The balance sheet method is
another simple method for calculating bad debt, but it too does not
consider how long a debt has been outstanding and the role that
plays in debt recovery. 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 percentage of receivables approach (also known as the balance sheet approach) estimates bad debt expenses based on the balance in accounts receivable. This approach looks at the balance of accounts receivable at the end of the period and assumes that a certain amount will not be collected.
To demonstrate the treatment of the allowance for doubtful accounts on the balance sheet, assume that a company has reported an Accounts Receivable balance of $90,000 and a Balance in the Allowance of Doubtful Accounts of $4,800. The following table reflects how the relationship would be reflected in the current (short-term) section of the company’s Balance Sheet. As you’ve learned, the delayed recognition of bad debt violates GAAP, specifically the matching principle. Therefore, the direct write-off method is not used for publicly traded company reporting; the allowance method is used instead. The understanding is that the couple will make payments each month toward the principal borrowed, plus interest. As you’ve learned above, the delayed recognition of bad debt violates GAAP, specifically the matching principle.
The necessary reduction is then recorded by means of an adjusting entry. A credit or increase to the contra asset account labelled Allowance for Doubtful or Uncollectible accounts is offset by debit or increase to the bad debt expense that also decreases net income and stockholders equity. As of January 1, 2018, GAAP requires a change in how health-care
entities record bad debt expense. Before this change, these
entities would record revenues for billed services, even if they
did not expect to collect any payment from the patient.
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This application probably violates the
matching principle, but if the IRS did not have this policy, there
would typically be a significant amount of manipulation on company
tax returns. For example, if the company wanted the deduction for
the write-off in 2018, it might claim that it was actually
uncollectible in 2018, instead of in 2019. The accountant for Sample Company may have estimated that 5% of its $7,500,000 of receivables were uncollectible in arriving at the desired balance of $375,000 used in the entry above.
The reported expense is the amount needed to adjust the allowance to this ending total. Both methods provide no more than an approximation of net realizable value based on the validity of the percentages that are applied. Under the percentage of sales method, the expense account is aligned with the volume of sales. In applying the percentage of receivables method, determining the uncollectible portion of ending receivables is the central focus. Regardless of the approach, both bad debt expense and the allowance for doubtful accounts are simply the result of estimating the final outcome of an uncertain event—the collection of accounts receivable.
- Both methods provide no more than an approximation of net realizable value based on the validity of the percentages that are applied.
- Since the entry that recognizes the expense also reduces current assets by an increase in the Allowance for Uncollectibles, it also reduces working capital.
- You are considering switching to the balance sheet aging of receivables method.
- On December 31, 2019, Ling Co. estimated that 2% of its net sales of $450,000 will become uncollectible.
- Thus, the allowance increases with a credit (creating a decrease in the net receivable balance) and decreases with a debit.
The method looks at the balance of accounts receivable at the end of the period and assumes that a certain amount will not be collected. Accounts receivable is reported on the balance sheet; thus, it is called the balance sheet method. The balance sheet method is another simple method for calculating bad debt, but it too does not consider how long a debt has been outstanding and the role that plays in debt recovery. To compensate for this problem, accountants have developed “allowance methods” to account for uncollectible accounts.
Though, it may be useful to note that, under the allowance method, we need to estimate the bad debt expense for the period that could happen as a result of the credit sale. The estimation of the bad debt expense can done through the percentage of sales or the percentage of receivables. 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.
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The allowance for doubtful accounts is an example of a “contra account,” one that always appears with another account but as a direct reduction to lower the reported value. Here, the allowance serves to decrease the receivable balance to its estimated net realizable value. As a contra asset account, debit and credit rules are applied that are the opposite of the normal asset rules.
Direct write-off method
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 payroll accounting basics individual accounts receivable will prove to be uncollectible. The income statement method (also known as the percentage of sales method) estimates bad debt expenses based on the assumption that at the end of the period, a certain percentage of sales during the period will not be collected. The estimation is typically based on credit sales only, not total sales (which include cash sales).
Understanding Accounts Uncollectible
Before computer systems became common, keeping the total of thousands of individual accounts in a subsidiary ledger in agreement with the corresponding general ledger T-account balance was an arduous task. Mechanical errors (mathematical problems as well as debit and credit mistakes) tended to abound. However, current electronic systems are typically designed so that the totals reconcile automatically.
The accountant assigns a larger percentage of assumed nonpayment probability to each of these time buckets, such as 5% to the balance in the day bucket, 20% to the day bucket, and 40% to the 90+ day bucket. These percentages are based on the historical experience of the firm in obtaining payments from each of these classifications. The totals of estimated unpaid amounts for each time bucket are then added together to arrive at the total amount of estimated uncollectible receivables. This approach works best when receivables include a small number of relatively large invoices. The amount of uncollectible accounts receivable must be estimated in order to create an allowance for doubtful accounts. This estimate can be derived from the aged accounts receivable report, or by using a percentage of sales.
BWW estimates that 5% of its overall credit sales
will result in bad debt. It’s eventually determined that Fancy Foot Store had creditors in line that received all assets as priority lenders, therefore, Barry and Sons Boot Makers will not be receiving the $1 million. The entire amount is written off as bad debt expense on the income statement and the allowance for doubtful accounts is also reduced by $1 million.
