Which method of accounting for uncollectible accounts receivable uses an estimate based on a percentage of sales?

Definition

The term uncollectible accounts receivable is used to describe the portion of credit sales in accounts receivable the company does not expect to collect from a customer. Uncollectible accounts is used in the valuation of accounts receivable, which appears on a company's balance sheet.

Explanation

Unfortunately, not all customers that make purchases on credit will pay companies the money owed. The matching principle requires companies align revenues with expenses in the current accounting period. Therefore, companies must adjust accounts receivable for the anticipated write off expense associated with uncollectible accounts.

Companies will normally use the methods below to adjust for uncollectible accounts:

• Direct Write-off Method: records bad debt expense in the same accounting period the company determines it will not collect the money owed. The direct write-off method does not require the company to perform estimates, since it will be based on factual reports.

This method is used for federal income tax purposes, which allows companies to expense bad debts after write off occurs. Since the company may attempt to collect money owed for several months, the direct write-off method violates the matching principle, and should not be used when valuing accounts receivable in financial statements.

• Allowance Method: records an estimate of bad debt expense in the same accounting period as the sale. The allowance method aligns with two important accounting guidelines. It follows the matching principle, which states revenues generated in an accounting period need to be matched with the expenses incurred in that same accounting period. It also abides by the conservatism constraint, which states when in doubt, report information that does not overstate income or assets or does not understate expenses or liabilities.

Accounts receivable is known as a control account. This means the total of all individual accounts found in the subsidiary ledger must equal the total balance in accounts receivable. The allowance method uses an estimate of uncollectible expense, also known as bad debts expense, and does not predict which individual accounts will be written off. For this reason, the adjustment to accounts receivable is made using the contra asset account allowance for doubtful accounts, which is sometimes referred to as the allowance for bad debts. This lets companies to display accounts receivable in what is known as "net realizable value" on the balance sheet.

Example

Company A's Q1 ending balance of accounts receivable was 3,867,000. Using the percentage of sales method, Company A determined bad debt expense in the current quarter would be 16,350 (2% of credit sales). The current balance in the allowance for doubtful accounts was $60,990. The journal entry for bad debts expense would be:

The balance in the allowance for doubtful accounts would now be:

= $60,990 + $16,350, or $77,340

The net realizable value of accounts receivable, as shown on Company A's balance sheet, would be:

Related Terms

balance sheet, matching principle, current assets, accounts receivable, accounts receivable valuation, allowance method, direct write off method

The amount of uncollectible accounts receivable must be estimated in order to create an allowance for doubtful accounts. This estimate can be derived from the aged accounts receivable report, or by using a percentage of sales. Both approaches are described next. This estimate is used in an accrual-basis business where reserves are set up in contra accounts to be paired with and offset various asset accounts.

Derivation from an Aging Analysis

A common estimation method is based on the aged accounts receivable report. This report categorizes unpaid customer invoices by time bucket. Each time bucket is usually in 30-day increments, so the 31-60 day bucket, the 61-90 day bucket, and the 90+ day bucket show those invoices with increasing probabilities of nonpayment. The accountant assigns a larger percentage of assumed nonpayment probability to each of these time buckets, such as 5% to the balance in the 31-60 day bucket, 20% to the 61-90 day bucket, and 40% to the 90+ day bucket. These percentages are based on the historical experience of the firm in obtaining payments from each of these classifications. The totals of estimated unpaid amounts for each time bucket are then added together to arrive at the total amount of estimated uncollectible receivables. This approach works best when receivables include a small number of relatively large invoices.

Derivation from Total Sales

A simpler approach is to assume that a percentage of total credit sales will not be collected. This percentage, which is based on historical experience, is multiplied by total credit sales. Thus, if the historical experience is a 0.5% bad debt rate, then this amount is applied to total credit sales. This approach is not as refined as a derivation from the aged receivables report, but can be adequate when sales are comprised of many small invoices.

Accounting for Uncollectible Receivables

No matter which method is used, the resulting estimate is added to the allowance for doubtful accounts by debiting the bad debt expense account and crediting the allowance for doubtful accounts.

Which method for estimating uncollectible accounts is calculated based on a percent of the accounts receivable balance?

Which method is used to estimate uncollectible accounts receivable?

When accounting for uncollectible receivables What is the percentage of sales method?

What are the two methods of estimating the allowance for uncollectible receivables?