Gideon Company Uses The Allowance Method

The allowance method is a crucial accounting technique for businesses that extend credit to customers, especially those dealing with potential bad debts. It's about realistically portraying a company's financial health by anticipating and accounting for the possibility that some customers may not fulfill their payment obligations. Let's dive into how Gideon Company implements this method, making the intricacies digestible for everyone.

Understanding the Allowance Method

At its core, the allowance method operates on the principle of matching. This accounting principle dictates that expenses should be recognized in the same period as the revenues they help generate. When Gideon Company makes a credit sale, it recognizes revenue immediately. However, the risk of non-payment is also created at that moment. The allowance method addresses this by estimating potential bad debts in the same accounting period as the related sales revenue.

Instead of waiting until a specific account is deemed uncollectible, Gideon Company proactively creates an allowance for doubtful accounts – a contra-asset account that reduces the carrying value of accounts receivable. This ensures the balance sheet presents a more accurate picture of what the company expects to actually collect from its customers.

Gideon Company's Approach: A Step-by-Step Breakdown

Here’s how Gideon Company implements the allowance method, step by step:

1. Estimating Bad Debts: The first and arguably most critical step is estimating the amount of accounts receivable that are likely to become uncollectible. Gideon Company employs several methods for this:

   • Percentage of Sales Method: Gideon Company calculates bad debt expense as a percentage of total credit sales. For example, if Gideon Company has credit sales of $500,000 and estimates that 1% will be uncollectible, the bad debt expense would be $5,000.

   • Percentage of Accounts Receivable Method: This method focuses on the outstanding accounts receivable balance. Gideon Company determines a percentage based on historical data and economic conditions. If the accounts receivable balance is $100,000 and Gideon Company estimates that 5% will be uncollectible, the required allowance for doubtful accounts would be $5,000.

   • Aging of Accounts Receivable Method: This is the most refined approach. Gideon Company categorizes accounts receivable based on how long they have been outstanding (e.g., 30 days, 60 days, 90+ days). A higher percentage of uncollectibility is applied to older receivables. This recognizes that the longer an account is overdue, the less likely it is to be collected.

2. Recording the Adjusting Entry: Once Gideon Company has estimated the bad debt expense, it records an adjusting entry at the end of the accounting period. This entry has two parts:

   • Debit Bad Debt Expense: This increases the expense on the income statement, reducing net income.

   • Credit Allowance for Doubtful Accounts: This increases the balance of the contra-asset account on the balance sheet, reducing the net realizable value of accounts receivable.

3. Writing Off Uncollectible Accounts: When Gideon Company determines that a specific account is uncollectible, it writes off the account. This involves:

   • Debit Allowance for Doubtful Accounts: This decreases the balance of the contra-asset account.

   • Credit Accounts Receivable: This decreases the balance of the accounts receivable account, removing the uncollectible amount.

   Important Note: Writing off an account does not affect net income. It simply adjusts the balance sheet by removing the uncollectible receivable and reducing the allowance for doubtful accounts. The expense was already recognized when the estimated bad debt expense was recorded.

4. Recovery of Previously Written Off Accounts: Occasionally, Gideon Company might recover an account that was previously written off. In this case, two entries are required:

   • Reverse the Write-Off:

     • Debit Accounts Receivable
     • Credit Allowance for Doubtful Accounts

   • Record the Cash Receipt:

     • Debit Cash
     • Credit Accounts Receivable

Diving Deeper: Methods for Estimating Bad Debts

Let's explore each estimation method Gideon Company uses with more detail.

Percentage of Sales Method: Simplicity and Directness

This method is favored for its simplicity. Gideon Company calculates bad debt expense as a percentage of credit sales. This percentage is typically derived from historical bad debt losses as a proportion of past credit sales.

• Pros: Easy to calculate and understand. Directly relates bad debt expense to sales revenue, adhering to the matching principle.
• Cons: May not accurately reflect the current economic climate or changes in Gideon Company's customer base. Ignores the existing balance in the allowance for doubtful accounts.

Example: Gideon Company has credit sales of $800,000. Based on past experience, they estimate that 0.75% of credit sales will be uncollectible.

Bad Debt Expense = $800,000 * 0.0075 = $6,000

The journal entry would be:

Percentage of Accounts Receivable Method: A Balance Sheet Focus

This method aims to ensure that accounts receivable are not overstated on the balance sheet. Gideon Company calculates the required balance in the allowance for doubtful accounts based on a percentage of outstanding accounts receivable.

• Pros: Directly addresses the accuracy of accounts receivable on the balance sheet.
• Cons: May not directly correlate bad debt expense with sales revenue. The calculation requires an adjustment to the allowance for doubtful accounts, taking into account any existing balance.

Example: Gideon Company has accounts receivable of $150,000. They estimate that 4% will be uncollectible. The allowance for doubtful accounts currently has a credit balance of $1,000.

