9 2: Account for Uncollectible Accounts Using the Balance Sheet and Income Statement Approaches Business LibreTexts

allowance for uncollectible accounts

The customer who filed for bankruptcy on August 3 manages to pay the company back the amount owed on September 10. The company would then reinstate the account that was initially written off on August 3. Bad Debt https://www.online-accounting.net/day-to-day-bookkeeping-basic-day-to-day/ Expense increases (debit) as does Allowance for Doubtful Accounts (credit) for $58,097. In order to use the allowance method, it is first necessary to estimate the allowance needed using a suitable method.

allowance for uncollectible accounts

Suppose that Ito Company has total accounts receivable of $425,000 at the end of the year, and is in the process or preparing a balance sheet. But, what if it is estimated that $25,500 of this amount may ultimately prove to be uncollectible? Thus, a more correct balance sheet presentation would show the total receivables along with an allowance account (which is a contra asset account) that reduces the receivables to the amount expected to be collected. This anticipated amount is often termed the net realizable value (receivables).

Thisjournal entry takes into account a debit balance of $20,000 andadds the prior period’s balance to the estimated balance of $58,097in the current period. Carefully consider that the allowance methods all result in the recording of estimated bad debts expense during the same time periods as the related credit sales. For example, say a company lists 100 customers who purchase on credit and the total amount owed is $1,000,000.

Estimating the Amount of Allowance for Doubtful Accounts

Note that allowance for doubtful accounts reduces the overall accounts receivable account, not a specific accounts receivable assigned to a customer. Because it is an estimation, it means the exact account that is (or will become) uncollectible is not yet known. For example, a customer takes out a $15,000 car loan on August 1, 2018 and is expected to pay the amount in full before December 1, 2018. For the sake of this example, assume that there was no interest charged to the buyer because of the short-term nature or life of the loan. When the account defaults for nonpayment on December 1, the company would record the following journal entry to recognize bad debt.

This entry assumes a zero balance in Allowance forDoubtful Accounts from the prior period. BWW estimates 15% of itsoverall accounts receivable will result in bad debt. Continuing our examination of the balance sheet method, assume that BWW’s end-of-year accounts receivable balance totaled $324,850. This entry assumes a zero balance in Allowance for Doubtful Accounts from the prior period. BWW estimates 15% of its overall accounts receivable will result in bad debt. 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.

When the estimation isrecorded at the end of a period, the following entry occurs. This chapter has devoted much attention to accounting for bad debts; but, don’t forget that it is more important to try to avoid bad debts by carefully monitoring credit policies. A business should carefully consider the credit history of a potential credit customer, and be certain that good business practices are not abandoned in the zeal to make sales.

Balance Sheet Aging of Receivables Method for Calculating Bad Debt Expenses

Bad Debt Expense increases (debit), and Allowance for DoubtfulAccounts increases (credit) for $48,727.50 ($324,850 × 15%). Thismeans that BWW believes $48,727.50 will be uncollectible debt.Let’s consider that BWW had a $23,000 credit balance from theprevious period. The direct write-off method delays recognitionof bad debt until the specific customer understanding prepaid expenses: examples and journal entry accounts receivable isidentified. Once this account is identified as uncollectible, thecompany will record a reduction to the customer’s accountsreceivable and an increase to bad debt expense for the exact amountuncollectible. Using the example above, let’s say that a company reports an accounts receivable debit balance of $1,000,000 on June 30.

By analyzing each customer’s payment history, businesses allocate an appropriate risk score—categorizing each customer into a high-risk or low-risk group. Once the categorization is complete, businesses can estimate each group’s historical bad debt percentage. The accounts receivable aging method uses accounts receivable aging reports to keep track of past due invoices. Using historical data from an aging schedule can help you predict whether or not you’ll receive an invoice payment.

