
Writing Off a Bad Debt
Some time later, the company in the
above example finds out that two custom-
ers with outstanding balances totaling
$15 are unable or unwilling to pay. These
accounts can now be written off. The im-
portant thing to remember here is that
the bad debt expense for these customers
has already been recorded, back when the
$50 allowance was set up. Do not record
any expense again! All that has happened
is that $15 of the $50 has been specifically
identified and tied to these customers. So
all you must do is reduce the allowance
by $15 (leaving the remaining $35 for as-
yet-to-be-identified bad debts) and also re-
duce receivables by $15, thus wiping the
known bad debts from your books. This
is what your balance sheet would look
like now:
Current assets:
Accounts receivable $ 985
Less Allowance for doubtful accounts 35
Net realizable value $ 950 There are three generally accepted ways to
The net realizable value hasnt changed,
because you still expect to collect the other
$950 from your other customers.
Transaction 6Recovery of a
Previously Written-Off Account
Remember those two customers whose $15
you wrote off a few years ago? You just got a
nice surprise in the maila payment of $10
from one of them. It seems you were hasty,
or pessimisticin hindsight, you shouldnt
have written that customer off. This does
not mean that your original $50 estimate
of bad debts was wrong. It only means that
you misidentified $10 of it. What you have
to do now is simply to put it back into the
allowance so that it can be applied later to
a real bad debt. This $10 is not revenue, or
Expert Insights
a gain, or a reduction of bad debt expense.
You just increase cash by $10 and increase
your allowance for bad debts by $10. This
is what your balance sheet would look
like now:
Current assets:
Accounts receivable $ 985
Less Allowance for doubtful accounts 45
Net realizable value $ 940
Receivables are unchanged at $985 be-
cause you received cash from this cus-
tomer. The allowance is now back up to
$45, which is the original $50 less the $5
from the one customer who you wrote off
and still hasnt paid you. The net realizable
value is now $940 because you collected
$10 of the o
riginal $950.
Note that the only transaction that af-
fects the income statement in any way
(other than the sales themselves in trans-
actions 1 and 2) is the bad debt estimate in
transaction 4. There are no further adjust-
ments to bad debt expense, and no subse-
quent gains or losses. Transactions 5 and 6
affect only the balance sheet.
How We Estimate the Allowance for
Doubtful Accounts
do this, and the easiest has already been il-
lustrated in the previous example. Just pick
a reasonable percentage and apply it to the
ending balance in accounts receivable. In
the previous example, that was 5 percent. If
you are using this method, the percentage
that you choose should be based on your
own companys experience, or on reliable
statistics in your industry. Remember that
it is only an estimate and can be changed
from year to year if better information
comes to light. If a positive balance in the
allowance is carried forward from year to
year, or if the allowance is rising over time,
then it is possible that the percentage used
is too high and can be reduced. After all, the
balance in the allowance is only reduced
by write-offs, and if you arent writing off
what you have allowed for, then you have
3