Valuation
Receivables of all types are normally reported on the balance sheet at their net realizable value, which is the amount the company expects to receive in cash .
Valuing Receivables
Receivables are recorded at net realizable value.
Business owners know that some customers who receive credit will never pay their account balances. These uncollectible accounts are called bad debts. Companies use two methods to account for bad debts: the direct write-off method and the allowance method.
Direct Write-Off Method
For tax purposes, companies must use the direct write-off method, under which bad debts are recognized only after the company is certain the debt will not be paid. Before determining that an account balance is not collectible, a company generally makes several attempts to collect the debt from the customer.
Recognizing the bad debt requires a journal entry that increases a bad debts expense account and decreases accounts receivable. If a customer named J. Smith fails to pay a $100 balance, for example, the company records the write-off by debiting bad debts expense and crediting accounts receivable from J. Smith.
Allowance Method
Under the allowance method, an adjustment is made at the end of each accounting period to estimate bad debts based on the business activity from that accounting period. Established companies rely on past experience to estimate unrealized bad debts, but new companies must rely on published industry averages until they have sufficient experience to make their own estimates.
The adjusting entry to estimate the expected value of bad debts does not reduce accounts receivable directly. Accounts receivable is a control account that must have the same balance as the combined balance of every individual account in the accounts receivable subsidiary ledger.
Since the specific customer accounts that will become uncollectible are not yet known when the adjusting entry is made, a contra-asset account named allowance for bad debts, which is sometimes called allowance for doubtful accounts, is subtracted from accounts receivable to show the net realizable value of accounts receivable on the balance sheet.