From this information, anyone studying these financial statements for Year One should understand that an expense estimated at $7,000 was incurred this year because the company made sales that will never be collected. In addition, year-end accounts receivable total $100,000 but have an anticipated net realizable value of only $93,000. Neither the $7,000 nor the $93,000 figure is expected to be exact but the eventual amounts should not be materially different. This basic portrait provides decision makers with fairly presented information about the accounts receivables held by the reporting company. An allowance for doubtful accounts is considered a “contra asset,” because it reduces the amount of an asset, in this case the accounts receivable.

• Note that allowance for doubtful accounts reduces the
  overall accounts receivable account, not a specific accounts
  receivable assigned to a customer.
• Bad debt expense also helps companies identify which customers default on payments more often than others.
• No physical evidence exists at the time of sale to indicate which will become worthless (buyers rarely make a purchase and then immediately declare bankruptcy or leave town).
• As a result, companies need to account for the possibility of uncollectible accounts, which are also known as bad debts.

For example, say a company lists 100 customers who purchase on credit and the total amount owed is $1,000,000. The purpose of the allowance for doubtful accounts is to estimate how many customers out of the 100 will not pay the full amount they owe. Rather than waiting to see exactly how payments work out, the company will debit a bad debt expense and credit allowance for doubtful accounts. An allowance for doubtful accounts is a contra account that nets against the total receivables presented on the balance sheet to reflect only the amounts expected to be paid. The allowance for doubtful accounts estimates the percentage of accounts receivable that are expected to be uncollectible. However, the actual payment behavior of customers may differ substantially from the estimate.

Specific Identification Method

Accounts receivable represent amounts due from customers as a result of credit sales. Unfortunately for various reasons, some accounts receivable will remain unpaid and will need to be provided for in the accounting records of the business. The amount credited to the bad debt expense account is the estimated amount of uncollectible accounts for the period. The inherent uncertainty as to the amount of cash that will actually be received affects the physical recording process. To illustrate, assume that a company makes sales on account to one hundred different customers late in Year One for $1,000 each. The earning process is substantially complete at the time of sale and the amount of cash to be received can be reasonably estimated.

• The sales method applies a flat percentage to the total dollar amount of sales for the period.
• In this example, the company often assigns a percentage to each classification of debt.
• Thus, virtually all of the remaining bad debt
  expense material discussed here will be based on an allowance
  method that uses accrual accounting, the matching principle, and
  the revenue recognition rules under GAAP.
• Therefore, there is no guaranteed way to find a specific value of bad debt expense, which is why we estimate it within reasonable parameters.

Another way to record bad debt expense or uncollectible accounts in the financial statements is by using the allowance method. This method adheres to the matching principle and the procedural standards of GAAP. In the allowance method, a company estimates the amount of uncollectible accounts it will incur as a percentage of credit sales.

Fundamentals of Bad Debt Expenses and Allowances for Doubtful

It is important to estimate the allowance accurately to ensure that the financial statements reflect the true financial position of the company. Once the company has identified accounts that are likely to be uncollectible, it needs to estimate the amount of uncollectible accounts. Suppose a company generated $1 million of credit sales in Year 1 but projects that 5% of those sales are very likely to be uncollectible based on historical experience. In effect, the allowance for doubtful accounts leads to the A/R balance recorded on the balance sheet to reflect a value closer to reality. The allowance for doubtful accounts is then used to approximate the percentage of “uncollectible” accounts receivable (A/R).

What is the bad debt expense allowance method? Establishing a bad debt reserve

If there is a carryover balance, that
must be considered before recording Bad Debt Expense. The balance
sheet aging of receivables method is more complicated than the
other two methods, but it tends to produce more accurate results. This entry decreases net income by $2,000 and creates a contra asset account for the allowance for doubtful accounts, which is used to reduce the accounts receivable balance. 27 day care invoice template collection The bad debt expense account is used to record the estimated uncollectible accounts for the period. The balance sheet method (also known as the
percentage of accounts receivable method) estimates bad debt
expenses based on the balance in accounts receivable. The method
looks at the balance of accounts receivable at the end of the
period and assumes that a certain amount will not be collected.

3: Direct Write-Off and Allowance Methods

The Allowance for Doubtful Accounts is a contra-asset account that estimates the future losses incurred from uncollectible accounts receivable (A/R). Contra assets are still recorded along with other assets, though their natural balance is opposite of assets. While assets have natural debit balances and increase with a debit, contra assets have natural credit balance and increase with a credit. You record the allowance for doubtful accounts by debiting the Bad Debt Expense account and crediting the Allowance for Doubtful Accounts account.

You currently use the income statement method to
estimate bad debt at 4.5% of credit sales. You are considering
switching to the balance sheet aging of receivables method. This
would split accounts receivable into three past- due categories and
assign a percentage to each group.

Based on this calculation the allowance method estimates that, of the credit sales of 65,000, an amount of 1,625 will become uncollectible at some point in the future. Using the allowance method, complying with the matching principle, the amount is recorded in the current accounting period with the following percentage of credit sales method journal. One way to record the affects of uncollectible accounts is the direct charge-off method. But it violates the matching principle and does not conform to GAAP standards and procedures.

Percentage of Credit Sales Method Example

For example, if the company wanted the deduction for
the write-off in 2018, it might claim that it was actually
uncollectible in 2018, instead of in 2019. The outstanding balance of $2,000 that Craft did not repay will remain as bad debt. Accounting for uncollectible accounts involves estimating the amount of uncollectible accounts and creating an allowance for doubtful accounts. Most balance sheets report them separately by showing the gross A/R balance and then subtracting the allowance for doubtful accounts balance, resulting in the “Accounts Receivable, net” line item. A Pareto analysis is a risk measurement approach that states that a majority of activity is often concentrated among a small amount of accounts.

As the accountant for a large publicly traded food company, you are considering whether or not you need to change your bad debt estimation method. You currently use the income statement method to estimate bad debt at 4.5% of credit sales. You are considering switching to the balance sheet aging of receivables method. This would split accounts receivable into three past- due categories and assign a percentage to each group. Allowance for uncollectible accounts can also be referred to as allowance for uncertain accounts, and may be expensed as bad debt expense or uncollectible accounts expense.

Time Value of Money

This is different from the last journal entry, where bad debt
was estimated at $58,097. That journal entry assumed a zero balance
in Allowance for Doubtful Accounts from the prior period. This
journal entry takes into account a debit balance of $20,000 and
adds the prior period’s balance to the estimated balance of $58,097
in the current period. Then all of the
category estimates are added together to get one total estimated
uncollectible balance for the period. The entry for bad debt would
be as follows, if there was no carryover balance from the prior
period. The direct write-off method delays recognition
of bad debt until the specific customer accounts receivable is
identified.