Allowance for Doubtful Accounts: Methods of Accounting for

It also states that the liquidation value of those assets is less than the amount it owes the bank, and as a result Gem will receive nothing toward its $1,400 accounts receivable. After confirming this information, Gem concludes that it should remove, or write off, the customer’s account balance of $1,400. When management knows that a specific account is budgetary planning true and false uncollectable, it writes off the balance by debiting the allowance account and crediting the accounts receivable account.

Accounts Receivable and Bad Debts Expense Outline

For example, a category might consist of accounts receivable that is 0–30 days past due and is assigned an uncollectible percentage of 6%. Another category might be 31–60 days past due and is assigned an uncollectible percentage of 15%. All categories of estimated uncollectible amounts are summed to get a total estimated uncollectible balance. That total is reported in Bad Debt Expense and Allowance for Doubtful Accounts, if there is no carryover balance from a prior period. If there is a carryover balance, that must be considered before recording Bad Debt Expense.

Cash Flow Statement

The seller’s accounting records now show that the account receivable was paid, making it more likely that the seller might do future business with this customer. Management may disclose its method of estimating the allowance for doubtful accounts in its notes to the financial statements. It reduces the accounts receivable by $2,000 and also reduces the reserve in the allowance for doubtful accounts. This entry establishes a $25,000 reserve for anticipated losses from uncollectible accounts. Further, allowance for doubtful accounts is debited when the debtor balance is identified as written off.

Percentage of Credit Sales Method

1. However, the actual payment behavior of customers may differ substantially from the estimate.
2. The direct write-off method delays recognition of bad debt until the specific customer accounts receivable is identified.
3. Bad Debt Expense increases (debit) as does Allowance for Doubtful Accounts (credit) for $58,097.
4. Before this change, these entities would record revenues for billed services, even if they did not expect to collect any payment from the patient.

Therefore, generally accepted accounting principles (GAAP) dictate that the allowance must be established in the same accounting period as the sale, but can be based on an propeller accounting anticipated or estimated figure. The allowance can accumulate across accounting periods and may be adjusted based on the balance in the account. And the estimates being made by these organizations are based on the number of sales being made for the reporting year. If the corporation prepares weekly financial statements, it might focus on the bad debts expense for its weekly financial statements, but at the end of each quarter focus on the allowance account.

The Allowance Method in accounting sets aside funds to cover anticipated bad debts from credit sales. It calculates a reserve based on past sales and customer risk assessment, ensuring a realistic reflection of expected uncollectible amounts in financial statements. 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. When the estimation is recorded at the end of a period, the following entry occurs. 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.

First, the allowance method agrees with the matching principle by recording an estimated bad debt expense in the period in which the related sale takes place. Second, it reports accounts receivable on the balance sheet at its realizable value. This means that investors and creditors will be able to see how much cash management is expecting to collect from its current customers on account. The percentage of receivables method estimates the allowance for doubtful accounts using a percentage of the accounts receivable at the end of the accounting period.

The balance sheet aging of receivables method is more complicated than the other two methods, but it tends to produce more accurate results. The allowance method works by using the allowance for doubtful accounts account to estimate the amount of receivables that are going to be uncollected in the future. Instead of directly writing off the customer balances in the account receivable account, bad debt expense is recorded by crediting the allowance account.

This hypothetical example illustrates how ABC Inc. effectively uses the allowance method to manage potential bad debts. By initially creating a reserve and then adjusting it for specific bad debts and recoveries, ABC Inc. ensures a more accurate reflection of its financial position. 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. If should be noted that the effect of these two entries to write off bad debt is to reduce an asset account and a contra asset account by equal amounts. As a result of this, the value of the net accounts receivable in the balance sheet does not change.

Additionally, the allowance method fosters transparency and credibility in financial reporting, as it enables companies to proactively address potential bad debts, ensuring more accurate and reliable financial statements. Ultimately, this approach enhances the overall reliability and usefulness of financial information, contributing to the stability and trustworthiness of a company in the eyes of investors, creditors, and other stakeholders. If the following accounting period results in net sales of $80,000, an additional $2,400 is reported in the allowance for doubtful accounts, and $2,400 is recorded in the second period in bad debt expense. The aggregate balance in the allowance for doubtful accounts after these two periods is $5,400.

This approach automatically expenses a percentage of its credit sales based on past history. The percentage of credit sales method directly estimates the bad debt expense and records this as an expense in the income statement. Suppose ABC Inc., a retail sector company, records total credit sales of $500,000 for a specific reporting period. To account for potential bad debts, they decide to set aside a reserve at 5% of their credit sales based on past trends and customer risk assessments.

Time Value of Money

Sometimes, the direct write-off for the account balance does not seem logical as the business may be unable to locate which debtor should be written off. Let’s assume that a corporation begins operations on November 1 in an industry where it is common to give credit terms of net 30 days. Bad Debt 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. It’s important to note that both methods aim to eliminate uncollectible debtors and present a true and fair view of the business. Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping.

He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University. Let us look at the examples of the allowance method to understand the concept better. Compared to the direct write-off method, the allowance method is preferred because of its usefulness and applicability.

Sales revenues of $500,000 are immediately matched with $1,500 of bad debts expense. The balance in the account Allowance for Doubtful Accounts is ignored at the time of the weekly entries. However, at some later date, the balance in the allowance account must be reviewed and perhaps further adjusted, so that the balance sheet will report the correct net realizable value. If the seller is a new company, it might calculate its bad debts expense by using an industry average until it develops its own experience rate. The allowance method has two distinct advantages over the direct write-off method for estimating bad debt expense.

For example, a company may assign a heavier weight to the clients that make up a larger balance of accounts receivable due to conservatism. 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. Two primary methods exist for estimating the dollar amount of accounts receivables not expected to be collected.