Then, in the next accounting period, a lot of their customers could default on their payments (not pay them), thus making the company experience a decline in its net income. Therefore, the direct write-off method can only be appropriate for small immaterial amounts. We will demonstrate how to record the journal entries of bad debt using MS Excel.
On August 24, that same customer informs Gem Merchandise Co. that it has filed for bankruptcy. It also states that the liquidation value of those assets is less than the amount it owes the bank, and as a result Gem will receive nothing toward its $1,400 accounts receivable. After confirming this information, Gem concludes that it should remove, or write off, the customer’s account balance of $1,400.
The Direct Write-Off Method
You are considering switching to the balance sheet aging of receivables method. This would split accounts receivable into three past- due categories and assign a percentage to each group. Net realizable value is the amount the company expects to collect from accounts receivable. When the firm makes the bad debts adjusting entry, it does not know which specific accounts will become uncollectible. Thus, the company cannot enter credits in either the Accounts Receivable control account or the customers’ accounts receivable subsidiary ledger accounts. If only one or the other were credited, the Accounts Receivable control account balance would not agree with the total of the balances in the accounts receivable subsidiary ledger.
- Traditionally, the amount is calculated based on the past performance of the portfolio.
- Later, the allowance for doubtful accounts is used instead of bad debt expense to offset losses resulting from nonpayment from customers.
- The allowance method estimates bad debt during a period, based on certain computational approaches.
- The companies that qualify for this exemption, however, are typically small and not major participants in the credit market.
- There is one more point about the use of the contra account, Allowance for Doubtful Accounts.
In order to use the allowance method, it is first necessary to estimate the allowance needed using a suitable method. The entry has reinstated the customer balance, and now we need to record the cash receipt. It’s important to note that we have assumed the opening allowance for the bad debt as zero in the above entry. Bad Debt Expense increases (debit) as does Allowance for Doubtful Accounts (credit) for $58,097. On the other hand, writing off through the allowance method helps to locate the creation of provision, use of the provision, reversal, etc. From a control perspective, the use of the direct method can be a little risky, it’s because if there are no sound controls manager might write off balances in a personal capacity.
Recovery of the accounts receivables
Recognition of bad debt allowance in the accounting record helps the business to present a true financial picture. It has been observed that not all receivables of the business are collected, and presenting such uncollectible balances with overall receivables can lead to impairment in the decision of the financial statement user. This is the only entry in the allowance method that impacts the income statement. Later entries for the write-off just make adjustments in the balance sheet, and the net impact of the presentation remains the same. To present a true and fair view of the financial statement, management needs to ensure that they are confident about collecting the accounts receivables recorded in the balance sheet.
Percentage of Accounts Receivable Method Example
So, the allowance method allows organizations to create a general reserve for bad debt that can be used when the business needs to write off specific balances. The bad debt expense is then the difference between the calculated allowance for doubtful accounts at the end of the account period and the current allowance for doubtful accounts before adjustment. The historical bad debt experience of a company has been 3% of sales, and the current month’s sales are $1,000,000. Based on this information, the bad debt reserve to be set aside is $30,000 (calculated as $1,000,000 x 3%). In the following month, $20,000 of the accounts receivable are written off, leaving $10,000 of the reserve still available for additional write-offs.
That journal entry assumed a zero balance in Allowance for Doubtful Accounts from the prior period. This journal entry takes into account a debit balance of $20,000 and adds the prior period’s balance to the estimated balance of $58,097 in the current period. The journal entry for the Bad Debt Expense increases (debit) the expense’s balance, and the Allowance for Doubtful Accounts increases (credit) the balance in the Allowance. 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 allowance method is the more widely used method because it satisfies the matching principle.
Free Financial Statements Cheat Sheet
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 individual accounts receivable will prove to be uncollectible. The percentage of receivables method estimates the allowance for doubtful accounts using a percentage of the accounts receivable at the end of the accounting period. As the accountant for a large publicly traded food company, you are considering whether or not you need to change your bad debt estimation method. You currently use the income statement method to estimate bad debt at 4.5% of credit sales.
Although, the number of days passed since invoice overdue is an essential factor in determining if a specific balance should be written down. However, several other factors like the reputation of the customer, past trends, and business relations with them must be assessed. At the end of an accounting period, the Allowance for Doubtful Accounts reduces the Accounts Receivable to produce Net Accounts Receivable. Note that allowance for doubtful accounts reduces the overall accounts receivable account, not a specific accounts receivable assigned to a customer. Because it is an estimation, it means the exact account that is (or will become) uncollectible is not yet known. Using this allowance method, the estimated balance required for the allowance for doubtful accounts at the end of the accounting period is 7,100.
Further, the creation of the reserve is based on the balance of receivables or the percentage of sales generated by the organization during a specific reporting period under consideration. The process is also encouraged by the prudence concept of accounting, as bad debt expense is recorded before the actual write-off. Sometimes the business has already written off a certain amount, and an unexpected receipt is made from the customer. In this scenario, we need to reverse the allowance for receivables and reinstate the account balance. The accounts receivable method for the allowance calculation is more sophisticated and uses the aging report to assess the amount for the allowance.
Example of the Allowance Method
The allowance method estimates bad debt during a period, based on certain computational approaches. When the estimation is recorded at the end of a period, the following entry occurs. 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.
Further, allowance for doubtful accounts is debited when the debtor balance is identified as written off. Sometimes, the direct write-off for the account balance does not seem logical continuously compounded rate as the business may be unable to locate which debtor should be written off. It refers to the requirement of developing expectations for the loss to be incurred in the future.
