Definition
The financial accounting term allowance method refers to an uncollectible accounts receivable process that records an estimate of bad debt expense in the same accounting period as the sale. The allowance method is used to adjust accounts receivable appearing on the balance sheet.
Explanation
Unfortunately, not all customers that make purchases on credit will pay companies the money owed. There are two methods companies use to account for uncollectible accounts receivable, the direct write-off method and the allowance method.
The direct write-off method relies on reports of accounts receivable the company has determined will not be collected. If write off is not material, this method can be used in financial reports. Typically, this approach is restricted to income tax returns.
The allowance method records an estimate of bad debt expense in the same accounting period as the sale. It often takes months for companies to identify specific uncollectible accounts. The allowance method follows the matching principle, which states revenues need to be matched with the expenses incurred in that same accounting period.
Generally, companies will choose between two approaches under the allowance method.
Percentage of Sales: Using historical data, a company examines the relationship between sales and uncollectible accounts receivable. If there is a fairly stable relationship between the two, a company will use the historical Uncollectible Accounts / Credit Sales ratio to estimate the bad debts expense in the current period.
For example, a company might find a historical trend indicating 2% of credit sales are never collected from customers. If that company had $100,000 of credit sales in the current period, it would also record the following journal entry:
Date | Account | Debit | Credit |
3/31/20XX | Bad Debts Expense | $2,000 | |
Allowance for Doubtful Accounts | $2,000 |
This method is sometimes referred to as the income statement approach.
Percentage of Accounts Receivable: Using historical data, a company examines the relationship between accounts receivable and uncollectible accounts. Companies will oftentimes increase the accuracy of these estimates by looking at their aging schedule for patterns, rather than using a composite (or total) of their receivables.
For example, a company might find a historical trend indicating 50% of credit sales over 150 days due are never collected, while 0.5% of credit sales over 30 days are never collected. This approach is illustrated below:
Aging Schedule | Bad Debts Estimate | A/R Balance | Allowance for Bad Debts |
Over 30 days | 0.5% | $300,000 | $1,500 |
31 to 60 days | 1.0% | $100,000 | $ 1,000 |
61 to 90 days | 2.0% | $50,000 | $1,000 |
91 to 120 days | 5.0% | $7,000 | $350 |
120 to 150 days | 15.0% | $5,000 | $750 |
Over 150 days | 50% | $3,000 | $1,500 |
Total Balance | $6,100 | ||
This method is sometimes referred to as the balance sheet approach.
Allowance for bad debt, also known as the allowance for doubtful accounts, is a contra asset account and is used as an offset to accounts receivable. This allows the account to be stated in what is known as net realizable value, where:
Net Realizable Value = Accounts Receivable - Allowance for Doubtful Accounts
Related Terms
Also known as a statement of financial position, the balance sheet is used to show the financial health of a company at a particular point in time. The balance sheet consists of assets, liabilities, and owner's equity in the company. It is one of the four key financial statements issued by public companies.
Moneyzine EditorNovember 6th, 2024
The matching principle is a financial accounting term that refers to a standard, which states that revenues generated in an accounting period need to be matched with the expenses incurred in that same accounting period.Moneyzine EditorNovember 6th, 2024
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Also referred to as "receivables," this is the accounting term used to describe claims the company has against others for goods, services, or money. Accounts receivable are usually non-written promises to pay for goods or services received but not yet paid for by a customer.Moneyzine EditorNovember 6th, 2024
A contra account is a balance sheet account that is used to offset a related asset, liability, or equity account. Contra accounts are used to ensure the proper valuation of these items is reflected on the balance sheet.Moneyzine EditorJanuary 12th, 2024
The term accounts receivable valuation describes the methods used to determine the value of accounts receivable appearing on the company's balance sheet. Typical adjustments to accounts receivable can include discounts, sales returns, and uncollectable accounts.Moneyzine EditorDecember 12th, 2023- 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.Moneyzine EditorSeptember 21st, 2023
The financial accounting term direct write-off method refers to an uncollectible accounts receivable process that records bad debt expense in the same accounting period the company determines the debt will never be collected. The direct write off method is typically used when calculating income taxes owed.Moneyzine EditorJanuary 16th, 2024
