How to use the percentage of AR method to establish the allowance for doubtful accounts reserve?
The percentage of AR method is one of the allowance methods that is allowed under US GAAP. The method is tested on the FAR section of the CPA exam, and students in accounting courses are often tested on this concept as well.
This method is a balance sheet focus as the company will apply a percentage to the outstanding accounts receivable balance to determine the ending allowance for doubtful accounts (ADA) balance. You will then need to prepare the ADA rollforward to determine what the adjustment to bad debt expense for the period would be.
Example Percentage-of-AR Method
Step 1) We’ll start by calculating the ending ADA balance by multiplying the gross accounts receivable balance by managements % uncollectible estimate:
Step 2) Next, we’ll prepare the ADA rollforward using the information in the question. This results in bad debt expense of $15,000 for the period. This isn’t necessarily the journal entry that would be prepared as the company may have recorded bad debt expense throughout the year.
The ADA rollforward is used to determine specific activities, but what if we are asked about the adjusting entry to the ADA balance at period-end? The question could tell us that the ADA balance on the unadjusted trial balance at period-end is $45,000 and based on the AR aging method, the balance should be $50,000. In that situation, we would record an adjusting entry to increase the ADA balance by crediting the account for $5,000. The offset would be a debit to bad debt expense for $5,000.
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