Question

The allowance method uses an estimated uncollectibe amount. Since it is estimated and not actual why do you think GAAP prefers this method in terms of the matching concept? How can they justify an estimated amount?

Answer 1

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.