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8.7.1 Allowance Method

The allowance method of accounting for bad debts matches the expected loss from
uncollectible A/R against the sales they helped produce. We must use expected losses since
management can’t exactly identify the customers who won’t pay their bills at the time of sale.
This means at the end of each period the allowance method requires us to estimate the total
bad debts expected to result from that period’s sales. An allowance is then recorded for this
expected loss. This method has two advantages over the direct write-off method:

(1) Bad debt expense is charged to the period in which the related sales are recognized, and
(2) A/R is reported on the Balance Sheet at the estimated amount of cash to be collected.

The allowance method estimates bad debt expense at the end of each accounting period and
records it through an adjusting entry. To illustrate this method, assume the A/R account has a
balance of Br. 50,000 and based on careful study of the experience of other companies, Nile
Co. estimates that a total of Br. 2000 will be uncollectible.

This estimated expense is recorded through the following adjusting entry.

Dec. 31 Uncollectible Accounts Expense 2000
Allowance for Doubtful Accounts 2000
To record estimated bad debts

The amount Br. 2000 is an estimated reduction in A/R;but it cannot be credited to specific
customer accounts or to the A/R controlling account. Instead, a contra asset account entitled
Allowance for Doubtful Accounts is credited.

As with all periodic adjustments the above entry serves two purposes. First, it reduces the
value of the receivable to the amount of cash expected to be realized in the future. This
amount, which is Br. 48,000 (Br. 50,000 – Br. 2,000), is called the Net Realizable value of the
receivables. Second, the adjusting entry matches the Br. 2000 expense of uncollectible
account with the related revenues of the period.

Write-off to the Allowance Account

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When specific accounts are identified as uncollectible, they are written-off against the
Allowance for Doubtful Accounts. Assume after spending some time trying to collect from
Shalla Co., Nile Co. decides that Shalla’s Br. 200 accounts receivable is uncollectible and
makes the following entry to writ-it off.
Jan. 25 Allowance for Doubtful Accounts 200
A/R-Shalla Co. 200
To write-off uncollectible accounts.

Note two aspects of this entry and its related accounts

Before Write-off After Write-off
A/R 50,000 49,800
Less Allowance for D. a/cs 2,000 1,800
NRV 48,000 48,000
Neither total assets nor net income are affected by the Write-off of a specific account. But
both total assets and net income are affected by the recognized bad debts expense for the year
in the adjusting entry.

Recovery of Uncollectibles Accounts

When a customer fails to pay and the account is written-off as uncollectibles, his or her credit
standing is jeopardized. To help restore credit standing, a customer may later choose to
voluntarily pay all or part of the amount owed. A company makes two entries when collecting
an account previously written-off. The first is to reverse the original write-off and reinstate the
customer’s account. For example, assume the amount written-of in the preceding entry is later
collected on February 15.

On Feb. 15- The entries to record this recovery are:

Feb. 15- A/R Shalla Co. 200
Allowance for Doubtful Accounts 200
To reinstate accounts previously written-off

Feb. 15- Cash 200

A/R-Shalla Co. 200

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 To record full payment of account

7.7.2 Estimating Uncollectible

The allowance method of accounting for bad debts requires an estimate of bad debts expense
to prepare the adjusting entry at the end of each accounting period. How does a company
estimate bad debts expense? There are two common methods. One is based on the Income
Statement relationship between bad debts expense and sales. The second is based on the
Balance Sheet relationship between A/R and the Allowance for Doubtful Accounts. Both
methods require an analysis of past experience.
7.7.2.1 ESTIMATING BASED ON SALES
Accounts receivable are created by credit sales. The amount of credits sales during the period
may therefore be used to estimate the amount of uncollectible accounts expense. The amount
of this estimate is added to whatever balance exists in Allowance for Doubtful Accounts. To
illustrate, assume Wonji Co. has credit sales of Br. 500,000 in 20X2. Based on past
experience and the experience of other Cos, Wonji Co. estimated 0.007% of credit sales are
uncollectible. Using this prediction, the adjusting entry for uncollectible accounts at the end of
the period, 20X2 is as follows.

