We will look at an example to see how the above information translates into practice.
A company that specializes in training services incurred the following transactions in 20X7:
- Recognized $3,000 of service revenue earned on account.
- Collected 1,800 cash from accounts receivable.
- Recognized $200 of bad debt expense for accounts receivable that are expected to be uncollectible in the future.
Event No.1. The first transaction is already familiar to us. Assets (Accounts Receivable) and equity (Service Revenue) increase by the like amount. This is an asset source transaction:
Illustration 1: Effect of revenue recognition in the horizontal model
| Event No. |
Assets |
= |
Liabilities |
+ |
Equity |
Rev. |
- |
Exp. |
= |
Net Inc. |
Cash Flow |
|
| 1 |
3,000 |
= |
n/a |
+ |
3,000 |
3,000 |
- |
n/a |
= |
3,000 |
n/a |
|
Event No.2. The collection of accounts receivable acts to decrease one asset (Accounts Receivable) and increase another (Cash). The transaction is an asset exchange one:
Illustration 2: Effect of cash collection in the horizontal model
| Event No. |
Assets |
= |
Liab. |
+ |
Equity |
Rev. |
- |
Exp. |
= |
Net Inc. |
Cash Flow |
|||
| Cash |
+ |
Accts Rec. |
||||||||||||
| 2 |
1,800 |
+ |
(1,800) |
= |
n/a |
+ |
n/a |
n/a |
- |
n/a |
= |
n/a |
1,800 |
OA |
Event No.3. A company usually cannot know for sure how much of accounts receivable will be uncollectible. In such a case, nevertheless, it is possible to make an estimate. For example, in our illustration the owner is not able to say exactly how much of the remaining $1,200 (i.e., $3,000 - $1,800) of accounts receivable will not be collected. But the owner can estimate that eventually clients will not be able to pay $200 of receivables. The company should recognize the anticipated future write-down (loss) of receivables in the current accounting period. An adjusting entry is booked. The adjusting entry recognizes bad debt expense by reducing the assets and equity:
Illustration 3: Effect of bad debt expense in the horizontal model
| Event No. |
Assets |
= |
Liabilities |
+ |
Equity |
Rev. |
- |
Exp. |
= |
Net Inc. |
Cash Flow |
|
| 3 |
(200) |
= |
n/a |
+ |
(200) |
n/a |
- |
(200) |
= |
(200) |
n/a |
|
The amount of accounts receivable that is expected to be uncollectible ($200) is recorded in a contra asset account called Allowance for Doubtful Accounts (also called Allowance for Bad Debts). The balance of this account is subtracted from Gross Accounts Receivable to arrive at the net realizable value of receivables:
| Gross Accounts Receivable |
$1,200 |
| Less: Allowance for Doubtful Accounts |
(200) |
|
|
|
| Net Realizable Value |
$1,000 |
Recall that the net realizable value is the amount of receivables a company actually expects to collect in the future.
