Allowance Method for Uncollectible Accounts

The allowance method is another method for accounting for bad debts or uncollectible accounts that involves estimating those uncollectible accounts at the end of each reporting period. The estimates are based on a company's prior receivables collection experience. The accumulation of these bad debt losses is reported in an account called allowance for doubtful accounts, which is a contra asset account. The normal balance, a credit balance, in this account is contrary to the typical debit balance in an asset account and is related to accounts receivable. Allowance for doubtful accounts, therefore, has the effect of reducing the overall accounts receivable balance to what is referred to as its net realizable value. Net realizable value is the net amount a company expects to receive in cash from its receivables.

The allowance method is the preferable method for reporting bad debt losses for a couple of reasons. First, by requiring that bad debt expense be estimated each reporting period, it better matches revenue and expenses. Bad debt expense is, therefore, reported in the same period in which the related sales revenue is reported.

Second, by using the allowance for doubtful accounts to capture the estimated accumulated bad debt losses, the allowance method ensures that receivables, as presented on the balance sheet, are reflective of what a company can expect to receive in cash from those receivables. Using the allowance for doubtful accounts, therefore, enhances the relevance of the balance sheet.

Because the allowance method provides a better matching of revenues and expenses and enhances the relevance of the income statement by properly measuring net income for the period, the allowance method is required for financial reporting purposes under generally accepted accounting principles.

When a company uses the allowance method to account for bad debts, it does so by using estimates derived from the company's prior collection experience. Companies do not wait for an account receivable to prove uncollectible before reporting bad debt expense. Rather, companies estimate their uncollectible accounts receivable each reporting period and record bad debt expense (for those expected uncollectible accounts) at that time. By doing so, a company matches its estimated expense against the revenue that was earned in creating the uncollectible accounts receivable during the same period.

No matter which approach to estimating the uncollectible accounts receivable, entries related to the allowance method are made.

One of the methods for estimating bad debt expense under the allowance method is the percentage-of-sales method, which computes bad debt expense as a percent of net credit sales (or sales that were sold on account). The percentage is based on a company's prior collection experience and other relevant factors.

The percentage-of-sales method embodies an income statement approach to estimating bad debts since it treats bad debt expense as a function of sales. Bad debt expense is simply the amount that results from multiplying net credit sales by the historical collection percentage determined by the company, which includes considerations such as current customer and industry conditions.

For example, Fusco BodyWorks reports $2,000,000 in net credit sales for the calendar year ended December 31, 2018. Based on past collection experience, Fusco estimates that 2% of net credit sales will become uncollectible. Fusco would compute bad debt expense as $\$2\text{,}000\text{,}000\;\times\;2\%\;=\$40\text{,}000$ and record the journal entry for the estimate of bad debts for 2018.