# Allowance Method for Uncollectible Accounts

The allowance method is a technique for estimating and recording of uncollectible amounts when a customer fails to pay, and is the preferred alternative to the direct write-off method.

Accounts receivable represent amounts due from customers as a result of credit sales. Unfortunately for various reasons, some accounts receivable will remain unpaid and will need to be provided for in the accounting records of the business.

The allowance method complies with the matching principle as an estimate of the bad debt expense is recorded in the same accounting period in which the credit sales and accounts receivable are recorded. This is in contrast to the direct write-off method which records the bad debt expense when the amount is identified as irrecoverable which might be a completely different period from when the original sale was recorded.

## Allowance Method Estimates

In order to use the allowance method, it is first necessary to estimate the allowance needed using a suitable method.

The various methods can be classified as either being an income statement approach or a balance sheet approach. With an income statement approach the bad debt expense is calculated, and the allowance account is the balancing figure. With a balance sheet approach the ending balance on the allowance account is calculated, and the bad debt expense is the balancing figure.

The preferred methods for doing this are as follows:

1. Percentage of credit sales method (income statement approach)
2. Percentage of receivables method (balance sheet approach)
3. Aging of accounts receivable method (balance sheet approach)

## Percentage of Credit Sales Method

The percentage of credit sales method is an income statement approach and estimates the required bad debt expense for an accounting period using a percentage of the credit sales made during the same period.

The percentage used in the method is based on the bad debt history of the business. The percentage of credit sales method formula is as follows:

### Percentage of Credit Sales Method Example

Suppose based on past experience the percentage uncollectible has been 2.5% of credit sales, and the credit sales recorded for the current accounting period were 65,000, then the bad debt expense for the current period using this allowance method would be calculated as follows:

```Bad debt expense = Credit sales for the period x Estimated % uncollectible
Bad debt expense = 65,000 x 2.5%
```

Based on this calculation the allowance method estimates that, of the credit sales of 65,000, an amount of 1,625 will become uncollectible at some point in the future. Using the allowance method, complying with the matching principle, the amount is recorded in the current accounting period with the following percentage of credit sales method journal.

Allowance method – Percentage of credit sales
Account Debit Credit
Allowance for doubtful accounts 1,625
Total 1,625 1,625

The percentage of credit sales method directly estimates the bad debt expense and records this as an expense in the income statement.

The allowance for doubtful accounts on the balance sheet is increased by credit journal entry. It should be noted that the adjustment is made irrespective of the balance already on the allowance account, and for this reason the allowance account balance can build up irrespective of the level of accounts receivable.

## Percentage of Receivables Method

The previous allowance method directly estimated the bad debt expense based on the credit sales recorded on the income statement of the business.

The percentage of receivables method on the other hand, estimates the allowance for doubtful accounts based on information from the balance sheet of the business, and then indirectly calculates the bad debt expense from the movement on the allowance for doubtful accounts account.

The percentage of receivables method estimates the allowance for doubtful accounts using a percentage of the accounts receivable at the end of the accounting period. Unlike the percentage of credit sales method, using this method the balance on the allowance account will reflect the level needed relative to the amount of accounts receivable in the balance sheet at the end of the accounting period.

The percentage used in the method is based on the bad debt history of the business. The percentage of accounts receivable method formula is as follows:

The bad debt expense is then the difference between the calculated allowance for doubtful accounts at the end of the account period and the current allowance for doubtful accounts before adjustment.

Bad debt expense = Ending allowance for doubtful accounts – Current allowance for doubtful accounts

### Percentage of Accounts Receivable Method Example

Suppose based on past experience, 5% of the accounts receivable balance has been uncollectible, and the accounts receivable at the end of the current accounting period is 150,000, then the allowance for doubtful accounts in the balance sheet at the end of the accounting period would be calculated using this allowance method as follows:

```Allowance for doubtful accounts balance = Accounts receivable at the end of the accounting period x Estimated % uncollectible
Allowance for doubtful accounts balance = 150,000 x 5%
Allowance for doubtful accounts balance = 7,500
```

Based on this calculation it has been estimated that the balance on the allowance for doubtful accounts needs to be 7,500 at the end of the accounting period. If the current balance on that account before the bad debt adjustment is say 5,550, then the adjustment needed is calculated as follows:

```Bad debt expense = Ending allowance for doubtful accounts - Current allowance for doubtful accounts
Bad debt expense = 7,500 - 5,550
```

The bad debt expense for the accounting period is recorded with the following percentage of accounts receivable method journal entry.

Allowance method – Percentage of accounts receivable
Account Debit Credit
Allowance for doubtful accounts 1,950
Total 1,950 1,950

## Aging of Accounts Receivable Method

The aging of accounts receivable method is another balance sheet approach and is a refinement of the percentage of accounts receivable method discussed above. The estimate is again based on a percentage of the accounts receivable at the end of the accounting period, except that the accounts receivable are first classified by age (eg 30 days, 60 days, 90 etc. days past the due date), and different percentages are applied to each classification.

### Aging of Accounts Receivable Method Example

Suppose in the example above the accounts receivable of 150,000 had been aged according to the number of days the invoice is past its due date, and based on past experience the percentage allowance required for each classification is as shown in the table below:

Aging of Accounts Receivable Method
Ageing % Bad debts Aged balance Allowance
0-30 days 1% 15,000 150
31-60 days 3% 50,000 1,500
61-90 days 5% 55,000 2,750
> 90 days 9% 30,000 2,700
Total 150,000 7,100

Using this allowance method, the estimated balance required for the allowance for doubtful accounts at the end of the accounting period is 7,100.

As before, if the current balance on the account is 5,550 then the adjustment required is calculated as follows

```Bad debt expense = Ending allowance for doubtful accounts - Current allowance for doubtful accounts
Bad debt expense = 7,100 - 5,550
```

The bad debt expense required is recorded with the following aging of accounts receivable method journal entry.

Allowance method – Aging of accounts receivable
Account Debit Credit