Saturday, October 08, 2011

Accounting for Credit Transactions

CFA Level 1 - Assets

LOS 30.a: Explain the relationship of financial statement elements and accounts, and classify accounts into the financial statement elements. NOTE: Determining the correct classification of investment securities can have important impacts on either the income statement or balance sheet, so the decision process should be consistent. An exam question or sample set can be impacted by your classification.
Most businesses give customers a certain number of days (30 to 60 days) to pay for delivered products and services. This is referred to as "extending credit to customers". Under accrual accounting, sales made on credit are recorded on the income statement. The not-yet-collected money is recorded under accounts receivable. Unfortunately, some customers will not want or be able to pay (because of bankruptcy) the company.

Company's can utilize two different approaches to account for these uncollectible accounts. The first is to account for them as they occur. Companies mostly use this method for income tax calculations and/or because its bad debts are immaterial. This method is called the "direct write-off method of accounting for bad debts". Once the company determines that an account is uncollectible, it will debit (which is an increase) the bad debt expense and credit accounts receivable (which is a decrease)
The second method used by companies, which is more consistent with the matching accounting principle, is to estimate the bad debt on an ongoing basis. This is referred to as the "allowance method for bad debt", and it is accounted for in allowance for doubtful accounts.
Accounting for Credit Sales

1) The direct write-off method

ABC sells and delivers $200,000 in products to 3C, which has 30 days to pay.

Here's the accounting record:
The 3C account has been overdue for six months and will most likely be uncollectible. The company decides to write it off:

2) Allowance method for bad debt
ABC sells and delivers $200,000 in products to 3C, which has 30 days to pay.
Accounting record:

The company estimates that 1% of accounts receivable will become uncollectible:

Unfortunately, 3C has declared Chapter 7 bankruptcy. The 3C account needs to be written off. Currently the Company has 400,000 in allowance for doubtful accounts:

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