9 2 Account for Uncollectible Accounts Using the Balance Sheet and Income Statement Approaches Principles of Accounting, Volume 1: Financial Accounting
The allowance for doubtful accounts is not always a debit or credit account, as it can be both depending on the transactions. When a doubtful account becomes uncollectible, it is a debit balance in the allowance for doubtful accounts. Yes, GAAP (Generally Accepted Accounting Principles) does require companies to maintain an allowance for doubtful accounts.
- The allowance for doubtful accounts is an estimate of the portion of accounts receivable that your business does not expect to collect during a given accounting period.
- All categories of estimated uncollectible amounts are summed to get a total estimated uncollectible balance.
- The specific identity and the actual amount of these bad accounts will probably not be known for several months.
- The direct write-off method delays recognition of bad debt until the specific customer accounts receivable is identified.
- However, the balance sheet would show $100,000 accounts receivable less a $5,300 allowance for doubtful accounts, resulting in net receivables of $ 94,700.
Management may disclose its method of estimating the allowance for doubtful accounts in its notes to the financial statements. Though the Pareto Analysis can not be used on its own, it can be used to weigh accounts receivable estimates differently. For example, a company may assign a heavier weight to the clients that make up a larger balance of accounts receivable due to conservatism. When a company sells goods or services on credit, there is always a risk that some customers will not pay their bills.
3: Direct Write-Off and Allowance Methods
When companies sell products to customers on credit, the customer receives the product and agrees to pay later. The customer’s obligation to pay later is recorded in accounts receivable on the balance sheet of the selling company. When customers don’t pay their bills, the selling company has to write-off the amount as bad debt or uncollectible accounts. In anticipation of the fact that some customer’s will not pay their bills, a company will create an account on the balance sheet called allowance for uncollectible accounts. This account is a contra asset account the value of which is subtracted from the value of the accounts receivable account on the balance sheet. Companies must estimate the amount of uncollectible accounts based on historic data.
- The previous allowance method directly estimated the bad debt expense based on the credit sales recorded on the income statement of the business.
- The actual payment behavior of customers, or lack thereof, can differ from management estimates, but management’s predictions should improve over time as more data is collected.
- The first step in accounting for the allowance for doubtful accounts is to establish the allowance.
- The net effect of this transaction is to reduce the accounts receivable balance and the allowance for doubtful accounts by $500.
When the account defaults for nonpayment on
December 1, the company would record the following journal entry to
recognize bad debt. 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. The allowance for doubtful accounts (or the “bad debt” reserve) appears on the balance sheet to anticipate credit sales where the customer cannot fulfill their payment obligations. You may notice that all three methods use the same accounts for the adjusting entry; only the method changes the financial outcome. Also note that it is a requirement that the estimation method be disclosed in the notes of financial statements so stakeholders can make informed decisions.
The matching principle states that revenue and expenses must be recorded in the same period in which they occur. Therefore, the allowance is created mainly so the expense can be recorded in the same period revenue is earned. A Pareto analysis is a risk measurement approach that states that a majority of activity is often concentrated among a small amount of accounts. In many different aspects of business, a rough estimation is that 80% of account receivable balances are made up of a small concentration (i.e. 20%) of vendors. Some companies may classify different types of debt or different types of vendors using risk classifications. For example, a start-up customer may be considered a high risk, while an established, long-tenured customer may be a low risk.
The allowance for doubtful accounts is an estimate of the portion of accounts receivable that your business does not expect to collect during a given accounting period. In the example above, we estimated an arbitrary number for the allowance for doubtful accounts. There are two primary methods for estimating the amount of accounts receivable that are not expected to be converted into cash. The various methods can be classified as either being an income statement approach or a balance sheet approach. With an income statement approach the bad debt expense is calculated, and the allowance account is the balancing figure.
Let’s say that ABC Company sells $100,000 of goods on credit during the month of January. ABC uses the percentage of sales method to estimate uncollectible accounts and has historically had bad debts of 2% of credit sales. One way to record the affects of uncollectible accounts is the direct charge-off method.
