4.4 Uncollectible Accounts
4.4.2 Allowance Method
The allowance method is used by companies that frequently experience bad debt. A new account—Allowance for Doubtful Accounts—is a contra asset account that absorbs this non-payment when the account receivable is closed out.
An allowance is an estimate. Companies that have continuous bad debt make an adjusting entry at the beginning of the year to estimate how much of its Accounts
Receivable it believes it will never collect due to non-payment. This is recorded
before any customer’s account actually defaults during the year.
ADJUSTING ENTRY TO SET UP BAD DEBT ESTIMATE of $15,000 FOR THE YEAR: A credit to Allowance for Doubtful Accounts increases it, since it is a contra asset. NOTE: The only time Bad Debt Expense is used under the allowance method is in the annual adjusting entry. There are two ways of estimating the amount of bad debt for the upcoming year; these will be discussed shortly.
Date Account Debit Credit ▲ Bad Debt Expense is an expense account
that is increasing.
1/1 Bad Debt Expense 15,000
Allowance for Doubtful Accounts 15,000 ▲ Allow Doubt Accts is a contra asset account
that is increasing.
SALE ON ACCOUNT: The company debits Accounts Receivable rather than
Cash when it sells on account.
Date Account Debit Credit ▲ Accounts Receivable is an asset account that is increasing.
4/1 Accounts Receivable 3,000
WRITE-OFF OF ALL OF AN ACCOUNTS RECEIVABLE: If none of what the customer owes will ever be received, Allowance for Doubtful Accounts is debited instead of Cash to close out the account.
Date Account Debit Credit ▼ Allow Doubt Accts is a contra asset account that
is decreasing.
4/30 Allowance Doubtful Accounts 3,000
Accounts Receivable 3,000 ▼ Accounts Receivable is an asset account that is decreasing.
WRITE-OFF OF PART OF AN ACCOUNTS RECEIVABLE: If the customer pays some of what he owes but will never be able to pay the rest, the company records the receipt of cash and also writes off the remaining amount that it will never receive. In this case the customer pays $1,000 and the company writes off the remaining $2,000.
Date Account Debit Credit ▲ Cash is an asset account that is increasing.
4/30 Cash 1,000 ▼ Allow Doubt Accts is a contra asset account that
is decreasing.
Allowance Doubtful Accounts 2,000
Accounts Receivable 3,000 ▼ Accounts Receivable is an asset account that is decreasing.
REINSTATEMENT OF FULL AMOUNT: If, for some reason, the customer returns to pay his entire bill AFTER the write-off, just “flip over” the previous transaction to void it. This is called reinstating. Then make the journal entry to collect the cash. Note that there are two journal entries for a reinstatement.
Date Account Debit Credit ▲ Accounts Receivable is an asset account that is increasing.
▲ Allow Doubt Accts is a contra asset account that is increasing.
▲ Cash is an asset account that is increasing. ▼ Accounts Receivable is an asset account that
is decreasing.
6/17 Accounts Receivable 3,000
Allowance for Doubtful Accounts 3,000
Cash 3,000
Accounts Receivable 3,000
REINSTATEMENT OF PARTIAL AMOUNT: If, for some reason, the customer returns to pay only part of what he owed AFTER the write-off (for example, $1,000), just “flip over” the previous transaction to void it. This is called reinstating. Then make the journal entry to collect the cash. Only include the amount the customer repays, not the entire amount that was written off.
Date Account Debit Credit ▲ Accounts Receivable is an asset account that is increasing.
▲ Allow Doubt Accts is a contra asset account that is increasing.
6/17 Accounts Receivable 1,000
Net Realizable Value is the amount of a company’s total Accounts Receivable
that it expects to collect. It is calculated and appears on the Balance Sheet as follows:
Accounts Receivable $97,000 (amount owed to a company)
Less: Allowance for Doubtful Accounts 12,000 (amount the company expects will “go bad”) Net Realizable Value $85,000
In fairness to the readers of the balance sheet, the company admits on the balance sheet that even though it is owed $97,000 from customers (an asset), it does not expect to ever receive $12,000 of it. The Accounts Receivable and
Allowance for Doubtful Accounts amounts on the balance sheet are the
current ledger balances.
