How to Calculate Allowance for Uncollectible Accounts

When businesses sell goods or services, they often extend credit to customers, allowing them to pay later. While this practice can boost sales, it introduces the possibility that some payments will never be received. Accurate financial reporting requires companies to anticipate these potential losses and reflect them in their financial statements to present a realistic view of financial health.

Understanding Uncollectible Accounts

Money owed to a company from customers for goods or services provided on credit is known as “accounts receivable.” The portion of these receivables deemed unlikely to be collected is referred to as “uncollectible accounts,” also commonly known as “bad debts” or “doubtful accounts.”

Businesses utilize an “allowance for uncollectible accounts.” This contra-asset account reduces the gross amount of accounts receivable on the balance sheet. Its purpose is to present accounts receivable at their “net realizable value,” the estimated cash a company expects to collect.

This practice aligns with the matching principle, which dictates that expenses should be recognized in the same accounting period as the revenues they helped generate. By estimating and recording uncollectible amounts in the period of related credit sales, businesses avoid overstating assets and ensure a more accurate representation of income.

Methods for Estimating Uncollectible Accounts

Companies rely on estimation methods to determine the allowance for uncollectible accounts, as exact uncollectible accounts are unknown at the time of sale. These estimations are based on historical data, industry averages, and current economic conditions. Companies must regularly review and adjust their methodologies to align with actual collection experience.

One common approach is the “percentage of sales method,” also known as the income statement approach. This method estimates bad debt expense based on a percentage of the current period’s credit sales. The percentage used is derived from a company’s past collection experience, reflecting the historical proportion of uncollectible credit sales.

For example, if a company has $1,000,000 in credit sales and historical data suggests 2% become uncollectible, the estimated bad debt expense for the period would be $20,000 ($1,000,000 x 0.02). This method directly focuses on matching the expense with the revenue earned in the same period.

Another widely used method is the “percentage of receivables method,” often referred to as the “aging method.” This approach estimates the appropriate ending balance for the allowance for uncollectible accounts. It involves classifying accounts receivable balances by their outstanding time, using an “aging schedule” that groups receivables into categories like 1-30 days, 31-60 days, 61-90 days, and over 90 days past due.

A higher uncollectible percentage is assigned to older receivables. For instance, accounts 1-30 days overdue might have a 2% uncollectibility rate, while those over 90 days overdue could have a 50% rate. The estimated uncollectible amount for each age category is calculated by multiplying the receivable balance by its assigned percentage. The sum of these amounts represents the total estimated uncollectible amount, which becomes the target ending balance for the allowance.

Once the target allowance balance is determined using the aging method, the bad debt expense for the period is the amount needed to adjust the existing allowance balance to this new target. For example, if an aging schedule indicates a required allowance balance of $8,000, and the existing allowance account has a credit balance of $1,000, the bad debt expense recognized would be $7,000 ($8,000 – $1,000). The percentage of sales method emphasizes the income statement, while the aging method prioritizes the accurate valuation of accounts receivable on the balance sheet.

Recording the Allowance for Uncollectible Accounts

Once the estimated allowance for uncollectible accounts is calculated, it must be formally recorded in a company’s financial records. The standard journal entry to recognize bad debt expense involves two accounts: “Bad Debt Expense” is debited, and “Allowance for Uncollectible Accounts” (or Allowance for Doubtful Accounts) is credited.

For instance, if the estimated bad debt expense is $20,000, the journal entry would be a debit to Bad Debt Expense for $20,000 and a credit to Allowance for Uncollectible Accounts for $20,000. The Allowance for Uncollectible Accounts is presented on the balance sheet as a direct deduction from gross Accounts Receivable.

This presentation shows the “Net Realizable Value of Accounts Receivable.” For example, if gross accounts receivable are $500,000 and the allowance is $20,000, the net realizable value reported on the balance sheet would be $480,000. This ensures assets are not overstated and provides a realistic view of the company’s liquid assets.

When a specific account is definitively determined to be uncollectible, it is “written off.” The journal entry for a write-off involves debiting the Allowance for Uncollectible Accounts and crediting Accounts Receivable. For example, if a $500 account is written off, the entry would be a debit to Allowance for Uncollectible Accounts for $500 and a credit to Accounts Receivable for $500. A write-off does not affect the net realizable value of accounts receivable or the bad debt expense at the time of the write-off, because the expense was already recognized when the allowance was initially created.

Occasionally, a company may collect on an account previously written off. This is known as a “recovery.” Recording a recovery involves two journal entries. First, the previously written-off receivable is reinstated by debiting Accounts Receivable and crediting Allowance for Uncollectible Accounts. Second, the collection of cash is recorded by debiting Cash and crediting Accounts Receivable.