What Is Impairment of Receivables in Accounting?

When a business sells on credit, it creates an accounts receivable, which is the right to collect cash from a customer. However, some customers may not pay the amount they owe. The impairment of receivables is the process of accounting for this potential loss by estimating the uncollectible portion and recording it in the financial statements. This adjustment ensures a company’s assets are not overstated, providing a more realistic view of its financial health.

The Allowance Method for Uncollectible Accounts

Accrual accounting requires a specific approach to handle the impairment of receivables, known as the allowance method. This method uses two accounts. The first is “Bad Debt Expense,” which appears on the income statement and represents the estimated uncollectible amount from sales made during a period. The second is “Allowance for Doubtful Accounts,” which is a contra-asset account on the balance sheet that reduces the overall value of accounts receivable.

The reason for using the allowance method is the matching principle, which dictates that expenses should be recorded in the same accounting period as the revenues they helped generate. The risk of a credit sale becoming uncollectible is an expense of making that sale and should be recognized in the same period. This is not delayed until the customer officially defaults.

This approach provides a more accurate representation of a company’s profitability. It contrasts with the direct write-off method, where a debt is only recognized when a specific invoice is deemed uncollectible. Generally Accepted Accounting Principles (GAAP) mandate the allowance method for financial reporting if uncollectible amounts are significant.

Estimating and Calculating Impairment

Percentage of Sales Method

One way to estimate bad debt is the percentage of sales method. This technique focuses on the income statement. A company determines a flat percentage based on its historical experience of uncollectible accounts and applies it to the total credit sales for the current period. For instance, if a business historically finds that 1.5% of its credit sales become uncollectible and it generated $200,000 in credit sales, it would estimate its bad debt expense to be $3,000.

This calculation directly determines the amount of Bad Debt Expense to be recorded for the period. It effectively matches the expense of bad debts with the sales revenue of the same period. However, it does not consider the existing balance in the Allowance for Doubtful Accounts.

Aging of Receivables Method

A more detailed approach is the aging of receivables method. This method focuses on the balance sheet and involves creating an aging schedule, which categorizes all outstanding customer invoices based on how long they have been due. Common categories include current (0-30 days), 31-60 days past due, 61-90 days past due, and over 90 days past due.

The company then applies a different, increasing percentage of uncollectibility to each age category, as the probability of collection decreases over time. For example, a company might estimate that 1% of current receivables will be uncollectible, but that percentage might jump to 40% for those over 90 days. By multiplying the total receivables in each category by its assigned percentage and summing the results, the company calculates the desired ending balance for the Allowance for Doubtful Accounts.

Current Expected Credit Losses (CECL)

Current accounting standards, under Accounting Standards Codification (ASC) 326, require the Current Expected Credit Losses (CECL) model. This forward-looking approach requires companies to estimate credit losses over the entire life of their receivables from the moment they are recorded. The estimation process must incorporate historical data, current conditions, and reasonable forecasts about the future.

A company must consider factors like changes in the economic environment and the financial health of its customer base. While this provides a more comprehensive view of credit risk, it also introduces greater judgment and complexity into the estimation process.

Recording Impairment and Subsequent Write-Offs

After calculating the total estimated uncollectible amount, a company records it with an adjusting journal entry. This entry involves a debit to Bad Debt Expense and a credit to Allowance for Doubtful Accounts. This action increases the expense on the income statement and increases the allowance account on the balance sheet. This initial entry is an estimate for all receivables, not a write-off of a specific customer’s account, which is a separate process.

When a company determines that a particular customer will not pay their outstanding balance of, for example, $500, a different journal entry is made. This entry involves a debit to Allowance for Doubtful Accounts and a credit to Accounts Receivable for that specific customer. This write-off entry reduces both the allowance account and the accounts receivable balance.

The Bad Debt Expense account is not affected at the time of the write-off because the expense was already recognized when the allowance was estimated. The write-off does not impact the income statement or net income; it is a balance sheet adjustment.

If a customer pays an invoice that was previously written off, it is called a recovery. This requires two journal entries. First, the write-off is reversed by debiting Accounts Receivable and crediting Allowance for Doubtful Accounts. Second, the cash collection is recorded by debiting Cash and crediting Accounts Receivable.

Financial Statement Presentation

On the balance sheet, the Allowance for Doubtful Accounts is presented directly below the Accounts Receivable line within the current assets section. The allowance is subtracted from the gross accounts receivable amount to arrive at a figure known as “Accounts Receivable, Net” or the “Net Realizable Value.” This shows the total amount owed alongside the company’s estimate of what it expects to collect.

For example, a balance sheet might show Gross Accounts Receivable of $500,000. Directly beneath it would be “Less: Allowance for Doubtful Accounts” with a balance of $25,000. The final reported number would be “Accounts Receivable, Net” of $475,000. This net value is included in the calculation of total current assets.

On the income statement, the Bad Debt Expense recorded for the period is reported as part of the company’s operating expenses. It is included within the “Selling, General, and Administrative” (SG&A) expenses category. By reporting it here, the expense is matched against the revenues of the period, providing a clear picture of the company’s operational profitability.