As a result, companies need to account for the possibility of uncollectible accounts, which are also known as bad debts. Bad debt expense is something that must be recorded and accounted for every time a company prepares its financial statements. When a company decides to leave it out, they overstate their assets and they could even overstate their net income.

Bad debt expense can be estimated using statistical modeling such as default probability to determine its expected losses to delinquent and bad debt. The statistical calculations can utilize historical data from the business as well as from the industry as a whole. The specific percentage will typically increase as the age of the receivable increases, to reflect increasing default risk and decreasing collectibility. The allowance method is an accounting technique that enables companies to take anticipated losses into consideration in its financial statements to limit overstatement of potential income.

Understanding the Allowance for Doubtful Accounts

The first entry reverses the bad debt write-off by increasing Accounts Receivable (debit) and decreasing Bad Debt Expense (credit) for the amount recovered. The second entry records the payment in full with Cash increasing (debit) and Accounts Receivable decreasing (credit) for the amount received of $15,000. At the end of the accounting period, the company needs to review the allowance for doubtful accounts and adjust it as necessary. Accounting for uncollectible accounts involves estimating the amount of uncollectible accounts and creating an allowance for doubtful accounts.

  • BWW estimates that 5% of its overall credit sales will result in bad debt.
  • The specific percentage will typically increase as the age of the receivable increases, to reflect increasing default risk and decreasing collectibility.
  • The company must record an additional expense for this amount to also increase the allowance’s credit balance.
  • On March 31, 2017, Corporate Finance Institute reported net credit sales of $1,000,000.
  • The matching principle states that revenue and expenses must be recorded in the same period in which they occur.

Therefore, the direct write-off method can only be appropriate for small immaterial amounts. We will demonstrate how to record the journal entries of bad debt using MS Excel. Continuing our examination of the balance sheet method, assume that BWW’s end-of-year accounts receivable balance totaled $324,850. This entry assumes a zero balance in Allowance for Doubtful Accounts from the prior period.

Risk Classification Method

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. Because it is an estimation, it
means the exact account that is (or will become) uncollectible is
not yet known. It’s eventually determined that Fancy Foot Store had creditors in line that received all assets as priority lenders, therefore, Barry and Sons Boot Makers will not be receiving the $1 million. The entire amount is written off as bad debt expense on the income statement and the allowance for doubtful accounts is also reduced by $1 million. Let’s consider a situation where BWW had a $20,000 debit balance from the previous period.

Are Allowance for Doubtful Accounts a Current Asset?

Management may disclose its method of estimating the allowance for doubtful accounts in its notes to the financial statements. 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.

BWW estimates 15% of its overall accounts receivable will result in bad debt. 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 article also discusses the practical aspects of disclosing the impact of non-collection and the entries that are made for dealing with bad debts. By a miracle, it turns out the company ended up being rewarded a portion of their outstanding receivable balance they’d written off as part of the bankruptcy proceedings. Of the $50,000 balance that was written off, the company is notified that they will receive $35,000. This means that the company underestimated its Bad Debt Expense last year— it had more bad debt than it had estimated it would have.

Other Allowances

It means, under this method, bad debt expense does not necessarily serve as a direct loss that goes against revenues. Contra assets are still recorded along with other assets, though their natural balance is opposite of assets. While assets have natural debit balances and increase with a debit, contra assets have natural credit balance and increase with a credit. Because the allowance for doubtful accounts is established in the same accounting period as the original sale, an entity does not know for certain which exact receivables will be paid and which will default. 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. The allowance can accumulate across accounting periods and may be adjusted based on the balance in the account.

Accounts uncollectible are receivables, loans, or other debts that have virtually no chance of being paid. An account may become uncollectible for many reasons, including the debtor’s bankruptcy, an inability to find the debtor, fraud on the part of the debtor, or lack of proper documentation to prove that debt exists. Write-off e-docs for sponsored funds will be originated by Sponsored Financial Services. See the instructions below for employee-related write-offs on sponsored accounts. Collection efforts continue subsequent to write off, and recoveries are applied as a reduction of bad debt losses.

Bad Debt Direct Write-Off Method

Note that the debit to the allowance for doubtful accounts reduces the balance in this account because contra assets have a natural credit balance. Also, note that when writing off the specific account, no income statement accounts are used. This is because the expense was already taken when creating or adjusting the allowance. If the following accounting period results in net sales of $80,000, an additional $2,400 is reported in the allowance for doubtful accounts, and $2,400 is recorded in the second period in bad debt expense.

Accounts receivable decreases because
there is an assumption that no debt will be collected on the
identified customer’s account. As you’ve learned, the delayed recognition of bad debt violates
GAAP, specifically the matching principle. Therefore, the direct
write-off method is not used for publicly traded company reporting;
the allowance method is used instead. When a customer purchases goods on credit with its vendor, the amount is booked by the vendor under accounts receivable.