In this video, we walk through 5 FAR practice questions teaching about calculating trade receivables and allowances. These questions are from FAR content area 2 on the AICPA CPA exam blueprints: Select Balance Sheet Accounts.
The best way to use this video is to pause each time we get to a new question in the video, and then make your own attempt at the question before watching us go through it.
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Calculating Trade Receivables and Allowances
Properly accounting for receivables and managing sales returns is crucial for accurate financial reporting. In this post, we’ll dive into key concepts such as the Allowance for Doubtful Accounts, bad debt expense, and net sales revenue calculation when returns are involved. We’ll break down the methods and provide clear examples to solidify your understanding.
1. The Allowance for Doubtful Accounts: An Overview
The Allowance for Doubtful Accounts is a contra-asset account used to estimate the portion of a company’s receivables that is unlikely to be collected. It’s paired with Accounts Receivable on the balance sheet to show the net realizable value—what the company actually expects to collect.
How is the Allowance for Doubtful Accounts Calculated?
The allowance is adjusted using a combination of beginning balances, written-off accounts, recovered accounts, and new estimates of uncollectible amounts. The most common methods used to estimate this allowance include the Aging Receivables Method and the Percentage of Sales Method.
Formula for Calculating Bad Debt Expense:
Bad Debt Expense = Required Ending Allowance – (Beginning Allowance – Accounts Written Off + Accounts Recovered)
Required Ending Allowance is typically determined based on the percentage of receivables deemed uncollectible using methods like the aging receivables method.
Example:
Suppose your beginning Allowance for Doubtful Accounts is $10,000. You wrote off $3,000 of uncollectible accounts during the year and recovered $1,500. Based on the aging receivables method, you determine that $9,000 should be the ending balance in the allowance account. Plugging into the formula:
Bad Debt Expense = 9,000 – (10,000 – 3,000 + 1,500) = 9,000 – 8,500 = 500
2. Journal Entry for Writing Off Accounts Using the Allowance Method
When using the allowance method, writing off a specific uncollectible account involves a journal entry that removes the receivable and reduces the allowance account. This does not impact the Bad Debt Expense since it was already recorded when the allowance was initially set up.
Journal Entry:
Debit: Allowance for Doubtful Accounts $X
Credit: Accounts Receivable $X
3. Bad Debt Expense as a Plug Figure
Sometimes, bad debt expense must be calculated as a “plug” figure to ensure the Allowance for Doubtful Accounts reaches its correct ending balance. This method is useful when beginning balances, write-offs, and recoveries are known, but the bad debt expense is not.
Formula:
Beginning Allowance + Bad Debt Expense – Accounts Written Off + Accounts Recovered = Ending Allowance
Solve for Bad Debt Expense to make the equation balance.
4. Calculating Net Sales Revenue with a Returns Allowance
When a company anticipates a portion of its sales will be returned, it must set up a Sales Returns Allowance to adjust total sales down to Net Sales Revenue. This provides a realistic view of the revenue expected to remain after returns.
Formula for Net Sales Revenue:
Net Sales = Total Sales – (Total Sales * Estimated Return Rate)
Example:
If your total sales are $1,200,000 and you expect 5% of these sales to be returned, the expected returns are:
Expected Returns = 1,200,000 * 0.05 = 60,000
Thus, Net Sales Revenue will be:
Net Sales = 1,200,000 – 60,000 = 1,140,000
By subtracting the expected returns, you present a more accurate measure of your sales revenue.
5. Sales Returns Allowance: Understanding its Role
The Sales Returns Allowance is a contra-revenue account, similar to how the Allowance for Doubtful Accounts works against Accounts Receivable. It is used to estimate and offset potential returns, making it easier to track the impact of returns on a company’s financial results.
Formula for Sales Returns Allowance:
Sales Returns Allowance = Total Sales * Estimated Return Rate
This figure is subtracted from gross sales to arrive at Net Sales on the income statement.
Putting It All Together: Managing Receivables and Returns
Understanding how to properly record allowances and account for expected returns is vital to presenting an accurate picture of a company’s financial health. By mastering these calculations and journal entries, you can ensure your financial statements reflect a realistic view of what’s collectible and what revenue is sustainable.
Key Takeaways:
- Allowance for Doubtful Accounts helps estimate uncollectible receivables and maintain accurate net realizable value.
- Use the plug figure approach to solve for unknown bad debt expenses.
- Net Sales Revenue should account for anticipated returns through a Sales Returns Allowance to avoid overstating revenue.
- Properly applying these concepts ensures better financial reporting and decision-making.
