Estimating Uncollectible Accounts Financial Accounting

The second method of estimating the allowance for doubtful accounts is the aging method. All outstanding accounts receivable are grouped by age, and specific percentages are applied to each group. Notice that bad debt expense in this case is simply the other half of the entry to get the balance sheet account adjusted. The focus in this case is on the net realizable value of the receivables, and the income statement is relegated to second place. The allowance for doubtful accounts, based on the percentage of sales, should be a credit balance of $20,760. Right now, it has a debit balance of $500 because last year we booked $7,500 but the actual write off was $8,000.

This application probably violates the matching principle, but if the ATO did not have this policy, there would typically be a significant amount of manipulation on company tax returns. For example, if the business wanted the deduction for the write-off in 2021, it might claim that it was actually uncollectible in 2021, instead of in 2022. This method also does not provide the best estimate of how accounts receivable affect expected cash inflow for the business. As stated in the previous section, accounts receivable are reported on the balance sheet as an asset. The percentage of sales of estimating bad debts involves determining the percentage of total credit sales that is uncollectible. The past experience with the customer and the anticipated credit policy plays a role in determining the percentage.

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With this approach, accounts receivable is organised into categories by length of time outstanding, and an uncollectible percentage is assigned to each category. For example, a category might consist of accounts receivable that is 1–30 days past due and is assigned an uncollectible percentage of 3%. Another category might be 31–60 days past due and is assigned an uncollectible percentage of 15%.

This debit balance will then be eliminated when the new adjusting entry is made. The entry is not to the Uncollectible Accounts Expense account because we are assuming that the $6,000 is included in the $12,500 debit to expense as part of the December 31, 2019 adjusting entry. In preparing a balance sheet, the dollar balance in the Allowance account is netted against the dollar balance of gross accounts receivable. The first two entries are the usual ones to record sales on account and the subsequent collection of cash. Waiting to record the bad-debt expense in the year following the sale would violate the matching convention. Those receivables that the firm is unable to collect the full amount due from the customer are called uncollectible accounts.

Allowance for Doubtful Accounts: Normal Balance

Since the estimate is made by taking historical data into account, it gives a very close idea of the bad debt a business might incur. For example, if a business has total accounts receivable of $1M and their allowance for doubtful accounts is 5%, which is $50,000, then the net AR will be $950,000. The sum of the estimated amounts for all categories yields the total estimated amount uncollectible and is the desired credit balance in the Allowance for Uncollectible Accounts.

It can help your business reduce bad debt by prioritizing collections from high-risk customers, automating dunning processes, and providing real-time data and analytics. It also cuts down the invoicing costs, and reduces payment friction and DSO to eventually lower your allowance for doubtful accounts and bad debt expense. 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.

Why Doubtful Accounts Expenses Matter

Thus it is important to note that the percentage of receivables approach considers any existing balance in the allowance when calculating the amount of bad debt expense. The bad debts are the losses that the business suffers because it did not receive immediate payment for the sold goods and provided services. It’s recorded in the financial statements as a provision for credit losses. While the percentage of net sales method is easier to apply, the aging method forces management to analyze the status of their accounts receivable and credit policies annually. All sales made on credit, and cash collections on account totaled $750,000. After analyzing the ending balance of $250,000 in Accounts Receivable, management estimated that $12,500 of these accounts would ultimately become uncollectible.

To record the bad debt expenses, you must debit bad debt expense and a credit allowance for doubtful accounts. Once the percentage is determined, it is multiplied by the total credit sales of the business to determine bad debt expense. The percentage of net sales method produces a larger amount because it takes all Accounts Receivable into account, whether allowance for uncollectible accounts formula past due or not. The aging method only takes into account accounts that are considered by management to be uncollectible. Either approach can be used as long as adequate support is generated for the numbers reported. However, financial accounting does stress the importance of consistency to help make the numbers comparable from year to year.