9 2: Account for Uncollectible Accounts Using the Balance Sheet and Income Statement Approaches Business LibreTexts

If the company does not provide for uncollectible accounts using the allowance method during each accounting period, then the matching principle will be violated, and the books will be a less accurate reflection of reality. Bad debt expense is an income statement account that is used to record client account balances deemed uncollectible by the accounting department. A company may use the direct write-off method or the allowance method. With this method, accounts receivable is organized into categories by length of time outstanding, and an uncollectible percentage is assigned to each category.

• The focus in this case is on the net realizable value of the receivables, and the income statement is relegated to second place.
• The Rule Of AccountingAccounting rules are guidelines to follow for registering daily transactions in the entity book through the double-entry system.
• Determine a required payment period and communicate that policy to customers.
• In that way, the receivable balance is shown at net realizable value while expenses are recognized in the same period as the sale to correspond with the matching principle.

If you use the general journal for the entry shown in the immediately previous cash receipts journal, you post the entry directly to cash and accounts receivable in the general ledger and also to J. Collection AgencyA collection agency refers to a firm engaged in the recovery of the default loans or dues from the borrowers on behalf of the lenders or creditors. A loan provider or creditor outsources its debt-collection function to such a third party to reduce bad debts. Credit SalesCredit Sales is a transaction type in which the customers/buyers are allowed to pay up for the bought item later on instead of paying at the exact time of purchase. It gives them the required time to collect money & make the payment.

The Allowance Method for Uncollectible Accounts

The first entry reinstates the customer’s accounts receivable balance by debiting accounts receivable and crediting allowance for bad debts. As in the previous example, the debit to accounts receivable must be posted to the general ledger control account and to the appropriate subsidiary ledger account. The adjusting entry to estimate the expected value of bad debts does not reduce accounts receivable directly. Accounts receivable is a control account that must have the same balance as the combined balance of every individual account in the accounts receivable subsidiary ledger. For tax purposes, companies must use the direct write‐off method, under which bad debts are recognized only after the company is certain the debt will not be paid. Before determining that an account balance is uncollectible, a company generally makes several attempts to collect the debt from the customer.

• The allowance method is the more widely used method because it satisfies the matching principle.
• Another way you can calculate ADA is by using the aging of accounts receivable method.
• BWW estimates 15% of its overall accounts receivable will result in bad debt.
• Recall the discussion of non bank credit card charges above; there, the service charge expense was recorded subsequent to the sale, and it was suggested that the approach was lacking but acceptable given the small amounts involved.

An allowance for doubtful accounts or uncollectible accounts is a prediction made by a company on the percentage of accounts receivable they foresee to be uncollectible. Use the accrual accounting method if you extend credit to customers. If a customer purchases from you but does not pay right away, you must increase your Accounts Receivable account to show the money that is owed to your business. When it comes to your small business, you don’t want to be in the dark. Your accounting books should reflect how much money you have at your business.

Allowance for doubtful accounts on the balance sheet

Bad debt expense also helps companies identify which customers default on payments more often than others. If a company does decide to use a loyalty system or a credibility system, they can use the information from the bad debt accounts to identify which customers are creditworthy and offer them discounts for their timely payments. Bad debt expense is something that must be recorded and accounted for every time a company prepares its financial statements. When a company decides to leave it out, they overstate their assets and they could even overstate their net income. Bad Debt Expense increases , and Allowance for Doubtful Accounts increases for $48,727.50 ($324,850 × 15%). Let’s consider that BWW had a $23,000 credit balance from the previous period.

For financial reporting purposes the allowance method is preferred since it means the loss is recognized closer to the time of the credit sales. This also means that the balance sheet will be reporting a lower, more realistic amount of its accounts receivable sooner. The journal entry of bad debt expense will be recorded against the debtor, and if the payment has been received, it will be written off, and the amount of cash received will be reported. So, when a company estimates it will have $15,000 in bad debt, they debit bad debt expense on the balance sheet and credit the allowance for doubtful accounts. Let’s say your business brought in $60,000 worth of sales during the accounting period. Based on historical trends, you predict that 2% of your sales from the period will be bad debts ($60,000 X 0.02).

What Are Uncollectible Accounts?

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. The balance sheet method estimates uncollectible accounts journal entry bad debt expenses based on the balance in accounts receivable. 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.

Debit your Bad Debts Expense account $1,200 and credit your Allowance for Doubtful Accounts $1,200 for the estimated default payments. When customers don’t pay you, your bad debts expenses account increases. A bad debt is debt that you have officially written off as uncollectible.