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Estimating Uncollectible Accounts Financial Accounting

Bad debt expense is a natural part of any business that extends credit to its customers. Because a small portion of customers will likely end up not being able to pay their bills, a portion of sales or accounts receivable must be ear-marked as bad debt. This small balance is most often estimated and accrued using an allowance account that reduces accounts receivable, though a direct write-off method (which is not allowed under GAAP) may also be used. 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. 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.

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. Then all of the category estimates are added together to get one total estimated uncollectible balance for the period. The entry for bad debt would be as follows, if there was no carryover balance from the prior period.

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. 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.

Though part of an entry for bad debt expense resides on the balance sheet, bad debt expense is posted to the income statement. Recognizing bad debts leads to an offsetting reduction to accounts receivable on the balance sheet—though businesses retain the right to collect funds should the circumstances change. An allowance for doubtful accounts is a contra account that nets against the total receivables presented on the balance sheet to reflect only the amounts expected to be paid. The allowance for doubtful accounts estimates the percentage of accounts receivable that are expected to be uncollectible.

  1. 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.
  2. During the year, similar entries are made to record other accounts declared uncollectible.
  3. Sponsored accounts receivable write-offs will be handled internally, following Sponsored Financial Services guidelines.
  4. When a specific customer has been identified as an uncollectible
    account, the following journal entry would occur.

A separate subsidiary ledger should be in place to monitor the amounts owed by each customer (Mr. A, Ms. B, and so on). The general ledger figure is used whenever financial statements are to be produced. The subsidiary ledger allows the company to access individual account balances so that appropriate action can be taken if specific receivables grow too large or become overdue. Two primary methods exist for estimating the dollar amount of accounts receivables not expected to be collected.

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Of the $50,000 balance that was written off, the company is notified that they will receive $35,000. 2Because the focus of the discussion here is on accounts receivable and their collectability, the recognition of cost of goods sold as well as the possible return of any merchandise will be omitted. The number of customers that owe the company will be lower due to more strict collection policies. Bad Debt Expense increases (debit) as does Allowance for
Doubtful Accounts (credit) for $58,097. Bad Debt Expense increases (debit) as does Allowance for Doubtful Accounts (credit) for $58,097. The previous entries demonstrate the entries made to write off an account declared uncollectible and reinstate an account that had previously been written off.

3 Uncollectible Accounts

However, the actual payment behavior of customers may differ substantially from the estimate. With the direct write-off method, many accounting periods may come and go before an account is finally determined to be uncollectible and written off. The bad debt expense for the accounting period is recorded with the following percentage of accounts receivable method journal entry. From this information, anyone studying these financial statements for Year One should understand that an expense estimated at $7,000 was incurred this year because the company made sales that will never be collected.

How do you estimate the amount of uncollectible accounts receivable?

Based on this review, ABC increases the allowance for doubtful accounts by $500 by debiting the allowance for doubtful accounts account and crediting 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 uncollectible accounts receivable will also be uncollectible. This can be done using different methods, such as the percentage of sales method or the aging of accounts receivable method. Using this allowance method, the estimated balance required for the allowance for doubtful accounts at the end of the accounting period is 7,100.

Adjusting Entries for Uncollectible Accounts

For this reason, the adjustment to accounts receivable is made using the contra asset account allowance for doubtful accounts, which is sometimes referred to as the allowance for bad debts. This lets companies to display accounts receivable in what is known as “net realizable value” on the balance sheet. With this method, accounts receivable is organized into
categories by length of time outstanding, and an uncollectible
percentage is assigned to each category.

As we have seen, reasonable errors in a prior year’s estimates are adjusted in current and future years; the accountant does not retroactively change a prior year’s statement. This debit balance will then be eliminated when the new adjusting entry is made. In preparing a balance sheet, the dollar balance in the Allowance account is netted against the dollar balance of gross accounts receivable.

As we have shown, the allowance method is based on the accountant’s ability to estimate future uncollectible accounts that result from current year’s sales. On the other hand, uncollectible accounts are amounts that, after prolonged efforts, are deemed uncollectable. These are not yet recognized as expenses, as you’re still clinging to the hope of being collected.

Allowance for Doubtful Accounts: Methods of Accounting for

At the end of March, ABC reviews the allowance for doubtful accounts and determines that the estimate of uncollectible accounts was too low. Based on this historical data, ABC estimates that $2,000 of the January credit sales will be uncollectible. This allows companies to account for the possibility of bad debts and maintain accurate financial statements. Once the company has identified accounts that are likely to be uncollectible, it needs to estimate the amount of uncollectible accounts. Uncollectible receivables, that are a result of revenue generating activities, should be recorded as a contra revenue so as to reduce the related revenue accounts.

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