Dec. 31 Uncollectible Accounts Exp. (500,000 X 0.007%) 3500

Allowance for Doubtful Accounts 3500
To record estimated Uncoll. Exp.

This entry doesn’t mean that the Dec. 31, 20X2, balance of Allowance for Doubtful Accounts
will be Br. 3500. A Br. 3500 balance results only if the account had a zero balance prior to
posting the adjusting entry. For example, assume that Allowance for Doubtful Accounts has a
credit balance of Br. 1000 before adjustment. Now, what will be the balance of Allowance for
Doubtful Accounts be at the end of 20X2 ? It will be Br. 4500. If there had been a debit
balance of Br. 500 in the Allowance for Doubtful Accounts before the year-end adjustment,
and the amount of adjustment. would still have been Br. 3500. What will have been the end
balance of Allowance for Doubtful Accounts at the end of 20X2? (Find by your own!)

7.7.2.2 Estimate Based on Analysis of Receivables

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The longer an A/R remains outstanding, the less likely that it will be collected. Thus, we can
base the estimate of uncollectible accounts on how long the accounts have been outstanding.
For this purpose, we can use a process called Ageing receivables which examines each A/R to
estimate the amount of uncollectible. Receivables are classified by how long they are past
their due date. Then, estimates of uncollectible are made assuming the longer an amount is
past due the more likely it is to be uncollectible. After the outstanding amounts are classified
and analyzed in the Aging schedule the expected balance for the Allowance for Doubtful
Accounts will be estimated. Let’s assume the amount estimated is Br. 5000. So, do you think
this is the adjustment amount required for the current period? NO!
Because, this estimated amount is the expected balance of the Allowance for Doubtful
Accounts after adjustment rather than the current year provision for Uncollectible Accounts
Expense. Therefore, to determine the current year provision we must take in to account the
balance before adjustment in the Allowance for Doubtful Accounts. To illustrate, assume
there is as credit Balance of Br. 1300 in the allowance account before adjustment. The amount
to be added to this balance is therefore Br. 3800 (Br 5000 – Br. 1200) and the adjustment
entry is as follows:
Dec. 31 Uncollectible Accounts Expense 3800
Allowance for Doubtful Accounts 3800
To record Uncollectible expense.

Alternatively, if the Allowance for Doubtful Accounts had an unadjusted debit balance of Br.
700, then the required adjustment is Br. 5700. (Br. 5000 + 700) and the adjustment entry is as
follows:
Dec. 31 . Uncollectible Accounts Expense 5700
Allowance for Doubtful Accounts 5700
To record Uncollectible expense.
7.7.3 The Direct- Write-Off Method
The Direct Write-off method of accounting for bad debts records the loss from an
uncollectible A/R at the time it is determined to be uncollectible. No attempt is made to
predict uncollectible accounts expense. Bad debt expense is recorded when specific accounts
are determined to be worthless. If Wonji Co. uses a direct write-off method and determines on

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Feb. 20, it can’t collect from a customer- Home Co.- Br. 500. The entry to write-off the
customer’s account is as follows

Feb. 20 Uncollectible Accounts Expense 500

A/R- Home Co. 500
To write-off Uncollectible accounts

Sometimes an amount previously written off is later collected. This can be due to factors such
as continual collection efforts or the good fortune of a customer. If the account of Home Co.
that was written-off directly to Bad Debt Expense is later collected in full, the following two
entries record this recovery.
Mar. 5 - A/R- Home Co. 500
Uncollectible Accounts Expense 500
To reinstate account
Mar. 5 - Cash 500
A/R- Home Co. 500
To record full payment of account

If the recovery is in the year following the writ- off, there is no balance in the Uncollectible
Accounts Expense account related to the previous year’s write-off and no other write-offs are
expected. So the credit portion of the entry recording the recovery can be made to a Bad
Debts Recoveries revenue account.

To conclude this part companies must weigh at least two principles when considering use of
the direct write-off method:
(1) Matching principle, & (2) Materiality principle

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