The bad debt expense account is used to record the estimated uncollectible accounts for the period. 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. With this method, accounts receivable is organized into categories by length of time outstanding, and an uncollectible percentage is assigned 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.

Bad Debt Expense increases (debit), and Allowance for Doubtful Accounts increases (credit) for $48,727.50 ($324,850 × 15%). The following table reflects how the relationship would be reflected in the current (short-term) section of the company’s Balance Sheet. 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. For the sake of this example, assume that there was no interest charged to the buyer because of the short-term nature or life of the loan. When the account defaults for nonpayment on December 1, the company would record the following journal entry to recognize bad debt. If collection efforts are more successful than anticipated, the company might cut its allowance, decrease bad debt expenses, or even record a gain from recovery.

Recording the Allowance for Uncollectible Accounts

The Allowance for Uncollectible Accounts is presented on the balance sheet as a direct deduction from gross Accounts Receivable. When an account is determined to be uncollectible, the journal entry to write off the uncollectible account involves debiting the allowance for doubtful accounts account and crediting the accounts receivable account. The retailer estimates that 2% of its total credit sales, or $ 500,000, will likely be uncollectible. 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.

• Here, we will break it down step by step and provide some helpful resources to make this concept easier to understand.
• At the end of March, ABC reviews the allowance for doubtful accounts and determines that the estimate of uncollectible accounts was too low.
• If this does not eventually prove to be true, an adjustment of the overall estimation rates may be indicated.
• On average, Apple’s bad debt expense (see Exhibit 3) has been significantly lower than its write-offs for the past nine years.

The percentage of sales method (income statement approach) estimates uncollectible accounts based on a percentage of total credit sales. This method links bad debt expense directly to the revenue recognized, emphasizing the matching principle. Businesses determine this percentage from historical bad debt experience relative to credit sales, adjusting for current economic factors or industry trends. Another way to record bad debt expense or uncollectible accounts in the financial statements is by using the allowance method. This method adheres to the matching principle and the procedural standards of GAAP.In the allowance method, a company estimates the amount of uncollectible accounts it will incur as a percentage of credit sales. Even though this method uses estimation – as opposed to the direct method which writes off bad debt when the actual amount is known – the estimates may not always be entirely accurate.

Allowance Method For Uncollectibles

The percentage of sales method estimates uncollectible accounts by applying a predetermined percentage to total sales. This percentage is derived from historical data, reflecting past trends in customer payment behavior. For example, if a company historically experiences a 2% default rate, it applies this percentage to current sales to estimate future uncollectible accounts.

Impact on Financial Statements

Companies rely on estimation methods to determine the allowance for uncollectible accounts, as exact uncollectible accounts are unknown at the time of sale. These estimations are based on historical data, industry averages, and current economic conditions. Companies must regularly review and adjust their methodologies to align with actual collection experience.

In the case of the allowance for doubtful accounts, it is a contra account that is used to reduce the Controlling account, Accounts Receivable. The allowance method is the more widely used method because it satisfies the matching principle. The allowance method estimates bad debt during a period, based on certain computational approaches.

What is a Contra Account?

It is created to reflect the reality that not all customers may fulfill their payment obligations, and some accounts may become uncollectible over time. Using the example above, let’s say that a company reports an accounts receivable debit balance of $1,000,000 on June 30. 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. 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 percentages are applied to each column to determine the total estimate for the current month.
• When an account is determined to be uncollectible, a company will do a journal entry to debit (increase) Bad Debts Expense (or Uncollectible Accounts Expense) and credit (decrease) Accounts Receivable for the specific customer.
• This provides a more accurate reflection of the net realizable value of accounts receivable, which is the amount truly expected to be collected.
• As a result, companies need to account for the possibility of uncollectible accounts, which are also known as bad debts.
• Sometimes, even in accounting, there are welcome surprises, e.g., when a previously written-off account pays unexpectedly.
• Businesses establish an “Allowance for Uncollectible Accounts” to anticipate potential losses from bad debts.

