Allowance Method for Uncollectible Accounts

If the total net sales for the period is $100,000, the company establishes an allowance for doubtful accounts for $3,000 while simultaneously reporting $3,000 in bad debt expense. The alternative to the allowance method is the direct write-off method, under which bad debts are only written off when specific receivables cannot be collected. This may not occur until several months after a sale transaction was completed, so the entire profitability of a sale may not be apparent for some time.

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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. Assume a company has 100 clients and believes there are 11 accounts that may go uncollected. Instead of applying percentages or weights, it may simply aggregate the account balance for all 11 customers and use that figure as the allowance amount. Companies often have a specific method of identifying the companies that it wants to include and the companies it wants to exclude.

Accounting Ratios

The bad debt expense required is recorded with the following aging of accounts receivable method journal entry. The Bad Debts Expense remains at $10,000; it is not directly affected by the journal entry write-off. The bad debts expense recorded on June 30 and July 31 had anticipated a credit loss such as this. It would be double counting for Gem to record both an anticipated estimate of a credit loss and the actual credit loss.

Financial Accounting

Under the direct write-off method, a bad debt is charged to expense as soon as it is apparent that an invoice will not be paid. This is the simplest way to recognize a bad debt, since the entry is only made when a specific customer invoice has been identified as a bad debt. 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. Let’s look at what is reported on Coca-Cola’s Form 10-K regarding its accounts receivable. You may notice that all three methods use the same accounts for the adjusting entry; only the method changes the financial outcome.

Then all of the category estimates are added together to get one total estimated uncollectible balance for the period. The entry for bad debt would be as follows, if there was no carryover balance from the prior period. To illustrate, let’s continue to use Billie’s Watercraft Warehouse (BWW) as the example.

The main advantage of the allowance method is that it recognizes all expenses related to a revenue-generating event in a single reporting period. This allows the readers of a company’s financial statements to gain a true picture of its profitability, rather than having to discern it from the results issued over several reporting periods. Using this allowance method, the estimated balance required for the allowance for doubtful accounts at the end of the accounting period is 7,100.

Because customers do not always keep their promises to pay, companies must provide for these uncollectible accounts in their records. 10 step accounting cycle The direct write-off method recognizes bad accounts as an expense at the point when judged to be uncollectible and is the required method for federal income tax purposes. The allowance method provides in advance for uncollectible accounts think of as setting aside money in a reserve account.

The company must be aware of outliers or special circumstances that may have unfairly impacted that 2.4% calculation. Bad Debt Expense increases (debit), and Allowance for Doubtful Accounts increases (credit) for $48,727.50 ($324,850 accept payments online × 15%). At the end of an accounting period, the Allowance for Doubtful Accounts reduces the Accounts Receivable to produce Net Accounts Receivable. Note that allowance for doubtful accounts reduces the overall accounts receivable account, not a specific accounts receivable assigned to a customer.

1. An allowance for doubtful accounts is a contra account that nets against the total receivables presented on the balance sheet to reflect only the amounts expected to be paid.
2. Note that if a company believes it may recover a portion of a balance, it can write off a portion of the account.
3. The matching principle states that revenue and expenses must be recorded in the same period in which they occur.
4. As of January 1, 2018, GAAP requires a change in how health-care entities record bad debt expense.

Fundamentals of Bad Debt Expenses and Allowances for Doubtful Accounts

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For example, a start-up customer may be considered a high risk, while an established, long-tenured customer may be a low risk. In this example, the company often assigns a percentage to each classification of debt. Then, it aggregates all receivables in each grouping, calculates each group by the percentage, and records an allowance equal to the aggregate of all products.

Therefore, the allowance is created mainly so the expense can be recorded in the same period revenue is earned. 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. 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.

You’ll notice the allowance account has a natural credit balance and will increase when credited. If it does not issue credit sales, requires collateral, or only uses the highest credit customers, the company may not need to estimate uncollectability. The allowance method is favored by Generally Accepted Accounting Principles (GAAP) due to its adherence to the matching principle and its ability to provide a more accurate representation of a company’s financial position. This method enhances transparency, allowing for better financial planning, informed decision-making, and reliable financial reporting, meeting the standards of accuracy and consistency upheld by GAAP. Let’s consider a situation where BWW had a $20,000 debit balance from the previous period.