How to Calculate Uncollectible Accounts Expense

By accounting for potential losses from uncollectible accounts, companies can better assess their financial health and profitability. Bad debt expense represents the portion of accounts receivable that a business expects will not be collected. This expense is a necessary consideration for companies extending credit to customers, as not all credit sales ultimately result in cash collection.

This method is labeled a balance sheet approach because the one figure being estimated (the allowance for doubtful accounts) is found on the balance sheet. Regardless of the approach, both bad debt expense and the allowance for doubtful accounts are simply the result of estimating the final outcome of an uncertain event—the collection of accounts receivable. The direct write-off method works by directly writing-off bad debt expenses from accounts receivable into the expense account. Whenever a company is sure a certain account balance is uncollectible, it will debit bad debt expense and credit accounts receivable for the amount. There is no calculation, just a recognition that an account has become uncollectible and a writing-off of the specific amount. Businesses regularly extend credit to customers, allowing them to receive goods or services now and pay later.

Payments

Continuing our examination of the balance sheet method, assume that BWW’s end-of-year accounts receivable balance totaled $324,850. This entry assumes a zero balance in Allowance for Doubtful Accounts from the prior period. By adhering to these best practices, companies can effectively manage their accounts receivable, reduce the risk of uncollectible accounts, and maintain healthier cash flows and more accurate financial reporting. The Percentage of Sales Method is a straightforward approach for estimating uncollectible accounts.

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. Bad Debt Expense increases (debit), and Allowance for Doubtful Accounts increases (credit) for $48,727.50 ($324,850 × 15%). By examining these real-world examples and case studies, companies across various industries can gain valuable insights into effective strategies for managing uncollectible accounts. This entry directly reduces both the accounts receivable and the net income for the period in which the receivable is written off.

In practice, companies usually use eitheraging method andsales methodfor its calculation as mentioned at the beginning of this article. Master how businesses proactively estimate and account for credit sales unlikely to be collected, ensuring accurate financial reporting. Calculate the sum of the amounts of each portion you expect will be uncollectible to calculate the total amount of uncollectible accounts. Estimate the smallest percentage of the portion that is not yet due and estimate larger percentages as the number of days past due increases.

Income Statement Method for Calculating Bad Debt Expenses

That is why unless bad debt expense is insignificant, the direct write-off method is not acceptable for financial reporting purposes. This allowance is your bad debt reserve, also known as the ‘allowance for doubtful accounts.’ It offsets the amount in your accounts receivable in your books. But you need to know how to calculate the bad debt expense percentage to estimate what your allowance should be. To record your bad debts, you debit the bad debt expense account and credit your allowance for the bad debts account. Calculate what amount of your accounts receivable it represents in each category and add them to get your total bad debts. That’s your projected bad debt, whose amount you can now allocate to your allowance account.

GAAP Guidelines

Tracking the bad debt to sales ratio is crucial for assessing a company’s financial health. This metric indicates the fraction of sales lost to uncollectible accounts, providing valuable insight into the efficiency of accounts receivable and credit policies. A lower ratio signifies effective credit management and robust cash flow, whereas a higher figure could point to lax credit policies or collection challenges.

Financial Reporting and Disclosure

Yes, bad debt expense is generally tax-deductible, but there are specific rules and requirements from the IRS. To be deductible, the debt must be considered a business bad debt, which is a loss from a debt created or acquired in a trade or business. The direct write-off method is the one typically required for federal income tax purposes. If an account you had previously marked as a bad debt does make a payment, it needs to be recorded for accounting purposes.

• That total is reported in Bad Debt Expense and Allowance for Doubtful Accounts, if there is no carryover balance from a prior period.
• This allowance ensures that the accounts receivable on the balance sheet are not overstated, giving a more accurate picture of expected cash inflows and improving financial reporting accuracy.
• Knowing how to record write-offs as part of financial reporting is necessary at the end of the accounting period, which may run from January to December or any other time period.
• You currently use the income statement method toestimate bad debt at 4.5% of credit sales.

