Allowance for Uncollectible Accounts

Businesses must offer good payment terms to their clients in order to compete in this harsh business world today, and what this means is that most businesses are sitting with heavy accounts receivable balances in their balance sheets. With every increase in accounts receivable, there is a higher risk of default that is borne by the business and such defaults or bad debts are a loss to the business. Whatever the reasons for non-payment, there is always a certain figure out of the receivable debts that needs to be written off as unrecoverable bad debts each year. Knowing this, US GAAP allows for the prudence of having an estimated figure kept aside in the balance sheet as an allowance for the uncollectible accounts. The idea behind it is to protect the debtors or receivables account from unnecessary figure tampering. While the whole accounts receivable account is the one that gets billed each time, the company has prudently already made allowances for a certain section defaulting on their payments. If this general explanation of the above concept has left you baffled or if you did not understand some accounting terms, I will give a detailed explanation below.

Concept of Allowance for Doubtful Accounts
It is basically a contra asset, i.e. an asset that offsets another accounts. Since an allowance is created to offset or reduce an asset (accounts receivables), it figures that it should have a credit balance. Such allowance is nothing but an experience estimate of expected losses arising out of bad debts or uncollectible accounts. The estimate is generally made afresh each year, at the end of each accounting year, based on economic and professional trends. The allowance is increased with each credit entry in its favor and decreased with each debit entry made. We can easily calculate the amounts that a business is expected to receive each year from its debtors, by netting the accounts receivable account and the allowance for bad debts.

How is an Allowance Set Up
When the allowance needs to be set up, the expense account titled uncollectible expense account (or bad debt account, provision for bad debt account) is debited and any loss due to actual bad debts is just recognized as a normal business expense in the income statement, thereafter. In accordance with the revenue recognition principle (all revenues should be recorded in the same time period as when they are actually earned) and the matching principle (expenses be recorded in the same time period as the incomes that they helped generate), all bad debt expenses are required to be recorded in the same time period as the sales.

The adjusting journal entries for actual bad debts and the writing off an accounts receivable account are as respectively given below.

Bad Debts Expense Account... Debited
To Allowance for Uncollectible Accounts

Allowance for Uncollectible Accounts..... Debited
To Accounts Receivable

As one can see from the above, the creation of an allowance for doubtful accounts helps in leaving the net income (income statement) and the net realizable value of accounts receivable (balance sheet) unchanged. If at all, it is required to reinstate an accounts receivable, the journal entry passed is as follows:

Accounts Receivable Account... Debited
To Allowance for Uncollectible Accounts

Estimating Uncollectible Account Expense or Bad Debt Expense
The allowance method requires a business to first come up with an expected uncollectible account figure. There are three main estimation allowance methods for uncollectible accounts and they are as follows:

• Percentage of Credit Sales Method: A certain pre-set percentage of credit sales that has been historically established can be taken up as an expected uncollectible accounts figure.
• Percentage of Ending Accounts Receivable: The method firstly requires an estimation of the ending balance of accounts receivable percentage, that is not expected to be collected. The allowance account is then prepared in accordance with this percentage figure.
• Aging Table of Accounts Receivable: An aging table lists out the age durations of outstanding receivables. Experience suggests that the more the age of the accounts receivables (the longer they have been due) the higher the probability of their default. Hence, an estimate of uncollectible accounts can be gleaned from this aging table.

The valuation reserve of allowance for these specific accounts is high or low depending on how conservative the company management is. The more conservative the management the higher the allowance for accounts receivable. If an allowance for doubtful debts is not entirely needed for the year, the left over amount can be released back into the profit potion of the company accounts. But still, keeping unusually high and unrealistic allowances for doubtful debts can get you into trouble with the auditors and so, all allowances should have an experience backing.