ALLOWANCE METHOD—ANALYSIS OF RECEIVABLES
The allowance method is used by companies that frequently experience bad debt. An allowance is an estimate. Companies that have continuous bad debt make an adjusting entry at the beginning of the year to estimate how much of its Accounts Receivable it believes it will never collect due to non-payment.
The question now is this: How is the amount of the adjusting entry determined?
Sample: ADJUSTING ENTRY TO SET UP BAD DEBT ESTIMATE FOR THE YEAR
Date Account Debit Credit ▲ Bad Debt Expense is an expense account
that is increasing.
1/1 Bad Debt Expense ?????
Allowance for Doubtful Accounts ????? ▲ Allow Doubt Accts is a contra asset account
that is increasing.
There are two ways to arrive at the estimate for the upcoming year (the amount of the adjusting entry) under the allowance method. These are analysis of
receivables and percent of sales.
1. Analysis of receivables involves analyzing and/or contacting all customers, determining who is likely to default and adding the amounts for all customers who are likely to become bad debt. The adjusting entry
should include the amount necessary to bring the Allowance for Doubtful Accounts ledger balance up to this number.
In the three examples that follow, assume that after analyzing receivables on 1/1, it is estimated that there will be $8,000 of bad debt during the upcoming year.
Example 1 – Analysis of Receivables: No balance in the Allowance for Doubtful Accounts ledger.
Allowance for Doubtful Accounts
Since there is no balance in the account “left over” from last year, it will take a credit of $8,000 to bring the year’s beginning balance up to $8,000.
Date Item Debit Credit Debit Credit 1/1 Balance
Date Account Debit Credit ▲ Bad Debt Expense is an expense account
that is increasing.
1/1 Bad Debt Expense 8,000
Allowance for Doubtful Accounts 8,000 ▲ Allow Doubt Accts is a contra asset account
that is increasing.
Allowance for Doubtful Accounts
The adjusting entry for the estimate brings the
Accumulated Depreciation credit balance to $8,000 Date Item Debit Credit Debit Credit
1/1 8,000 8,000
Example 2– Analysis of Receivables: A $600 credit balance in the Allowance for Doubtful Accounts ledger.
This means that the company overestimated its Bad Debt Expense last year—it had less bad debt than it had estimated it would have.
Allowance for Doubtful Accounts
Since there is already a $600 credit balance in the account “left over” from last year, it will only take an additional credit of $7,400 to bring the year’s beginning balance up to $8,000.
Date Item Debit Credit Debit Credit
1/1 Balance 600
Date Account Debit Credit ▲ Bad Debt Expense is an expense account
that is increasing.
1/1 Bad Debt Expense 7,400
Allowance for Doubtful Accounts 7,400 ▲ Allow Doubt Accts is a contra asset account
that is increasing.
Example 3– Analysis of Receivables: A $600 debit balance in the Allowance for Doubtful Accounts ledger.
This means that the company underestimated its Bad Debt Expense last year— it had more bad debt than it had estimated it would have.
Allowance for Doubtful Accounts
Since there is already a $600 debit balance in the account “left over” from last year, it will take an additional credit of $8,600 to bring the year’s beginning balance up to $8,000.
Date Item Debit Credit Debit Credit
1/1 Balance 600
Date Account Debit Credit ▲ Bad Debt Expense is an expense account
that is increasing.
1/1 Bad Debt Expense 8,600
Allowance for Doubtful Accounts 8,600 ▲ Allow Doubt Accts is a contra asset account
that is increasing.
Allowance for Doubtful Accounts
The adjusting entry for the estimate brings the
Accumulated Depreciation credit balance to $8,000. Date Item Debit Credit Debit Credit
1/1 Balance 600
1/1 8,600 8,000
ALLOWANCE METHOD – PERCENT OF SALES
2. Percent of Sales involves a simple calculation: Sales on account in previous year times the historical percent of sales that default. The
adjusting entry should include the result of the calculation; the credit to Allowance for Doubtful Accounts increases the account’s ledger balance.
In the three examples below assume that sales on account for the previous year were $400,000 and an estimated 2% of those sales will have to be written off. The amount of $8,000, which his $400,000 x 2%, is the amount that will be entered in the adjusting entry for the estimate.