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 accounts receivable balance decreases, reflecting the removal of the uncollectible amount, ensuring assets are reported at realizable value. On the income statement, the write-off is recorded as an expense, reducing net income and highlighting credit risk costs. Another widely used method is the “percentage of receivables method,” often referred to as the “aging method.” This approach estimates the appropriate ending balance for the allowance for uncollectible accounts.

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. This variance in treatment addresses taxpayers’ potential to manipulate when a bad debt is recognized. Generally Accepted Accounting Principles (GAAP) require companies with a large amount of receivables to estimate future uncollectible amounts at the end of each current accounting period. Because the risk to the business is relative to the number of accounts and the amount of cash tied up in receivables, larger companies cannot take a “wait and see” approach to capturing potential bad debts.

How to Calculate the Allowance for Uncollectible Accounts

Learn how companies estimate and account for uncollectible customer debts, ensuring accurate financial reporting and true asset valuation. A company uses the Accounts Receivable Aging Report to determine the amount of the estimate for Allowance for Doubtful Accounts. A percentage is applied to each column based on the company’s previous experience with bad debts. The percentages are applied to each column to determine the total estimate for the current month. The Allowance for Doubtful Accounts is a contra-asset account that estimates the future losses incurred from uncollectible accounts receivable (A/R). For example, if gross Accounts Receivable is $100,000 and the Allowance is $8,000, the balance sheet reports Accounts Receivable, Net, as $92,000.

The inconsistency in the relationship between Apple’s allowance balance and write-offs is evidenced by the high, relative to the mean, standard deviation of that ratio over the period. This inference of inconsistency is confirmed upon review of the wide range (from lows of 3.20 in 2001 and 3.06 in 2007 to a high of 15.67 in 2008) exhibited by Apple’s beginning-allowance-to-write-offs ratio over the period. On average, Apple’s bad debt expense (see Exhibit 3) has been significantly lower than its write-offs for the past nine years. The multiyear bad-debt-expense-to-write-off ratio of 0.77 shows that Apple’s bad debt expense for the nine years has fallen short of the write-offs it recorded over the same period. Exhibit 1 uses three years of data from Dell Inc. to describe three simple techniques for assessing past estimates of the allowance for doubtful accounts. Because the techniques use historical data, they give an indication of the effectiveness of past estimates.

In the example above, we estimated an arbitrary number for the allowance for doubtful accounts. There are two primary methods for estimating the amount of accounts receivable that are not expected to be converted into cash. Units should consider using an allowance for doubtful accounts when they are regularly providing goods or services “on credit” and have experience with the collectability of those accounts. The following entry should be done in accordance with your revenue and reporting cycles (recording the expense in the same reporting period as the revenue is earned), but at a minimum, annually. Accounting for potentially uncollectible accounts involves several distinct steps while creating a paper trail that tracks your expectations about customer payments and what actually happens when some customers don’t pay. What we are showing on the Balance Sheet is the full value of Accounts Receivable and the realistic value of what we expect to collect of that amount.

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. If actual experience differs, then management adjusts its estimation methodology to bring the reserve more into alignment with actual results. At the time revenue is recorded, a company does not yet know which accounts will prove to be uncollectible. We don’t want to record any reduction in the Accounts Receivable account so we use a related contra account called Allowance for Doubtful Accounts or Allowance for Uncollectible Accounts to track the estimate. By using the contra account, we can preserve the true Accounts Receivable balance while also recognizing that some portion of that balance is overvalued because of potential bad debt. Occasionally, a previously written-off account may be recovered, requiring a reversal.

How Do You Write-off Bad Debt Using the Allowance Method?

Cisco’s estimation history with respect to the allowance for doubtful accounts illustrates the potential for overestimates of bad debt expense to have long-lasting effects. Accountants have typically relied on accounts receivable aging as the primary tool for evaluating collectibility. Aging allows companies to generate estimates of uncollectible accounts at specific times. However, the technique does not consider the accuracy of past estimates, as mandated by SAS no. 57. An analysis of historical trends can provide useful information about an entity’s past accuracy and possible biases in estimating allowance for uncollectible accounts its allowance for doubtful accounts.