Objective 4: Allowance Method of Accounting for Uncollectibles
Most large businesses use the allowance method to estimate the uncollectible portion of their trade receivables. To illustrate this method, we will use assumed data for Richards Company. This new business began in August and chose to use the calendar year as its fiscal year. The accounts receivable account has a balance of $105,000 at tha end fo December.
The customer accounts making up the $105,000 balance in Accounts Receivable include some that are past due. However, Richards doesn’t know which specific accounts will be uncollentible at this time. It is likely that some accounts will be collected only in part and that others will become worthless. Based on a careful study, Richards estimates that a tolal of $4,000 will eventually be uncollectible. The following adjusting entry at the end of the fiscal period records this estimate:
Adjusting Entry
Dec. 31 Uncollectible Accounts Expense 4000
Allowance for Doubtful Accounts 4000
Because the $4,000 reduction in accounts receivable in an estimate, it cannot be credited to specific customer accounts or to the accounts receivable controlling account. Instead, a contra asset account entitled Allowance for Doubtful Accounts in credited.
As with all periodic adjustments,the entry above serves two purposes. First, it reduces the value of the receivables to the amount of cash expected to be realized in the future. This amount, which is $101,000 ($105,000 — $4,000), is called the net realizable value of the receivables. Second, the adjusting entry matches the $4,000 expense fo uncollectible accounts with the related revenues of the period.
After the adjusting entry has been posted, an shown in the following T accounts, Accounts Receivable still has a debit balance of $105,000. This balance is the amount of the total claims against customers on account. The credit balance of $4,000 in Allowance for Doubtful Account is the amount to be deducted from Accounts Receivable to determine the net realizable value. The balance of the Uncollectible Account Expense is reported in the current period income statement, normally as an administrative expense. This classification is used because the credit-granting and collection duties are the responsibilities of departments within the administrative area.
Write-Offs to the Allowance Account:
When a customer’s account is identified as uncollectible, it is written off against the allowance account as follows:
Jan. 21 Allowance for Doubtful Accounts 610
Allowance Receivable—John Parker 610
To write off the uncollectible account.
The authorization to support this entry should come from a designated manager. It should normally be in writing.