Required Allowance = $150,000 * 0.04 = $6,000

Adjustment Needed = $6,000 (Required) - $1,000 (Existing) = $5,000

The journal entry would be:

Aging of Accounts Receivable Method: Precision Through Categorization

This method is considered the most accurate because it recognizes that the probability of non-payment increases as an account becomes overdue. Gideon Company categorizes accounts receivable by age (e.g., current, 31-60 days past due, 61-90 days past due, over 90 days past due) and applies different percentages to each category.

• Pros: Provides the most accurate estimate of uncollectible accounts. Tailors the estimation to the specific risk associated with each age group of receivables.
• Cons: More complex and time-consuming to implement. Requires careful tracking of accounts receivable aging.

Example: Gideon Company's aging schedule looks like this:

The allowance for doubtful accounts currently has a credit balance of $800.

Adjustment Needed = $6,300 (Required) - $800 (Existing) = $5,500

The journal entry would be:

The Journal Entries: Bringing it All Together

To solidify your understanding, let's review the typical journal entries Gideon Company would make under the allowance method.

1. Estimating Bad Debt Expense (using the percentage of sales method):

2. Writing Off an Uncollectible Account:

Assume a customer, John Doe, owes Gideon Company $500 and is declared bankrupt.

3. Recovery of a Previously Written Off Account:

Assume John Doe unexpectedly pays Gideon Company $200.

• Reverse the Write-Off:

• Record the Cash Receipt:

Advantages and Disadvantages of the Allowance Method

Like any accounting method, the allowance method has its pros and cons.

Advantages:

• Adherence to Matching Principle: Accurately matches bad debt expense with the related sales revenue in the same accounting period.
• More Accurate Financial Statements: Presents a more realistic view of a company's financial position by recognizing the potential for uncollectible accounts.
• Improved Decision-Making: Provides more reliable information for credit management and investment decisions.

Disadvantages:

• Requires Estimation: Relies on estimates, which can be subjective and may not always be accurate.
• Complexity: More complex than the direct write-off method.
• Potential for Manipulation: The estimation process can be manipulated to influence reported earnings.

The Direct Write-Off Method: A Simpler Alternative

While Gideon Company uses the allowance method, it’s important to understand the direct write-off method, its main alternative. Under this method, bad debt expense is not recognized until a specific account is deemed uncollectible. At that point, the expense is directly written off.

• Pros: Simple and easy to implement.
• Cons: Violates the matching principle. Overstates accounts receivable on the balance sheet. Not acceptable under GAAP (Generally Accepted Accounting Principles) if bad debts are material.

The direct write-off method is generally only suitable for companies with very few credit sales and insignificant bad debts.

Why Gideon Company Chooses the Allowance Method

Gideon Company chooses the allowance method because it provides a more accurate and realistic picture of its financial performance. As a company that extends credit to customers, Gideon Company recognizes the importance of accounting for potential bad debts in a timely and transparent manner. The allowance method allows Gideon Company to:

• Comply with GAAP: Ensure that its financial statements are prepared in accordance with generally accepted accounting principles.
• Provide Investors with Reliable Information: Offer investors a clear understanding of the company's financial health and risk profile.
• Make Informed Business Decisions: Use accurate financial data to make informed decisions about credit policies, sales strategies, and investment opportunities.

Factors Influencing Gideon Company's Bad Debt Estimates

Several factors can influence Gideon Company's bad debt estimates. These include:

• Economic Conditions: A downturn in the economy can lead to increased unemployment and financial hardship, making it more difficult for customers to repay their debts.
• Industry Trends: Changes in the industry, such as increased competition or new technologies, can affect customers' ability to pay.
• Credit Policies: Gideon Company's credit policies, such as the credit terms offered to customers and the procedures for collecting overdue accounts, can impact the level of bad debts.
• Historical Data: Past experience with bad debt losses is a valuable indicator of future trends.
• Changes in Customer Base: Significant changes in the customer base, such as an increase in sales to higher-risk customers, can affect the level of bad debts.

Best Practices for Implementing the Allowance Method

To effectively implement the allowance method, Gideon Company adheres to the following best practices:

• Regularly Review and Update Estimates: Bad debt estimates should be reviewed and updated regularly to reflect changes in economic conditions, industry trends, and the company's own experience.
• Use a Combination of Estimation Methods: Consider using a combination of estimation methods to arrive at the most accurate estimate.
• Document the Estimation Process: Clearly document the estimation process, including the methods used, the assumptions made, and the data relied upon.
• Maintain Accurate Records: Maintain accurate records of accounts receivable, write-offs, and recoveries.
• Seek Professional Advice: Consult with an accountant or financial advisor to ensure that the allowance method is being implemented correctly.

Conclusion: The Importance of Prudent Accounting

The allowance method is a cornerstone of prudent accounting for companies like Gideon Company that extend credit to customers. By proactively estimating and accounting for potential bad debts, Gideon Company presents a more accurate and transparent picture of its financial health. This not only ensures compliance with GAAP but also provides investors and stakeholders with the reliable information they need to make informed decisions. Through careful estimation, diligent record-keeping, and adherence to best practices, Gideon Company effectively manages its credit risk and maintains the integrity of its financial reporting.