Describe the allowance method for uncollectible accounts

Answer 1

ALLOWANCE METHOD FOR UNCOLLECTIBLE ACCOUNTS

The two accounting issues for accounts receivable are (1) measurement of the amount on the balance sheet and (2) timing of recognition of the reduction in income caused by the uncollectibility of some accounts. With regard to measurement, both U.S. GAAP and IFRS require that sellers report accounts receivable net of the estimated uncollectible amount; that is, at the amount the firm expects to collect from customers, which will be less than the amount that all customers have agreed to pay. With regard to timing, both U.S. GAAP and IFRS require that a seller recognize an expense for estimated uncollectible accounts receivable in the same period when it recognizes the related revenue. The following example illustrates these accounting requirements.

Recognizing revenue before the seller collects cash requires estimating the amount of uncollectible accounts with reasonable accuracy. Both U.S. GAAP and IFRS require the allowance method for uncollectible accounts, which involves estimating the amount of uncollectible accounts receivable associated with each accounting period's credit sales. The firm recognizes this estimated amount as an expense in the period of the sale, thereby matching expenses with associated revenue. The credit is to a contra-asset account, Allowance for Uncollectibles, that reduces total accounts receivable (Accounts Receivable, Gross) to the amount of cash the firm expects to collect from customers (Accounts Receivable, Net).

Bad Debt Expense is also called the Provision for Bad Debts and the Provision for Uncollectible Accounts. Provision in this context refers to an expense in U.S. GAAP, not a liability; that provision in IFRS refers to a liability whose timing or amount, or both, are uncertain.

Recognizing bad debt expense matches the amount the firm does not expect to collect in cash from that period's credit sales with that period's credit sales. The firm making the entry is not writing off specific customers' accounts as uncollectible; rather, the firm is measuring accounts receivable at the amount it expects to collect. It does not yet know which accounts it will need to write off because they have not yet proved to be uncollectible.

Allowance for Uncollectibles contra account appears among the assets on a firm's balance sheet as a subtraction. It typically has a credit balance which, netted against the debit balance in the asset account, reduces asset totals. A credit to the Allowance for Uncollectibles contra account increases the amount subtracted from Accounts Receivable, Gross, reducing the net debit balance in Accounts Receivable,

Accounts Receivable, Gross, is a control account. A control account (sometimes called a controlling account) aggregates into a single account a group of like accounts. The firm keeps a separate account for each customer, including that customer's name. The sum of the balances in the individual customers' accounts is the balance in the control account, Accounts Receivable, Gross. When the firm receives cash from a customer, it debits Cash and credits the account receivable of that specific customer. When the firm sums the balances in the individual customers' accounts, it derives the balance in the control account, Accounts Receivable, Gross.

The firm must account for the estimated expense associated with its portfolio of individual accounts receivable. To do this, the firm creates a separate account, Allowance for Uncollectibles, that is contra to Accounts Receivable, Gross. The gross amount less the allowance yields Accounts Receivable, Net, which reflects the amount of cash the firm expects to collect.

Firms typically write off specific customers' accounts during the reporting period as they identify specific customers whose accounts have become uncollectible, and recognize bad debt expense as an adjusting entry at the end of the period. As a result, before it makes this adjusting entry, the firm may have a debit balance in the Allowance for Uncollectibles. After the adjusting entry to recognize bad debt expense, this account always has a credit balance. Because adjusting entries precede balance sheet preparation, a debit balance in the Allowance for Uncollectibles never appears on the balance sheet.

U.S. GAAP and IFRS require that firms disclose sufficient information to allow the reader of financial statements to calculate Accounts Receivable, Gross, Allowance for Uncollectibles, and Accounts Receivable, Net.

ESTIMATING THE AMOUNT OF UNCOLLECTIBLE ACCOUNTS

There are two approaches that management can use to estimate the amount of credit sales that would prove to be uncollectible: (1) the percentage-of-sales procedure and (2) the aging-of-accounts-receivable procedure. Over time, the two methods, correctly used, will give the same cumulative income and asset totals. U.S. GAAP and IFRS do not require firms to use one or the other, and some firms use both methods.

PERCENTAGE-OF-SALES PROCEDURE

The percentage-of-sales procedure arises from the idea that uncollectible amounts will vary with the volume of credit business. The firm estimates the appropriate percentage by studying its own experience or by inquiring into the experience of similar firms. Default rates generally fall within the range of 1% to 2% of credit sales. After the firm estimates the amount of uncollectible accounts associated with the credit sales of each period, it makes an adjusting entry to debit Bad Debt Expense and credit Allowance for Uncollectibles.

AGING-OF-ACCOUNTS-RECEIVABLE PROCEDURE

The aging-of-accounts-receivable procedure involves two steps:

1 . Estimating the amount that the firm does not expect to collect from existing accounts receivable, and

2 . Adjusting the balance in the Allowance for Uncollectibles so that the balance in this account, when netted against Accounts Receivable, Gross, reflects the amount of cash the firm expects to collect.

Estimating the amount owed by customers that the firm does not expect to collect relies on information about the ages of accounts receivable (the number of days they have been uncollected).

COMPARING PERCENTAGE-OF-SALES AND AGING PROCEDURES

Under the percentage-of-sales procedure, the firm estimates and recognizes its bad debt expense; the offsetting credit increases the balance in the Allowance for Uncollectibles. Under the aging procedure, the firm estimates the ending balance in the Allowance for Uncollectibles account and makes a credit entry to bring the balance to this amount; the offsetting debit is to Bad Debt Expense. If the percentage used under the percentage-of-sales method reasonably reflects collection experience, the balance in the allowance account should be approximately the same at the end of each period under both of these procedures. Many auditors require a periodic aging analysis as a check on the balance in the Allowance for Uncollectibles account, even when the firm uses the percentage method.

DEALING WITH CHANGES IN ESTIMATES OF UNCOLLECTIBLE ACCOUNTS

Changes in economic conditions, changes in credit-granting policies, changes in collection efforts, and other similar factors cause differences between estimated and actual uncollectible amounts. These differences necessitate revising the estimates every accounting period to reflect up-to-date information. Both U.S. GAAP and IFRS require firms to reflect any changes in estimates prospectively. That is, firms make no retroactive adjustment to the income statements and balance sheets of previous periods to reflect differences between estimated and actual uncollectible accounts. Rather, the firm adjusts the balance in the Allowance for Uncollectibles going forward. The adjustments for changes in estimates occur naturally under the aging-of-accounts method, because this method first estimates the ending balance in the Allowance for Uncollectibles and then calculates the amount of Bad Debt Expense based on this amount.

The prospective application of changes in estimates results from the view that estimates are an essential component of accrual accounting. If firms make conscientious estimates, adjustments for differences between estimated outcomes and actual outcomes will be recurring and small, absent a sudden and substantial change in economic conditions. Retroactive adjustment of previously reported amounts because of differences between estimates and outcomes would lead to continual restatements of prior financial statements, likely confusing users of those financial statements and undermining their credibility.