Allowance for Doubtful Accounts: Deduction Technique Explained

Using the percentage of sales method, they estimated that 1% of their credit sales would be uncollectible. It’s eventually determined that Fancy Foot Store had creditors in line that received all assets as priority lenders, therefore, Barry and Sons Boot Makers will not be receiving the $1 million. The entire amount is https://personal-accounting.org/cash-basis-accounting-definition/ written off as bad debt expense on the income statement and the allowance for doubtful accounts is also reduced by $1 million. Let’s say Barry and Sons Boot Makers sold $5 million worth of boots to many customers. Barry and Sons Boot Makers would record revenues of $5 million and accounts receivable of $5 million.

If Ito Company’s management knew which accounts were likely to not be collectible, they would have avoided selling to those customers in the first place. Allowance for Doubtful Accounts decreases (debit) and Accounts Receivable for the specific customer also decreases (credit). Allowance for doubtful accounts decreases because the bad debt amount is no longer unclear.

Pareto Analysis Method

All outstanding accounts receivable are grouped by age, and specific percentages are applied to each group. The aggregate of all group results is the estimated uncollectible amount. Because the allowance for doubtful accounts is established in the same accounting period as the original sale, an entity the allowance for uncollectible accounts is a does not know for certain which exact receivables will be paid and which will default. Therefore, generally accepted accounting principles (GAAP) dictate that the allowance must be established in the same accounting period as the sale, but can be based on an anticipated or estimated figure.

• The outstanding balance of $2,000 that Craft did not repay will
  remain as bad debt.
• Thus, virtually all of the remaining bad debt
  expense material discussed here will be based on an allowance
  method that uses accrual accounting, the matching principle, and
  the revenue recognition rules under GAAP.
• The allowance for doubtful accounts, based on the percentage of sales, should be a credit balance of $20,760.
• 1Some companies include both accounts on the balance sheet to explain the origin of the reported balance.
• In the example above, we estimated an arbitrary number for the allowance for doubtful accounts.

There is one more point about the use of the contra account,
Allowance for Doubtful Accounts. In this example, the $85,200 total
is the net realizable value, or the amount of accounts anticipated
to be collected. However, the company is owed $90,000 and will
still try to collect the entire $90,000 and not just the
$85,200.

What Are Accounts Uncollectible, Example

Note that allowance for doubtful accounts reduces the
overall accounts receivable account, not a specific accounts
receivable assigned to a customer. Because it is an estimation, it
means the exact account that is (or will become) uncollectible is
not yet known. For example, a customer takes out a $15,000 car loan on August
1, 2018 and is expected to pay the amount in full before December
1, 2018. For the sake of this example, assume that there was no
interest charged to the buyer because of the short-term nature or
life of the loan. When the account defaults for nonpayment on
December 1, the company would record the following journal entry to
recognize bad debt. At the end of an accounting period, the Allowance for Doubtful Accounts reduces the Accounts Receivable to produce Net Accounts Receivable.

If this does not eventually prove to be true, an adjustment of the overall estimation rates may be indicated. The outstanding balance of $2,000 that Craft did not repay will remain as bad debt. For the taxpayer, this means that if a company sells an item on credit in October 2018 and determines that it is uncollectible in June 2019, it must show the effects of the bad debt when it files its 2019 tax return. This application probably violates the matching principle, but if the IRS did not have this policy, there would typically be a significant amount of manipulation on company tax returns. For example, if the company wanted the deduction for the write-off in 2018, it might claim that it was actually uncollectible in 2018, instead of in 2019. Management may disclose its method of estimating the allowance for doubtful accounts in its notes to the financial statements.

Allowance for Doubtful Accounts

On the balance sheet, an allowance for doubtful accounts is considered a “contra-asset” because an increase reduces the accounts receivable (A/R) account. The allowance for doubtful accounts is management’s objective estimate of their company’s receivables that are unlikely to be paid by customers. The Allowance for Doubtful Accounts is a contra-asset account that estimates the future losses incurred from uncollectible accounts receivable (A/R). Allowance for Doubtful Accounts decreases (debit) and Accounts
Receivable for the specific customer also decreases (credit). Allowance for doubtful accounts decreases because the bad debt
amount is no longer unclear.

• Using the allowance method, complying with the matching principle, the amount is recorded in the current accounting period with the following percentage of credit sales method journal.
• Notice that bad debt expense in this case is simply the other half of the entry to get the balance sheet account adjusted.
• This variance in treatment addresses taxpayers’ potential to manipulate when a bad debt is recognized.