Companies can use it to refine credit terms, enhance collection methods, and even reassess customer creditworthiness. Additionally, maintaining a favorable bad debt to sales ratio demonstrates fiscal responsibility, potentially improving relationships with investors and creditors. These disclosures help users of the financial statements understand the company’s approach to managing credit risk and the potential impact of uncollectible receivables on the financial results.

• The final point relates to companies with very little exposureto the possibility of bad debts, typically, entities that rarelyoffer credit to its customers.
• In this example, assume that any credit card sales that are uncollectible are the responsibility of the credit card company.
• Regardless of the approach, both bad debt expense and the allowance for doubtful accounts are simply the result of estimating the final outcome of an uncertain event—the collection of accounts receivable.
• By accounting for potential losses from uncollectible accounts, companies can better assess their financial health and profitability.
• On the surface, the reason behind it might seem to be limited only to the client, but how a company handles its AR also plays an important role.

As you’ve learned, the delayed recognition of bad debt violates GAAP, specifically the matching principle. Therefore, the direct write-off method is not used for publicly traded company reporting; the allowance method is used instead. For the taxpayer, this means that if a company sells an item on credit in October 2018 how to calculate uncollectible accounts expense and determines that it is uncollectible in June 2019, it must show the effects of the bad debt when it files its 2019 tax return. This application probably violates the matching principle, but if the IRS did not have this policy, there would typically be a significant amount of manipulation on company tax returns. For example, if the company wanted the deduction for the write-off in 2018, it might claim that it was actually uncollectible in 2018, instead of in 2019. As a result of these measures, DEF Financial saw a 20% reduction in uncollectible accounts over two years, improving both its cash flow and profitability.

Once bad debt expense has been identified and calculated, it must be recorded in the company’s accounting records through journal entries. The recording method depends on whether the Direct Write-off Method or the Allowance Method is employed. Look at the final income statement from the previous year to determine the amount of bad debts expense. The allowance method is the more widely used method because itsatisfies the matching principle. The allowancemethodestimates bad debt during a period, based oncertain computational approaches.

Allowance Method in Detail

Budgeting and planning for bad debts or doubtful accounts is also known as an allowance for uncollectible accounts. The balance sheet approach for estimating uncollectible accounts that computes the allowance for doubtful accounts by multiplying accounts receivable by the percentage that are not expected to be collected. In applying the percentage-of-sales method, companies annually review the percentage of uncollectible accounts that resulted from the previous year’s sales. For example, assume Rankin’s allowance account had a $300 credit balance before adjustment. However, the balance sheet would show $100,000 accounts receivable less a $5,300 allowance for doubtful accounts, resulting in net receivables of $ 94,700.

This application probably violates thematching principle, but if the IRS did not have this policy, therewould typically be a significant amount of manipulation on companytax returns. For example, if the company wanted the deduction forthe write-off in 2018, it might claim that it was actuallyuncollectible in 2018, instead of in 2019. 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 Debt Expense increases (debit), and Allowance for Doubtful Accounts increases (credit) for $22,911.50 ($458,230 × 5%). Let’s say that on April 8, it was determined that Customer Robert Craft’s account was uncollectible in the amount of $5,000.

The journal entry for the Bad Debt Expense increases (debit) the expense’s balance, and the Allowance for Doubtful Accounts increases (credit) the balance in the Allowance. The allowance for doubtful accounts is a contra asset account and is subtracted from Accounts Receivable to determine the Net Realizable Value of the Accounts Receivable account on the balance sheet. In the case of the allowance for doubtful accounts, it is a contra account that is used to reduce the Controlling account, Accounts Receivable. The allowance method is the more widely used method because it satisfies the matching principle. The allowance method estimates bad debt during a period, based on certain computational approaches.

With this method, accounts receivable is organized intocategories by length of time outstanding, and an uncollectiblepercentage is assigned to each category. For example,a category might consist of accounts receivable that is 0–30 dayspast due and is assigned an uncollectible percentage of 6%. Anothercategory might be 31–60 days past due and is assigned anuncollectible percentage of 15%.