What is the main advantage of the allowance method of handling uncollectible accounts?
What Is an Allowance for Doubtful Accounts?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. However, the actual payment behavior of customers may differ substantially from the estimate. Show
Key Takeaways
Allowance for Doubtful AccountsUnderstanding the Allowance for Doubtful AccountsRegardless of company policies and procedures for credit collections, the risk of the failure to receive payment is always present in a transaction utilizing credit. Thus, a company is required to realize this risk through the establishment of the allowance for doubtful accounts and offsetting bad debt expense. In accordance with the matching principle of accounting, this ensures that expenses related to the sale are recorded in the same accounting period as the revenue is earned. The allowance for doubtful accounts also helps companies more accurately estimate the actual value of their account receivables. Because the allowance for doubtful accounts is established in the same accounting period as the original sale, an entity does not know for certain which exact receivables will be paid and which will default. Therefore, generally accepted accounting principles (GAAP) dictate that the allowance must be established in the same accounting period as the sale, but can be based on an anticipated or estimated figure. The allowance can accumulate across accounting periods and may be adjusted based on the balance in the account. Recording the Allowance for Doubtful AccountsTwo primary methods exist for estimating the dollar amount of accounts receivables not expected to be collected. Percentage of Sales MethodThe sales method applies a flat percentage to the total dollar amount of sales for the period. For example, based on previous experience, a company may expect that 3% of net sales are not collectible. If the total net sales for the period is $100,000, the company establishes an allowance for doubtful accounts for $3,000 while simultaneously reporting $3,000 in 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. The aggregate balance in the allowance for doubtful accounts after these two periods is $5,400. Accounts Receivable Aging MethodThe 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. The aggregate of all group results is the estimated uncollectible amount. For example, a company has $70,000 of accounts receivable less than 30 days outstanding and $30,000 of accounts receivable more than 30 days outstanding. Based on previous experience, 1% of accounts receivable less than 30 days old will be uncollectible, and 4% of those accounts receivable at least 30 days old will be uncollectible. Therefore, the company will report an allowance of $1,900 (($70,000 * 1%) + ($30,000 * 4%)). If the next accounting period results in an estimated allowance of $2,500 based on outstanding accounts receivable, only $600 ($2,500 - $1,900) will be the adjusting entry amount. Definition of Allowance MethodThe allowance method usually refers to one of the two ways for reporting bad debts expense that results from a company selling goods or services on credit. (The other way is the direct write-off method.) Under the allowance method, a company records an adjusting entry at the end of each accounting period for the amount of the losses it anticipates as the result of extending credit to its customers. The entry will involve the operating expense account Bad Debts Expense and the contra-asset account Allowance for Doubtful Accounts. Later, when a specific account receivable is actually written off as uncollectible, the company debits Allowance for Doubtful Accounts and credits Accounts Receivable. The allowance method is preferred over the direct write-off method because:
The allowance method can be applied in one or both of the following ways:
Examples of Allowance MethodLet's assume that a corporation begins operations on November 1 in an industry where it is common to give credit terms of net 30 days. In this industry approximately 0.3% of credit sales will not be collected. Next, let's assume that the corporation focuses on the bad debts expense. If the corporation's actual credit sales for November are $800,000 it will record an adjusting entry dated November 30 to debit Bad Debts Expense for $2,400 ($800,000 X 0.003) and credit Allowance for Doubtful Accounts for $2,400. As a result, its November income statement will be matching $2,400 of bad debts expense with the credit sales of $800,000. If the balance in Accounts Receivable is $800,000 as of November 30, the corporation will report Accounts Receivable (net) of $797,600. Focusing on the balance in the account Allowance for Doubtful Accounts, the corporation will adjust the balance in the account Allowance for Doubtful Accounts so that the combination of that credit balance and the debit balance in Accounts Receivable will be equal to the amount that is expected to turn to cash. The expected amount will likely be determined by aging the accounts receivable. If the corporation prepares weekly financial statements, it might focus on the bad debts expense for its weekly financial statements, but at the end of each quarter focus on the allowance account. What are the advantages and disadvantages of allowance method?Pros and Cons of Allowance Method
Another advantage is that the balance sheet accurately reports accounts receivable, which benefits investors and management. A disadvantage is that management might inaccurately estimate write-offs by a large margin, which can cause companies to misstate net income.
Why is allowance method better?The allowance method can be better for a business than the direct write-off method because: The bad debts expense closer to the point of the sale or service. The allowance prepares a more accurate estimation of end-of-period financials, so the business knows what they have and how to prepare.
What is the purpose of recording an allowance for uncollectible accounts?The purpose of the allowance for doubtful accounts is to estimate how many customers out of the 100 will not pay the full amount they owe. Rather than waiting to see exactly how payments work out, the company will debit a bad debt expense and credit allowance for doubtful accounts.
What is the general impact of the allowance methods for uncollectible accounts?Allowance methods will result in the recording of an estimated bad debts expense in the same period as the related credit sales, and generally result in a fairer balance sheet valuation for outstanding receivables. As will soon be shown, the actual write-off in a subsequent period will generally not impact income.
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