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. 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 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.
Balance Sheet Aging of Receivables Method for Calculating Bad Debt Expenses
However, if the management has decided to write off some specific balance, there is a specific process of journal entries to be followed. The outstanding balance of $2,000 that Craft did not repay will remain as bad debt. There is one more point about the use of the contra account, Allowance for Doubtful Accounts.
- The business may have the policy to provide for a certain amount based on their past trend etc.
- Further, providing an allowance is in line with the prudence concept of accounting, which suggests early recording of an expense and delay in recording the income.
- Since it may not be easy for the business to identify which parties will not pay their money back, they set up some general reserve in proportion to the credit sales during the period.
- This entry assumes a zero balance in Allowance for Doubtful Accounts from the prior period.
- The direct write-off method is used only when we decide a customer will not pay.
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. The reason why this contra account is important is that it exerts no effect on the income statement accounts. It means, under this method, bad debt expense does not necessarily serve as a direct loss that goes against revenues. To illustrate, let’s continue to use Billie’s Watercraft Warehouse (BWW) as the example.
That journal entry assumed a zero balance in Allowance for Doubtful Accounts from the prior period. This journal entry takes into account a debit balance of $20,000 and adds the prior period’s balance to the estimated balance of $58,097 in the current period. The journal entry for the Bad Debt Expense increases (debit) the expense’s balance, and the Allowance for Doubtful Accounts increases (credit) the balance in the Allowance. The allowance for doubtful accounts is a contra asset account and is subtracted from Accounts Receivable to determine the Net Realizable Value of the Accounts Receivable account on the balance sheet. In the case of the allowance for doubtful accounts, it is a contra account that is used to reduce the Controlling account, Accounts Receivable. The allowance method is the more widely used method because it satisfies the matching principle.
Percentage of Accounts Receivable Method Example
In order to use the allowance method, it is first necessary to estimate the allowance needed using a suitable method. The entry has reinstated the customer balance, and now we need to record the cash receipt. It’s important to note that we have assumed the opening allowance for the bad debt as zero in the above entry. Bad Debt Expense increases (debit) as does Allowance for Doubtful Accounts (credit) for $58,097. On the other hand, writing off through the allowance method helps to locate the creation of provision, use of the provision, reversal, etc. From a control perspective, the use of the direct method can be a little risky, it’s because if there are no sound controls manager might write off balances in a personal capacity.
The allowance method estimates bad debt during a period, based on certain computational approaches. When the estimation is recorded at the end of a period, the following entry occurs. The final point relates to companies with very little exposure to the possibility of bad debts, typically, entities that rarely offer credit to its customers.
Percentage of Credit Sales Method Example
After writing off the bad account on August 24, the net realizable value of the accounts receivable is still $230,000 ($238,600 debit balance in Accounts Receivable and $8,600 credit balance in Allowance for Doubtful Accounts). So, management needs to analyze the individual party balances with the help of an aging statement. This helps decide if a specific balance should be presented as a net debtor in the balance sheet for the accounting period or if an allowance should be created against it.
Further, providing an allowance is in line with the prudence concept of accounting, which suggests early recording of an expense and delay in recording the income. The financial statements are viewed by investors and potential investors, and they need to be reliable and where current property are situated on the steadiness sheet must possess integrity. Bad Debt Expense increases (debit), and Allowance for Doubtful Accounts increases (credit) for $22,911.50 ($458,230 × 5%). Let’s say that on April 8, it was determined that Customer Robert Craft’s account was uncollectible in the amount of $5,000.
What is the allowance method?
When we decide a customer will not pay the amount owed, we use the Allowance for Doubtful accounts to offset this loss instead of Bad Debt Expense. Compared to the direct write-off method, the allowance method is preferred because of its usefulness and applicability. Furthermore, this is called an income statement or statement of the comprehensive income approach. An alternate way is to provide an allowance based on the debtor’s balance. It’s equally important to note that only a direct method of write-off is acceptable under the income tax reporting statute of the United States. It’s important to note that both methods aim to eliminate uncollectible debtors and present a true and fair view of the business.
Fundamentals of Bad Debt Expenses and Allowances for Doubtful Accounts
Then, in the next accounting period, a lot of their customers could default on their payments (not pay them), thus making the company experience a decline in its net income. Therefore, the direct write-off method can only be appropriate for small immaterial amounts. We will demonstrate how to record the journal entries of bad debt using MS Excel.
What is the Allowance Method? (Definition, Calculation, Example, and More)
Further, allowance for doubtful accounts is debited when the debtor balance is identified as written off. Sometimes, the direct write-off for the account balance does not seem logical as the business may be unable to locate which debtor should be written off. It refers to the requirement of developing expectations for the loss to be incurred in the future.