Recording Uncollectible Accounts Expense and Bad Debts

The allowance for doubtful accounts is an important accounting tool that helps companies to account for the possibility of uncollectible accounts. In this case, it’s a set amount that represents how much bad debt or how many doubtful accounts you predict you’ll have. When you want to land investors or determine where your company is headed, you need to navigate some treacherous financial waters. In addition to bad debts, there are several other reasons why a company may fail to collect the face amount of its receivables. When an account that has been written off is collected, cash is increased and the net amount of accounts receivable is decreased. The allowance is a contra account and is credited instead of the Accounts Receivable control account because it is not known which individual accounts are uncollectible.

How to Account for the Allowance for Doubtful Accounts

Thus, the allowance increases with a credit (creating a decrease in the net receivable balance) and decreases with a debit. The more accounts receivable a company expects to be bad, the larger the allowance. This increase, in turn, reduces the net realizable value shown on the balance sheet. However, while the direct write-off method records the exact amount of uncollectible accounts, it fails to uphold the matching principle used in accrual accounting and generally accepted accounting principles (GAAP). The matching principle requires that expenses be matched to related revenues in the same accounting period in which the revenue transaction occurs.

2: Account for Uncollectible Accounts Using the Balance Sheet and Income Statement Approaches

• 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.
• The entries to post bad debt using the direct write-off method result in a debit to ‘Bad Debt Expense’ and a credit to ‘Accounts Receivable’.
• If you don’t have a lot of bad debts, you’ll probably write them off on a case-by-case basis, once it becomes clear that a customer can’t or won’t pay.
• If the total net sales for the period is $100,000, the company establishes an allowance for doubtful accounts for $3,000 while simultaneously reporting $3,000 in bad debt expense.
• The first entry reverses the bad debt write-off by increasingAccounts Receivable (debit) and decreasing Bad Debt Expense(credit) for the amount recovered.

To illustrate, let’s continue to use Billie’s Watercraft Warehouse (BWW) as the example. The allowance for doubtful accounts is a contra asset account and is subtracted from Accounts Receivable to determine the Net Realizable Value of the Accounts Receivable account on the balance sheet. how to calculate uncollectible accounts expense 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. When the estimation is recorded at the end of a period, the following entry occurs.

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With the percentage of receivables method, you can find out how much allowance to set for doubtful accounts in a different manner. For example, if receivables are recorded gross, that is, before cash discounts, it may be appropriate to establish an allowance for the discounts that might be taken on the accounts that are eligible for them. All approaches involve an analysis of the existing accounts and the application of one or more percentage factors. Most accountants take the position that the expense is incurred in order to increase sales and, therefore, should be reported in the same time period as those sales if cause and effect are to be related. It is determined by adding to $0 any additions to the allowance account during the year, then adding to that total any write-offs of Accounts Receivable during the year.

This schedule classifies the receivables on the basis of the length of time they have been outstanding. The reliability of this approach is potentially high because it does not rely on estimates. However, it has the potential for income manipulation by allowing management to determine when to record the expense. Most accounting theorists have endorsed the position that the loss arising from bad debt is an expense. The article also discusses the practical aspects of disclosing the impact of non-collection and the entries that are made for dealing with bad debts. The aim is to estimate what percentage of outstanding receivables at year-end will not be collected.

Financial and Managerial Accounting

Thisjournal entry takes into account a debit balance of $20,000 andadds the prior period’s balance to the estimated balance of $58,097in the current period. The allowance for doubtful accounts is a contra-asset account that nets against accounts receivable, which means that it reduces the total value of receivables when both balances are listed on the balance sheet. This allowance can accumulate across accounting periods and may be adjusted based on the balance in the account. 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.

Simultaneously, the allowance for doubtful accounts is increased on the balance sheet, reducing the net accounts receivable by the same amount, thereby presenting a more accurate financial position. Uncollectible accounts, commonly known as bad debts, refer to amounts that a business deems unlikely to be collected from its customers. These are typically accounts receivable that have been outstanding for an extended period, and after exhaustive efforts to collect, the company concludes that these debts will not be paid. Uncollectible accounts arise in the normal course of business and are an inherent risk of extending credit to customers.

Note that if a company believes it may recover a portion of a balance, it can write off a portion of the account. Our team is ready to learn about your business and guide you to the right solution. Our mission is to empower readers with the most factual and reliable financial information possible to help them make informed decisions for their individual needs. Collection efforts continue subsequent to write off, and recoveries are applied as a reduction of bad debt losses. Most individuals feel that the benefits of this proper matching outweigh the disadvantages of using estimates.

Assuming that credit is not a significant component of its sales, these sellers can also use the direct write-off method. The companies that qualify for this exemption, however, are typically small and not major participants in the credit market. Thus, virtually all of the remaining bad debt expense material discussed here will be based on an allowance method that uses accrual accounting, the matching principle, and the revenue recognition rules under GAAP.

However, the entries to record this bad debt expense may be spread throughout a set of financial statements. The allowance for doubtful accounts resides on the balance sheet as a contra asset. Meanwhile, any bad debts that are directly written off reduce the accounts receivable balance on the balance sheet. Each year, an estimation of uncollectible accounts must be made as a preliminary step in the preparation of financial statements. Some companies use the percentage of sales method, which calculates the expense to be recognized, an amount which is then added to the allowance for doubtful accounts.