Sales and the ultimate decision that specific accounts receivable will never be collected can happen months apart. During the interim, bad debts are estimated and recorded on the income statement as an expense and on the balance sheet through an allowance account, a contra asset. In that way, the receivable balance is shown at net realizable value https://personal-accounting.org/ while expenses are recognized in the same period as the sale to correspond with the matching principle. When financial statements are prepared, an estimation of the uncollectible amounts is made and an adjusting entry recorded. Thus, the expense, the allowance account, and the accounts receivable are all presented properly according to U.S.

1. Ideally, you’d want 100% of your invoices paid, but unfortunately, it doesn’t always work out that way.
2. If, like most businesses, you use the accrual method, the process is a little more complicated.
3. 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.
4. When a specific customer has been identified as an uncollectible
   account, the following journal entry would occur.

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.

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

If an institution finds itself in a position where fund balance is not sufficient to cover budget basis uncollectible amounts, a funding plan must be devised to address the reserve inequity on the Budget Basis. The institution’s original budget submission must contain an amount set aside for this purpose. Institutions should budget this activity within a unique department created to clearly identify the planned contributions towards reducing the reserve inequity.

Matching Principle: Bad Debt and Revenue

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. 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 allowance for uncollectible accounts 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 journal entry for the Bad Debt Expense increases (debit) the expense’s balance, and the Allowance for Doubtful Accounts increases (credit) the balance in the Allowance.

Further details of the use of this allowance method can be found in our aged accounts receivable tutorial. Many countries have very liberal laws that make it difficult to enforce collection on customers who decide not to pay or use “legal maneuvers” to escape their obligations. As a result, businesses must be very careful in selecting parties that are allowed trade credit in the normal course of business. 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.

Allowance for Uncollectible Accounts

With an income statement approach the bad debt expense is calculated, and the allowance account is the balancing figure. With a balance sheet approach the ending balance on the allowance account is calculated, and the bad debt expense is the balancing figure. The second method of estimating the allowance for doubtful accounts is the aging method.

Fundamentals of Bad Debt Expenses and Allowances for Doubtful

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. In this context, the contra asset would be deducted from your accounts receivable assets and considered a write-off.

Therefore, the direct
write-off method is not used for publicly traded company reporting;
the allowance method is used instead. Later, a customer who purchased goods totaling $10,000 on June 25 informed the company on August 3 that it already filed for bankruptcy and would not be able to pay the amount owed. The company would then write off the customer’s account balance of $10,000. As you’ve learned, the delayed recognition of bad debt violates GAAP, specifically the matching principle. Therefore, the direct write-off method is not used for publicly traded company reporting; the allowance method is used instead. The bad debt expense is then the difference between the calculated allowance for doubtful accounts at the end of the account period and the current allowance for doubtful accounts before adjustment.

The balance sheet aging of receivables method is more complicated than the other two methods, but it tends to produce more accurate results. 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).

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.

With this method, accounts receivable is organized into categories by length of time outstanding, and an uncollectible percentage is assigned to each category. 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.

Thus, it cannot be used to record the write-offs of uncollectible accounts in financial statements prepared for the public in accordance with FASB and GAAP regulations. In the direct charge-off method, once the company determines that a certain amount due to the company will not be collected at all, the company writes it off in that fiscal period. In other words, the company writes off the bad debt expense once it realizes the bill will not be paid. The amount of bad debt is then subtracted from accounts receivable and added to bad debt expense or uncollectible accounts expense. The allowance method follows GAAP matching principle since we estimate uncollectible accounts at the end of the year.

Write off an account

The allowance method estimates the “bad debt” expense near the end of a period and relies on adjusting entries to write off certain customer accounts determined as uncollectable. To illustrate, let’s continue to use Billie’s Watercraft
Warehouse (BWW) as the example. BWW estimates that 5% of its overall credit sales
will result in bad debt. According to the revenue realization principle found within accrual accounting, the company should immediately recognize the $100,000 revenue generated by these transactions2. Using the example above, let’s say that a company reports an accounts receivable debit balance of $1,000,000 on June 30.

The allowance method is the more widely used method because it
satisfies the matching principle. The allowance
methodestimates 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.