The two methods of accounting for uncollectible receivables are the allowance method and the

Last updated 7th Nov 2022

Definition

The financial accounting term allowance method refers to an uncollectible accounts receivable process that records an estimate of bad debt expense in the same accounting period as the sale. The allowance method is used to adjust accounts receivable appearing on the balance sheet.

Explanation

Unfortunately, not all customers that make purchases on credit will pay companies the money owed. There are two methods companies use to account for uncollectible accounts receivable, the direct write-off method and the allowance method.

The direct write-off method relies on reports of accounts receivable the company has determined will not be collected. If write off is not material, this method can be used in financial reports. Typically, this approach is restricted to income tax returns.

The allowance method records an estimate of bad debt expense in the same accounting period as the sale. It often takes months for companies to identify specific uncollectible accounts. The allowance method follows the matching principle, which states revenues need to be matched with the expenses incurred in that same accounting period.

Generally, companies will choose between two approaches under the allowance method.

Percentage of Sales: Using historical data, a company examines the relationship between sales and uncollectible accounts receivable. If there is a fairly stable relationship between the two, a company will use the historical Uncollectible Accounts / Credit Sales ratio to estimate the bad debts expense in the current period.

For example, a company might find a historical trend indicating 2% of credit sales are never collected from customers. If that company had $100,000 of credit sales in the current period, it would also record the following journal entry:

Date Account Debit Credit 3/31/20XX Bad Debts Expense $2,000 Allowance for Doubtful Accounts $2,000

This method is sometimes referred to as the income statement approach.

Percentage of Accounts Receivable: Using historical data, a company examines the relationship between accounts receivable and uncollectible accounts. Companies will oftentimes increase the accuracy of these estimates by looking at their aging schedule for patterns, rather than using a composite (or total) of their receivables.

For example, a company might find a historical trend indicating 50% of credit sales over 150 days due are never collected, while 0.5% of credit sales over 30 days are never collected. This approach is illustrated below:

Aging Schedule Bad Debts Estimate A/R Balance Allowance for Bad Debts Over 30 days 0.5% $300,000 $1,500 31 to 60 days 1.0% $100,000 $ 1,000 61 to 90 days 2.0% $50,000 $1,000 91 to 120 days 5.0% $7,000 $350 120 to 150 days 15.0% $5,000 $750 Over 150 days 50% $3,000 $1,500 Total Balance $6,100

This method is sometimes referred to as the balance sheet approach.

Allowance for bad debt, also known as the allowance for doubtful accounts, is a contra asset account and is used as an offset to accounts receivable. This allows the account to be stated in what is known as net realizable value, where:

Net Realizable Value = Accounts Receivable - Allowance for Doubtful Accounts

Related Terms

balance sheet, matching principle, current assets, accounts receivable, contra account, accounts receivable valuation, uncollectible accounts, direct write off method

What is the Allowance Method?

The allowance method involves setting aside a reserve for bad debts that are expected in the future. The reserve is based on a percentage of the sales generated in a reporting period, possibly adjusted for the risk associated with certain customers. By creating this allowance, bad debt expenses are being matched against sales within the same period, so that readers of the financial statements will have a better understanding of the true profitability of sales.

The mechanics of the allowance method are that the initial entry is a debit to bad debt expense and a credit to the allowance for doubtful accounts (which increases the reserve). The allowance is a contra account, which means that it is paired with and offsets the accounts receivable account. When a specific bad debt is identified, the allowance for doubtful accounts is debited (which reduces the reserve) and the accounts receivable account is credited (which reduces the receivable asset). If a customer subsequently pays an invoice that has already been written off, then the process is reversed to increase both the allowance and the accounts receivable account, after which the cash account is debited to increase the cash balance and the accounts receivable account is credited to reduce the receivable asset.

Example of the Allowance Method

The historical bad debt experience of a company has been 3% of sales, and the current month’s sales are $1,000,000. Based on this information, the bad debt reserve to be set aside is $30,000 (calculated as $1,000,000 x 3%). In the following month, $20,000 of the accounts receivable are written off, leaving $10,000 of the reserve still available for additional write-offs.

The Direct Write-Off Method

The alternative to the allowance method is the direct write-off method, under which bad debts are only written off when specific receivables cannot be collected. This may not occur until several months after a sale transaction was completed, so the entire profitability of a sale may not be apparent for some time. The direct write-off method is a less theoretically correct approach to dealing with bad debts, since it does not match revenues with all applicable expenses in a single reporting period.

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