Allowance Method for Uncollectible Accounts

The company must record an additional expense for this amount to also increase the allowance’s credit balance. Assume a company has 100 clients and believes there are 11 accounts that may go uncollected. Instead of applying percentages or weights, it may simply aggregate the account balance for all 11 customers and use that figure as the allowance amount. Companies often have a specific method of identifying the companies that it wants to include and the companies it wants to exclude. 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.

Income Statement

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.

On the other hand, writing off through the allowance method helps to locate the taking your accounts payable paperless creation of provision, use of the provision, reversal, etc. From a control perspective, the use of the direct method can be a little risky, it’s because if there are no sound controls manager might write off balances in a personal capacity. In addition, from an audit perspective, the default risk of debtors is an overstatement. The creation of the allowance helps to bring an element of fairness to the financial statement as the net balance is shown after deducting the provision. For the past 52 years, Harold Averkamp (CPA, MBA) hasworked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. For the past 52 years, Harold Averkamp (CPA, MBA) has worked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online.

Historical Percentage Method

An allowance account is a contra account for the assets; the amount is recorded in this contra account to offset overstated debtors that the business cannot collect. When the organization’s financial statements are finalized, these expenses are reviewed by the higher management to understand the financial reporting process better and control the business’s credit aspects. Let’s consider a situation where BWW had a $20,000 debit balance from the previous period.

At the end of the accounting cycle, management analyzes an aging schedule and estimates the amount of uncollectable accounts. It then makes a journal entry to record the non-creditworthy customers by debiting bad debt expense and crediting the allowance account. Other than management’s estimation, there is no reason to believe that these customers will not pay their full invoice. As a result, its November income statement will be matching $2,400 of bad debts expense with the credit sales of $800,000. If the balance in Accounts Receivable is $800,000 as of November 30, the corporation will report Accounts Receivable (net) of $797,600. Another way sellers apply the allowance method of recording bad debts expense is by using the percentage of credit sales approach.

What is the Allowance Method? (Definition, Calculation, Example, and More)

This hypothetical example illustrates how ABC Inc. effectively uses the allowance method to manage potential bad debts. By initially creating a reserve and then adjusting it for specific bad debts and recoveries, ABC Inc. ensures a more accurate reflection of its financial position. Then, the company establishes the allowance by crediting an allowance account often called ‘Allowance for Doubtful Accounts’. Though this allowance for doubtful accounts is presented on the balance sheet with other assets, it is a contra asset that reduces the balance of total assets. If should be noted that the effect of these two entries to write off bad debt is to reduce an asset account and a contra asset account by equal amounts. As a result of this, the value of the net accounts receivable in the balance sheet does not change.

Contra assets are still recorded along with other assets, direct material variance 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. 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. 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. The company must be aware of outliers or special circumstances that may have unfairly impacted that 2.4% calculation.

1. The company can recover the account by reversing the entry above to reinstate the accounts receivable balance and the corresponding allowance for the doubtful account balance.
2. Credit The amount owed by the customer of 2,000 has been removed from accounts receivable by the credit entry, as it is no longer recoverable.
3. The allowance method works by using the allowance for doubtful accounts account to estimate the amount of receivables that are going to be uncollected in the future.
4. Yes, allowance accounts that offset gross receivables are reported under the current asset section of the balance sheet.
5. Bad Debt Expense increases (debit), and Allowance for Doubtful Accounts increases (credit) for $22,911.50 ($458,230 × 5%).

Note that if a company believes it may recover a portion of a balance, it can write off a portion of the account. Double Entry Bookkeeping is here to provide you with free online information to help you learn and understand bookkeeping and introductory accounting. However, excess allowance creation can significantly reduce the accounting profit, which can also be questioned.

For this example, let’s say a company predicts it will incur $500,000 of uncollected accounts receivable. The allowance method is a technique for estimating and recording of uncollectible amounts when a customer fails to pay, and is the preferred alternative to the direct write-off method. This scenario illustrates how XYZ Corp. utilizes the allowance method to manage its accounts receivable, making adjustments based on changing assessments of credit risk. It reflects a decrease in the provision required for potential bad debts based on the latest assessment of outstanding receivables.

Double Entry Bookkeeping

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. And the estimates being made by these organizations are based on the number of sales being made for the reporting year. If the corporation prepares weekly financial statements, it might focus on the bad debts expense for its weekly financial statements, but at the end of each quarter focus on the allowance account.

However, if you have written off the account balance, it can be deducted on a business income tax return to get relief. It applies only to receivables that can’t be collected, and bad debts can only be written off if the company or the organization cannot collect them. The amount for the allowance is calculated as a percentage of the sales or debtor balance. In the Sales method, a certain percentage is applied to the sales amount to create a reserve. The debit impact of the above-given journal entry is the recording of the expense in the income stated that leads to a reduction in the profitability.

First, the allowance method agrees with the matching principle by recording an estimated bad debt expense in the period in which the related sale takes place. Second, it reports accounts receivable on the balance sheet at its realizable value. This means that investors and creditors will be able to see how much cash management is expecting to collect from its current customers on account. 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.

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. The bad debt expense for the accounting period is recorded with the following percentage of accounts receivable method journal entry.

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.