Because customers do not always keep their promises to pay, companies must provide for these uncollectible accounts in their records. Companies use two methods for handling uncollectible accounts. The direct write-off method recognizes bad accounts as an expense at the point when judged to be uncollectible and is the required method for federal income tax purposes.  The allowance method provides in advance for uncollectible accounts think of as setting aside money in a reserve account.  The allowance method represents the accrual basis of accounting and is the accepted method to record uncollectible accounts for financial accounting purposes.

Direct Write-off

The direct write-off method is used only when we decide a customer will not pay.  We do not record any estimates or use the Allowance for Doubtful Accounts under the direct write-off method.  We record Bad Debt Expense for the amount we determine will not be paid.  This method violates the GAAP matching principle of revenues and expenses recorded in the same period.

When we write-off an account under this method, the entry would be:

                                       Debit                  Credit

Bad Debt Expense        X

            Accounts Receivable                    X

The amount used will be the amount the customer owes that we will not be able to collect.

Allowance Method

The allowance method follows GAAP matching principle since we estimate uncollectible accounts at the end of the year.  We use this estimate to record Bad Debt Expense and to setup a reserve account called Allowance for Doubtful Accounts (also called Allowance for Uncollectible Accounts) based on previous experience with past due accounts.  We can calculate this estimates based on Sales (income statement approach) for the year or based on Accounts Receivable balance at the time of the estimate (balance sheet approach).

As a contra asset account to the Accounts Receivable account, the Allowance for Doubtful Accounts (also called Allowance for uncollectible accounts or Allowance for bad debts) reduces accounts receivable to their net realizable value. Net realizable value is the amount the company expects to collect from accounts receivable. When the firm makes the bad debts adjusting entry, it does not know which specific accounts will become uncollectible. Thus, the company cannot enter credits in either the Accounts Receivable control account or the customers’ accounts receivable subsidiary ledger accounts. If only one or the other were credited, the Accounts Receivable control account balance would not agree with the total of the balances in the accounts receivable subsidiary ledger. Without crediting the Accounts Receivable control account, the allowance account lets the company show that some of its accounts receivable are probably uncollectible.

When we decide a customer will not pay the amount owed, we use the Allowance for Doubtful accounts to offset this loss instead of Bad Debt Expense.

At the end of each year, we ESTIMATE bad debts expense and make the following entry:

                                        Debit                  Credit

Bad Debt Expense      X

       Allowance for Doubtful Accounts     X

The amount used will be the ESTIMATED amount calculated using sales or accounts receivable.

When we write-off a customer account under the allowance method, the entry would be:

                                                                          Debit                  Credit

Allowance for Doubtful Accounts        X

                                     Accounts Receivable                    X

Notice how we do not use bad debts expense in a write-off under the allowance method.

 Accounting in the Headlines

Let’s try and make accounts receivable more relevant or understandable using an actual company.

What does Coca-Cola’s Form 10-k communicate about its accounts receivable?

The Coca-Cola Company (KO), like other U.S. publicly-held companies, files its financial statements in an annual filing called a Form 10-K with the Securities & Exchange Commission (SEC).