Allowance for Uncollectible Accounts Explained With Examples

To approximate this as much as possible, a company must rely on the accrual-basis accounting method to periodically estimate certain revenues and expenses. Accrual-basis accounting is required for a company to be in compliance with GAAP. In the case of uncollectible accounts, there is often a big gap of time between a credit sale and the company realizing that the credit sale cannot be collected. Bad debt expense is an income statement account that is used to record client account balances deemed uncollectible by the accounting department. A company may use the direct write-off method or the allowance method.

• One way to handle uncollectible accounts is to consider them accounts receivable until it becomes evident they will never pay out.
• This chapter has devoted much attention to accounting for bad debts; but, don’t forget that it is more important to try to avoid bad debts by carefully monitoring credit policies.
• Using this allowance method, the estimated balance required for the allowance for doubtful accounts at the end of the accounting period is 7,100.
• Hopefully, your accounting software has a process in place to accomplish this transaction, but it’s rare enough that you may have to figure out the result you want and then make it happen using the built-in systems.
• 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.

Notice, other than the amount and description, this is the same entry we made under the percentage of sales method. Accounts uncollectible can provide a significant amount of insight into a company’s lending practices and its customers. For example, if a company notices that its accounts uncollectible are either remaining steady or increasing, it is extending credit to risky customers and therefore should improve its vetting measures. 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.

The allowance for doubtful accounts estimates the percentage of accounts receivable that are expected to be uncollectible. However, the actual payment behavior of customers may differ substantially from the estimate. Sometimes, at the end of the fiscal period, when a company goes to prepare its financial statements, it needs to determine what portion of its receivables is collectible.

When companies sell products to customers on credit, the customer receives the product and agrees to pay later. The customer’s obligation to pay later is recorded in accounts receivable on the balance sheet of the selling company. When customers don’t pay their bills, the selling company has to write-off the amount as bad debt or uncollectible accounts.

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As you’ve learned, the delayed recognition of bad debt violates GAAP, specifically the matching principle. 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. Accounts use this method of estimating the allowance to adhere to the matching principle. The matching principle states that revenue and expenses must be recorded in the same period in which they occur.

From this information, anyone studying these financial statements for Year One should understand that an expense estimated at $7,000 was incurred this year because the company made sales that will never be collected. In addition, year-end accounts receivable total $100,000 but have an anticipated net realizable value of only $93,000. Neither the $7,000 nor the $93,000 figure is expected to be exact but the eventual amounts should not be materially different. This basic portrait provides decision makers with fairly presented information about the accounts receivables held by the reporting company. The previous allowance method directly estimated the bad debt expense based on the credit sales recorded on the income statement of the business. The direct write-off method works by directly writing-off bad debt expenses from accounts receivable into the expense account.

It also reduces the loan receivable balance, because the loan default is no longer simply part of a bad debt estimate. One method is based on sales, while the other is based on accounts receivable. The following table reflects how the relationship would be reflected in the current (short-term) section of the company’s Balance Sheet. Contra assets are still recorded along with other assets, though their natural balance is opposite of assets. While assets have natural debit balances and increase with a debit, contra assets have natural credit balance and increase with a credit. The first step in accounting for the allowance for doubtful accounts is to establish the allowance.

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Bad Debt Expense increases (debit) as does Allowance for Doubtful Accounts (credit) for $58,097. By a miracle, it turns out the company ended up being rewarded a portion of their outstanding receivable balance they’d written off as part of the bankruptcy proceedings. Of the $50,000 balance that was written off, the company is notified that they will receive $35,000. Rebekiah received her BBA from Georgia Southwestern State University and her MSM from Troy University.

As will soon be shown, the actual write-off in a subsequent period will generally not impact income. Another way to record bad debt expense or uncollectible what are adjusting entries accounts in the financial statements is by using the allowance method. This method adheres to the matching principle and the procedural standards of GAAP.

