An accurate estimate of the allowance for bad debt is necessary to determine the actual value of accounts receivable. One method is based on sales, while the other is based on accounts receivable. The purpose of making an allowance for bad debts is to try to guess the total amount of bad debts that you’re likely to incur during the tax year. The following table reflects how the relationship would be reflected in the current (short-term) section of the company’s Balance Sheet. The bad debt expense is then the difference between the calculated allowance for doubtful accounts at the end of the account period and the current allowance for doubtful accounts before adjustment.
Thus, the total allowance for doubtful accounts is $40,000 ($25,000 + $15,000). For example, a jewelry store earns $100,000 in net sales, but they estimate that 4% of the invoices will be uncollectible. Based on this historical data, ABC estimates that $2,000 of the January credit sales will be uncollectible.
The balance for those accounts is $4,000, which it records as an allowance for doubtful accounts on the balance sheet. The Pareto analysis method relies on the Pareto principle, which states that 20% of the customers cause 80% of the payment problems. By analyzing each customer’s payment history, businesses allocate an appropriate risk score—categorizing each customer into a high-risk or low-risk group.
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.
Requirements for an Allowance for Bad Debt
It’s important to note that an allowance for doubtful accounts is simply an informed guess, and your customers’ payment behaviors may not align. Let’s explore the importance of allowance for doubtful accounts, the methods of estimating it, and how to record it. When a company sells goods or services on credit, there is always a risk that some customers will not pay their bills.
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. For example, if a company has historically had bad debts of 3% of credit sales, it may estimate that 3% of current credit sales will also be uncollectible. 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. For example, a company may know that its 10-year average of bad debt is 2.4%. 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.
Time Value of Money
- This would split accounts receivable into three past- due categories and assign a percentage to each group.
- Then, the company establishes the allowance by crediting an allowance account often called ‘Allowance for Doubtful Accounts’.
- Having established that an allowance method for uncollectibles is preferable (indeed, required in many cases), it is time to focus on the details.
- Once the amount of uncollectible accounts has been estimated, the company needs to create an allowance for doubtful accounts.
Once the amount of uncollectible accounts has been estimated, the company needs to create an allowance for doubtful accounts. 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 company may use historical data, credit ratings, and other information to estimate the likelihood of uncollectible accounts.
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, 5 accounting principles the more likely it is that the debt will never pay. In this case, perhaps only 1% of 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.
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. 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 estimate bad debt at 4.5% of credit sales. 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. The percentage of receivables method estimates the allowance for doubtful accounts using a percentage of the accounts receivable at the end of the accounting period.
With this method, accounts receivable is organized into categories by length of time outstanding, and an uncollectible percentage is assigned starting a bookkeeping business 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%. All categories of estimated uncollectible amounts are summed to get a total estimated uncollectible balance.
Income Statement Method for Calculating Bad Debt Expenses
Once the estimated amount for the allowance account is determined, a journal entry will be needed to bring the ledger into agreement. Assume that Ito’s ledger revealed an Allowance for Uncollectible Accounts credit balance of $10,000 (prior to performing the above analysis). At the end of an accounting period, the Allowance for Doubtful Accounts reduces the Accounts Receivable to produce Net Accounts Receivable. Note that allowance for doubtful accounts reduces the overall accounts receivable account, not a specific accounts receivable assigned to a customer.
For the taxpayer, this means that if a company sells an item on credit in October 2018 and determines that it is uncollectible in June 2019, it must show the effects of the bad debt when it files its 2019 tax return. This application probably violates the matching principle, but if the IRS did not have this policy, there would typically be a significant amount of manipulation on company tax returns. For example, if the company wanted the deduction for the write-off in 2018, it might claim that it was actually uncollectible in 2018, instead of in 2019.
If you use the accrual basis of accounting, you will record doubtful accounts in the same accounting period as the original credit sale. This will help present a more realistic picture of the accounts receivable amounts you expect to collect versus what goes under the allowance for doubtful accounts. In conclusion, accounting for uncollectible accounts involves estimating the amount of uncollectible accounts and creating an allowance for doubtful accounts. To create the allowance, the company debits the allowance for doubtful accounts account and credits the bad debt expense account. As a result, companies need to account for the possibility of uncollectible accounts, which are also known as bad debts.
Allowance for Bad Debt: Definition and Recording Methods
When assessing accounts receivable, there may come a time when it becomes clear that one or more accounts are simply not going to be paid. The adjustment process involves analyzing the current accounts, assessing their collectibility, and updating the allowance accordingly. The net effect is a reduction in total assets and a reduction in the allowance for doubtful accounts. A Pareto analysis is a risk measurement approach that states that a majority of activity is often concentrated among a small amount of accounts. In many different aspects of business, a rough estimation is that 80% of account receivable balances are made up of a small concentration (i.e. 20%) of vendors.
