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It should be noted that the adjustment is made irrespective of the balance already on the allowance account, and for this reason the allowance account balance can build up irrespective of the level of accounts receivable. Accounts receivable represent amounts due from customers as a result of credit sales. Unfortunately for various reasons, some accounts receivable will remain unpaid and will need to be provided for in the accounting records of the business. At the closing of the accounting period, the business needs to decide the allowance (contra balance) to be recorded in the books of account. Traditionally, the amount is calculated based on the past performance of the portfolio.

This approach automatically expenses a percentage of its credit sales based on past history. With the direct write-off method, the company usually record bad debt expenses in a different period of those revenues that they are related to. This method doesn’t attempt to match bad debt expense to sales revenue in the income statement. Likewise, the direct write-off method does not conform to the matching principle of accounting at all. Sometimes, at the end of the fiscal period, when a company goes to prepare its financial statements, it needs to determine what portion of its receivables is collectible. The portion that a company believes is uncollectible is what is called “bad debt expense.” The two methods of recording bad debt are 1) direct write-off method and 2) allowance method.

• It should be noted that the adjustment is made irrespective of the balance already on the allowance account, and for this reason the allowance account balance can build up irrespective of the level of accounts receivable.
• However, GAAP and IFRS have issued certain guidance to estimate an amount based on the expected performance of the portfolio, probability, and other expected conditions.
• The exact amount of the bad debt expense is known under the direct write-off method, since a specific invoice is being written off, while only an estimate is being charged off under the allowance method.
• Accounts receivable represent amounts due from customers as a result of credit sales.
• 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.

For instance, Mr. X has defaulted, and his balance no more seems to be collectible. The receivable line item in the balance sheet tends to be lower under the allowance method, since a reserve is being netted against the receivable amount. Further details of the use of this allowance method can be found in our aged accounts receivable tutorial. The recovery of a bad debt, like the write-off of a bad debt, affects only balance sheet accounts. However, if the management has decided to write off some specific balance, there is a specific process of journal entries to be followed.

On March 31, 2017, Corporate Finance Institute reported net credit sales of $1,000,000. Using the percentage of sales method, they estimated that 1% of their credit sales would be uncollectible. 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.

Accounts Receivable and Bad Debts Expense Outline

The direct write-off method is a less theoretically correct approach to dealing with bad debts, since it does not match revenues with all applicable expenses in a single reporting period. Unlike the allowance method, the company only records bad debt expense when they determine a particular account to be uncollectible. And as the name suggested, bad debt expense will only show up when the company decides to write off any particular accounts. The company usually uses the allowance method to account for bad debt expense as it excludes the accounts receivable that are unlikely to be recoverable in the report. This helps the company to have a more realistic view of its accounts receivable.

If the seller is a new company, it might calculate its bad debts expense by using an industry average until it develops its own experience rate. The allowance method of accounting for Bad Debts involves estimating uncollectible accounts at the end of each period. It provides better matching of expenses and revenues on the Income Statement and ensures that receivables are stated at their cash (net) realizable value on the Balance Sheet. Cash (net) realizable value is the net amount of cash expected to be received. Receivables are therefore reduced by estimated uncollectible amounts on the balance sheet through use of the allowance method. The allowance method is required for financial reporting purposes when bad debts are material.

Let’s look at what is reported on Coca-Cola’s Form 10-K regarding its accounts receivable. On June 3, a customer purchases $1,400 of goods on credit from Gem Merchandise Co. 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.

It then makes a journal entry to record the non-creditworthy customers by debiting bad debt expense and crediting the allowance account. Other than management’s estimation, there is no reason to believe that these customers will not pay their full invoice. The allowance method follows GAAP matching principle since we estimate uncollectible accounts at the end of the year. We use this estimate managing an audit to record Bad Debt Expense and to setup a reserve account called Allowance for Doubtful Accounts (also called Allowance for Uncollectible Accounts) based on previous experience with past due accounts. We can calculate this estimates based on Sales (income statement approach) for the year or based on Accounts Receivable balance at the time of the estimate (balance sheet approach).

Based on past experiences and its credit policy, the company estimates that 1% of credit sales which is USD 18,500 will be uncollectible. The business may have the policy to provide for a certain amount based on their past trend etc. On the contrary, a specific allowance is provided against a specific account balance.

Writing Off an Account under the Allowance Method

This means that investors and creditors will be able to see how much cash management is expecting to collect from its current customers on account. 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.

Percentage of Receivables Method

We do not record any estimates or use the Allowance for Doubtful Accounts under the direct write-off method. This method violates the GAAP matching principle of revenues and expenses recorded in the same period. Using this allowance method, the estimated balance required for the allowance for doubtful accounts at the end of the accounting period is 7,100.

The various methods can be classified as either being an income statement approach or a balance sheet approach. With an income statement approach the bad debt expense is calculated, and the allowance account is the balancing figure. With a balance sheet approach the ending balance on the allowance account is calculated, and the bad debt expense is the balancing figure.

Free Financial Statements Cheat Sheet

When management knows that a specific account is uncollectable, it writes off the balance by debiting the allowance account and crediting the accounts receivable account. This completely removes the customer’s balance from the accounting system. The Bad Debts Expense remains at $10,000; it is not directly affected by the journal entry write-off. The bad debts expense recorded on June 30 and July 31 had anticipated a credit loss such as this. It would be double counting for Gem to record both an anticipated estimate of a credit loss and the actual credit loss.

Allowance Method

After confirming this information, Gem concludes that it should remove, or write off, the customer’s account balance of $1,400. The allowance method is a technique for estimating and recording of uncollectible amounts when a customer fails to pay, and is the preferred alternative to the direct write-off method. 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. For example, the company ABC Ltd. had the credit sales amount to USD 1,850,000 during the year.

Each write-off should be approved in writing by authorized management personnel. Under the allowance method, every bad debt write-off is debited to the allowance account (not to Bad Debt Expense) and credited to the appropriate Account Receivable. 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. The amount of the accounts receivable can be material and impact the decision of the financial statement user. The allowance for doubtful accounts on the balance sheet is increased by credit journal entry.