The allowance for impairment of receivables is a contra account that reduces the total receivables presented on the balance sheet to reflect the estimated amount of receivables that are expected to be uncollectible (Investopedia, n.d.).
Key Facts
- Definition: The allowance for doubtful accounts is a contra account that reduces the total receivables presented on the balance sheet to reflect the estimated amount of receivables that are expected to be uncollectible.
- Purpose: The purpose of the allowance for doubtful accounts is to use the matching principle between revenue and expenses while also reporting the net amount of assets using the conservatism principle.
- Estimation Methods: There are several methods that companies can use to estimate the allowance for doubtful accounts, including the percentage of sales method, accounts receivable aging method, risk classification method, historical percentage method, Pareto analysis method, and specific identification method.
- Accounting Treatment: The allowance for doubtful accounts is established in the same accounting period as the original sale, with an offset to bad debt expense. It is adjusted over time based on the actual payment behavior of customers.
Purpose
The purpose of the allowance for impairment of receivables is twofold:
- To adhere to the matching principle by recognizing the expense of uncollectible accounts in the same period as the revenue is earned (Cornell University, n.d.).
- To report the net amount of assets using the conservatism principle by reducing the gross amount of receivables by the estimated amount of uncollectible accounts (Investopedia, n.d.).
Estimation Methods
There are several methods that companies can use to estimate the allowance for impairment of receivables, including:
- Percentage of sales methodApplies a flat percentage to the total dollar amount of sales for the period (Investopedia, n.d.).
- Accounts receivable aging methodGroups outstanding accounts receivable by age and applies specific percentages to each group (Investopedia, n.d.).
- Risk classification methodAssigns different percentages to different types of debt or vendors based on their risk level (Investopedia, n.d.).
- Historical percentage methodUses the historical percentage of bad debt as an estimate for the current period (Investopedia, n.d.).
- Pareto analysis methodAssumes that a majority of uncollectible accounts are concentrated among a small number of customers (Investopedia, n.d.).
- Specific identification methodIdentifies specific accounts receivable that are considered uncollectible and aggregates their balances (Investopedia, n.d.).
Accounting Treatment
The allowance for impairment of receivables is established in the same accounting period as the original sale, with an offset to bad debt expense (Investopedia, n.d.). It is adjusted over time based on the actual payment behavior of customers.
References
- Cornell University. (n.d.). Allowance for Doubtful Accounts and Bad Debt Expenses. https://finance.cornell.edu/accounting/topics/revenueclass/baddebt
- Investopedia. (n.d.). Allowance for Doubtful Accounts. https://www.investopedia.com/terms/a/allowancefordoubtfulaccounts.asp
- Investopedia. (n.d.). Allowance For Credit Losses. https://www.investopedia.com/terms/a/allowance-for-credit-losses.asp
FAQs
What is the purpose of the allowance for impairment of receivables?
The allowance for impairment of receivables serves two purposes: to adhere to the matching principle by recognizing the expense of uncollectible accounts in the same period as the revenue is earned, and to report the net amount of assets using the conservatism principle by reducing the gross amount of receivables by the estimated amount of uncollectible accounts.
What are the different methods that companies can use to estimate the allowance for impairment of receivables?
Companies can use various methods to estimate the allowance for impairment of receivables, including the percentage of sales method, accounts receivable aging method, risk classification method, historical percentage method, Pareto analysis method, and specific identification method.
How is the allowance for impairment of receivables accounted for?
The allowance for impairment of receivables is established in the same accounting period as the original sale, with an offset to bad debt expense. It is adjusted over time based on the actual payment behavior of customers.
What are some factors that companies should consider when estimating the allowance for impairment of receivables?
Companies should consider factors such as the creditworthiness of their customers, their historical experience with bad debts, and the current economic conditions when estimating the allowance for impairment of receivables.
What are the implications of underestimating or overestimating the allowance for impairment of receivables?
Underestimating the allowance for impairment of receivables can lead to an overstatement of net income and assets, while overestimating the allowance can lead to an understatement of net income and assets.
How does the allowance for impairment of receivables affect financial ratios?
The allowance for impairment of receivables can affect financial ratios such as the accounts receivable turnover ratio and the gross profit margin.
What are some best practices for managing the allowance for impairment of receivables?
Best practices for managing the allowance for impairment of receivables include regularly reviewing and adjusting the allowance based on changes in the creditworthiness of customers and economic conditions, and using a consistent methodology for estimating the allowance.
What are the potential consequences of not maintaining an adequate allowance for impairment of receivables?
Not maintaining an adequate allowance for impairment of receivables can lead to financial misstatement, reduced profitability, and increased risk of default.