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. 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. Sales and the ultimate decision that specific accounts receivable will never be collected can happen months apart.
1Some companies include both accounts on the balance sheet to explain the origin of the reported balance. Others show only the single net figure with additional information provided in the notes to the financial statements. The net effect of this transaction is to reduce the accounts receivable balance and the allowance for doubtful accounts by $1,000.
Definition of Provision for Bad Debts
If so, the account Provision for Bad Debts is a contra asset account (an asset account with a credit balance). It is used along with the account Accounts Receivable in order for the balance sheet to report the net realizable value of the company’s accounts receivable. The entry to increase the credit balance in these contra accounts is a debit to the income statement account Bad Debts Expense. Hence, the income statement is delaying the reporting of bad debts the allowance for uncollectible accounts is a contra account to expense on its income statement until an account receivable is actually written off as uncollectible. The allowance for doubtful accounts is an example of a “contra account,” one that always appears with another account but as a direct reduction to lower the reported value.
This allows companies to account for the possibility of bad debts and maintain accurate financial statements. It is important to note that writing off an uncollectible account does not affect the bad debt expense account. Once the amount of uncollectible accounts has been estimated, the company needs to create an allowance for doubtful accounts. For example, if accounts receivable that are days past due historically have a bad debt rate of 5%, the company may estimate that 5% of the current day past due accounts will also be uncollectible.
- 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.
- It is important to estimate the allowance accurately to ensure that the financial statements reflect the true financial position of the company.
- The amount credited to the bad debt expense account is the estimated amount of uncollectible accounts for the period.
- ABC creates an allowance for doubtful accounts by debiting the allowance for doubtful accounts account and crediting the bad debt expense account for $2,000.
Reporting
For the past 52 years, Harold Averkamp (CPA, MBA) has worked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. The net effect is a reduction in total assets and a reduction in the allowance for doubtful accounts. When a company sells goods or services on credit, there is always a risk that some customers will not pay their bills. 2Because the focus of the discussion here is on accounts receivable and their collectability, the recognition of cost of goods sold as well as the possible return of any merchandise will be omitted.
Accounting
The net effect of this transaction is to reduce the accounts receivable balance and the allowance for doubtful accounts by $500. This entry reduces the accounts receivable balance by $1,000 and reduces the allowance for doubtful accounts balance by $1,000. The first step is to identify accounts that are likely to be uncollectible.
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Then create an average amount of money lost over the number of years measured. Once done, a company can compare these to the records of other companies or industry statistics. The company can use this information to attempt to bring this amount to an equal level, as compared to common industry best practices. The net effect of this transaction is to reduce the accounts receivable balance and the allowance for doubtful accounts by the same amount. As a result, companies need to account for the possibility of uncollectible accounts, which are also known as bad debts.
Journal Entry for Allowance for Doubtful Accounts
Here, the allowance serves to decrease the receivable balance to its estimated net realizable value. As a contra asset account, debit and credit rules are applied that are the opposite of the normal asset rules. Thus, the allowance increases with a credit (creating a decrease in the net receivable balance) and decreases with a debit. The more accounts receivable a company expects to be bad, the larger the allowance. This increase, in turn, reduces the net realizable value shown on the balance sheet.
Assume further that the company’s past history and other relevant information indicate to officials that approximately 7 percent of all credit sales will prove to be uncollectible. An expense of $7,000 (7 percent of $100,000) is anticipated because only $93,000 in cash is expected from these receivables rather than the full $100,000. Finding the proper amount for the allowance for doubtful accounts is not an instant process. To create a standard allowance, have those financial records that indicate how many accounts have not been collected.
The inherent uncertainty as to the amount of cash that will actually be received affects the physical recording process. To illustrate, assume that a company makes sales on account to one hundred different customers late in Year One for $1,000 each. The earning process is substantially complete at the time of sale and the amount of cash to be received can be reasonably estimated. According to the revenue realization principle found within accrual accounting, the company should immediately recognize the $100,000 revenue generated by these transactions2. The allowance for uncollectible accounts is a contra account to accounts receivable, meaning it is used to reduce the value of accounts receivable to reflect the estimated amount of uncollectible debts. An allowance for doubtful accounts is considered a “contra asset,” because it reduces the amount of an asset, in this case the accounts receivable.
This journal entry records the estimated uncollectible amount as an expense on the income statement. This ensures that the financial statements accurately reflect the expected collectible amount of accounts receivable. Some companies might use the description provision for bad debts on its income statement in order to report the credit losses that pertain to the period of the income statement. In that case, provision for bad debts would be an income statement account.
- 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.
- An allowance for doubtful accounts is considered a “contra asset,” because it reduces the amount of an asset, in this case the accounts receivable.
- When a company sells goods or services on credit, there is always a risk that some customers will not pay their bills.
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- When financial statements are prepared, an estimation of the uncollectible amounts is made and an adjusting entry recorded.
What is Accounts Receivable Collection Period? (Definition, Formula, and Example)
After reviewing the customers’ balances the company estimates that $10,000 of the $1,000,000 will not be collected. At the end of the accounting period, the company needs to review the allowance for doubtful accounts and adjust it as necessary. It is important to estimate the allowance accurately to ensure that the financial statements reflect the true financial position of the company. Using the account Allowance for Doubtful Accounts is preferred for financial reporting. You should always consultant with a tax professional for the income tax rules. For the past 52 years, Harold Averkamp (CPA, MBA) hasworked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online.
The retailer estimates that 2% of its total credit sales, or $ 500,000, will likely be uncollectible. The Allowance for Uncollectible Accounts, also known as the Allowance for Doubtful Accounts or Bad Debt Allowance. It is a contra-asset account used in accounting to estimate and record the portion of accounts receivable that is expected to be uncollectible. It is created to reflect the reality that not all customers may fulfill their payment obligations, and some accounts may become uncollectible over time. The credit balance in Allowance for Doubtful Accounts reduces the amount reported on a company’s balance sheet for accounts receivable to the amount that is expected to be collected.
