By estimating potential losses before they occur, companies present a more honest picture of their financial health while properly matching expenses to the periods when they earn revenue. Though, it may be useful to note that, under the allowance method, we need to estimate the bad debt expense for the period that could happen as a result of the credit sale. The estimation of the bad debt expense can done through the percentage of sales or the percentage of receivables. In accordance with GAAP revenue recognition policies, the company must still record credit sales (i.e. not cash) as revenue on the income statement and accounts receivable on the balance sheet.
Because it does not conform to GAAP, larger companies and those companies with many receivables accounts cannot use this method. It is a matter of judgment, relating only to the conclusion that the choice among alternatives really has very little bearing on the reported outcomes. Assessing the effectiveness of past estimates provides a potential basis for confidence in future estimates. The techniques illustrated in this article are designed to help with and clarify assessment of an entity’s past success in estimating its allowance for doubtful accounts. While economic circumstances vary, historical trends provide useful information about the process used to form estimates.
This approach applies a single percentage to the total outstanding accounts receivable balance. This method is simpler than the aging method but may be less precise as it does not differentiate based on the age of the receivables. ABC creates an allowance for doubtful accounts by debiting the allowance for doubtful accounts account and crediting the bad debt expense account for $2,000. The journal entry for allowance for doubtful accounts involves debiting the bad debt expense account and crediting the allowance for doubtful accounts account. 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.
- This ensures assets are not overstated and provides a realistic view of the company’s liquid assets.
- For instance, a construction materials supplier might assess the collectibility of receivables from its 20 largest customers (representing 75% of outstanding balances) while applying a standard percentage to smaller accounts.
- It is a contra-asset account used in accounting to estimate and record the portion of accounts receivable that is expected to be uncollectible.
This entry reduces the accounts receivable balance by $1,000 and reduces the allowance for doubtful accounts balance by $1,000. By making this journal entry, companies can ensure that the allowance for doubtful accounts is properly recorded and maintained. Once the amount of uncollectible accounts has been estimated, the company needs to create an allowance for doubtful accounts. Accounting for uncollectible accounts involves estimating the amount of uncollectible accounts and creating an allowance for doubtful accounts. It is customary to gather this information by getting a credit application from a customer, checking out credit references, obtaining reports from credit reporting agencies, and similar measures. Oftentimes, it becomes necessary to secure payment in advance or receive some other substantial guaranty such as a letter of credit from an independent bank.
Applying Estimation Methods
- The allowance for doubtful accounts is then used to approximate the percentage of “uncollectible” accounts receivable (A/R).
- 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.
- This historical experience helps establish a reliable percentage to apply to current financial figures, serving as a starting point for the estimation process.
This can be done using different methods, such as the percentage of sales method or the aging of accounts receivable method. The Allowance Method for Doubtful or Uncollectible Accounts is used to estimate future bad debts based on current month revenues. Using past performance data, a company can estimate that a certain allowance for uncollectible accounts percentage of current sales can reasonably expect to become bad debts. To conform to the Matching Principle, the company records that potential bad debt in the same month that the related revenue is recorded. Dell’s increased write-off activity in the past few years is likely evidence that the higher expenses are warranted.
Why is the Direct Write-off Method Unacceptable Under GAAP?
Based on this review, ABC increases the allowance for doubtful accounts by $500 by debiting the allowance for doubtful accounts account and crediting the bad debt expense account. The aging of accounts receivable method involves categorizing accounts receivable by the length of time they have been outstanding and estimating the percentage of each category that will not be collected. For example, if a company has historically had bad debts of 3% of credit sales, it may estimate that 3% of current credit sales will also be uncollectible. 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.
Disadvantages of Allowance for Uncollectible Accounts:
Businesses often analyze previous percentages of credit sales that have ultimately become uncollectible or historical rates of outstanding receivables that were written off as bad debt. This historical experience helps establish a reliable percentage to apply to current financial figures, serving as a starting point for the estimation process. This journal entry for uncollectible accounts will increase the total expenses on the income statement by $3,000 as the result of $3,000 bad debt expense estimation for the period. At the same time, it will decrease the total assets on the balance sheet by the same amount of $3,000 as of December 31. The balance sheet method (also known as the percentage of accounts receivable method) estimates bad debt expenses based on the balance in accounts receivable.
What is the Journal Entry if the Balance in Allowance for Doubtful Accounts is a Credit?
In accounting, an item is deemed material if it is large enough to affect the judgment of an informed financial statement user. Accounting expediency sometimes permits “incorrect approaches” when the effect is not material. For example, on December 31 which is our period-end adjusting entry, we estimate that 3% of the credit sales we made during the year will be uncollectible. This estimation is based on our past experiences and it is in line with the industry average data that is publicly available.
Direct write off method
In addition, this accounting process prevents the large swings in operating results when uncollectible accounts are written off directly as bad debt expenses. Hence, the journal entry for uncollectible accounts will increase the total expenses on the income statement while decreasing the total assets on the balance sheet. When businesses sell goods or services, they often extend credit to customers, allowing them to pay later.
How to Find Allowance for Uncollectible Accounts
The net effect is a reduction in total assets and a reduction in the allowance for doubtful accounts. But, when compared to industry trends and prior years, they will reveal important signals about how well receivables are being managed. In addition, the calculations may provide an “early warning” sign of potential problems in receivables management and rising bad debt risks. If this does not eventually prove to be true, an adjustment of the overall estimation rates may be indicated. There is one more point about the use of the contra account, Allowance for Doubtful Accounts.
Allowance Method: Journal Entries (Debit and Credit)
On the income statement, the Bad Debt Expense is reported as an operating expense, reducing the company’s net income. The estimated uncollectible amount for each category is calculated by multiplying its total receivables by its assigned uncollectibility percentage. Summing these amounts across all categories yields the total estimated Allowance for Uncollectible Accounts.