When a company sells goods or services on credit, there is always a risk that some customers will not pay their bills.
As a result, companies need to account for the possibility of uncollectible accounts, which are also known as bad debts.
Accounting for uncollectible accounts involves estimating the amount of uncollectible accounts and creating an allowance for doubtful accounts.
Here are the steps involved in accounting for uncollectible accounts:
Step 1: Identify Accounts that are Likely to be Uncollectible
The first step is to identify accounts that are likely to be uncollectible. This involves reviewing the accounts receivable balance and assessing the likelihood of customers not paying their bills.
The company may use historical data, credit ratings, and other information to estimate the likelihood of uncollectible accounts.
Step 2: Estimate the Amount of Uncollectible Accounts
Once the company has identified accounts that are likely to be uncollectible, it needs to estimate the amount of uncollectible accounts.
This can be done using different methods, such as the percentage of sales method or the aging of accounts receivable method.
The percentage of sales method involves estimating the percentage of credit sales that will not be collected based on historical data.
For example, if a company has historically had bad debts of 3% of credit sales, it may estimate that 3% of current credit sales will also be uncollectible.
The aging of accounts receivable method involves categorizing accounts receivable by the length of time they have been outstanding and estimating the percentage of each category that will not be collected.
For example, if accounts receivable that are 30-60 days past due historically have a bad debt rate of 5%, the company may estimate that 5% of the current 30-60 day past due accounts will also be uncollectible.
Step 3: Create an Allowance for Doubtful Accounts
Once the amount of uncollectible accounts has been estimated, the company needs to create an allowance for doubtful accounts.
The allowance is a contra asset account that reduces the accounts receivable balance on the balance sheet.
To create the allowance, the company debits the allowance for doubtful accounts account and credits the bad debt expense account.
The amount credited to the bad debt expense account is the estimated amount of uncollectible accounts for the period.
Journal Entry for Allowance for Doubtful Accounts
The journal entry for allowance for doubtful accounts involves debiting the bad debt expense account and crediting the allowance for doubtful accounts account.
This entry is made at the end of an accounting period to estimate the amount of accounts receivable that are expected to be uncollectible. Here is an example of a journal entry for allowance for doubtful accounts:
Assume that XYZ Company has $100,000 in accounts receivable and estimates that 2% of these accounts will not be collected. The journal entry to record the allowance for doubtful accounts would be:
Debit: Bad debt expense $2,000
Credit: Allowance for doubtful accounts $2,000
This entry decreases net income by $2,000 and creates a contra asset account for the allowance for doubtful accounts, which is used to reduce the accounts receivable balance. The bad debt expense account is used to record the estimated uncollectible accounts for the period.
The allowance for doubtful accounts is an important accounting tool that helps companies to account for the possibility of uncollectible accounts.
It is important to estimate the allowance accurately to ensure that the financial statements reflect the true financial position of the company.
By making this journal entry, companies can ensure that the allowance for doubtful accounts is properly recorded and maintained.
Step 4: Write Off Uncollectible Accounts
When an account is determined to be uncollectible, the company needs to write it off. This involves debiting the allowance for doubtful accounts account and crediting the accounts receivable account.
The net effect of this transaction is to reduce the accounts receivable balance and the allowance for doubtful accounts by the same amount.
Journal Entry for Write Off Uncollectible Accounts
When an account is determined to be uncollectible, the journal entry to write off the uncollectible account involves debiting the allowance for doubtful accounts account and crediting the accounts receivable account.
This entry reduces both the accounts receivable balance and the allowance for doubtful accounts balance. Here is an example of a journal entry for writing off uncollectible accounts:
Assume that XYZ Company determines that a customer’s account with a balance of $1,000 is uncollectible. The journal entry to write off the uncollectible account would be:
Debit: Allowance for doubtful accounts $1,000
Credit: Accounts receivable $1,000
This entry reduces the accounts receivable balance by $1,000 and reduces the allowance for doubtful accounts balance by $1,000.
The net effect is a reduction in total assets and a reduction in the allowance for doubtful accounts.
It is important to note that writing off an uncollectible account does not affect the bad debt expense account.
The bad debt expense account is used to record the estimated uncollectible accounts for the period, whereas the write-off entry simply reflects the actual uncollectible accounts.
Step 5: Adjust the Allowance for Doubtful Accounts
At the end of the accounting period, the company needs to review the allowance for doubtful accounts and adjust it as necessary.
If the estimate of uncollectible accounts was too high, the company can reverse some of the allowance.
If the estimate was too low, the company needs to increase the allowance. This involves debiting or crediting the allowance for doubtful accounts account and the bad debt expense account.
In conclusion, accounting for uncollectible accounts involves estimating the amount of uncollectible accounts and creating an allowance for doubtful accounts.
This allows companies to account for the possibility of bad debts and maintain accurate financial statements.
Let’s say that ABC Company sells $100,000 of goods on credit during the month of January. ABC uses the percentage of sales method to estimate uncollectible accounts and has historically had bad debts of 2% of credit sales.
Based on this historical data, ABC estimates that $2,000 of the January credit sales will be uncollectible.
ABC creates an allowance for doubtful accounts by debiting the allowance for doubtful accounts account and crediting the bad debt expense account for $2,000. This reduces the accounts receivable balance by $2,000.
In February, ABC determines that a customer who owes $500 is unlikely to pay. ABC writes off the account by debiting the allowance for doubtful accounts account and crediting the accounts receivable account for $500.
The net effect of this transaction is to reduce the accounts receivable balance and the allowance for doubtful accounts by $500.
At the end of February, ABC reviews the allowance for doubtful accounts and determines that the estimate of uncollectible accounts was accurate. As a result, no adjustment is necessary.
In March, ABC determines that another customer who owes $1,000 is unlikely to pay. ABC writes off the account by debiting the allowance for doubtful accounts account and crediting the accounts receivable account for $1,000.
The net effect of this transaction is to reduce the accounts receivable balance and the allowance for doubtful accounts by $1,000.
At the end of March, ABC reviews the allowance for doubtful accounts and determines that the estimate of uncollectible accounts was too low.
Based on this review, ABC increases the allowance for doubtful accounts by $500 by debiting the allowance for doubtful accounts account and crediting the bad debt expense account.
This example demonstrates the steps involved in accounting for uncollectible accounts, including estimating the amount of uncollectible accounts, creating an allowance for doubtful accounts, writing off uncollectible accounts, and adjusting the allowance as necessary.
By following these steps, companies can maintain accurate financial statements and account for the possibility of bad debts.
