# 7 4 Estimating the Amount of Uncollectible Accounts Financial Accounting

The estimation is typically based on credit sales only, not total sales (which include cash sales). In this example, assume that any credit card sales that are uncollectible are the responsibility of the credit card company. It may be obvious intuitively, but, by definition, a cash sale cannot become a bad debt, assuming that the cash payment did not entail counterfeit currency. The allowance for doubtful accounts method is an estimate of how much of the company’s accounts receivable will be uncollectible.

• There is no calculation, just a recognition that an account has become uncollectible and a writing-off of the specific amount.
• Most companies use the allowance method, which is to estimate the amount of doubtful expense it expects.
• This is done to be in compliance with the matching principle which requires that revenues be matched to their related expenses within an accounting period.
• The final point relates to businesses with very little exposure to the possibility of bad debts, typically, entities that rarely offer credit to its customers.

Because bad debt expense had a zero balance prior to this entry, it is now based solely on the \$27,000 amount needed to establish the proper allowance. This adjustment increases the expense to the appropriate \$32,000 figure, the proper percentage of the sales figure. However, the allowance account already held a \$3,000 debit balance (\$7,000 Year One estimation less \$10,000 accounts written off). As can be seen in the T-accounts, the \$32,000 recorded expense results in only a \$29,000 balance for the allowance for doubtful accounts.

## How to Calculate Bad Debt Expense

Because the time difference between the sale and the time a company realizes an account is uncollectible is usually long, using the direct write-off method will violate the matching principle. A portion of a company’s customers that buy products or services from the company on credit may not be able to pay the company for various reasons. You can estimate your company’s uncollectible accounts to determine the amount of money that you expect your customers will not be able to pay using the percentage of receivables method. With this approach, accounts receivable is organised into categories by length of time outstanding, and an uncollectible percentage is assigned to each category. For example, a category might consist of accounts receivable that is 1–30 days past due and is assigned an uncollectible percentage of 3%. Another category might be 31–60 days past due and is assigned an uncollectible percentage of 15%.

This means that when it is subtracted from Accounts Receivable, the difference represents an estimate of the cash value of accounts receivable. The contra account may also be called the Provision for Bad Debts or the Allowance for Bad Debts in practice. The final point relates to businesses with very little exposure to the possibility of bad debts, typically, entities that rarely offer credit to its customers.

## How do I Calculate Uncollectible Accounts?

Regardless of the approach, both bad debt expense and the allowance for doubtful accounts are simply the result of estimating the final outcome of an uncertain event—the collection of accounts receivable. The direct write-off method works by directly writing-off bad debt expenses from accounts receivable into the expense account. Whenever a company is sure a certain account balance is uncollectible, it will debit bad debt expense and credit accounts receivable for the amount. There is no calculation, just a recognition that an account has become uncollectible and a writing-off of the specific amount.

Next, we’ll look at a more sophisticated way to calculate the net realizable value of accounts receivable and the allowance for doubtful accounts, but first check your understanding of the percentage of receivables method. The above entry is recorded every time a receivable actually proves to be uncollectible. This entry reduces the face value of accounts receivable as well as the balance in allowance for doubtful accounts with the same amount.

## Uncollectible accounts expense – allowance method

This estimate is entered as an adjustment in the books at the end of each accounting period. A journal entry debiting bad debt expense and crediting allowance for uncollectible accounts will be made with the estimate amount. Producing financial statements in compliance with GAAP (Generally Accepted Accounting Principles) is a requirement for public companies listed on a US Exchange. The matching principle requires that revenues be matched to their related expense within an accounting period. To approximate this as much as possible, a company must rely on the accrual-basis accounting method to periodically estimate certain revenues and expenses. Accrual-basis accounting is required for a company to be in compliance with GAAP.

Calculate the sum of the amounts of each portion you expect will be uncollectible to calculate the total amount of uncollectible accounts. Estimate the percentage of each portion that you expect will be uncollectible. Estimate the smallest percentage of the portion that is not yet due and estimate larger percentages as the number of days past due increases. As you’ve learned above, the delayed recognition of bad debt violates GAAP, specifically the matching principle.

## Allowance Method for Uncollectible Accounts

Assuming that credit is not a significant component of its sales, these sellers can also use the direct write-off method. The companies that qualify for this exemption, however, are typically small and not major participants in the credit market. Thus, virtually all of the remaining bad debt expense material discussed here will be based on an allowance method that uses accrual accounting, the matching principle, and the revenue recognition rules under GAAP. Here, the proper balance for the allowance for doubtful accounts is determined based on the percentage of ending accounts receivable that are presumed to be uncollectible. This method is labeled a balance sheet approach because the one figure being estimated (the allowance for doubtful accounts) is found on the balance sheet.

For example, assume Kenco makes a \$5000 credit sale to Bennards on 28th March. On 30th August, Kenco Ltd determines that it will be unable to collect from Bennards. When the account defaults for non-payment on 30th August, Kenco would record the following journal entry to recognise bad debt. Either approach can be used as long as adequate support is generated for the numbers reported. However, financial accounting does stress the importance of consistency to help make the numbers comparable from year to year. Once a method is selected, it normally must continue to be used in all subsequent periods.