Bookkeeping

Allowance for Uncollectible Accounts

A loan provider or creditor outsources its debt-collection function to such a third party to reduce bad debts. It records bad debt expense when the related sales are recorded. For example, if your company assesses A/R with a total value of $10,000,000 and your historical default rate is 2%, you can assume that $200,000 of your total will fall https://personal-accounting.org/ under doubtful accounts receivable. This method is simple and works best for companies with straightforward billing cycles that operate primarily on credit. 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.

This means that the customer’s balance is still recorded in the receivables account. We have to figure out how much we think we’re not going to get and reduce our accounts receivables accordingly by recording a bad debt expense. The first method involves examining credit sales (or the percentage of total collected A/R) and using historical collection data to determine how much of your invoices are written off, on average. By establishing two T-accounts, a company such as Dell can manage a total of $4.843 billion in accounts receivables while setting up a separate allowance balance of $112 million. Prepare the adjusting entry necessary to reduce accounts receivable to net realizable value and recognize the resulting bad debt expense. Know that bad debt expenses must be anticipated and recorded in the same period as the related sales revenue to conform to the matching principle. The desired $6,000 ending credit balance in the Allowance for Doubtful Accounts serves as a “target” in making the adjustment.

Microsoft Allowance for Doubtful Accounts Example

If, like most businesses, you use the accrual method, the process is a little more complicated. It’s complicated because you actually accrue a bad debt when you sell your goods or services on credit to a customer who does not pay you. You must recognize the income from the sale at that time, but you won’t know that the customer did not pay until you’ve exhausted all of your collection alternatives. Since this can take a year or more to determine, you often won’t know that a past-due account is a bad debt until a later tax year. Thus, you may be in the position of recognizing income that you never actually receive, and not knowing this until a later tax year. 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. Most B2B businesses operate by extending trade credit to their customers for a fixed time period.

If the customer does not pay, then the company has a bad debt on its books. The allowance is established in the same accounting period as the original sale, with an offset to bad debt expense.

Allowance Method

So for an allowance for doubtful accounts journal entry, credit entries increase the amount in this account and debits decrease the amount in this account. The allowance for doubtful accounts account is listed on the asset side of the balance sheet, but it has a normal credit balance because it is a contra asset account, not a normal asset account. An allowance for doubtful accounts is considered a “contra asset,” because it reduces the amount of an asset, in this case the accounts receivable. The allowance, sometimes called a bad debt reserve, represents management’s estimate of the amount of accounts receivable that will not be paid by customers.

He is the sole author of all the materials on AccountingCoach.com. For more ways to add value to your company, download your free A/R Checklist. See how simple changes in your A/R process can free up a significant amount of cash. 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.

What is the effect on the income statement when the allowance for uncollectible accounts is not established?

GAAP since the expense is recognized in a different period as when the revenue was earned. GAAP allows for this provision to mitigate the risk of volatility in share price movements caused by sudden changes on the balance sheet, which is the A/R balance in this context.

To protect your business, you can create an allowance for doubtful accounts. 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. You do this by calculating the bad debts as a percentage of your sales. In some scenarios, there is a chance that a customer is unable to pay, and their AR is written off as bad debt. But a few weeks or months later, they make the payment and clear their dues.

Allowance for doubtful accounts on the balance sheet

However, some companies use a different percentage for each age category of accounts receivable. When accountants decide to use a different rate for each age category of receivables, they prepare an aging schedule. An aging schedule classifies accounts receivable allowance for uncollectable accounts according to how long they have been outstanding and uses a different uncollectibility percentage rate for each age category. In Exhibit 1, the aging schedule shows that the older the receivable, the less likely the company is to collect it.