It's a sad but true fact that, from time to time, a company might not be able to collect all the money owed it. This is an expense that the company must recognize on the balance sheet. The loss reduces accounts receivable. The term "receivables" refers to the amount of money the company expects to collect from customers who purchased goods or services on credit.
Understanding the Matching Principle
Under generally accepted accounting principles (GAAP), companies that use accrual accounting must book income when earned and expenses when incurred. This differs from cash accounting, where companies recognize income when collected and expenses when paid. In accrual accounting, it's important to allocate expenses to the correct period and to associate them with the activities that generated them. The account allowance for doubtful accounts helps to assign lost revenue to the correct period.
Collecting Net Receivables
A net receivable is a short-term asset on the balance sheet. It records the total amount of money owed the company for delivery of goods and services minus the amount it doesn't expect to collect. Usually, a company will actively attempt to collect past due receivables after they've lapsed a set period such as 30, 60 or 90 days.
Video of the Day
Collection methods include dunning letters, phone calls, referrals to collection agencies and in some cases, lawsuits. Inevitably, some collections will not succeed, creating a bad debt expense.
Understanding Allowance for Doubtful Accounts
If a company uses accrual accounting, it cannot simply post a bad debt expense when it writes off an account. The reason is that the write-off can occur in a later period. Posting a bad debt expense in the wrong period violates the GAAP matching principle and reduces the explanatory power of the posting. Therefore companies estimate their uncollectable accounts at the start of the period and post the estimate in the allowance for doubtful accounts, which is a _contra asset accoun_t that reduces accounts receivable.
Estimating Allowance for Doubtful Accounts
Suppose that a company's accounts receivable balance for the quarter is $100,000. The company can choose from three common methods for estimating allowance for doubtful accounts, which include:
- Percentage of accounts receivable. The allowance is estimated as a percentage of the period's opening A/R balance. For example, suppose a company has found that bad debts run at 3 percent of accounts receivable. The company sets the allowance for doubtful accounts to $3,000, creating a $97,000 net A/R balance. This assumes that no allowance was carried forward from the previous period.
- Percentage of sales. This method uses a percentage of sales to estimate the allowance. For example, if a company with $1 million in sales estimates 1 percent will not be collected, it adds $10,000 to the allowance for doubtful accounts. Assuming no allowance carryover from previous periods, the net receivables will be $90.000.
- A/R aging. In this method, a company estimates the allowance based on the amount of the most delinquent debt such as debt that is past due by 90 days or more. If at the start of the period, the 90-plus day balance is $6,000 and the company has found that 90 percent of such debt is uncollectable, then the allowance is increased by (0.9 x $6,000) or $5,400. Net receivables will then be $94,600, assuming no carryforward.
Recognizing a Bad Debt
When a company using accrual accounting finally recognizes an account as uncollectible, it enters a transaction to reduce A/R and allowance for bad debts by the write-off amount. Any allowance on the balance sheet left over at the end of the period is carried forward into the next period. The new period's estimate for the allowance is then added to the carried-forward balance.
However, in a cash-accounting company, the bad debt is an expense that directly reduces accounts receivable. Bad debt expenses appear on the income statement, not the balance sheet.
Companies can refine their projections of allowance for doubtful accounts over time if they find they are consistently underestimating or overestimating it.