If the estimate of uncollectible accounts was too high, the company can reverse some of the allowance. Once the amount of uncollectible accounts has been estimated, the company needs to create an allowance for doubtful accounts. In addition, it’s important to note the change in the allowance from one year to the next. Because the allowance went relatively unchanged at $1.1 billion in both 2020 and 2021, the entry to bad debt expense would not have been material. However, the jump from $718 million in 2019 to $1.1 billion in 2022 would have resulted in a roughly $400 million bad debt expense to reconcile the allowance to its new estimate.
Why would a business want to use the aging method rather than the percentage of net sales method?
This method involves creating an allowance for doubtful accounts, a contra-asset account that offsets the accounts receivable on the balance sheet. The purpose of the allowance method is to anticipate potential losses from uncollectible accounts and match these estimated losses to the same period in which the related sales occurred. This ensures that the financial statements accurately reflect the true economic condition of the company. The balance sheet aging of receivables method estimates bad debt expenses based on the balance in accounts receivable, but it also considers the uncollectible time period for each account. Bad debt expense is reported within the selling, general, and administrative expense section of the income statement.
Understanding the Allowance for Doubtful Accounts
However, the entries to record this bad debt expense may be spread throughout a set of financial statements. The allowance for doubtful accounts resides on the balance sheet as a contra asset. Meanwhile, any bad debts that are directly written off reduce the accounts receivable balance on the balance sheet.
What Is an Allowance for Doubtful Accounts?
- This would split accounts receivable into three past- due categories and assign a percentage to each group.
- The second entry records thepayment in full with Cash increasing (debit) and AccountsReceivable decreasing (credit) for the amount received of$15,000.
- The debit part of the adjusting entry is made to the Uncollectible Accounts Expense account.
This entry is a reversal, in the amount of $400, of the entry to write off the receivable. In some cases, a customer whose account has been written off will subsequently pay part or all of his or her account. The entry on April 14, 2020 just decreases the Allowance account and the Accounts Receivable account by the same amount, $6,000. Because this is the first year of the firm’s operations, the balance in the Allowance account equals the amount of the Journal entry.
In either case, bad debt represents a reduction in net income, so in many ways, bad debt has characteristics of both an expense and a loss account. Generally Accepted Accounting Principles (GAAP) are a set of rules and standards established to ensure consistency, transparency, and comparability in financial reporting across all industries in the United States. GAAP encompasses a broad range of principles and procedures, governing how financial statements are prepared and presented. The primary objective of GAAP is to provide reliable financial information that can be used by investors, creditors, and other stakeholders to make informed decisions.
Direct Write-Off Method
Accurately recording bad debt expenses is crucial if you want to lower your tax bill and not pay taxes on profits you never earned. The percentage of net sales method produces a larger amount cash flow worksheet because it takes all Accounts Receivable into account, whether past due or not. The aging method only takes into account accounts that are considered by management to be uncollectible.
In Exhibit 1, the aging schedule shows that the older the receivable, the less likely the company is to collect it. This provides information which can be used to determine whether any further collection efforts are justified or not. The aging method also makes it easier for management to make changes in credit policies and discounts offered to customers. For example, in these firms, the percentage of net sales method is typically used to prepare monthly and quarterly statements, whereas the aging method is used to make the final adjustment at year-end.
Bad debt expense is a natural part of any business that extends credit to its customers. Because a small portion of customers will likely end up not being able to pay their bills, a portion of sales or accounts receivable must be ear-marked as bad debt. This small balance is most often estimated and accrued using an allowance account that reduces accounts receivable, though a direct write-off method (which is not allowed under GAAP) may also be used. The Percentage of Sales Method is a practical and efficient way to estimate uncollectible accounts, particularly for businesses with consistent sales patterns and predictable bad debt rates. The journal entry ensures that the bad debt expense is recognized on the income statement, reducing the net income by $20,000. Simultaneously, the allowance for doubtful accounts is increased on the balance sheet, reducing the net accounts receivable by the same amount, thereby presenting a more accurate financial position.
As of January 1, 2018, GAAP requires a change in how health-careentities record bad debt expense. Before this change, theseentities would record revenues for billed services, even if theydid not expect to collect any payment from the patient. Mechanically, the underestimation still exists in the accounting records in Year Two. It creates the $3,000 debit in the allowance for doubtful accounts before the expense adjustment.