Allowance for Uncollectible Accounts Explained

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 remaining amount from the bad debt expense account (the portion of the $10,000 that is never paid) will show up on a company’s income statement. That percentage can now be applied to the current accounting period’s total sales, to get a allowance for doubtful accounts figure. You record the allowance for doubtful accounts by debiting the Bad Debt Expense account and crediting the Allowance for Doubtful Accounts account. You’ll notice the allowance account has a natural credit balance and will increase when credited.

• Doubtful accounts represent the amount of money deemed to be uncollectible by a vendor.
• There is the obvious cost of hiring them, represented by either a flat fee or a percentage of the amount collected.
• 1Some companies include both accounts on the balance sheet to explain the origin of the reported balance.
• The amount is reflected on a company’s balance sheet as “Allowance For Doubtful Accounts”, in the assets section, directly below the “Accounts Receivable” line item.

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.

Monitoring and Managing Accounts Receivable

For example, if accounts receivable that are days past due historically have a bad debt rate of 5%, the company may estimate that 5% of the current day past due accounts will also be uncollectible. 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. The percentage of sales method involves estimating the percentage of credit sales that will not be collected based on historical data.

2Because the focus of the discussion here is on accounts receivable and their collectability, the recognition of cost of goods sold as well as the possible return of any merchandise will be omitted. Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.

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 https://kelleysbookkeeping.com/ 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. In particular, your allowance for doubtful accounts includes past-due invoices that your business does not expect to collect before the end of the accounting period. In other words, doubtful accounts, also known as bad debts, are an estimated percentage of accounts receivable that might never hit your bank account.

Advice on Avoiding Uncollectible Receivables in the Future

Suppose a company generated $1 million of credit sales in Year 1 but projects that 5% of those sales are very likely to be uncollectible based on historical experience. In effect, the allowance for doubtful accounts leads to the A/R balance recorded on the balance sheet to reflect a value closer to reality. Many countries have very liberal laws that make it difficult to enforce collection on customers who decide not to pay or use “legal maneuvers” to escape their obligations. As a result, businesses must be very careful in selecting parties that are allowed trade credit in the normal course of business.

For example, a category might consist of accounts receivable that is 0–30 days past due and is assigned an uncollectible percentage of 6%. Another 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.

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. With this method, accounts receivable is organized into
categories by length of time outstanding, and an uncollectible
percentage https://quick-bookkeeping.net/ is assigned to each category. For example,
a category might consist of accounts receivable that is 0–30 days
past due and is assigned an uncollectible percentage of 6%. Another
category might be 31–60 days past due and is assigned an
uncollectible percentage of 15%.

Financial Management: Overview and Role and Responsibilities

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. As the accountant for a large publicly traded food company, you are https://business-accounting.net/ considering whether or not you need to change your bad debt estimation method. 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.

Accounts Previously Written Off

When a specific customer has been identified as an uncollectible account, the following journal entry would occur. The doubtful accounts will be reflected on the company’s next balance sheet, as a separate line. Risk Classification is difficult and the method can be inaccurate, because it’s hard to classify new customers. As well, customers in any risk category can change their behavior and start or stop paying their invoices. The amount is reflected on a company’s balance sheet as “Allowance For Doubtful Accounts”, in the assets section, directly below the “Accounts Receivable” line item.

Most accountants take the position that the expense is incurred in order to increase sales and, therefore, should be reported in the same time period as those sales if cause and effect are to be related. Most balance sheets report them separately by showing the gross A/R balance and then subtracting the allowance for doubtful accounts balance, resulting in the “Accounts Receivable, net” line item. The allowance for doubtful accounts is then used to approximate the percentage of “uncollectible” accounts receivable (A/R).

As of January 1, 2018, GAAP requires a change in how health-care
entities record bad debt expense. Before this change, these
entities would record revenues for billed services, even if they
did not expect to collect any payment from the patient. Bad Debt Expense increases (debit), and Allowance for Doubtful
Accounts increases (credit) for $48,727.50 ($324,850 × 15%). Let’s consider that BWW had a $23,000 credit balance from the
previous period.

Allowance for Doubtful Accounts: Balance Sheet Accounting

For more ways to add value to your company, download your free A/R Checklist to see how simple changes in your A/R process can free up a significant amount of cash. The allowance for doubtful accounts, aka bad debt reserves, is recorded as a contra asset account under the accounts receivable account on a company’s balance sheet. It’s a contra asset because it’s either valued at zero or has a credit balance. In this context, the contra asset would be deducted from your accounts receivable assets and considered a write-off. One way to record the affects of uncollectible accounts is the direct charge-off method. But it violates the matching principle and does not conform to GAAP standards and procedures.