Allowance Method for Doubtful Accounts.

In this video, we explain allowance method for doubtful accounts.
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Allowance Method
The Allowance Method is an accounting technique used to estimate bad debts (uncollectible accounts) before they are confirmed as uncollectible. It adheres to the matching principle, ensuring bad debt expenses are recorded in the same period as the related revenues, which makes it compliant with Generally Accepted Accounting Principles (GAAP).
How the Allowance Method Works
The Allowance Method estimates bad debts and records them in a contra-asset account called Allowance for Doubtful Accounts, reducing the total accounts receivable on the balance sheet.
Estimate Bad Debt: At the end of the period, companies estimate potential bad debts using past trends or other relevant factors.
Record Bad Debt Expense: The estimate is recorded through a journal entry:
Debit: Bad Debt Expense
Credit: Allowance for Doubtful Accounts
Write-Off Uncollectible Accounts: When an account is confirmed as uncollectible, it is written off against the allowance:
Debit: Allowance for Doubtful Accounts
Credit: Accounts Receivable
Estimating Bad Debts
Two common approaches for estimating bad debts under the Allowance Method are:
Percentage of Sales Method: Estimates bad debts as a percentage of total credit sales. For example, if 2% of credit sales are expected to be uncollectible, a company with $100,000 in sales would record a $2,000 bad debt expense.
Journal Entry:
Debit: Bad Debt Expense $2,000
Credit: Allowance for Doubtful Accounts $2,000
Aging of Accounts Receivable: Evaluates outstanding receivables by their age. Older receivables have a higher likelihood of becoming uncollectible. The company applies different percentages based on the age of the receivables to estimate bad debts.
Journal Entries for the Allowance Method
Establishing the Allowance:
At the period’s end, an estimate is recorded:
Debit: Bad Debt Expense
Credit: Allowance for Doubtful Accounts
Writing Off Uncollectible Accounts:
When a specific account is uncollectible:
Debit: Allowance for Doubtful Accounts
Credit: Accounts Receivable
Recovering a Previously Written-Off Account:
If a previously written-off account is later paid:
Debit: Accounts Receivable
Credit: Allowance for Doubtful Accounts
Debit: Cash
Credit: Accounts Receivable
Advantages of the Allowance Method
Adherence to the Matching Principle: By estimating bad debts in the same period as the revenue, this method aligns expenses with the revenue that generated the receivables.
More Accurate Financial Reporting: The method provides a clearer picture of the company’s actual financial position by adjusting receivables for expected bad debts.
GAAP Compliance: The Allowance Method is required under GAAP for its ability to reflect financial accuracy in accordance with the matching principle.
Example of the Allowance Method
Suppose a company estimates that 3% of its $200,000 in credit sales will be uncollectible. It would record a $6,000 bad debt expense.
End-of-Period Entry:
Debit: Bad Debt Expense $6,000
Credit: Allowance for Doubtful Accounts $6,000
Later, if a $2,000 account is deemed uncollectible, it is written off:
Write-Off Entry:
Debit: Allowance for Doubtful Accounts $2,000
Credit: Accounts Receivable $2,000
If the customer eventually pays the $2,000, the company reverses the write-off and records the cash:
Reversing Write-Off & Payment:
Debit: Accounts Receivable $2,000
Credit: Allowance for Doubtful Accounts $2,000
Debit: Cash $2,000
Credit: Accounts Receivable $2,000
Allowance Method vs. Direct Write-Off Method
Timing: The Allowance Method records estimated bad debts before specific accounts are uncollectible, whereas the Direct Write-Off Method records bad debt expense only when an account is confirmed as uncollectible.
Matching Principle: The Allowance Method complies with the matching principle by recognizing expenses in the same period as the revenue. The Direct Write-Off Method, on the other hand, can mismatch expenses and revenues.
Financial Statement Impact: The Allowance Method ensures a more accurate depiction of accounts receivable and net income since bad debt estimates are made ahead of time, unlike the Direct Write-Off Method which may overstate assets and income until write-offs are recorded.
Conclusion
The Allowance Method provides a systematic, GAAP-compliant way to estimate and record bad debts. By using this method, companies ensure that expenses related to uncollectible accounts are matched with the revenue they generated, resulting in more accurate financial statements. This method not only adheres to accounting standards but also provides businesses with a clearer view of their receivables and financial health.
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