The allowance for uncollectible accounts method is an estimate of how much of the company's credit sales will be uncollectible. This estimate is entered as an adjustment in the books at the end of each accounting period. It allows a company to remain in compliance with financial reporting requirements. Well-established companies with a long accounts receivables history will rely on past experience to make their estimate. New companies must rely on published industry averages to make their estimates. If a company expects total sales in April to be $750,000 and expects 1% of that to be uncollectible, then, using the allowance method, it would make a journal entry at the end of the month to provision. In accounting parlance, this means expense, $7,500 as an allowance for possible bad debt. The entry looks like this:
| Date | Account | Debit | Credit | Explanation |
| Apr 30 | Bad Debts Expense | $7,500 | | Estimate for bad debts 1% |
| Allowance for Uncollectible Accounts | | $7,500 | Estimate for bad debts 1% |
Accounts Receivable
Companies that provide goods and services often give their customers credit in the way of a certain number of days within which to pay the outstanding balance on their account. Not all businesses ask clients to pay cash up-front. Some provide an invoice that must be paid within 15, 30, or even 60 days. When a company makes a credit sale, the sale is recorded in the accounts receivable account. If a company sells $850.00 worth of goods due within 30 days, the entry will be:
| Date | Account | Debit | Credit | Explanation |
| Apr 1 | Accounts Receivable | $850 | | Invoice 3524 |
| Sales Revenue | | $850 | Invoice 3524 |
All amounts in the accounts receivable account are credit sales. If the sale becomes uncollectible, then the following entry will be made if the direct write-off method is being used:
| Date | Account | Debit | Credit | Explanation |
| Aug 31 | Bad Debts Expense | $850 | | Write-off Invoice 3524 |
| Accounts Receivable | | $850 | Write-off Invoice 3524 |
If the Allowance Method is being used, the entry will be:
| Date | Account | Debit | Credit | Explanation |
| Aug 31 | Bad Debts Expense | $850 | | Write-off Invoice 3524 |
| Allowance for Uncollectible Accounts | | $850 | Write-off Invoice 3524 |
How to Calculate Bad Debt Expense
Bad debt expense is an income statement account that is used to record client account balances deemed uncollectible by the accounting department. When an account is deemed uncollectible, a debit will be made to the bad debt expense account and a credit will be made to either accounts receivable or allowance for uncollectible accounts, depending on which method the company uses to account for bad debt expense. A company may use the direct write-off method or the allowance method.
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.
The allowance for doubtful accounts method is the one most commonly used because it allows the company to be in compliance with financial regulatory reporting requirements. It works by provisioning for bad debt with the creation of a contra-asset account called allowance for bad debt and then estimating the amount of expected bad debt for each accounting period. The most common ways to estimate the allowance that should be made for bad debt are:
- Percentage of Sales - also known as the income statement method because sales are reported on the income statement, is usually based on historical information related to sales and how much was uncollectible in the past. i.e. 1% of Total Sales
- Percentage of Outstanding Receivables - aka the balance sheet method because accounts receivable is an asset account on the balance sheet, usually a percentage based on historical information about how much of the company's credit sales were uncollectible in the past. i.e. 2% of A/R
- The Aging Method - also known as the balance sheet percentage of receivables for calculating bad debt method, uses information regarding how long receivables have been outstanding to estimate uncollectible accounts.
To unlock this lesson you must be a Study.com Member.
Create your account
FAQs
The allowance method is an estimate of the amount the company expects will be uncollectible made by debiting bad debt expense and crediting allowance for uncollectible accounts. If a specific account becomes uncollectible, it will debit allowance for doubtful accounts and credit accounts receivable.
What is the allowance method example? ›
Example of Allowance Method
Estimate the amount of uncollectible accounts: Uncollectible accounts = 5% * $100,000 = $5,000. Record the bad debt expense: XYZ Company would record the following adjusting journal entry at the end of the year: Debit: Bad Debt Expense $5,000 Credit: Allowance for Doubtful Accounts $5,000.