Allowance for Uncollectible Accounts Explained With Examples

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. The longer the time passes with a receivable unpaid, the lower the probability that it will get collected. An account that is 90 days overdue is more likely to be unpaid than an account that is 30 days past due. Producing financial statements in compliance with GAAP (Generally Accepted Accounting Principles) is a requirement for public companies listed on a US Exchange. The matching principle requires that revenues be matched to their related expense within an accounting period.

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Strategic CFO Lab Member Extra
Access your Cash Flow Tune-Up Tool Execution Plan in SCFO Lab. The balance sheet method (also known as the percentage of accounts receivable method) estimates bad debt expenses based on the balance in accounts receivable. The method 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.

Estimating the Amount of Allowance for Doubtful Accounts

The doubtful accounts will be reflected on the company’s next balance sheet, as a separate line. Recording the amount here allows the management of a company to immediately see the extent of the expected bad debt, and how much it is offsetting the company’s account receivables. 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. Materiality considerations permitted a departure from the best approach. It is a matter of judgment, relating only to the conclusion that the choice among alternatives really has very little bearing on the reported outcomes. Whenever a balance sheet is to be produced, these two accounts are netted to arrive at net realizable value, the figure to be reported for this asset.

This is done to be in compliance with the matching principle which requires that revenues be matched to their related expenses within an accounting period. When this bad debt is written off, the allowance for doubtful accounts is credited by the write-off amount. If, however, a company uses the direct write-off method, it will credit accounts receivable to write off the bad debt. Because the time difference between the sale and the time a company realizes an account is uncollectible is usually long, using the direct write-off method will violate the matching principle.

Accounting for Uncollectible Accounts

The percentage-of-receivables method estimates uncollectible accounts by determining the estimated net realizable value of accounts receivable, so many accountants refer to this as the balance-sheet method. It’s eventually determined that Fancy Foot Store had creditors in line that received all assets as priority lenders, therefore, Barry and Sons Boot Makers will not be receiving the $1 million. The entire amount is written off as bad debt expense on the income statement and the allowance for doubtful accounts is also reduced by $1 million. Then, the company establishes the allowance by crediting an allowance account often called ‘Allowance for Doubtful Accounts’. Though this allowance for doubtful accounts is presented on the balance sheet with other assets, it is a contra asset that reduces the balance of total assets. If a company has a history of recording or tracking bad debt, it can use the historical percentage of bad debt if it feels that historical measurement relates to its current debt.

The allowance can accumulate across accounting periods and may be adjusted based on the balance in the account. The Bad Debts Expense remains at $10,000; it is not directly affected by the journal entry write-off. The bad debts expense recorded on June 30 and July 31 had anticipated a credit loss such as this. It would be double counting for Gem to record both an anticipated estimate of a credit loss and the actual credit loss.

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The company anticipates that some customers will not be able to pay the full amount and estimates that $50,000 will not be converted to cash. Additionally, the allowance for doubtful accounts in June starts with a balance of zero. 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.

For example, a company has $70,000 of accounts receivable less than 30 days outstanding and $30,000 of accounts receivable more than 30 days outstanding. Based on previous experience, 1% of accounts receivable less than 30 days old will be uncollectible, and 4% of those accounts receivable at least 30 days old will be uncollectible. The seller’s accounting records now show that the account receivable was paid, making it more likely that the seller might do future business with this customer. A mortgage lender, for example, expects a certain percentage of loans to enter default.

For the purposes of this example, let’s assume the 14k is 100% accurate and that none of that amount gets collected from the company’s clients. An allowance for doubtful accounts is a technique used by a business to show the total amount from the goods or products it has sold that it does not expect to receive payments for. This allowance is deducted against the accounts receivable amount, on the balance sheet. Consider why the direct write-off method is not to be used in those cases where bad debts are material; what is “wrong” with the method? That is, costs related to the production of revenue are reported during the same time period as the related revenue (i.e., “matched”). While the direct write-off method is simple, it is only acceptable in those cases where bad debts are immaterial in amount.