The most prevalent approach — called the “percent of sales method” — uses a pre-determined percentage of total sales assumption to forecast the uncollectible credit sales. The direct write-off method is used only when we decide a customer will not pay. We do not record any estimates or use the Allowance for Doubtful Accounts under the direct write-off method. This method violates the GAAP matching principle of revenues and expenses recorded in the same period.

The allowance method estimates the “bad debt” expense near the end of a period and relies on adjusting entries to write off certain customer accounts determined as uncollectable. 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. To illustrate, let’s continue to use Billie’s Watercraft
Warehouse (BWW) as the example.

In accordance with GAAP revenue recognition policies, the company must still record credit sales (i.e. not cash) as revenue on the income statement and accounts receivable on the balance sheet. The final point relates to companies with very little exposure
to the possibility of bad debts, typically, entities that rarely
offer credit to its customers. Assuming that credit is not a
significant component of its sales, these sellers can also use the
direct write-off method. The companies that qualify for this
exemption, however, are typically small and not major participants
in the credit market.

What Are Accounts Uncollectible, Example

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. Having established that an allowance method for uncollectibles is preferable (indeed, required in many cases), it is time to focus on the details. Suppose that Ito Company has total accounts receivable of $425,000 at the end of the year, and is in the process or preparing a balance sheet.

• The allowance reserve is set in the period in which the revenue was “earned,” but the estimation occurs before the actual transactions and customers can be identified.
• Let’s consider that BWW had a $23,000 credit balance from the
  previous period.
• Fancy Foot Store declares bankruptcy and it is uncertain if they will be able to pay the $1 million.

The final point relates to companies with very little exposure to the possibility of bad debts, typically, entities that rarely offer credit to its customers. Assuming that credit is not a significant component of its sales, these sellers can also use the direct write-off method. The companies that qualify for this exemption, however, are typically small and not major participants in the credit market. Thus, virtually advantages and disadvantages of just-in-time inventory chron com 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. 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.

What are the Benefits of Factoring Your Account Receivable?

The allowance method provides in advance for uncollectible accounts think of as setting aside money in a reserve account. The allowance method represents the accrual basis of accounting and is the accepted method to record uncollectible accounts for financial accounting purposes. 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.

Step 2: Estimate the Amount of Uncollectible Accounts

Thus, the company cannot enter credits in either the Accounts Receivable control account or the customers’ accounts receivable subsidiary ledger accounts. If only one or the other were credited, the Accounts Receivable control account balance would not agree with the total of the balances in the accounts receivable subsidiary ledger. Without crediting the Accounts Receivable control account, the allowance account lets the company show that some of its accounts receivable are probably uncollectible. The income statement method (also known as the
percentage of sales method) estimates bad debt expenses based on
the assumption that at the end of the period, a certain percentage
of sales during the period will not be collected. The estimation is
typically based on credit sales only, not total sales (which
include cash sales).

Once this account is identified as uncollectible, the company will record a reduction to the customer’s accounts receivable and an increase to bad debt expense for the exact amount uncollectible. The inherent uncertainty as to the amount of cash that will actually be received affects the physical recording process. To illustrate, assume that a company makes sales on account to one hundred different customers late in Year One for $1,000 each. The earning process is substantially complete at the time of sale and the amount of cash to be received can be reasonably estimated.

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 company may use historical data, credit ratings, and other information to estimate the likelihood of uncollectible accounts. The two methods used in estimating bad debt expense are 1) Percentage of sales and 2) Percentage of receivables. When a customer purchases goods on credit with its vendor, the amount is booked by the vendor under accounts receivable. The payment terms vary, but 30 days to 90 days is normal for most companies.

Financial Management: Overview and Role and Responsibilities

Sales and the ultimate decision that specific accounts receivable will never be collected can happen months apart. During the interim, bad debts are estimated and recorded on the income statement as an expense and on the balance sheet through an allowance account, a contra asset. In that way, the receivable balance is shown at net realizable value while expenses are recognized in the same period as the sale to correspond with the matching principle. When financial statements are prepared, an estimation of the uncollectible amounts is made and an adjusting entry recorded. Thus, the expense, the allowance account, and the accounts receivable are all presented properly according to U.S.

Assume further that the company’s past history and other relevant information indicate to officials that approximately 7 percent of all credit sales will prove to be uncollectible. An expense of $7,000 (7 percent of $100,000) is anticipated because only $93,000 in cash is expected from these receivables rather than the full $100,000. 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.

ABC writes off the account by debiting the allowance for doubtful accounts account and crediting the accounts receivable account for $1,000. In February, ABC determines that a customer who owes $500 is unlikely to pay. ABC writes off the account by debiting the allowance for doubtful accounts account and crediting the accounts receivable account for $500.