When a doubtful account becomes uncollectible, it is a debit balance in the allowance for doubtful accounts. By analyzing such benchmarks, businesses can make informed decisions about their approach to managing their accounts receivable and avoiding potential financial losses. Adjusting the allowance for doubtful accounts is important in maintaining accurate financial statements and assessing financial risk. Companies create an allowance for doubtful accounts to recognize the possibility of uncollectible debts and to comply with the matching principle of accounting. After figuring out which method you’ll use, you can create the account in the chart of accounts. As a result, the estimated allowance for doubtful accounts for the high-risk group is $25,000 ($500,000 x 5%), while it’s $15,000 ($1,500,000 x 1%) for the low-risk group.
The accounts receivable method is considerably more sophisticated and takes advantage of the aging of receivables to provide better estimates of the allowance for bad debts. The basic idea is that the longer a debt goes unpaid, the more likely it is that the debt will never pay. In this case, perhaps only 1% of martin frauenlob initial sales would be added to the allowance for bad debt. Continuing our examination of the balance sheet method, assume that BWW’s end-of-year accounts receivable balance totaled $324,850.
Bad Debt Expense increases (debit), and Allowance for Doubtful Accounts increases (credit) for $22,911.50 ($458,230 × 5%). Let’s say that on April 8, it was determined that Customer Robert Craft’s account was uncollectible in the amount of $5,000. There is one more point about the use of the contra account, Allowance for Doubtful Accounts. In this example, the $85,200 total is the net realizable value, or the amount of accounts anticipated to be collected. However, the company is owed $90,000 and will still try to collect the entire $90,000 and not just the $85,200.
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. The balance sheet aging of receivables method is more complicated than the other two methods, but it tends to produce more accurate results. 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.
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. The bad debt expense required is recorded with the following aging of accounts receivable method journal entry.
Because it is an estimation, it means the exact account that is (or will become) uncollectible is not yet known. In March, ABC determines that another customer who owes $1,000 is unlikely integrated 3-statement build to pay. ABC writes off the account by debiting the allowance for doubtful accounts account and crediting the accounts receivable account for $1,000.
Percentage of Credit Sales Method
The allowance method is the more widely used method because it satisfies the matching principle. The allowance method estimates 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. When a business makes credit sales, there’s a chance that some of its customers won’t pay their bills—resulting in uncollectible debts.
Are Allowance for Doubtful Accounts a Current Asset?
The companies that qualify for this exemption, however, are typically small and not major participants in the credit market. Thus, virtually all of the remaining bad debt expense material discussed here will be based on an allowance method that uses accrual accounting, the matching principle, and the revenue recognition rules under GAAP. The percentage of sales method assigns a flat rate to each accounting period’s total sales.
In accrual-basis accounting, recording the allowance for doubtful accounts at the same time as the sale improves the accuracy of financial reports. The projected bad debt expense is properly matched against the related sale, thereby providing a more accurate view of revenue and expenses for a specific period of time. In addition, this accounting process prevents the large swings in operating results when uncollectible accounts are written off directly as bad debt expenses. 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.
Accounting Ratios
- Accounts use this method of estimating the allowance to adhere to the matching principle.
- The accounts receivable aging method uses accounts receivable aging reports to keep track of past due invoices.
- Assume a company has 100 clients and believes there are 11 accounts that may go uncollected.
- You record the allowance for doubtful accounts by debiting the Bad Debt Expense account and crediting the Allowance for Doubtful Accounts account.
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. Further details of the use of this allowance method can be found in our aged accounts receivable tutorial.
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 you believe he will pay all of it back, you may want to go ahead and make the accounting entries as if he had paid the amount in full. If you do not believe he will pay it all back, you should make entries to reflect only that he has paid you $25. In order to use the allowance method, it is first necessary to estimate the allowance needed using a suitable method.
Let’s say that ABC Company sells $100,000 of goods on credit during the month of January. ABC uses the percentage of sales method to estimate uncollectible accounts and has historically had bad debts of 2% of credit sales. 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. The allowance for doubtful accounts is a contra asset account and is subtracted from Accounts Receivable to determine the Net Realizable Value of the Accounts Receivable account on the balance sheet. In the case of the allowance for doubtful accounts, it is a contra account that is used to reduce the Controlling account, Accounts Receivable. For example, when companies account for bad debt expenses in their financial statements, they will use an accrual-based method; however, they are required to use the direct write-off method on their income tax returns.
This entry decreases net income by $2,000 and creates a contra asset account for the allowance for doubtful accounts, which is used to reduce the accounts receivable balance. The bad debt expense account is used to record the estimated uncollectible accounts for the period. The balance sheet aging of receivables method estimates bad debt expenses based on the balance in accounts receivable, but it also considers the uncollectible time period for each account.
You’ll notice the allowance account has a natural credit balance and will increase when credited. The company now has a better idea of which account receivables will be collected and which will be lost. For example, say the company now thinks that a total of $600,000 of receivables will be lost. The company must record an additional expense for this amount to also increase the allowance’s credit balance.
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