9 2: Account for Uncollectible Accounts Using the Balance Sheet and Income Statement Approaches Business LibreTexts

That total is reported in Bad Debt Expense and Allowance for Doubtful Accounts, if there is no carryover balance from a prior period. If there is a carryover balance, that must be considered before recording Bad Debt Expense. The balance sheet aging of receivables method is more complicated than the other two methods, but it tends to produce more accurate results. This is because it considers the amount of time that accounts receivable has been owed, and it assumes that the longer the time owed, the greater the possibility that individual accounts receivable will prove to be uncollectible.

Therefore, it is the method approved by GAAP.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. The income statement method (also known as thepercentage of sales method) estimates bad debt expenses based onthe assumption that at the end of the period, a certain percentageof sales during the period will not be collected. The estimation istypically based on credit sales only, not total sales (whichinclude cash sales). In this example, assume that any credit cardsales that are uncollectible are the responsibility of the creditcard company. It may be obvious intuitively, but, by definition, acash sale cannot become a bad debt, assuming that the cash paymentdid not entail counterfeit currency.

• When accountants decide to use a different rate for each age category of receivables, they prepare an aging schedule.
• This application probably violates thematching principle, but if the IRS did not have this policy, therewould typically be a significant amount of manipulation on companytax returns.
• The first one is known as aging method or balance sheet approach and the second one is known as sales method or income statement approach.
• To make things easier to understand, let’s go over an example of bad debt reserve entry.
• The net effect of this transaction is to reduce the accounts receivable balance and the allowance for doubtful accounts by $500.
• The balance sheet aging of receivables method is more complicated than the other two methods, but it tends to produce more accurate results.

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If this does not eventually prove to be true, an adjustment of the overall estimation rates may be indicated. 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. The outstanding balance of $2,000 that Craft did not repay will remain as bad debt. Bad Debt Expense increases (debit), and Allowance for Doubtful Accounts increases (credit) for $22,911.50 ($458,230 × 5%). Let’s say that on April 8, it was determined that Customer Robert Craft’s account was uncollectible in the amount of $5,000. For the taxpayer, this means that if a company sells an item on credit in October 2018 and determines that it is uncollectible in June 2019, it must show the effects of the bad debt when it files its 2019 tax return.

Double Entry Bookkeeping

Companies typically use methods like aging of accounts receivable or a percentage of sales to determine the allowance amount. Many businesses use a more refined version of the percentage-of-receivables approach, known as the Aging of receivables approach. This approach estimates bad debt expenses based on the balance in accounts receivable, but it also considers the uncollectible time period for each account.

• The outstanding balance of $2,000 that Craft did not repay willremain as bad debt.
• With a balance sheet approach the ending balance on the allowance account is calculated, and the bad debt expense is the balancing figure.
• In this article, we will delve into the world of uncollectible accounts, exploring the reasons behind them, the methods used to account for them, and the impact they have on a company’s financial statements.
• If a wholesale distributor finds that over a decade, about 3.2% of total AR typically becomes uncollectible, they might apply this percentage to their current receivables balance.
• Analysis of collection patterns of accounts receivable may suggest the need for changes in credit policies or for added financing.

Cash Flow Statement

At the end of March, ABC reviews the allowance for doubtful accounts and determines that the estimate of uncollectible accounts was too low. The net effect of this transaction is to reduce the accounts receivable balance and the allowance for doubtful accounts by $1,000. The net effect of this transaction is to reduce the accounts receivable balance and the allowance for doubtful accounts by $500. At the end of the accounting period, the company needs to review the allowance for doubtful accounts and adjust it as necessary. The net effect of this transaction is to reduce the accounts receivable balance and the allowance for doubtful accounts by the same amount.

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

However, the company is owed $90,000 and willstill try to collect the entire $90,000 and not just the$85,200. Accounting for uncollectible accounts involves estimating the amount of uncollectible accounts and creating an allowance for doubtful accounts. Analysts carefully monitor the days outstanding numbers for signs of weakening business conditions. These delays tend to have ripple effects; if a company has trouble collecting its receivables, it won’t be long before it may have trouble paying its own obligations.

The second entry records the payment in full with Cash increasing (debit) and Accounts Receivable decreasing (credit) for the amount received of $15,000. Since a small percentage of customers often represent a large portion of receivables, some companies employ Pareto analysis (the 80/20 principle). They focus their estimates on major accounts that constitute most of their receivables. Even though the company sold only to credit worthy customers, the company’s experience is that a small percent of customers will not pay the full amount. After reviewing the customers’ balances the company estimates that $10,000 of the $1,000,000 will not be collected. The sum of the estimated amounts for all categories yields the total estimated amount uncollectible and is the desired credit balance (the target) in the Allowance for Uncollectible Accounts.

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. During the following year, if a customer with an outstanding balance of $6,000 defaults on payment and is determined to be uncollectible, the company will make a journal entry to write off this specific amount. This entry reduces both accounts receivable and the allowance for uncollectible accounts by $6,000.

Assuming that credit is not asignificant component of its sales, these sellers can also use thedirect write-off method. The companies that qualify for thisexemption, however, are typically small and not major participantsin the credit market. Thus, virtually all of the remaining bad debtexpense material discussed here will be based on an allowancemethod that uses accrual accounting, the matching principle, andthe revenue recognition rules under GAAP. ABC creates an allowance for doubtful accounts by debiting the allowance for doubtful accounts account and crediting the bad debt expense account for $2,000.

Percentage-of-receivables approach

This involves debiting or crediting the allowance for doubtful accounts account and the bad debt expense account. For example, if a company has historically had bad debts of 3% of credit sales, it may estimate that 3% of current credit sales will allowance for uncollectible accounts on balance sheet also be uncollectible. The percentage of sales method involves estimating the percentage of credit sales that will not be collected based on historical data.