To illustrate, let’s continue to use Billie’s Watercraft Warehouse (BWW) as the example. BWW estimates that 5% of its overall credit sales will result in bad debt. 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.
- That is why this direct write-off method is usually used by some companies that have a small amount of receivables or its bad debt expense is insignificant or immaterial in the first place.
- The greater the credit sales, the greater we expect the expense to be.
- Bad debt is a specific account that has been determined to be uncollectible.
- When the nature and timing of the loss have been determined, our attention can be focused on a dollar measurement of the amount to be recorded.
- Normally, a higher rate is used for accounts that are older because they are considered more likely to become uncollectible.
When it is confirmed that the company will not receive payment, this will be reflected in the income statement with the amount not collected as bad debt expense. Hence, $3,000 ($100,000 x 3%) of the credit sales is estimated to uncollectible. And we use the allowance method to estimate and record the bad debt expense. Specifically, capital budgeting: what it is and how it works under the direct write-off method, we will only record the bad debt expense when we decide to write off any specific accounts. In other words, once we decide which accounts are uncollectible, we will directly write them off with the debit of bad debt expense account and the credit of the accounts receivable.
Understanding Accounts Uncollectible
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. The balance sheet aging of receivables method estimates bad debt expenses based on the balance in accounts receivable, but it also considers the uncollectible time period for each account. 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.
- This result is compared to the preadjustment balance in the allowance account, and the change is recorded in an adjusting entry.
- Analysts carefully monitor the days outstanding numbers for signs of weakening business conditions.
- For example,
a category might consist of accounts receivable that is 0–30 days
past due and is assigned an uncollectible percentage of 6%. - This variance in treatment addresses taxpayers’ potential to manipulate when a bad debt is recognized.
- Other companies use the percentage of receivable method (or a variation known as the aging method).
- It is the factor to increase sales as the customer does not have the cash to make immediate payments.
The first entry reverses the bad debt write-off by increasing Accounts Receivable (debit) and decreasing Bad Debt Expense (credit) for the amount recovered. The second entry records the payment in full with Cash increasing (debit) and Accounts Receivable decreasing (credit) for the amount received of $15,000. 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.
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As will soon be shown, the actual write-off in a subsequent period will generally not impact income. With this method, accounts receivable is organized 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 0–30 days
past due and is assigned an uncollectible percentage of 6%. Another
category might be 31–60 days past due and is assigned an
uncollectible percentage of 15%.
Other Allowances
Let’s say Barry and Sons Boot Makers sold $5 million worth of boots to many customers. Barry and Sons Boot Makers would record revenues of $5 million and accounts receivable of $5 million. This entry can be made because it is known which receivables account to remove from the subsidiary ledger. The action does not affect either the net amount of accounts receivable or the bad debt expense. This result is compared to the preadjustment balance in the allowance account, and the change is recorded in an adjusting entry.
Fundamentals of Bad Debt Expenses and Allowances for Doubtful
In other words, this method of recording the uncollectible accounts complies with the matching principle of accounting. 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. BWW estimates 15% of its
overall accounts receivable will result in bad debt.
Learning Activity 7.1 – Accounts Receivable
The outstanding balance of $2,000 that Craft did not repay will
remain as bad debt. The outstanding balance of $2,000 that Craft did not repay will remain as bad debt. Notice, other than the amount and description, this is the same entry we made under the percentage of sales method. Fancy Foot Store declares bankruptcy and it is uncertain if they will be able to pay the $1 million. Barry and Sons Boot Makers shows $5 million in accounts receivable but now also $1 million in allowance for doubtful accounts, which would be $4 million in net accounts receivable. Since the entry that recognizes the expense also reduces current assets by an increase in the Allowance for Uncollectibles, it also reduces working capital.
Introduction to Financial Accounting
Another approach that may be acceptable (e.g., due to a lack of materiality for a small or medium-sized business) is to record a credit to Miscellaneous Revenue. Again, this entry would be the only one made during the year that would affect the expense account. For example, suppose instead that the accountant at Sample Company estimates that the Allowance for Uncollectibles should be $375,000 after it is adjusted. When the appropriate year-end balance is computed, it is compared with the preadjustment balance and the needed change is determined. Under this direct approach for estimating the expense, the increase in the allowance is computed indirectly.