Allowance for Doubtful Accounts: Methods of Accounting for

Before this change, these entities would record revenues for billed services, even if they did not expect to collect any payment from the patient. 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. Therefore, it can assign this fixed percentage to its total accounts receivable balance since more often than not, it will approximately be close to this amount.

Accounts receivable represent amounts due from customers as a result of credit sales. Unfortunately for various reasons, some accounts receivable will remain unpaid and will need to be provided for in the accounting records of the business. As of January 1, 2018, GAAP requires a change in how health-care entities record bad debt expense.

1. It reduces the accounts receivable by $2,000 and also reduces the reserve in the allowance for doubtful accounts.
2. 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.
3. Therefore, generally accepted accounting principles (GAAP) dictate that the allowance must be established in the same accounting period as the sale, but can be based on an anticipated or estimated figure.
4. It then makes a journal entry to record the non-creditworthy customers by debiting bad debt expense and crediting the allowance account.
5. My Accounting Course  is a world-class educational resource developed by experts to simplify accounting, finance, & investment analysis topics, so students and professionals can learn and propel their careers.

Unit 10: Receivables

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. The mechanics of the allowance method are that the initial entry is a debit to bad debt expense and a credit to the allowance for doubtful accounts (which increases the reserve).

Fundamentals of Bad Debt Expenses and Allowances for Doubtful Accounts

It reflects a decrease in the provision required for potential bad debts based on the latest assessment of outstanding receivables. It plays a crucial role in prudent financial planning, guiding credit policies, aiding in decision-making, and ensuring the company’s financial stability. Acknowledging and preparing for possible losses from uncollectible accounts contributes to a more realistic depiction of the company’s financial situation, fostering transparency and informed financial management. When a specific customer has been identified as an uncollectible account, the following journal entry would occur. Some companies may classify different types of debt or different types of vendors using risk classifications.

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 allowance method is a technique for estimating and recording of uncollectible amounts when a customer fails to pay, and is the preferred alternative to the direct write-off method. This scenario illustrates how XYZ Corp. utilizes the allowance method to manage its accounts receivable, making adjustments based on changing assessments of credit risk.

Bad Debts Expense as a Percent of Sales

The direct write-off method is a less theoretically correct approach to dealing with bad debts, since it does not match revenues with all applicable expenses in a single reporting period. The aging of accounts receivable method is another balance sheet approach and is a refinement of the percentage of accounts receivable method discussed above. The various methods can be classified as either being an income statement approach or a balance sheet approach. With an income statement approach the bad debt expense is calculated, and the allowance account is the balancing figure. With a balance sheet approach the ending balance on the allowance account is calculated, and the bad debt expense is the balancing figure. The allowance method holds substantial importance in financial accounting as it provides a structured approach to anticipate and manage potential losses from uncollectible accounts.

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 income statement method is a simple method for calculating bad debt, but it may be more imprecise than other measures because it 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 is assigned to each category.

What Is an Allowance for Doubtful Accounts?

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. 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.

The percentage of credit sales method is an income statement approach and estimates the required bad debt expense for an accounting period using a percentage of the credit sales made during the same period. The percentage of credit sales approach focuses on the income statement and the matching principle. Sales revenues of $500,000 are immediately matched with $1,500 of bad debts expense. The balance in the account Allowance for Doubtful Accounts is ignored at the time of the weekly entries. However, at some later date, the balance in the allowance account must be reviewed and perhaps further adjusted, so that the balance sheet will report the correct net realizable value. If the seller is a new company, it might calculate its bad debts expense by using an industry average until it develops its own experience rate.

On June 3, a customer purchases $1,400 of goods on credit from Gem Merchandise Co. On August 24, that same 3 ways to calculate days in inventory customer informs Gem Merchandise Co. that it has filed for bankruptcy. It also states that the liquidation value of those assets is less than the amount it owes the bank, and as a result Gem will receive nothing toward its $1,400 accounts receivable. After confirming this information, Gem concludes that it should remove, or write off, the customer’s account balance of $1,400. 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.

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. This is because it considers the amount of time that accounts receivable has been owed, and it assumes that the longer the time owed, the greater the possibility that individual accounts receivable will prove to be uncollectible.

As the accountant for a large publicly traded food company, you are considering whether or not you need to change your bad debt estimation method. You currently use the income statement method to bookkeeping vs accounting vs auditing estimate bad debt at 4.5% of credit sales. This would split accounts receivable into three past- due categories and assign a percentage to each group. The allowance method complies with the matching principle as an estimate of the bad debt expense is recorded in the same accounting period in which the credit sales and accounts receivable are recorded.

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