Definition of Estimating Uncollectible Accounts Receivable
When a company sells goods and/or provides services on account (on credit) using the accrual basis or method of accounting, the amount of the sales or service revenues is reported on the income statement and the related accounts receivable is reported on the balance sheet (until the receivables are collected). Unfortunately, some customers may not pay the amount owed to the company. In order to not overstate the company’s profits and current assets, the following is required:
- The income statement must report the estimated uncollectible accounts expense (bad debts expense, doubtful accounts expense) that occurred during the accounting period
- The balance sheet must report in the contra asset account Allowance for Uncollectible Accounts (or Allowance for Doubtful Accounts) the estimated amount of the accounts receivable that will not be collected
Examples of Estimating Uncollectible Accounts Receivable
Two common ways of estimating the amount of uncollectible receivables are:
- Preparing an aging of accounts receivable to identify the potentially uncollectible accounts. The aging lists every customer’s balance and then sorts each customer’s balance according to the amount of time since the sale(s) occurred. The most recent sales are assumed to be fully collectible, but receivables that are past their due dates are past due. The more days they are past due, the greater the likelihood the receivable will not be collected in full. Based on a detailed review of the past due accounts, a reasonable estimate is recorded as uncollectible. For example, if a company’s accounts receivable is $90,000 and it is estimated that $6,000 will not be collected, the balance in the account Allowance for Uncollectible Accounts must be a credit balance of $6,000. This will communicate that the net amount that will be turning to cash is $94,000. If the balance in the Allowance for Uncollectible Accounts is presently a credit balance of $1,500, the entry needed is a $4,500 credit to Allowance for Uncollectible Accounts, and a $4,500 debit to Uncollectible Accounts Expense.
- Estimating the amount of uncollectible accounts by simply recording a percentage of the credit sales that occur in each accounting period. For example, if a company and its industry have the experience of 0.2% of credit sales being uncollectible, the company might enter 0.2% of each period’s credit sales as a debit to Uncollectible Account Expense and a credit to Allowance for Uncollectible Accounts. For example, if the company has $100,000 of credit sales in May, it will record an entry to debit Uncollectible Accounts Expense for $200 ($100,000 X 0.002) and credit Allowance for Uncollectible Accounts for $200. (Periodically, the company should also prepare an aging to be certain that the credit balance in the Allowance account is reasonable. If needed, an adjustment should be made to the balance.)
FAQs
The allowance for uncollectible accounts is calculated by multiplying the receivable balance in the various aging categories (see table below) by a reserve rate. A higher reserve rate is applied to older receivables because those receivables are less likely to be collected.
How do you calculate estimated uncollectible accounts receivable? ›
The allowance for uncollectible accounts is calculated by multiplying the receivable balance in the various aging categories (see table below) by a reserve rate. A higher reserve rate is applied to older receivables because those receivables are less likely to be collected.
What is a method used to estimate uncollectible accounts receivable? ›
The percentage of sales method and the accounts receivable aging method are the two most common ways to estimate uncollectible accounts. Companies can also use specific identification, historical evidence, and or risk assignment to determine the estimate.
What are the two methods of estimating the allowance for uncollectible receivables? ›
Explanation: The two basic methods for estimating uncollectible accounts under the allowance method are the percentage of credit sales method and the percentage of receivables. The percentage of sales method estimates uncollectible accounts based on a percentage of credit sales for the period.
How to estimate accounts receivable? ›
Follow these steps to calculate accounts receivable:
- Add up all charges. You'll want to add up all the amounts that customers owe the company for products and services that the company has already delivered to the customer. ...
- Find the average. ...
- Calculate net credit sales. ...
- Divide net credit sales by average accounts receivable.
Answer and Explanation: To record estimated uncollectible accounts using the allowance method, the adjusting entry would be a C. debit to Bad Debt Expense and a credit to Allowance for Doubtful Accounts.
What is the normal balance of uncollectible accounts? ›
Because the allowance for doubtful accounts account is a contra asset account, the allowance for doubtful accounts normal balance is a credit balance. So for an allowance for doubtful accounts journal entry, credit entries increase the amount in this account and debits decrease the amount in this account.
What is the direct method of uncollectible accounts? ›
Under the direct write off method, when a small business determines an invoice is uncollectible they can debit the Bad Debts Expense account and credit Accounts Receivable immediately. This eliminates the revenue recorded as well as the outstanding balance owed to the business in the books.
What is the balance sheet approach to estimate uncollectible accounts? ›
The balance sheet method (also known as the percentage of accounts receivable method) estimates bad debt expenses based on the balance in accounts receivable. The method looks at the balance of accounts receivable at the end of the period and assumes that a certain amount will not be collected.
What is the aging method for estimating uncollectible accounts? ›
The aging method is used to estimate the number of accounts receivable that cannot be collected. This is usually based on the aged receivables report, which divides past due accounts into 30-day buckets. Each bucket is assigned a percentage, based on the likelihood of payment.
The allowance method can be better for a business than the direct write-off method because: The bad debts expense closer to the point of the sale or service. The allowance prepares a more accurate estimation of end-of-period financials, so the business knows what they have and how to prepare.
What is another name for an uncollectible accounts receivable account? ›
An allowance for doubtful accounts is considered a “contra asset,” because it reduces the amount of an asset, in this case the accounts receivable. The allowance, sometimes called a bad debt reserve, represents management's estimate of the amount of accounts receivable that will not be paid by customers.
How can an estimate of the uncollectible accounts expense be estimated in advance of the write-off using the allowance method? ›
How can an estimate of the uncollectible accounts expense be estimated in advance of the write - off using the Allowance method? Cash sales plus a percentage of credit sales. As a percentage of credit sales or as a percentage of accounts receivable.
What are three ways to measure accounts receivable performance? ›
5 key metrics to assess your AR performance
- Days Sales Outstanding (DSO) ...
- Average Days Delinquent (ADD) ...
- Accounts Receivable Turnover Ratio (ART) ...
- Collection Effectiveness Index (CEI) ...
- Number of revised invoices.
Using the formula for their respective days outstanding, we can forecast future accounts receivables, inventory, and accounts payables. The following are the formulas for annual days outstanding: Accounts Receivable Days = Average AR / Sales Revenue x 365. Inventory Days = Average Inventory / Cost of Goods Sold x 365.
How to calculate accounts receivable from average collection period? ›
To do that, take the value of your receivables at the start of the period plus the value of the receivables at the end of the period and divide the sum by two. Then divide your average accounts receivable for the period by your net credit sales and multiply by the number of days in the period (365 for a year).
Which method calculates the total estimated uncollectible accounts as a percentage of the outstanding accounts receivables balance? ›
The percentage-of-receivables method estimates uncollectible accounts by determining the estimated net realizable value of accounts receivable, so many accountants refer to this as the balance-sheet method.
