In the previous illustration we assumed the amount of allowance for doubtful accounts ($200). However, how is it estimated in real life? Usually, accountants use data from previous periods and adjust it to the current period situation. For example, in prior periods uncollectible receivables were 5% of the gross accounts receivable balance. This is an example of historical data usage. In addition, for this period, it is expected that a larger amount will not be collected because there were many purchases by customers with bad credit history. This is an example of adjusting to the current period situation. Taking the two factors into account, the company's management decides to increase this percentage to 7 (%). So, if the company has an ending balance of the accounts receivable of $10,000, then the allowance for doubtful debts will be $700 (i.e., $10,000 x 7%). The net realizable value will be $9,300 ($10,000 - $700). Remember that the net realizable value is included in total assets in the balance sheet.

Let us go on to transactions in the next accounting period (20X8). The company:

1. Wrote off an uncollectible accounts receivable in amount of $150.
2. Provided $2,000 of training services on account during the period.
3. Recovered a part ($30) of bad debt expense that was written-off.
4. Recognized bad debts expense for 20X8.

Explanations to the transactions follow below.

Event No. 1. When we recognized bad debts expense (Event No. 3 in 20X7) we actually did not write-off the receivable, and recorded an allowance for a future write-off. Only when we know for sure that an amount ($150) is uncollectible (for example, a customer refuses or can't pay), do we decrease Accounts Receivable and Allowance for Bad Debts. By doing this, we write-off the amount from receivables and from the allowance account. This is an asset exchange transaction:

Illustration 7: Effect of receivables write-off in the horizontal model

The write-off does not change net realizable value of receivables on the balance sheet. Look at the presentation below and you will see that the net realizable value (respectively, total assets) remain unchanged before and after the write-off transaction:

Illustration 8: Impact of receivables write-off on their net realizable value

Event No. 2. Proving services on account acts to increase Accounts Receivable and Training Revenue. This is an asset source transaction:

Illustration 9: Effect of revenue recognition in the horizontal model

Event No. 3. Sometimes a favorable to a company situation takes place. A customer, whose debt was written-off, is able to pay the amount owed. In this case the company should re-establish the receivable amount and then record the cash collection. In our example, $30 that has already been written-off is re-established in the records. The journal entry to do that is a reversal of the entry made at the write-off point. So, Accounts Receivable and Allowance for Bad Accounts increase:

Illustration 10: Effect of receivables write-off reversal in the horizontal model

Then the collection of cash from receivables is recorded:

Illustration 11: Effect of cash collection in the horizontal model

4) As we mentioned before, the company owner (management) estimates what receivables amount is expected to be uncollectible. Let us assume that for this year, based on historical data and current period situation, the uncollectible percentage is set to 8% of gross receivables. As the ending balance of Accounts Receivable is $1,050, the allowance for doubtful accounts should have a balance of $84 (i.e., $1,050 x 8%). However, the balance is in fact only $80 ($200 of beginning balance - $150 written-off + $30 recovery of bad debt). Accordingly, it is necessary to adjust the allowance for doubtful accounts by $4 to arrive at the desired $84 ending balance. We recognize that additional amount of bad debt expense by posting the period-end adjusting entry. This entry acts to increase both Allowance and Bad Debts Expense:

Illustration 12: Effect of adjusting allowance for bad debt in the horizontal model