Example 1 – Percent of Sales: No balance in the Allowance for Doubtful Accounts ledger.
Allowance for Doubtful Accounts
There is no balance in the account “left over” from last year.
Date Item Debit Credit Debit Credit 1/1 Balance
Date Account Debit Credit $400,000 x 2% = $8,000
▲ Bad Debt Expense is an expense account that is increasing.
▲ Allow Doubt Accts is a contra asset account that is increasing.
1/1 Bad Debt Expense 8,000
Allowance for Doubtful Accounts 8,000
Allowance for Doubtful Accounts
The adjusting entry for the estimate brings the Allowance for Doubtful Accounts credit balance to $8,000.
Date Item Debit Credit Debit Credit
1/1 8,000 8,000
Example 2– Percent of Sales: A $600 credit balance in the Allowance for Doubtful Accounts ledger.
This means that the company overestimated its Bad Debt Expense last year—it had less bad debt than it had estimated it would have.
Allowance for Doubtful Accounts
There is a $600 credit balance in the account “left over” from last year.
Date Item Debit Credit Debit Credit
1/1 Balance 600
Date Account Debit Credit $400,000 x 2% = $8,000
▲ Bad Debt Expense is an expense account that is increasing.
▲ Allow Doubt Accts is a contra asset account that is increasing.
1/1 Bad Debt Expense 8,000
Allowance for Doubtful Accounts 8,000
Allowance for Doubtful Accounts
The adjusting entry for the estimate adds the additional $8,000 to the previous credit balance.
Date Item Debit Credit Debit Credit
1/1 Balance 600
Example 3– Percent of Sales: A $600 debit balance in the Allowance for Doubtful Accounts ledger.
This means that the company underestimated its Bad Debt Expense last year— it had more bad debt than it had estimated it would have.
Allowance for Doubtful Accounts
There is a $600 debit balance in the account “left over” from last year.
Date Item Debit Credit Debit Credit
1/1 Balance 600
Date Account Debit Credit $400,000 x 2% = $8,000
▲ Bad Debt Expense is an expense account that is increasing.
▲ Allow Doubt Accts is a contra asset account that is increasing.
1/1 Bad Debt Expense 8,000
Allowance for Doubtful Accounts 8,000
Allowance for Doubtful Accounts
The adjusting entry for the estimate adds the additional $8,000 to the previous debit balance.
Date Item Debit Credit Debit Credit
1/1 Balance 600
1/1 8,000 7,400
The following table summaries the new asset accounts.
ACCOUNTS SUMMARY TABLE
ACCOUNT
TYPE ACCOUNTS INCREASETO DECREASETO BALANCENORMAL STATEMENTFINANCIAL CLOSE OUT?
Asset Accounts Receivable Notes Receivable debit credit debit Balance Sheet NO Contra Asset Allowance for Doubtful Accounts credit debit credit Balance Sheet NO Revenue Interest Revenue credit debit credit StatementIncome YES Expense Bad Debt Expense debit credit debit StatementIncome YES
Topics – The basic accounting cycle Fact Journal Entry Calculate Amount Format
Concept of short-term loans x
Review sales transactions on account x
Journalize the receipt of a note receivable for cash x x
Journalize the receipt of a note receivable on account x x
Journalize the receipt of payment for a note due x r
Journalize the receipt of a new note for a note due x x
Journalize a dishonored note x x
Journalize the receipt of payment on a dishonored note x x
Concept of bad debt and write-offs x
Journalize a full write-off under the direct write-off method x x
Journalize a partial write-off under the direct write-off method x x
Journalize a full reinstatement under the direct write-off method x x
Journalize a partial reinstatement under the direct write-off method x x
Journalize bad debt estimates using an analysis of receivables x x
Journalize a full write-off under the allowance method x x
Journalize a partial write-off under the allowance method x x
Journalize a full reinstatement under the allowance method x x
Journalize a partial reinstatement under the allowance method x x
Journalize bad debt estimates using percent of sales x x
Financial statements x x
Journalize closing entries x
The accounts that are highlighted in bright yellow are the new accounts you just learned. Those highlighted in light yellow are the ones you learned previously.