Estimating the Amount of Uncollectible Accounts

Under the allowance method, the uncollectible account expense for the period is matched against the sales for that period. This example demonstrates how the estimation of uncollectible receivables can differ depending on the method used. Companies typically choose the method that best suits their needs and gives them the most accurate estimate based on their specific circumstances. Please note that these methods should be used consistently and in accordance with Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS). Always consult with an accountant or finance professional when dealing with financial estimates and reporting. Bad debts end up as such because the debtor can’t or refuses to pay because of bankruptcy, financial difficulty, or negligence.

total estimated uncollectibles

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. A bad debt expense is a measure of the total amount of “bad debt” during an accounting period. Bad debt is all debt or outstanding credit sales that cannot be collected on during a given period. Contra assets are still recorded along with other assets, though their natural balance is opposite of assets. While assets have natural debit balances and increase with a debit, contra assets have natural credit balance and increase with a credit. Mechanically, the underestimation still exists in the accounting records in Year Two.

Difference between Estimates and Actual Experience

A separate subsidiary ledger should be in place to monitor the amounts owed by each customer (Mr. A, Ms. B, and so on). The general ledger figure is used whenever financial statements are to be produced. The subsidiary ledger allows the company to access individual account balances so that appropriate action can be taken if specific receivables grow too large or become overdue. The amount of uncollectible accounts receivable must be estimated in order to create an allowance for doubtful accounts.

  • During the year, similar entries are made to record other accounts declared uncollectible.
  • The aggregate balance in the allowance for doubtful accounts after these two periods is $5,400.
  • The percentage-of-receivables method estimates uncollectible accounts by determining the estimated net realizable value of accounts receivable, so many accountants refer to this as the balance-sheet method.
  • A common method is the percent of credit sales that determines total uncollectible accounts.
  • Our work has been directly cited by organizations including Entrepreneur, Business Insider, Investopedia, Forbes, CNBC, and many others.

Let’s use a hypothetical company, BestTech Inc., to illustrate both methods we discussed. By a miracle, it turns out the company ended up being rewarded a portion of their outstanding receivable balance they’d written off as part of the bankruptcy proceedings. Of the $50,000 balance that was written off, the company is notified that they will receive $35,000. Note that if a company believes it may recover a portion of a balance, it can write off a portion of the account.

Why You Can Trust Finance Strategists

In order to understand the required journal entries used with the allowance method, assume that during 2019, Delta Corporation’s first year in business, sales totaled $1 million. A Pareto analysis is a risk measurement approach that states that a majority of activity is often concentrated among a small amount of accounts. In many different aspects of business, a rough estimation is that 80% of account receivable balances are made up of a small concentration (i.e. 20%) of vendors.

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. If fewer accounts in dollars are written off than previously estimated, the Allowance account will have a credit balance prior to the adjustment. The primary accounting issue regarding accounting for uncollectible accounts is matching the bad debts with the sales of the period that gave rise to the bad debts.

How to Estimate Uncollectible Receivables?

The percentage-of-net-sales method is the simpler of the two and involves calculating an allowance based on a percentage of net sales. The aging method is more complex and requires analyzing customer accounts to determine their collectibility. This method is usually superior as it takes into account factors such as past-due payments and the payment habits of customers. It is a part of operating a business if that company allows customers to use credit for purchases. Bad debt is accounted for by crediting a contra asset account and debiting a bad expense account, which reduces the accounts receivable. The first is the direct write-off method, which involves writing off accounts when they are identified as uncollectible.

This type of account is a contra asset that reduces the amount of the gross accounts receivable account. If a company has a history of recording or tracking bad debt, it can use the historical percentage of bad debt if it feels that historical measurement relates to its current debt. Therefore, it can assign this fixed percentage to its total accounts receivable balance since more often than not, it will approximately be close to this amount. The company must be aware of outliers or special circumstances that may have unfairly impacted that 2.4% calculation. Thus, a $75 sale on credit to Mr. A raises the overall accounts receivable total in the general ledger by that amount while also increasing the balance listed for Mr. A in the subsidiary ledger. As shown in the T-accounts below, this entry successfully changes the allowance from a $3,000 debit balance to the desired $24,000 credit.

What Type of Asset Is Bad Debt?

The credit part of the entry is to an account called Allowance for Uncollectible Accounts. Another title for this account is Bad Debt Expense, This account is closed to Income Summary and is generally shown as a selling expense on the income statement. The debit part of the adjusting entry is made to the Uncollectible Accounts Expense account. Payments received later for bad debts that have already been written off are booked as bad debt recovery. Once again, the difference between the expense ($27,000) and the allowance ($24,000) is $3,000 as a result of the estimation being too low in the prior year. Most individuals feel that the benefits of this proper matching outweigh the disadvantages of using estimates.

total estimated uncollectibles

Bad debt is an amount of money that a creditor must write off if a borrower defaults on the loans. If a creditor has a bad debt on the books, it becomes uncollectible and is recorded as a charge-off. Bad debt is a contingency that must be accounted for by all businesses that extend credit to customers, as there is always a risk that payment won’t be collected. These entities can estimate how much of their receivables may become uncollectible by using either the accounts receivable (AR) aging method or the percentage of sales method. Each time bucket is usually in 30-day increments, so the day bucket, the 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 day bucket, 20% to the day bucket, and 40% to the 90+ day bucket.