What is the allowance method principle? ›
The allowance method provides in advance for uncollectible accounts think of as setting aside money in a reserve account. The allowance method represents the accrual basis of accounting and is the accepted method to record uncollectible accounts for financial accounting purposes.
What is the main advantage of the allowance method? ›
The main advantage of using the allowance method in business is; it allows the firm to provide accurate financial reports to the interested parties. The accurate account receivable in the balance sheet can be estimated through allowance method.
What are the two methods under the allowance method to estimate uncollectible accounts? ›
The percentage of sales method and the accounts receivable aging method are the two most common ways to estimate uncollectible accounts.
What is the allowance method for dummies? ›
The allowance method is an estimate of the amount the company expects will be uncollectible made by debiting bad debt expense and crediting allowance for uncollectible accounts. If a specific account becomes uncollectible, it will debit allowance for doubtful accounts and credit accounts receivable.
What is a allowance example? ›
In business, an allowance is a payment made to an employee to cover expenses or compensate for specific working conditions. For example, many employees are given an allowance to pay for the cost of travel or entertainment. Allowances can also be compulsory for employees in certain situations.
What does the allowance method require? ›
The allowance method is required by GAAP for financial reporting purposes 2. The allowance method requires managers to estimate future uncollectible accounts and to record that estimate in the current year. 3. Collecting cash on an account previously written off increases total assets but has no effect on net income.
What is one disadvantage of the allowance method? ›
One disadvantage of the allowance method (over the direct write-off method) for recording uncollectible accounts is that it generally matches bad debt expense with the revenue it helped to generate.
Why is the allowance method preferred over the direct method? ›
Since the direct write-off method can sometimes give the wrong impression of how much money was made or lost in a financial period, professional accountants prefer the allowance method, which is in keeping with their accrual practices.
no balance sheet effect. There is no income statement impact from the write-off under the allowance method because income was already reduced by the estimated bad debt expense in the year of the sale. statement.
Why is the allowance method required by GAAP? ›
Under U.S. GAAP, only the allowance method is an allowable method to estimate uncollectible accounts receivable. The allowance method recognizes bad debt expense when the company believes there is a high likelihood the receivable will not be collected, which follows the matching principle.
What happens when a company writes off an uncollectible account under the allowance method? ›
When a company writes off an uncollectible account under the allowance method, several things happen: 1. Expenses increase: - Writing off an uncollectible account means recognizing the amount as a loss. This loss is recorded as an expense on the income statement, which reduces the company's net income.
When using the allowance method, as bad debt expense is recorded.? ›
Recording bad debt expenses under the allowance method
When the business entity uses the allowance method, the business entity records the bad debt expenses in the period when the sales revenue is earned. Such expenses are recorded at the period end when the adjusting entries are made.
What happens under the allowance method of recognizing uncollectible? ›
Answer and Explanation: Under the allowance method of recognizing uncollectible accounts, the entry to write off an uncollectible account has no effect on net income (C). The allowance method of recognizing uncollectible accounts estimates and accrues bad debt expense at the time of the related sale.
What are examples of allowances in accounting? ›
Two typical examples of an allowance are the allowance for doubtful accounts, which are contra-asset accounts to accounts receivable, and the allowance for returns and discounts.
What is an example of allowance in a sentence? ›
Examples of allowance in a Sentence
Noun a monthly allowance for household expenses Each of their children gets a weekly allowance of five dollars.
What is an example of buying allowances? ›
An example of an allowance would be to offer a 2% discount on a bill paid in 10 days but no discount for paying in 30 days. When a company provides a discount or an allowance to a customer it appears on a company's income statement as a reduction to revenue.
How do you calculate allowance? ›
General Guidelines For Teens. A good (and fair) way to calculate your child's allowance (especially when you have more than one) is to take the child's age and multiply it by 1.5. For example, in general, if your child is 16 years old, 1.5 times that is $24.00. So your child's allowance is $24.00 per week.
