Allowance for Doubtful Accounts

At some point during the life of your business, you’ll likely have to write off an invoice for a customer who never makes payment. If you maintain the business’s books and records in accordance with generally accepted accounting principles, or GAAP, there are two methods for writing off part of an accounts receivable balance to choose from. Regardless of the method you choose, however, the impact on your company’s balance sheet and income statement is ultimately the same. At the time revenue is recorded, a company does not yet know which accounts will prove to be uncollectible.

The Allowance Method for Doubtful or Uncollectible Accounts is used to estimate future bad debts based on current month revenues. Using past performance data, a company can estimate that a certain percentage of current sales can reasonably expect to become bad debts. To conform to the Matching Principle, the company records that potential bad debt in the same month that the related revenue is recorded. The direct write-off method records bad debt expense in the year the specific https://online-accounting.net/ account receivable is determined to be uncollectible. For example, a business receives notification of a customer’s bankruptcy. Under the Allowance Method, potential bad debts are estimated monthly based on current month’s sales or current month’s outstanding Accounts Receivable. When a business grants credit to a customer, the customer is able to buy from the business “on account.” The customer gets the merchandise or service now and pays for the merchandise or service later.

What is Accounts Receivable (Trade Receivable)?

A primary difference between the direct write-off and allowance method is whether or not bad debts is based on a percentage of sales. The direct write-off method records bad debt expense when an account is determined to be uncollectible.

GAAP requires companies with a large amount of receivables to use the allowance method. Allowance for Doubtful Accounts is debited when a specific account is determined to be uncollectible. When a note is received from a customer on account, it is recorded by debiting Notes Receivable and crediting Accounts Receivable.

GAAP Rules for Writing Off Accounts Receivable

The amount due from the customer is tracked using an account called Accounts Receivable. The Accounts Receivable balance on the Balance Sheet is made up of all the individual customers and customer invoices currently outstanding. As sales on account are made to customers, the Accounts Receivable balance increases. As customers pay their accounts, Accounts Receivable is decreased. When a business grants credit to its customers, it runs the risk of the customer not paying the bill. Specific accounting rules apply to how a business records bad debts or potential bad debts.

A company can write-off a bad debt by using either the Direct Write-off Method or the Allowance for Doubtful Accounts Method. This can only be done by businesses operating under an accounting method called Accrual Accounting.

What is the Allowance Method for Bad Debts?

If a company is smaller and has a small number of customers who buy on credit , the business is able to use the Direct Write Off Method. When accounting for uncollectible receivables and using the percentage of sales method, the matching principle is violated. Which of the following statements is true when comparing the percent of sales method and the analysis of receivables method? The analysis of receivables method emphasizes matching revenues and expenses.

• The Allowance Method complies with the Generally Accepted Accounting Principle of matching revenues with related expenses.
• The revenue of $10,000 and the expense of $5,000 should be reported in June, the month when the revenue is reported as earned.
• The Direct Write-off Method only captures an expense when a company determines a debt to be uncollectible.
• If you maintain the business’s books and records in accordance with generally accepted accounting principles, or GAAP, there are two methods for writing off part of an accounts receivable balance to choose from.
• A company can write-off a bad debt by using either the Direct Write-off Method or the Allowance for Doubtful Accounts Method.
• On the balance sheet, the Allowance account will reflect the desired balance once the account balance is updated with the journal entry.

Direct write-off method Allowance method Both the direct write-off and allowance methods None of these choices are correct. Once you finalize the allowance estimate, you need a debit entry to “Bad Debts Expense” so that the revenue reported on the income statement reflects the uncollectible amount. A corresponding credit entry to the allowance account is also necessary. Whenever you have sufficient information to draw the conclusion that a specific customer is unlikely to make payment, that is when you’ll reduce the AR balance. Since you’re using up some of the estimate, you make a debit entry to the allowance account in the amount of the customer’s invoice. You then permanently reduce accounts receivable by the same amount with a credit entry.

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

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. Companies commonly use either credit sales or the age of AR balances as the basis for their allowance estimates. The percentage you use will depend on the specific factors that affect your business, such as financial data from prior years.

• Which method of accounting for uncollectible accounts receivable uses an estimate based on a percent of sales?
• Two common methods used to estimate the possible bad debts are Percentage of Sales and Accounts Receivable Aging.
• A completed journal and general ledger accounts are given in the Working Papers.
• Once re-instated, a payment can be applied to the re-instated invoice amount.
• This method does not conform to Generally Accepted Accounting Principles so it is not used for businesses with larger amounts and numbers of Accounts Receivable.

One of the most confusing chapters in your first accounting class is the bad debts and allowance for doubtful accounts chapter. Here, we will break it down step by step and provide some helpful resources to make this concept easier to understand. If Percent of Sales, take the current months’ credit sales x the estimated percentage to determine the estimate.

Related Accounting Q&A

The interest on a 6%, 60-day note for $5,000 is $300.

The maturity value of a 12%, 60-day note for $5,000 is $5,600. The due date of a 60-day note dated July 10 is September 10. Allowance for Doubtful Accounts is a liability account. Residual value is not incorporated in the initial calculations for double-declining-balance depreciation.

chapter 8 quiz

A completed journal and general ledger accounts are given in the Working Papers. Helen Orr owns a service business which uses the following accounts. $$ \begin \text & \text\\ \text & \text\\ \text & \text\\ \text & \text\\ \text & \text\\ \text & \text\\ \text & \text\\ \end $$ Post all the entries in the general journal. On the Balance Sheet, we can see that the desired balance of $4,905 is reflected in the new balance of the account. Capital expenditures are costs that are charged to stockholders’ equity accounts.

The cost of computer equipment does not include the consultant’s fee to supervise installation of the equipment. In computing the maturity date of a note, the date the note is issued is included but the due date is omitted.

Company

Generally accepted accounting principles require companies with a large amount of receivables gaap requires companies with a large amount of receivables to use the allowance method. to use the allowance method. Either the allowance method or the direct write-off method.