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Allowance Method: Aging Receivables

Allowance Method: Aging Receivables

Author: Evan McLaughlin
Description:

In this lesson, the student will learn about the allowance method and aging receivables.

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Tutorial

"Allowance Method: Aging Receivables"

Source: Instrumental “Drops of H2O ( The Filtered Water Treatment )" by J.Lang (feat. Airtone),” Creative Commons, http://ccmixter.org/files/djlang59/37792

Video Transcription

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Hey everyone, and welcome to our video today, Allowance Method, Aging Receivables. So what is today's video about? Well, we're going to start with an uncollectible accounts review. And then we're going to talk about the allowance method. And within that, we're going to talk about calculating our allowance using aging receivables.

Well, let's go ahead and get started with an uncollectible accounts review. So uncollectible accounts, what is an uncollectible account? It's accounts receivable that are unpaid and are written off as bad debt expense.

Do we need to recognize and record these uncollectible accounts? Well, of course we do. Yes, we do. We need to recognize the amounts expected not to be collected from credit customers. So any sales that we've made on credit and now if we don't expect those customers to fulfill their obligation to pay us, we need to record those uncollectible accounts. We need to recognize those in our financial statements.

So why would we use the allowance method? Well, it's required for financial reporting. So we have to use it for financial reporting. And it allows us to achieve matching, so we can match our bad debts expense with our revenue. And it helps us match that expense with the period that the event occurred.

So how do we determine the uncollectible accounts? Well, there are a few common methods that are used to calculate this allowance. There's the percentage of net credit sales, percentage of receivables, and aging receivables.

Now today, we're going to focus on aging receivables, so let's talk about that now. So aging receivables, what is it? It's estimating percent of accounts receivable for which payment will not be collectible. So again, we're using our accounts receivable in order to create our estimate, to make our estimate.

How is the estimate made? Well, we still use industry standards or past experience or any other logical method that management has determined.

What relationship is emphasized in aging receivables? Well, because we're focusing on accounts receivable, it's our balance sheet relationship. Again, we're using accounts receivable to help us determine our allowance for uncollectible accounts, which are both balance sheet accounts. And the existing balance in the allowance account is considered, so we need to take into consideration any existing balance that we already have in our allowance account.

So under the aging of receivables method within the allowance method, the accounts receivable are categorized based on the total days outstanding. So what does that mean? That means we can categorize our accounts receivable into these time periods, 1 to 30 days, 31 to 60 days, 61 to 90 days, 91 to 180 days, and then anything over 180 days.

So the estimated percentage of our uncollectible accounts increase as the days outstanding increase. So if we start with 2% in that first time period, that 2% is going to go up the farther out we go from that due date. So it's going to get higher for our older receivables. OK. So that's aging receivables in a nutshell.

But let's do a demonstration of calculating aging receivables by performing an example. So this is going to help us to understand how we can use aging receivables to calculate our allowance.

OK. So what you're looking at here is an aging schedule of all of our accounts receivable. An aging schedule is we summarize all of our accounts receivable for each customer. And then we categorize it into the time period that that accounts receivable is outstanding. So just for example, Customer A here has a $10,000 balance that's 30 days or less outstanding and a $5,000 balance that's between 31 and 60 days outstanding. So that's our aging schedule for all of our accounts receivable.

Now we need to look at the percent that we estimate of those accounts receivable that are uncollectible. And you'll see here that that percentage grows over time as we get out to this category of receivables that have been outstanding for over 181 days. So we take those percentage estimates and we calculate the total uncollectible balance.

So this uncollectible dollar amount here, this $220 is $11,000 balance that's 30 days or less outstanding, multiplied by that percentage estimate to get to $220. And we do the same thing down the line to get us to this total estimated uncollectible allowance of $9,320. So now that we know what our total allowance should be, this $9,320, let's look at a couple different scenarios for recording that entry into our financial system.

So let's first make an assumption that there is no balance in our Allowance for Uncollectible Accounts. So if there's no balance in that account, our journal entry looks like this. It would be a debit to Bad Debt Expense and a credit to our Allowance for Uncollectible Accounts for the full allowance that we calculated doing our aging receivables.

But let's look at a second scenario. So if we assume there is a $2,000 balance in that Allowance for Uncollectible Accounts, what does that do to our journal entry? So we already have a balance in that Allowance for Uncollectible Accounts.

Well, we still debit Bad Debt Expense and we credit Allowance for Uncollectible Accounts. But you'll see here that the amount of that entry is $7,320. That's because we already have a $2,000 balance. So in order to get to a balance of $9,320 in that Allowance account, we only need to increase it by $7,320.

Great. So now that we've seen how to calculate that allowance using aging receivables, let's summarize what we talked about today. In a nutshell, we talked about the allowance method. We did an uncollectible accounts review. And then we looked at calculating our allowance using aging receivables.

I hope everybody enjoyed this video. And I hope to see you next time.