These percentages vary by company, but the older the account, the more likely it is to represent a bad account. As a result, the estimated allowance for doubtful accounts for the high-risk group is $25,000 ($500,000 x 5%), while it’s $15,000 ($1,500,000 x 1%) for the low-risk group. Thus, the total allowance for doubtful accounts is $40,000 ($25,000 + $15,000). As you’ve learned, the delayed recognition of bad debt violates GAAP, specifically the matching principle.

  1. All categories of estimated uncollectible amounts are summed to get a total estimated uncollectible balance.
  2. Wolters Kluwer is a global provider of professional information, software solutions, and services for clinicians, nurses, accountants, lawyers, and tax, finance, audit, risk, compliance, and regulatory sectors.
  3. The second method of estimating the allowance for doubtful accounts is the aging method.
  4. It’s important to note that an allowance for doubtful accounts is simply an informed guess, and your customers’ payment behaviors may not align.

The balance sheet method is another simple method for calculating bad debt, but it too does not consider how long a debt has been outstanding and the role that plays in debt recovery. The income statement method (also known as the percentage of sales method) estimates bad debt expenses based on the assumption that at the end of the period, a certain percentage of sales during the period will not be collected. The estimation is typically based on credit sales only, not total sales (which include cash sales). In this example, assume that any credit card sales that are uncollectible are the responsibility of the credit card company. It may be obvious intuitively, but, by definition, a cash sale cannot become a bad debt, assuming that the cash payment did not entail counterfeit currency.

Let’s consider a situation where BWW had a $20,000 debit balance from the previous period. Allowance for Doubtful Accounts decreases (debit) and Accounts Receivable for the specific customer also decreases (credit). Allowance for doubtful accounts decreases because the bad debt amount is no longer unclear. Accounts receivable decreases because there is an assumption that no debt will be collected on the identified customer’s account.

What is allowance for doubtful accounts?

It may be obvious intuitively, but, by definition, acash sale cannot become a bad debt, assuming that the cash paymentdid not entail counterfeit currency. The income statement method isa simple method for calculating bad debt, but it may be moreimprecise than other measures because it does not consider how longa debt has been outstanding and the role that plays in debtrecovery. 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. Accounts receivable is reported on the balance sheet; thus, it is called the balance sheet method.

Allowance for Doubtful Accounts: Methods of Accounting for

New businesses must use industry averages, rules of thumb, or numbers from another business. The journal entry for the Bad Debt Expense increases (debit) theexpense’s balance, and the Allowance for Doubtful Accountsincreases (credit) the balance in the Allowance. Theallowance for doubtful accounts is a contra assetaccount and is subtracted from Accounts Receivable to determine theNet Realizable Value of the Accounts Receivableaccount on the balance sheet. In the case of the allowance for doubtfulaccounts, it is a contra account that is used to reduce theControlling account, Accounts Receivable. The allowance for doubtful accounts, aka bad debt reserves, is recorded as a contra asset account under the accounts receivable account on a company’s balance sheet. It’s a contra asset because it’s either valued at zero or has a credit balance.

Yes, GAAP (Generally Accepted Accounting Principles) does require companies to maintain an allowance for doubtful accounts. According to GAAP,  your allowance for doubtful accounts must accurately reflect the company’s collection history. It’s important to note that an allowance for doubtful accounts is simply an informed guess, and your customers’ payment behaviors may not align. The outstanding balance of $2,000 that Craft did not repay will remain as bad debt.

Allowance for Doubtful Accounts decreases (debit) and AccountsReceivable for the specific customer also decreases (credit).Allowance for doubtful accounts decreases because the bad debtamount is no longer unclear. Accounts receivable decreases becausethere is an assumption that no debt will be collected on theidentified customer’s account. To demonstrate the treatment of the allowance for doubtfulaccounts on the balance sheet, assume that a company has reportedan Accounts Receivable balance of $90,000 and a Balance in theAllowance of Doubtful Accounts of $4,800. The following tablereflects how the relationship would be reflected in the current(short-term) section of the company’s Balance Sheet.