Under the allowance method, if the business feels a specific account balance cannot be recovered, it’s removed from books of accounts. This write-off entry only impacts the balance sheet as allowance for receivables is debited, and accounts receivable is credited from books.
It’s important to note that the creation of allowance in the balance sheet requires recording expenses in the income statement. However, once allowance exists in the balance sheet, it can be used to remove receivables without affecting the income statement.
To present a true and fair view of the financial statement, management needs to ensure that they are confident about collecting the accounts receivables recorded in the balance sheet. The amount of the accounts receivable can be material and impact the decision of the financial statement user. Hence, the concept is important from an audit perspective as well.
So, management needs to analyze the individual party balances with the help of an aging statement. This helps decide if a specific balance should be presented as a net debtor in the balance sheet for the accounting period or if an allowance should be created against it. Although, the number of days passed since invoice overdue is an essential factor in determining if a specific balance should be written down. However, several other factors like the reputation of the customer, past trends, and business relations with them must be assessed.
However, if the management has decided to write off some specific balance, there is a specific process of journal entries to be followed. Let’s understand the concept with step by step approach.
1) Estimation of allowance for the bad debts
At the closing of the accounting period, the business needs to decide the allowance (contra balance) to be recorded in the books of account. Traditionally, the amount is calculated based on the past performance of the portfolio. However, GAAP and IFRS have issued certain guidance to estimate an amount based on the expected performance of the portfolio, probability, and other expected conditions.
It’s based on an idea to estimate the loss amount on the balanced portfolio in the future depending on certain circumstances. So, the approach has changed from incurred loss to an expected loss model.
Further, providing an allowance is in line with the prudence concept of accounting, which suggests early recording of an expense and delay in recording the income.
How to estimate the allowance for bad debts?
Traditionally, the companies have estimated allowance for receivables based on the following methods,
- Sales method of allowance calculation.
- Accounts receivable method of allowance calculation.
The sales method of allowance calculation uses total credit sales during an accounting period and applies a certain percentage to it. For instance, the credit sales made by the business amount to $100,000 during a specific accounting period, and the allowance for bad debt is estimated to be 2% of the credit sales. Hence, an allowance amounting to $2,000 (100,000*2%) will be provided in the account books.
The accounts receivable method for the allowance calculation is more sophisticated and uses the aging report to assess the amount for the allowance. For instance, the company may have a policy to (Based on past trends) provide 30% on balance overdue from 60-90 days and 50% on balance due 90 plus days.
2) Record a journal entry for providing an allowance
Suppose an estimated amount of the allowance amounts to $12,000. To record this allowance, the following journal entry is posted in the books,
|Bad debt expense (income statement)||$12,000|
|Allowance for bad debt (Contra account of an asset in the balance sheet)||$12,000|
This is the only entry in the allowance method that impacts the income statement. Later entries for the write-off just make adjustments in the balance sheet, and the net impact of the presentation remains the same.
It’s important to note that we have assumed the opening allowance for the bad debt as zero in the above entry. Hence, we had to provide the full amount for the allowance.
Suppose there is $2,000 in the opening balance of the allowance, and the management’s estimate remains amounting to $12,000. In this case, the following journal entry will be posted in the accounting books,
|Bad debt expense (income statement) (12,000-2000)||$10,000|
|Allowance for bad debt (Contra account of an asset in the balance sheet)||$10,000|
Since we had $2,000 in the opening and the required estimate for the allowance was $12,000. Hence, we had to provide $ 10,000 to reach our estimate. This can be presented in the following balance movement.
Opening allowance for bad debt $2,000
Bad debt provided during period $10,000
Bad debt allowance closing $12,000
3) Make write-off against the allowance.
Allowance for the bad debt already exists in the accounting record. So, when it’s time to make a write-off, we can use allowance without affecting the business’s income statement, and the entry will only impact the balance sheet.
Suppose the management decides to write off debtors amounting to $5000. This balance can be written off with the following entry,
|Allowance for bad debt (Contra account of an asset in the balance sheet is reversed)||$5,000|
The allowance of $5,000 used in the write-off will be removed from books. Hence, there will not be any impact on the income statement. It’s also important to note that the net balance of debtors’ remains the same if we write off the full amount by using allowance in the books as shown,
|Before write off||After write off|
|– Gross amount = $20,000 |
– Allowance for receivables = $(7,000)
– Net balance = $13,000
|– Gross amount = $15,000 |
– Allowance for receivables = $(2,000)
– Net balance =$13,000
The net balance before and after write-off remains the same. As the movement just takes place between gross amount and allowance for receivables.
4) Recovery of the accounts receivables
Sometimes the business has already written off a certain amount, and an unexpected receipt is made from the customer. In this scenario, we need to reverse the allowance for receivables and reinstate the account balance.
Suppose recovery of $5,000 is made from the customer previously written off,
Following entry is to be made to reinstate the balance,
|Allowance for bad debts||$5,000|
The entry has reinstated the customer balance, and now we need to record the cash receipt. Following entry can be posted to record receipt of the cash.
The net impact of these two entries is receipt of the cash and elimination of the debtor’s balance in the books; the treatment is the same as a normal cash receipt.
Under the allowance method, the company’s management needs to assess the percentage of the uncollectible amount. This can be done via sales percentage and the receivables balance. However, GAAP and IFRS have issued guidance, and the management needs to assess expected loss to be recorded in the balance sheet.
Journal entry for providing allowance impacts on the income statement as it’s debited and contra accounts are created in the balance sheet to set off expected uncollectible assets. However, if an unexpected collection is made, the account balance is reinstated by the recreation of the consumed allowance.
Frequently asked questions
What’s the importance of a bad debt allowance?
Recognition of bad debt allowance in the accounting record helps the business to present a true financial picture. It has been observed that not all receivables of the business are collected, and presenting such uncollectible balances with overall receivables can lead to impairment in the decision of the financial statement user.
What’s the nature of allowance accounts? Is it an asset or liability?
Allowance account is contra account for the asset. It’s created to offset the uncollectible receivables in the balance sheet. So, it’s not a permanent account like asset or liability: and it is removed from the books when the balance is written off.
What are general allowance and specific allowance?
General allowance is created for the overall debtor portfolio. The business may have the policy to provide for a certain amount based on their past trend etc. It can be deducted against any of the balances. On the contrary, a specific allowance is provided against a specific account balance. For instance, Mr. X has defaulted, and his balance no more seems to be collectible. So, the creation of the provision against Mr. X is a specific provision.
What is credit expected credit loss?
This is the expected loss model presented by US GAAP. It refers to the requirement of developing expectations for the loss to be incurred in the future. GAAP and IFRS 9 require companies to shift on the expected loss model from incurred loss model.