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Case Study: Uncollectible Accounts

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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

Hey everyone, and welcome to our video today, a case study on uncollectible accounts. So what's today's video about? Well, we're going to look at a subject company called Legacy Clothing. And we're going to discuss that company and uncollectible accounts, and how uncollectible accounts relates to our subject company. So then we're going to do a case study of calculating uncollectible accounts for our subject company.

So let's start by learning a little bit about the company itself. So what type of company is Legacy Clothing? It's a sole proprietorship, so a type of company that's owned by a single individual and where the individual and the business are legally treated as the same.

What is the business's purpose? Well, it owns and operates its own clothing and merchandise stores, sells men's, women's, children's clothing and other related items. Where are the business's locations? Well, they have locations throughout Washington, DC. And they have a staff of 50 people.

So now let's talk about how uncollectible accounts relate to our company. So does our company need to estimate uncollectible accounts? Yes. Of course they do.

Well, why? Well, our company needs to recognize the amounts expected not to be collected from credit customers, so if there are any customers that we've sold merchandise to on credit, on account, that we do not expect to collect payment for those goods.

Why do we need to do that? Well, we need to have accurate reporting. It's a requirement for our financial reporting. And we need to be able to match the expense of this bad debt expense with the credit sales, so record the expected loss from our credit sales. And again, matching the expense with the period that the event or the transaction occurred.

And now there are common methods that we can use to estimate our uncollectible accounts. We can use percentage of net credit sales. And the balance in the allowance account is not considered. We can use the percentage of receivables, where we need to consider the balance in our allowance account. Or we can use aging receivables, where we would also need to consider the balance in our allowance account.

So yes, our subject company needs to estimate uncollectible accounts. So what we're going to do now for our subject company is look at calculating, estimating our uncollectible accounts. That's the easiest way to walk through those three common methods that we just talked about. So let's go ahead and do that right now.

OK. So the first calculation we're going to look at is percentage of net credit sales. So the information that we're going to need is our total net credit sales, our estimated percent uncollectible, so that we can perform our calculation here to figure out our allowance, which is net credit sales multiplied by percent uncollectible to determine our allowance.

So for our purposes, Legacy Clothing has total net credit sales of $500,000. We estimate the percent uncollectible is 3%. So if we take our net credit sales, our percent uncollectible, we can then calculate our allowance. So our allowance using percentage of net credit sales is $15,000.

So then how do we record that? Well, we need to record a journal entry. We're going to debit Bad Debt Expense for $15,000 and credit Allowance for Uncollectible Accounts for $15,000, because again, using this method, we don't need to consider the balance that's already in the Allowance account.

OK. Now we're going to look at estimating our allowance using the percentage of receivables. So if we take our total receivables, and we need to know our total estimated percent uncollectible, we can then plug that information into our formula here. So we take our accounts receivable, multiply it by that percent uncollectible to give us our allowance. So for Legacy Clothing they have $200,000 in receivables and an estimated percent uncollectible of 3%. So if we plug that information into our formula, we'll get that our allowance should be $6,000.

So now let's look at a couple different scenarios. So this first one, there's no balance in our Allowance account. Remember, under this percentage of receivables, we have to consider the balance in that Allowance account.

So in our first scenario, there is no balance. So what does our journal entry look like? It's going to be a debit to Bad Debt Expense and a credit to Allowance for Uncollectible Accounts of $6,000, which we calculated here.

So now in another scenario, let's assume that there's a $2,000 balance already in our Allowance for Uncollectible Accounts. What impact does that have on our journal entry? Well, it's still going to be a debit to Bad Debt Expense and a credit to Allowance for Uncollectible Accounts.

But you'll see here it's only for $4,000, because the total balance needs to be $6,000. We already have $2,000 in there. So we only need to increase that allowance account by $4,000.

OK. Our last method is aging receivables. So what you're looking at here is an aging schedule of all of our receivables from all of our customers. And it categorizes all of our receivables based on the days outstanding.

So what we need to do is we need to take this aging schedule and then apply these uncollectible percentages that we've estimated. And again, these grow as the days outstanding of that receivable increase. So what we do is we calculate the total uncollectible balance based on the total balance of receivables that fall into our day category, and multiply that-- take this total and multiply that by the uncollectible percentage to get to the total uncollectible amount in dollars. So we'll see that our total uncollectible balance is $46,295, which is our allowance.

OK. So now if we take this total allowance that we just calculated, let's take a look at a couple different scenarios. In the first one, let's assume there's no balance in our Allowance for Uncollectible Accounts. So what does our journal entry look like? We're going to have a debit to Bad Debt Expense and a credit to Allowance for Uncollectible Accounts for the full amount, $46,295.

But now if we look at a second scenario, and let's assume there's already a $6,000 balance in our Allowance for Uncollectible Accounts, how does that impact our journal entry? Well, it's still a debit to Bad Debt Expense and a credit to Allowance for Uncollectible Accounts. But it's only for $40,295. Because there's already $6,000 in that Allowance account, we only need to increase it by the difference in order to get to that total balance of $46,295.

Great. So now that we've seen how to estimate our uncollectible accounts using percentage of net credit sales, percentage of receivables, and aging receivables, let's summarize what we talked about today. In a nutshell, we discussed our case study company, Legacy Clothing. We looked at examples of estimating uncollectible accounts using percentage of net credit sales, percentage of receivables, as well as aging receivables.

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