The allowance for doubtful accounts is an example of a “contra account,” one that always appears with another account but as a direct reduction to lower the reported value. Here, the allowance serves to decrease the receivable balance to its estimated net realizable value. As a contra asset account, debit and credit rules are applied that are the opposite of the normal asset rules. Thus, the allowance increases with a credit (creating a decrease in the net receivable balance) and decreases with a debit. The more accounts receivable a company expects to be bad, the larger the allowance.
- Bad Debt Expense increases (debit) as does Allowance for
Doubtful Accounts (credit) for $58,097.
- This method is simple and consistent, but it does not reflect the actual collectibility of the accounts receivable.
- Credit sales all come with some degree of risk that the customer might not hold up their end of the transaction (i.e. when cash payments left unmet).
- When an account is determined to be uncollectible, the company needs to write it off.
Therefore, the direct write-off method is not used for publicly traded company reporting; the allowance method is used instead. The first entry reverses the bad debt write-off by increasing Accounts Receivable (debit) and decreasing Bad Debt Expense (credit) for the amount recovered. The second entry records the payment in full with Cash increasing (debit) and Accounts Receivable decreasing (credit) for the amount received of $15,000. Next, we’ll look at a more sophisticated way to calculate the net realizable value of accounts receivable and the allowance for doubtful accounts, but first check your understanding of the percentage of receivables method.
2 Account for Uncollectible Accounts Using the Balance Sheet and Income Statement Approaches
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. The estimation is
typically based on credit sales only, not total sales (which
include cash sales). In this example, assume that any credit card
sales that are uncollectible are the responsibility of the credit
card company. 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. The estimation is typically based on credit sales only, not total sales (which include cash sales). In this example, assume that any credit card sales that are uncollectible are the responsibility of the credit card company.
Thus, a company is required to realize this risk through the establishment of the allowance for doubtful accounts and offsetting bad debt expense. In accordance with the matching principle of accounting, this ensures that expenses related to the sale are recorded in the same accounting period as the revenue is earned. The allowance for doubtful accounts also helps companies more accurately estimate the actual value of their account receivables. If you work in corporate accounting for a telecom company, you know that not all customers pay their bills on time or at all.
What is allowance for doubtful accounts?
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. The customer has $5,000 in unpaid invoices, so its allowance for doubtful accounts is $500, or $5,000 x 10%. If you use the accrual basis of accounting, you will record doubtful accounts in the same accounting period as the original credit sale.
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.
For this example, let’s say a company predicts it will incur $500,000 of uncollected accounts receivable. Two primary methods exist for estimating the dollar amount of accounts receivables not expected to be collected. The net effect of this transaction is to reduce the accounts receivable balance and the allowance for doubtful accounts by $1,000. The net effect of this transaction is to reduce the accounts receivable balance and the allowance for doubtful accounts by $500.
Module 6: Receivables and Revenue
Barry and Sons Boot Makers would record revenues of $5 million and accounts receivable of $5 million. Finding the proper amount for the allowance for doubtful accounts is not an instant process. To create a standard allowance, have those financial records that indicate how many accounts have not been collected. Then create an average amount of money lost over the number of years measured.
Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts. Recovering an account may involve working with the debtor directly, working with a collection agency, or pursuing legal action. In practice, adjusting can happen semiannually, quarterly, or even monthly—depending on the size and complexity of the organization’s receivables. As a general rule, the longer a bill goes uncollected past its due date, the less likely it is to be paid. Double Entry Bookkeeping is here to provide you with free online information to help you learn and understand bookkeeping and introductory accounting.
Understanding Accounts Uncollectible
looks at the balance of accounts receivable at the end of the
period and assumes that a certain amount will not be collected. Accounts receivable is reported on the balance sheet; thus, it is
called the balance sheet method. The balance sheet method is
another simple method for calculating bad debt, but it too does not
consider how long a debt has been outstanding and the role that
plays in debt recovery. Continuing our examination of the balance sheet method, assume that BWW’s end-of-year accounts receivable balance totaled $324,850. This entry assumes a zero balance in Allowance for Doubtful Accounts from the prior period. BWW estimates 15% of its overall accounts receivable will result in bad debt.
By estimating the expected uncollectible debts and creating an allowance for them, you can minimize the risk of significant losses arising from bad debts and ensure accurate financial statements. When a business makes credit sales, there’s a chance that some of its customers won’t pay their bills—resulting in uncollectible debts. To account for this possibility, businesses create an allowance for doubtful accounts, which serves as a reserve to cover potential losses. Contra assets are still recorded along with other assets, though their natural balance is opposite of assets.
It is important to estimate the allowance accurately to ensure that the financial statements reflect the true financial position of the company. Once the company has identified accounts that are likely to be uncollectible, it needs to estimate the amount of uncollectible accounts. Accounting for uncollectible accounts involves estimating the amount of uncollectible accounts and creating an allowance for doubtful accounts. The sum of the estimated amounts for all categories yields the total estimated amount uncollectible and is the desired credit balance (the target) in the Allowance for Uncollectible Accounts.
However, the actual payment behavior of customers may differ substantially from the estimate. For bookkeeping, it will write off the amount with journal entries as a debit to allowance for doubtful accounts and credit to accounts receivable. When it is confirmed that the company will not receive payment, this will be reflected in the income statement with the amount not collected revenue and cash budgets as bad debt expense. This is different from the last journal entry, where bad debt
was estimated at $58,097. That journal entry assumed a zero balance
in Allowance for Doubtful Accounts from the prior period. This
journal entry takes into account a debit balance of $20,000 and
adds the prior period’s balance to the estimated balance of $58,097
in the current period.