Principles of Financial Accounting: Receivables - Allowance Method, Percentage of Sales vs. Percentage of Receivables

What It Is

The Allowance Method is an accounting technique used to estimate and record bad debts or uncollectible accounts. It involves setting aside a portion of accounts receivable as an allowance for doubtful accounts. This method is essential in financial accounting as it provides a more accurate representation of a company's financial position and performance. For instance, if a company has $100,000 in accounts receivable and estimates that 5% of these accounts will become uncollectible, it would record an allowance for doubtful accounts of $5,000.

Key Concepts & Formulas

• Allowance for Doubtful Accounts (ADA): A contra-asset account that represents the estimated amount of uncollectible accounts receivable. Example: If a company estimates 5% of its $100,000 in accounts receivable will become uncollectible, the ADA would be $5,000.
• Percentage of Sales Method: An approach to estimating bad debts based on a percentage of total sales. Example: If a company has $1,000,000 in sales and estimates 2% of these sales will become uncollectible, the ADA would be $20,000.
• Percentage of Receivables Method: An approach to estimating bad debts based on a percentage of total accounts receivable. Example: If a company has $100,000 in accounts receivable and estimates 5% of these accounts will become uncollectible, the ADA would be $5,000.
• Allowance for Doubtful Accounts Formula: ADA = (Percentage of Sales or Receivables) x (Total Sales or Receivables) Example: ADA = 2% x $1,000,000 = $20,000
• Bad Debt Expense: The expense account that represents the estimated amount of uncollectible accounts receivable. Example: If a company estimates $5,000 in accounts receivable will become uncollectible, the bad debt expense would be $5,000.
• Debit/Credit Rule: To record the allowance for doubtful accounts, debit the bad debt expense and credit the allowance for doubtful accounts. Example: Dr. Bad Debt Expense $5,000, Cr. Allowance for Doubtful Accounts $5,000

Journal Entry Examples

1. To record the initial allowance for doubtful accounts: Dr. Bad Debt Expense $5,000 Cr. Allowance for Doubtful Accounts $5,000 Explanation: The company is estimating that $5,000 in accounts receivable will become uncollectible, so it debits the bad debt expense and credits the allowance for doubtful accounts.

2. To record the adjustment at the end of the period: Dr. Bad Debt Expense $5,000 Cr. Allowance for Doubtful Accounts $5,000 Explanation: The company is adjusting its estimate of uncollectible accounts receivable, so it debits the bad debt expense and credits the allowance for doubtful accounts.

Common Mistakes

1. Mistake: Confusing the allowance for doubtful accounts with the bad debt expense. Correction: The allowance for doubtful accounts is a contra-asset account, while the bad debt expense is an expense account. Remember: "ADA" is a contra-asset account, while "BDE" is an expense account.
2. Mistake: Not adjusting the allowance for doubtful accounts at the end of the period. Correction: The allowance for doubtful accounts should be adjusted at the end of the period to reflect the company's current estimate of uncollectible accounts receivable. Remember: "Adjust, adjust, adjust" to keep the allowance for doubtful accounts up-to-date.
3. Mistake: Not considering the impact of the allowance for doubtful accounts on the company's financial statements. Correction: The allowance for doubtful accounts affects the company's balance sheet and income statement. Remember: "ADA" affects the balance sheet and income statement, so consider its impact when preparing financial statements.

Exam Tips

1. Tip: When recording the allowance for doubtful accounts, remember to debit the bad debt expense and credit the allowance for doubtful accounts. Example: Dr. Bad Debt Expense $5,000, Cr. Allowance for Doubtful Accounts $5,000
2. Tip: When adjusting the allowance for doubtful accounts at the end of the period, remember to debit the bad debt expense and credit the allowance for doubtful accounts. Example: Dr. Bad Debt Expense $5,000, Cr. Allowance for Doubtful Accounts $5,000
3. Tip: When considering the impact of the allowance for doubtful accounts on the company's financial statements, remember to consider its effect on the balance sheet and income statement.

Quick Practice

1. What is the adjusting entry for accrued salaries of $5,000? Answer: Dr. Salaries Expense $5,000, Cr. Salaries Payable $5,000 Explanation: The company is recognizing the expense of accrued salaries, so it debits the salaries expense and credits the salaries payable.

2. If a company has $100,000 in accounts receivable and estimates 5% of these accounts will become uncollectible, what is the allowance for doubtful accounts? Answer: $5,000 Explanation: The company is estimating that 5% of its $100,000 in accounts receivable will become uncollectible, so the allowance for doubtful accounts would be $5,000.

3. What is the bad debt expense if a company estimates $5,000 in accounts receivable will become uncollectible? Answer: $5,000 Explanation: The company is estimating that $5,000 in accounts receivable will become uncollectible, so the bad debt expense would be $5,000.

Last-Minute Cram Sheet

1. Allowance for Doubtful Accounts (ADA): A contra-asset account that represents the estimated amount of uncollectible accounts receivable.
2. Bad Debt Expense: The expense account that represents the estimated amount of uncollectible accounts receivable.
3. Percentage of Sales Method: An approach to estimating bad debts based on a percentage of total sales.
4. Percentage of Receivables Method: An approach to estimating bad debts based on a percentage of total accounts receivable.
5. Allowance for Doubtful Accounts Formula: ADA = (Percentage of Sales or Receivables) x (Total Sales or Receivables)
6. Debit/Credit Rule: To record the allowance for doubtful accounts, debit the bad debt expense and credit the allowance for doubtful accounts.
7. Dividends are NOT an expense – they go directly to retained earnings.
8. The allowance for doubtful accounts affects the balance sheet and income statement.
9. The bad debt expense is an expense account, while the allowance for doubtful accounts is a contra-asset account.
10. Adjust the allowance for doubtful accounts at the end of the period to reflect the company's current estimate of uncollectible accounts receivable.