You currently use the income statement method to estimate bad debt at 4.5% of credit sales. You are considering switching to the balance sheet aging of receivables method. This would split accounts receivable into three past- due categories and assign a percentage to each group. The allowance for uncollectible accounts is an estimated amount of receivables a business does not expect to collect.
Historical Percentage Method
A contra account has an opposite normal balance to its paired account, thus reducing or increasing the balance in the paired account at the end of a period; the adjustment can be an addition or a subtraction from a controlling account. In the case of the Allowance for bad debts, it is a contra account that is used to reduce the Controlling account, Accounts Receivable. At the end of an accounting period, the Allowance for bad debts reduces the Accounts Receivable to produce Net Accounts Receivable. Note that allowance for bad debts reduces the overall accounts receivable account, not a specific accounts receivable assigned to a customer.
At the end of February, ABC reviews the allowance for doubtful accounts and determines that the estimate of uncollectible accounts was accurate. This involves reviewing the accounts receivable balance and assessing the likelihood of customers not paying their bills. 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).
What is the difference between the Direct Write-Off Method and the Allowance Method?
The methodlooks at the balance of accounts receivable at the end of theperiod and assumes that a certain amount will not be collected.Accounts receivable is reported on the balance sheet; thus, it iscalled the balance sheet method. The balance sheet method isanother simple method for calculating bad debt, but it too does notconsider how long a debt has been outstanding and the role thatplays in debt recovery. The balance sheet aging of receivables methodestimates bad debt expenses based on the balance in accountsreceivable, but it also considers the uncollectible time period foreach account. The longer the time passes with a receivable unpaid,the lower the probability that it will get collected. An accountthat is 90 days overdue is more likely to be unpaid than an accountthat is 30 days past due. As the accountant for a large publicly traded food company, youare considering whether or not you need to change your bad debtestimation method.
2: Account for Uncollectible Accounts Using the Balance Sheet and Income Statement Approaches
Accounts receivable decreases because there is an assumption that no debt will be collected on the identified customer’s account. To demonstrate the treatment of the allowance for doubtful accounts on the balance sheet, assume that a company has reported an Accounts Receivable balance of $90,000 and a Balance in the Allowance of Doubtful Accounts of $4,800. The following table reflects how the relationship would be reflected in the current (short-term) section of the company’s Balance Sheet. Finding the proper amount for the allowance for doubtful accounts is not an instant process.
Cash Flow Statement
For example, a customer takes out a $15,000 car loan on August 1, 2018 and is expected to pay the amount in full before December 1, 2018. For the sake of this example, assume that there was no interest charged to the buyer because of the short-term nature or life of the loan. When the account defaults for nonpayment on December 1, the company would record the following journal entry to recognize bad debt.
- It is calculated by multiplying the total accounts receivable by the percentage of uncollectible accounts, based on historical data and industry trends.
- Under this method, the uncollectible accounts expense is recognized on the basis of estimates.
- So for an allowance for doubtful accounts journal entry, credit entries increase the amount in this account and debits decrease the amount in this account.
Understanding how businesses account for potential failures to pay makes how a firm manages risk far clearer. You may notice that all three approaches use the same accounts for the adjusting entry; only the approach changes the financial outcome. Also note that it is a requirement that the estimation approach be disclosed in the notes of financial statements so stakeholders can make informed decisions. On 30th August, Kenco Ltd determines that it will be unable to collect from Bennards.
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. Then companies must apply a certain percentage of accounts receivable to the uncollectible accounts account using the percentage rate determined by analyzing the historical data. It may be obvious intuitively, but, by definition, a cash sale cannot become a bad debt, assuming that the cash payment did not entail counterfeit currency.
Direct write off method (Non-GAAP) – a receivable that is not considered collectible is charged directly to the income statement. We’ll do one month of your bookkeeping and prepare a set of financial statements for you to keep. Bench gives you a dedicated bookkeeper supported by a team of knowledgeable small business experts.The unpaid accounts receivable is zeroed out at the end of the year by drawing down the amount in the allowance account. When it’s clear that a customer invoice will remain unpaid, the invoice amount is charged directly to bad debt expense and removed from the account accounts receivable. The bad debt expense account is debited, and the accounts receivable account is credited.
Accounting Business and Society
- By understanding the reasons behind them and using the appropriate accounting methods, businesses can minimize their impact and ensure that their financial statements accurately reflect their financial position.
- This approach looks at the balance of accounts receivable at the end of the period and assumes that a certain amount will not be collected.
- After reviewing the customers’ balances the company estimates that $10,000 of the $1,000,000 will not be collected.
- This method also does not provide the best estimate of how accounts receivable affect expected cash inflow for the business.
Once this account is identified as uncollectible, the business will record a reduction to the customer’s accounts receivable and an increase to bad debt expense for the exact amount uncollectible. The journal entry for the Bad Debt Expense increases (debit) theexpense’s balance, and the Allowance for Doubtful Accountsincreases (credit) the balance in the Allowance. Theallowance for allowance for uncollectible accounts on balance sheet doubtful accounts is a contra assetaccount and is subtracted from Accounts Receivable to determine theNet Realizable Value of the Accounts Receivableaccount on the balance sheet. A contra account hasan opposite normal balance to its paired account, thereby reducingor increasing the balance in the paired account at the end of aperiod; the adjustment can be an addition or a subtraction from acontrolling account. In the case of the allowance for doubtfulaccounts, it is a contra account that is used to reduce theControlling account, Accounts Receivable.
Once the estimated amount for the allowance account is determined, a journal entry will be needed to bring the ledger into agreement. Assume that Ito’s ledger revealed an Allowance for Uncollectible Accounts credit balance of $10,000 (prior to performing the above analysis). Using this allowance method, the estimated balance required for the allowance for doubtful accounts at the end of the accounting period is 7,100. 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.