Accounts receivable aging method
Accounts receivable decreases because
there is an assumption that no debt will be collected on the
identified customer’s account. The understanding is that the couple
will make payments each month toward the principal borrowed, plus
interest. Units should consider using an allowance for doubtful accounts when they are regularly providing goods or services “on credit” and have experience with the collectability of those accounts. The following entry should be done in accordance with your revenue and reporting cycles (recording the expense in the same reporting period as the revenue is earned), but at a minimum, annually. Assume further that the company’s past history and other relevant information indicate to officials that approximately 7 percent of all credit sales will prove to be uncollectible. An expense of $7,000 (7 percent of $100,000) is anticipated because only $93,000 in cash is expected from these receivables rather than the full $100,000.
An aging schedule classifies accounts receivable according to how long they have been outstanding and uses a different uncollectibility percentage rate for each age category. In Exhibit 1, the aging schedule shows that the older the receivable, the less likely the company is to collect it. The Allowance for Doubtful Accounts account can have either a debit or credit balance before the year-end adjustment. It’s eventually determined that Fancy Foot Store had creditors in line that received all assets as priority lenders, therefore, Barry and Sons Boot Makers will not be receiving the $1 million. The entire amount is written off as bad debt expense on the income statement and the allowance for doubtful accounts is also reduced by $1 million. If a customer has not paid after three months, the amount may be assigned under «aged» receivables, and if more time passes, the vendor could classify it as a «doubtful» account.
This basic portrait provides decision makers with fairly presented information about the accounts receivables held by the reporting company. By establishing two T-accounts, a company such as Dell can manage a total of $4.843 billion in accounts receivables while setting up a separate allowance balance explicit and implicit costs definition and examples of $112 million. To illustrate, let’s continue to use Billie’s Watercraft Warehouse (BWW) as the example. The allowance method is the more widely used method because it satisfies the matching principle. The allowance method estimates bad debt during a period, based on certain computational approaches.
This allows companies to account for the possibility of bad debts and maintain accurate financial statements. The desired $6,000 ending credit balance in the Allowance for Doubtful Accounts serves as a “target” in making the adjustment. On the income statement, Rankin would match the bad debt expense against sales revenues in the period. We would classify this expense as a selling expense since it is a normal consequence of selling on credit. Let’s say Barry and Sons Boot Makers sold $5 million worth of boots to many customers.
2 Account for Uncollectible Accounts Using the Balance Sheet and Income Statement Approaches
Once done, a company can compare these to the records of other companies or industry statistics. The company can use this information to attempt to bring this amount to an equal level, as compared to common industry best practices. 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.
By analyzing such benchmarks, businesses can make informed decisions about their approach to managing their accounts receivable and avoiding potential financial losses. It’s important to note that an allowance for doubtful accounts is simply an informed guess, and your customers’ payment behaviors may not align. For example, our jewelry store assumes 25% of invoices that are 90 days past due are considered uncollectible. Say it has $10,000 in unpaid invoices that are 90 days past due—its allowance for doubtful accounts for those invoices would be $2,500, or $10,000 x 25%. Let’s explore the importance of allowance for doubtful accounts, the methods of estimating it, and how to record it. Fancy Foot Store declares bankruptcy and it is uncertain if they will be able to pay the $1 million.
While assets have natural debit balances and increase with a debit, contra assets have natural credit balance and increase with a credit. Then, the company establishes the allowance by crediting an allowance account often called ‘Allowance for Doubtful Accounts’. Though this allowance for doubtful accounts is presented on the balance sheet with other assets, it is a contra asset that reduces the balance of total assets. The allowance account is subtracted from the accounts receivable account on the balance sheet.
Monitoring and Managing Accounts Receivable
In the case of the allowance for doubtful accounts, it is a contra account that is used to reduce the Controlling account, Accounts Receivable. The final point relates to companies with very little exposure to the possibility of bad debts, typically, entities that rarely offer credit to its customers. Assuming that credit is not a significant component of its sales, these sellers can also use the direct write-off method.