Businesses that extend credit to customers risk not being paid. However, the risk of uncollectible accounts is balanced by the additional revenue a business gains when it extends credit to customers. In the accounting cycle, the process of recording uncollectible accounts is called the allowance method. Several accounts are used to separate the unpaid accounts receivables from the paying accounts, and specific journal entries are included on the financial statements.
Determine the Uncollectible Amount
No fast rule or equation exists to know how much of your accounts receivable will go unpaid. The percentage is discovered over time, using historical data. However, as a starting point, 3 percent is an acceptable amount to use for accounting purposes. You can adjust the percentage later, once you can calculate your business' percentage. So, if your business has $25,000 in accounts receivables, and you use 3 percent for the uncollectible amount, your business' allowance for uncollectible accounts is $750.
At the end of the accounting period, the amount of uncollectible accounts in accounts receivable is adjusted. Two accounts are used to complete the adjusting entries: Allowance for Doubtful Accounts and Bad Debt Expense. Allowance for Doubtful Accounts is the running total of the business' past-due accounts receivable, and Bad Debt Expense is the amount of past-due accounts receivable for a particular accounting period. If you had $750 in uncollectible accounts, the adjusting entry is a debit to Bad Debt Expense for $750 and a credit to Allowance for Doubtful Accounts for $750.
Balance Sheet and Income Summary
Both the Allowance for Doubtful Accounts and Bad Debt Expense are recorded on the financial statements. Allowance for Doubtful accounts is placed on the balance sheet, while Bad Debt Expense is listed on the income statement. In the final stage of the accounting cycle, Bad Debt Expense is closed out to the income summary, which is a placeholder for temporary accounts. Allowance for Doubtful Accounts is a permanent account, and, therefore, the account balance is carried over from one accounting period to the next.
Tracking bad debts through the allowance method enables a business to examine its credit extension methods. By isolating the bad debt, a business can check for trends or patterns in its credit granting policies and possibly lower its uncollectible percentage. It removes the bad debt from the accounts receivable, which makes the accounts receivable account more accurate. Accuracy is important for financial statements because the more accurate the records, the better those records reflect the financial health of the business.