Overview of Allowance Method
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.
Estimate of Uncollectible Accounts Entry
|December 31, year 1||Bad Debt Expense||$40,000|
|Allowance for Doubtful Accounts||$40,000|
|To record estimate of uncollectible accounts at December 31.|
Write-Off of Specific Customer's Account Entry
|July 31, year 2||Allowance for Doubtful Accounts||$1,000|
|To record write-off of specific customer's account.|
Reinstatement of Specific Customer's Account Entry
|September 15, year 2||Accounts Receivable||$1,000|
|Allowance for Doubtful Accounts||$1,000|
|To record reinstatement of specific customer's account due to full payment received of amount previously written off (entries of this nature are rare)|
Cash Received for Specific Customer's Account Entry
|September 15, year 2||Cash||$1,000|
|To record cash received for full payment of amount previously written off|
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 and record the journal entry for the estimate of bad debts for 2018.
Allowance for Doubtful Accounts, Percentage-of-Sales Method Entry
|December 31||Bad Debt Expense||$40,000|
|Allowance for Doubtful Accounts||$40,000|
|To record estimate of uncollectible accounts for 2018 based on 2% of net credit sales|
A popular method for estimating bad debts and uncollectible accounts under the allowance method is the aging-of-receivables method, which utilizes a report that classifies customer balances by the length of time those accounts have been unpaid.
When using the aging-of-receivables method, companies prepare an aging of their accounts receivable, which details each individual customer account balance that comprises the total accounts receivables balance and further categorizes those individual balances into aging categories. These categories indicate the length of time the account has been outstanding. Individual collection percentages are assigned to each category in order to determine the estimated uncollectible amounts for each category. Each percentage is multiplied by its respective category total, and the sum of these amounts represents the estimated end of period balance to be reported in allowance for doubtful accounts. It is important to note that the focus of this method is on accounts receivable outstanding at the end of the period, not on the credit sales during the period.The aging-of-receivables method is said to take a balance sheet approach to estimating bad debts because of its focus on computing an appropriate end of period estimate of allowance for doubtful accounts.