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Allowance Method: Percentage of Net Credit Sales and Percentage of Receivables

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

[MUSIC PLAYING] Hey everyone, and welcome to our video today, allowance method percentage of net credit sales and percentage of receivables. So what is today's video about? We'll going to start with an uncollectible accounts review, and then we're going to focus on the allowance method. And within the allowance method, we're going to look at the percentage of net credit sales and percentage of receivables methods that will help us to calculate our allowance under the allowance method. But let's start with that uncollectible accounts review.

What is an uncollectible account? That's in accounts receivable that are unpaid and are written off as bad debts expense. Do we need to recognize or record these uncollectible accounts? Short answer is yes, we do. We need to recognize the amounts that are expected not to be collected from credit customers. So any customers that made purchases on credit and we don't expect to collect on those sales, we need to record those uncollectible accounts.

So why would we use the allowance method? Well it's required for financial reporting. So we're required to use the allowance method. And the allowance method helps us to achieve matching, so we can match our expense, our bad debts expense, with the period that the event took place, that the sale took place. That this determination of uncollectibility took place. How do we determine uncollectible accounts?

Well we can use some common methods to help us calculate our uncollectible accounts, so our allowance. We can use the percentage of net credit sales, percentage of receivables, and aging receivables. Now today, we're going to focus on those first two. Let's start by discussing the percentage of net credit sales. What is it?

It is estimating the percent of credit sales made for which payment will not be received. So we're trying to estimate the percent of our credit sales made for which payment will not be received. How is the estimate made? We can use industry standards, past experience, or any other logical method. What relationship is emphasized in the percentage of net credit sales method? Well, its income statement relationship.

OK, because we're looking at sales in order to make our estimate to record our bad debts expense. So it's an income statement relationship. And again, this helps us achieve matching because we're matching that expense with the period that that revenue took place. So under the percentage of net credit sales method, the existing balance in our allowance account is not considered. So we don't need to worry about any balance that's already in our allowance account.

We can focus on our sales and our estimates for bad debt expense. So what we're going to do is we're going to look at an example scenario of calculating percentage of net credit sales. So let's do that now. So here's the first piece of information. Company ABC estimates that 2% of their net credit sales will become uncollectible. And two, net credit sales for 2012 were $100,000. So what is the estimated allowance?

Well, we take our net credit sales, multiply that by the percent uncollectible, so that our percentage estimate, to give us our allowance. So in this case, we take $100,000, that's our net credit sales, multiply that by our estimate of 2%, to give us an allowance of $2,000. So that's what our allowance should be. So what's the journal entry to record that allowance?

Well, we'd have a debit and a credit, and we're going to debit bad debt expense for $2,000 and we're going to credit allowance for uncollectible accounts for $2,000. So that's what a calculation under the percentage of net credit sales looks like for recording the allowance. Now let's look at that next method. Let's look at percentage of receivables. What is percentage of receivables? It's estimating percent of accounts receivable for which payment will not be collected.

So now we're focusing on the accounts receivable to create our estimate. How is the estimate made? Well, just like with percentage of net credit sales, we use industry standards, past experience, or any other logical method. And what's the relationship that's emphasized? Well, since we're dealing with receivables and focusing on that piece, it's balance sheet. So we're looking at accounts receivable to help us determine our allowance for uncollectible accounts, which are both balance sheet accounts.

So we're focusing on that balance sheet relationship. And under the percentage of receivables method, that existing balance in the allowance account is considered. So now when we're performing our calculation, we need to make sure we take into account any balance that's already in the allowance account. So the easiest way to explain that and demonstrate it is doing a sample scenario. So let's go ahead and do that now.

First piece of information. Company ABC estimates that 2% of their accounts receivable will become uncollectible. And the accounts receivable balance is $100,000. So what is the estimated allowance? It's going be a similar calculation like we performed before, we take our accounts receivable, multiply it by the percent uncollectible that we estimated to get to our allowance. So in this case, we take $100,000 multiply it by 2%, to get to $2,000. But we're not done yet. So we've calculated our allowance of $2,000.

So what's the journal entry? Well, first we also need to take into consideration the balance in our allowance account. So in this case, we're going to assume that the balance in the allowance account is $500. So what does that do to our journal entry? We're still going to have a debit and credit, still going to be to bad debt expense, but in this case, it's only going to be for $1,500, and the credit is going to be allowance for uncollectible accounts for $1,500.

Because we have an existing balance in that allowance account of $500, and we needed to get to that $2,000 that we calculated in our allowance. And in order to get to that $2,000, we only needed to increase the allowance account $1,500. So that's that slight difference and that slight variation with percentage of receivables.

Now let's summarize what we talked about today. In a nutshell, we talked about the allowance method, we looked at an uncollectible accounts review, and then we looked at calculating percentage of net credit sales to record our allowance as well as percentage of receivables to record our allowance. I hope everybody enjoyed this video. I hope to see you next time.