That is, the first result of the analysis is the amount of bad debt expense for the period. Most accountants take the position that the expense is incurred in order to increase sales and, therefore, should be reported in the same time period as those sales if cause and effect are to be related. what is a by-product by-products examples and pricing strategies During the month, they have realized that one customer was out of business, and they still own the company for $ 5,000. Please prepare a journal entry to write off an uncollectible account. There are two methods in accounting that allow the company to write off such balance to income statement.
- 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. - This approach allows the reader to calculate the proportion of the total group that is believed to be collectible or uncollectible.
- The allowance method estimates bad debt during a period, based on certain computational approaches.
- Under this direct approach for estimating the expense, the increase in the allowance is computed indirectly.
- The outstanding balance of $2,000 that Craft did not repay will
remain as bad debt.
A common variation used by many companies is the “aging method,” which first categorizes all receivable balances by age and then multiplies each of the individual totals by a different percentage. Normally, a higher rate is used for accounts that are older because they are considered more likely to become uncollectible. This alternative computes doubtful accounts expense by anticipating the percentage of sales (or credit sales) that will eventually fail to be collected. The percentage of sales method is sometimes referred to as an income statement approach because the only number being estimated (bad debt expense) appears on the income statement. 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.
How to estimate uncollectible receivables
An aging of accounts receivable stratifies receivables according to how long they have been outstanding. These percentages vary by company, but the older the account, the more likely it is to represent a bad account. In the preceding illustration, the $25,500 was simply given as part of the fact situation.
For example, assume BDCC recorded a $1,000 credit sale to XYA Company in April, 2015. Assume further that in 2016 it was determined that the $1,000 receivable from XYA Company would never be collected. The bad debt arising from the credit sale to XYA Company should be matched to the period in which the sale occurred, namely, April, 2015. But how can that be done if it is not known which receivables will become uncollectible? A means of estimating and recording the amount of sales that will not be collected in cash is needed. This is done by establishing a contra current asset account called Allowance for Doubtful Accounts (AFDA) in the general ledger to record estimated uncollectible receivables.
1 Accounts Receivable
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. It is important to consider other issues in the treatment of bad debts. 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.
What are the different types of uncollectible accounts expense?
The
allowance for doubtful accounts is a contra asset
account and is subtracted from Accounts Receivable to determine the
Net Realizable Value of the Accounts Receivable
account on the balance sheet. In the case of the allowance for doubtful
accounts, it is a contra account that is used to reduce the
Controlling account, Accounts Receivable. The final point relates to companies with very little exposure
to the possibility of bad debts, typically, entities that rarely
offer credit to its customers. Assuming that credit is not a
significant component of its sales, these sellers can also use the
direct write-off method. The companies that qualify for this
exemption, however, are typically small and not major participants
in the credit market.
Bad Debt Estimation
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. Subsidiary ledgers can be utilized in connection with any general ledger account where the availability of component information is helpful. Other than accounts receivable, they are commonly set up for inventory, equipment, and accounts payable. As might be imagined, big companies maintain subsidiary ledgers for virtually every T-account, whereas small companies are likely to limit use to accounts receivable and—possibly—a few other large balances. Bad Debt Expense increases (debit), and Allowance for Doubtful Accounts increases (credit) for $22,911.50 ($458,230 × 5%).
The allowance method is the more widely used method because it satisfies the matching principle. The allowance method estimates bad debt during a period, based on certain computational approaches. The calculation matches bad debt with related sales during the period. When the estimation is recorded at the end of a period, the following entry occurs. As the name suggests, this method will directly remove accounts receivable to bad debt expenses.
Financial Accounting
This transaction will not impact anything, the accounts receivable net balance will remain the same. While the direct write-off method is simple, it is only acceptable in those cases where bad debts are immaterial in amount. In accounting, an item is deemed material if it is large enough to affect the judgment of an informed financial statement user. Accounting expediency sometimes permits “incorrect approaches” when the effect is not material.