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The Corporate Finance Institute    Accounting









                                              Risks associated with Accounts Receivable
                                              1.  Uncollected debt – High A/R that goes uncollected for a long time
                                                 is written off as bad debt. This situation occurs when customers
                                                 who purchase on credit go bankrupt, or otherwise shirk the invoice
                                                 without reason.
                                              2.  Cash flow deficiencies – A business needs cash flow for its
                                                 operations. Selling on credit may boost revenue and income, but
                                                 present no actual cash inflow. In the short-term this is acceptable,
                                                 but in the long run can cause the company to run short on cash and
                                                 have to take on other liabilities to fund its operations.


                                              Measurement of Bad Debts in Accounts Receivable
                                              There are two ways to account for balances in accounts receivable
                                              that are predicted to not be collected, which is also known as bad debt
                                              expense. To account for this expense, the percentage of sales method
                                              (income statement approach) or the aging of accounts method (balance
                                              sheet approach) can be used.


                                              Percentage of Sales Method:
                                              •    This method uses the idea that some fraction of sales will be
                                                 uncollectible. Therefore, to match expenses with revenues, the bad
                                                 debts expense is a certain percentage of sales.
                                              •    This method focuses on the computation of the expense, hence, an
                                                 income statement approach.
                                              •    For example, if 2% of sales is considered bad debt expense and sales
                                                 were $100,000, the bad debt expense is $2,000.
                                              •    Bad debt expense is debited while the allowance for doubtful
                                                 accounts (a contra AR account) is credited.


                                              DR Bad Debt Expense: 2,000
                                              CR Allowance for Doubtful Accounts (ADA): 2,000
















           corporatefinanceinstitute.com                                                                        32
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