Determining the Allowance Account
In the preceding illustration, the $25,500 was simply given as part of the fact situation. But, how would such an amount actually be determined? If Ito Company's management knew which accounts were likely to not be collectible, they would have avoided selling to those customers in the first place. Instead, the $25,500 simply relates to the balance as a whole. It is likely based on past experience, but it is only an estimate. It could have been determined by one of the following techniques:
o AS A PERCENTAGE OF TOTAL RECEIVABLES: Some companies anticipate that a certain percentage of outstanding receivables will prove uncollectible. In Ito's case maybe 6% ($425,000 X 6% = $25,500).
VIA AN AGING ANALYSIS: Other companies employ more sophisticated aging of accounts receivable analysis. They will stratify the receivables according to how long they have been outstanding (i.e., perform an aging), and apply alternative percentages to the different strata. Obviously, the older the account, the more likely it is to represent a bad account. Ito's aging may have appeared as follows:
Both the percentage of total receivables and the aging are termed "balance sheet approaches." In both cases, the allowance account is determined by an analysis of the outstanding accounts receivable on the balance sheet. Once the estimated amount for the allowance account is determined, a journal entry will be needed to bring the ledger into agreement. Assume that Ito's ledger revealed an Allowance for Uncollectible Accounts credit balance of $10,000 (prior to performing the above analysis). As a result of the analysis, it can be seen that a target balance of $25,500 is needed; necessitating the following adjusting entry:
You should carefully note two important points: (1) with balance sheet approaches, the amount of the entry is based upon the needed change in the account (i.e., to go from an existing balance to the balance sheet target amount), and (2) the debit is to an expense account, reflecting the added cost associated with the additional amount of anticipated bad debts.
Rather than implement a balance sheet approach as above, some companies may follow a simpler income statement approach. With this equally acceptable allowance technique, an estimated percentage of sales (or credit sales) is simply debited to Uncollectible Accounts Expense and credited to the Allowance for Uncollectible Accounts each period. Importantly, this technique merely adds the estimated amount to the Allowance account. To illustrate, assume that Pick Company had sales during the year of $2,500,000, and it records estimated uncollectible accounts at a rate of 3% of total sales. Therefore, the appropriate entry to record bad debts cost is as follows:
This entry would be the same even if there was already a balance in the allowance account. In other words, the income statement approach adds the calculated increment to the allowance, no matter how much may already be in the account from prior periods.
Writing off Uncollectible Accounts
Now, we have seen how to record uncollectible accounts expense, and establish the related allowance. But, how do we write off an individual account that is determined to be uncollectible? This part is easy. The following entry would be needed to write off a specific account that is finally deemed uncollectible:
Notice that the entry reduces both the allowance account and the related receivable, and has no impact on the income statement. Further, consider that the write off has no impact on the net realizable value of receivables, as shown by the following illustration of a $5,000 write off:
BEFORE WRITE-OFF AFTER WRITE-OFF