Financial Accounting

Learn the toughest concepts covered in your Financial Accounting class with step-by-step video tutorials and practice problems.

7. Receivables and Investments

Net Accounts Receivable: Direct Write-off Method


Net Accounts Receivable: Direct Write-off Method

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Alright when we extend credit to our customers, there's a chance that we won't get paid, Right? So let's see what happens in those situations. So if we allow our customers to pay us later. Yeah, there might be a chance that we will not get paid right? So we're gonna have what's called bad debt expense, right? We're like, we're extending this credit to our customers and they don't pay us back. Well, that's bad debt. So these are losses that result from extending credit but not getting paid. Okay, that's the bad debt expense. So the first method we're gonna talk about is the direct right off method and I want to go right away and tell you that this is not gap. Okay. This method is not gap but it's simple to use. So this is why we explain it first. Okay, So this basically the direct right off, we're gonna take bad debt expense as soon as the company decides that they're not gonna collect on that account. So if they say, hey, this customer doesn't look like they're ever gonna pay us, right, then we take the bad debt expense. Okay? But let's see why this would not be gap. Okay, This method does not follow the matching principle. Okay, We have the matching principle. If you remember the matching principle tells us that we have to match our expenses with our revenues right? When we earn revenue, what did it take us to earn that revenue where those expenses that we had to take on. Okay. And we want to make sure that when we earned the revenue, we take the expenses in the same period. So let's see how this affects our bad debt expense entry. So in year one we could have some credit sales, right? And the key word credit, meaning that we sold it on account, they're gonna pay us later. So we would debit accounts receivable for whatever amount and we would credit revenue notice we're taking revenue in year one in this case, right? We're taking revenue in year one. But however it takes us till february of year two. Now we're in year two and we're like, you know what, I don't think we're gonna collect on some of these accounts. Let's write off those accounts and then we make some sort of entry in year two notice in year one, we took the revenue in year one, we took the revenue, but now in year two when we decide, okay, we're not gonna get this money back. Now we're gonna take the expense, bad debt expense in year two and then we're gonna credit our accounts receivable to get rid of that account, right? We said, hey we're not gonna collect this account. So we credit it to get rid of the account receivable and we take the bad debt expense. But notice in the problem with this and why it's not gap, we're taking bad debt expense in year two and we're taking revenue in year one. Okay, so that bad debt expense that we took in year two, it's related to year one sales. So we should have taken that bad debt expense in year one and we'll learn more about how to do this properly. But they do love to test you on the direct right off method as well. So let's go ahead and do an example here. Alright, so our example, a company sold items on a count to three customers. Quick. Quinn owes 100 and $50. Slow joe owes 3 50 sketchy. Jack owes 500. Quinn paid after two days joe paid after six weeks and sketchy. Jack has not still not paid the company and the company has lost contact with Jack. That doesn't sound very good. Right? So it tells us here, the company deemed his account uncollectible. Sojourn, allies these transactions. So at first we make our sales to these three people. Right? So pretty simple. When we make a sale, we're going to debit accounts receivable because he's gonna pay us later. Right, so we're debating it 150 and we're going to credit. And this is quick Quinn. Right, Quick Quinn owes 1 50 we would credit revenue for 1 50. So let's go ahead and do it one at a time. So that would be Quinn's uh, that would be Quinn's revenue entry when we got the revenue. And how about when Quinn pays us? Well, he pays us two days later. Easy enough. We got cash of 1 50 when he paid us. And we get rid of the accounts receivable with a credit he no longer owes us that money. Okay, how about slow joe. Now, let's look at slow joe. Slow joe. It's gonna be very similar actually. Almost identical. Other than the numbers. So we're gonna take our A. R. And R. Revenue entries. 3 53 50 for slow joe. And actually it's gonna be the same thing here. Right? He paid us in cash. It just took him a little longer. But notice this doesn't change the entries just because he took longer to pay us. These are still the entries that get made. Okay? But now let's go into sketchy Jack. So at first we sold the stuff to sketchy Jack and we didn't, we maybe only knew him as Jack. We didn't know he was sketchy Jack. And this is what we find out. So we, at first we sell it to him and we make our standard revenue entry For the $500, right? He he took $500 worth of stuff, so we're expecting to receive $500 for him. And then later on, we realize he's not gonna pay us. Well, at that point when we realize he's not gonna pay us what we're gonna make an entry for bad debt expense. Right? We're going to debit bad debt expense. Right? Our expenses go up with debits for the 500? And we're going to credit accounts receivable in this case for the 500, right? And that gets rid of the account receivable. And it creates a bad debt expense. That's going to go to the income statement, right? But again, remember this is not gap. Alright, let's just write it down here. Nice and big. Not gap. Alright, cool. Let's go ahead and move on to the other methods and let's see what Gap prescribes.