How to Calculate the Allowance for Uncollectible Accounts

The allowance for uncollectible accounts, often called the allowance for doubtful accounts, is an important contra-asset account on a company’s balance sheet. It serves as an estimate of the portion of accounts receivable that a business expects will not be collected from customers.

This accounting practice ensures that accounts receivable are presented at their net realizable value, which is the amount of cash the company truly anticipates collecting. Establishing this allowance also aligns with the matching principle, a foundational accounting concept requiring that expenses be recognized in the same period as the revenues they helped generate. By estimating potential uncollectible amounts when sales occur, businesses can more accurately portray their financial health and profitability.

Information Needed for Estimation

Calculating the allowance for uncollectible accounts requires specific foundational data to estimate future uncollectible amounts. One primary source of insight is historical data, which includes past collection experiences. Businesses often analyze previous percentages of credit sales that have ultimately become uncollectible or historical rates of outstanding receivables that were written off as bad debt. This historical experience helps establish a reliable percentage to apply to current financial figures, serving as a starting point for the estimation process.

Another essential piece of information is the accounts receivable aging schedule. This report categorizes outstanding customer invoices based on the length of time they have been outstanding, typically in increments such as 0-30 days, 31-60 days, and so on. An aging schedule is important because older receivables generally have a higher likelihood of becoming uncollectible. This schedule is important for the estimation process, providing organized data.

Additionally, current sales data, specifically total credit sales figures, are necessary if using a sales-based estimation method. This figure represents the total amount of sales made on credit during a specific period. This data, combined with historical uncollectibility rates, allows for a forward-looking estimate of potential bad debts arising from current period sales.

Applying Estimation Methods

Once compiled, this information allows for various estimation methods, each offering a distinct approach. The Percentage of Sales Method, also known as the income statement approach, estimates bad debt expense by applying a historical percentage to current period credit sales. This method directly focuses on the impact on the income statement by determining the bad debt expense for the period. For example, if a company has $1,000,000 in credit sales and historically 1.5% of credit sales become uncollectible, the estimated bad debt expense would be $15,000 ($1,000,000 x 0.015).

The Aging of Accounts Receivable Method, a balance sheet approach, uses the accounts receivable aging schedule to estimate the desired ending balance for the allowance for uncollectible accounts. This method applies different uncollectible percentages to various age categories of receivables, recognizing that older receivables are less likely to be collected. For instance, if accounts receivable are categorized as: $500,000 (0-30 days, 1% uncollectible), $200,000 (31-60 days, 5% uncollectible), and $100,000 (over 60 days, 15% uncollectible), the estimated uncollectible amounts would be $5,000 ($500,000 x 0.01), $10,000 ($200,000 x 0.05), and $15,000 ($100,000 x 0.15) respectively. Summing these amounts ($5,000 + $10,000 + $15,000) results in a desired allowance balance of $30,000.

The Percentage of Accounts Receivable Method, another balance sheet approach, estimates the allowance for uncollectible accounts by applying a single historical bad debt percentage to the total outstanding accounts receivable balance. Similar to the aging method, this calculation directly determines the desired ending balance for the allowance account. For example, if a company has a total accounts receivable balance of $850,000 and historical data suggests 4% of receivables are uncollectible, the desired allowance balance would be $34,000 ($850,000 x 0.04).

Accounting for the Allowance

Once the allowance is estimated, the next step involves recording it in the accounting system and understanding its impact on financial statements. To record the estimated bad debt, a journal entry is made by debiting Bad Debt Expense and crediting Allowance for Uncollectible Accounts. For methods like the aging of accounts receivable or percentage of accounts receivable, this entry adjusts the Allowance for Uncollectible Accounts to its desired ending balance, ensuring the balance sheet reflects the correct estimated amount. The amount of the debit to Bad Debt Expense will be the amount needed to bring the allowance account to its calculated target.

When a specific customer account is identified as uncollectible and is formally written off, a separate journal entry is prepared. This entry involves debiting Allowance for Uncollectible Accounts and crediting Accounts Receivable. It is important to note that this write-off entry does not affect Bad Debt Expense or total assets at the time it occurs, as the expense was recognized when the allowance was initially estimated. The write-off simply reclassifies the uncollectible amount from accounts receivable to the allowance.

The allowance for uncollectible accounts significantly impacts a company’s financial statements. On the balance sheet, the Allowance for Uncollectible Accounts is presented as a contra-asset account, directly reducing the gross Accounts Receivable balance. On the income statement, the Bad Debt Expense recognized through the initial adjusting entry reduces the company’s net income for the period. This expense reflects the cost of extending credit that is ultimately not collected.