See also:
Does Your Management Team Understand the Financials?
General Ledger Reconciliation and Analysis
Allowance for Uncollectible Accounts
When companies sell products to customers on credit, the customer receives the product and agrees to pay later. The customer’s obligation to pay later is recorded in accounts receivable on the
balance sheet of the selling company. However, sometimes customers simply don’t pay their bills. When customers don’t pay their bills, the
selling company has to write-off the amount as bad debt or uncollectible accounts.
In anticipation of the fact that some customer’s will not pay their bills, a company will create an account on the
balance sheet called allowance for uncollectible accounts. You can also call this allowance for doubtful accounts. This account is a contra asset account the value of which is subtracted from the value of the accounts receivable account on the
balance sheet. Companies must estimate the amount of uncollectible accounts based on historic data. Then companies must apply a certain percentage of accounts receivable to the uncollectible accounts account using the percentage rate determined by
analyzing the historical data.
Direct Charge-Off Method: Meaning
One way to record the affects of uncollectible accounts is the direct charge-off method. This method is simple. But it violates the matching principle and does not conform to GAAP standards and procedures. Thus, it cannot be used to record the write-offs of uncollectible accounts in
financial statements prepared for the public in accordance with FASB and GAAP regulations.
In the direct charge-off method, once the
company determines that a certain amount due to the company will not be collected at all, the company writes it off in that fiscal period. In
other words, the company writes off the bad debt expense once it realizes the bill will not be paid. The amount of bad debt is then subtracted from accounts
receivable and added to bad debt expense or uncollectible accounts expense. This is the simplest way to record uncollectible accounts or bad debt.
Allowance Method
Another way to record bad
debt expense or uncollectible accounts in the financial statements is by using the allowance method. This method adheres to the matching principle and the procedural standards of GAAP.
In the allowance method, a
company estimates the amount of uncollectible accounts it will incur as a percentage of credit sales. Then they apply that percentage to credit sales as they earn the
revenues. The allowance for doubtful accounts matches with the revenues. Even though this method uses estimation – as opposed to the direct method which writes off bad
debt when the actual amount is known – the estimates may not always be entirely accurate. However, this method adheres to the matching principle. Therefore, it is the method approved by GAAP.
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An allowance for doubtful accounts is considered a “contra asset,” because it reduces the amount of an asset, in this case the accounts receivable. The allowance, sometimes called a bad debt reserve, represents management’s estimate of the amount of accounts receivable that will not be paid by customers. If actual experience differs, then management adjusts its estimation methodology to bring the reserve more into alignment with actual results.
In accrual-basis accounting, recording the allowance for doubtful accounts at the same time as the sale improves the accuracy of financial reports. The projected bad debt expense is properly matched against the related sale, thereby providing a more accurate view of revenue and expenses for a specific period of time. In addition, this accounting process prevents the large swings in operating results when uncollectible accounts are written off directly as bad debt expenses.
Units should consider using an allowance for doubtful accounts when they are regularly providing goods or services “on credit” and have experience with the collectability of those accounts. The following entry should be done in accordance with your revenue and reporting cycles (recording the expense in the same reporting period as the revenue is earned), but at a minimum, annually.
DR Bad Debt Expense
CR Allowance for Doubtful Accounts
6330 | Bad Debt Expense | Write off of uncollectable Accounts Receivable. Use: Use with approval from the Division of Financial Affairs only. |
1250 | Allowance for Doubtful Accts | Allowance for Doubtful Accounts is a contra current asset object code associated with A/R. When the allowance object code is used, the unit is anticipating that some accounts will be uncollectible in advance of knowing the specific amount. Use: Units billing sales to external customers where the possibility of default exists. The allowance normalizes fund balance activity. |
When it is determined that an account cannot be collected, the receivable balance should be written off. When the unit maintains an allowance for doubtful accounts, the write-off reduces the outstanding accounts receivable, and is charged against the allowance – do not record bad debt expense again!
DR Allowance for Doubtful Accounts
CR Accounts Receivable
For detailed expectations and guidelines related to write offs, see Writing Off Uncollectable Receivables.