Adjusting Entry for Bad Debts Expense
The statistical calculations can utilize historical data from the business as well as from the industry as a whole. The specific percentage will typically increase as the age of the receivable increases, to reflect increasing default risk and decreasing collectibility. When a company has accounts receivable, and some of the accounts are uncollectible, bad debt expense is recognized and recorded in the proper amount. The bad debt can result from defaults on notes receivable, trade receivables arising through the normal course of business or another type of receivable.
For example, if 2% of your sales were uncollectible, you could set aside 2% of your sales in your ADA account. Let’s say you have a total of $50,000 in accounts receivable ($50,000 X 2%).
The projected bad debt expense is properly matched against the related sale, thereby providing a more accurate view of revenue and expenses for a specific period of time. In addition, this accounting process prevents the large swings in operating results when uncollectible accounts are written off directly as bad debt expenses. Companies that use the percentage of credit sales method base the adjusting entry solely on total credit sales and ignore any existing balance in the allowance for bad debts account. If estimates fail to match actual bad debts, the percentage rate used to estimate bad debts is adjusted on future estimates. In general, the longer an account balance is overdue, the less likely the debt is to be paid.
However, the balance sheet would show $100,000 accounts receivable less a $5,300 allowance for doubtful accounts, resulting in net receivables of $ 94,700. On the income statement, Bad Debt Expense would still be 1%of total net sales, or $5,000. As an example of the allowance method, ABC International records $1,000,000 of credit sales in the most recent month. Historically, ABC usually experiences a bad debt percentage of 1%, so it records a bad debt expense of $10,000 with a debit to bad debt expense and a credit to the allowance for doubtful accounts. The journal entry to estimate and record bad debt using either method will result in a debit to bad debt expense and a credit to allowance for doubtful accounts.
Therefore, many companies maintain an accounts receivable aging schedule, which categorizes each customer’s credit purchases by the length of time they have been outstanding. Each category’s overall balance is multiplied by an estimated percentage of uncollectibility for that category, and the total of all such calculations serves as the estimate of bad debts. The accounts receivable aging schedule shown below includes five categories for classifying the age of unpaid credit purchases. To illustrate, let’s assume that on December 31 a company had $100,000 in Accounts Receivable and its balance in Allowance for Doubtful Accounts was a credit balance of $3,000.
This approach does not consider the balance in the allowance for doubtful accounts because such balance is not used in the calculation of bad debt expense. Use the percentage of bad debts you had in the previous accounting period and apply it to your estimate.
The aggregate balance in the allowance for doubtful accounts after these two periods is $5,400. A company will debit bad debts expense and credit this allowance account. This allowance can accumulate across accounting periods and may be adjusted based on the balance in the account. A bad debt expense is recognized when a receivable is no longer collectible because a customer is unable to fulfill their obligation to pay an outstanding debt due to bankruptcy or other financial problems.
Yet Journal Entry 1 records every dollar that you bill your customers as revenue. is one way to estimate bad debts expense as part of the income statement. The percentage of sales method figures the bad debts expense as a percent of credit sales for an accounting period.
Like a looming storm, the best thing you can do is prepare for bad debt and uncollectible accounts. Using the percentage of sales method, you can do just this and determine what percentage or amount of bad debt needs to be built into your finances. To predict your company’s bad debts, you must create an allowance for doubtful accounts entry.
Bad debt expense is recorded using a technical accounting method, such as the direct write-off method or the allowance method. Selecting the right method, and making the right calculation, impacts the relevance and accuracy of a company’s financial statements. Estimated uncollectibles are recorded as an increase to Bad Debts Expense and an increase to Allowance for Doubtful Accounts (a contra asset account) through an adjusting entry at the end of each period. Where the percentage of sales method looks at sales, the percentage of receivables method looks at the current amount of accounts receivable the business has accumulated at its point of calculation. The resulting figure indicates what the allowance for the doubtful accounts balance should be.
Bad Debts Expense is an income statement account while the latter is a balance sheet account. Bad Debts Expense represents the uncollectible amount for credit sales made during the period. Allowance for Bad Debts, on the other hand, is the uncollectible portion of the entire Accounts Receivable. In accrual-basis accounting, recording the allowance for doubtful accounts at the same time as the sale improves the accuracy of financial reports.
Companies that extend credit to their customers report bad debts as an allowance for doubtful accounts on the balance sheet, which is also known as a provision for credit losses. When a business makes sales on credit, even customers with the best credit record and financial standing can go bankrupt and fail to pay the bills they owe. To better match the credit risk to the period in which revenue was earned, generally accepted accounting principles allow a company to estimate and record bad debt expense using the allowance method. Under the allowance method, a percentage of each period’s sales/revenue or ending accounts receivable is estimated to eventually prove uncollectible. Consequently, the amount estimated is charged to bad debts of the period and the credit is made to an account such as allowance for doubtful accounts.
- When the company has to actually write off uncollectible accounts, those are written off against the allowance account.
- In short, the percentage of sales method estimates the amount of bad debt expense a company will incur based on the amount of sales it makes on credit.
DIRECT WRITE-OFF METHOD
For example, in periods of recession and high unemployment, a firm may increase the percentage rate to reflect the customers’ decreased ability to pay. However, if the company adopts a more stringent credit policy, it may have to decrease the percentage rate because the company would expect fewer uncollectible accounts. AccountDebitCreditBad debt expense100Allowance for uncollectible A/R100Journal Entry 3 records an estimate of the uncollectible portion of accounts receivable. (Businesses that don’t want to keep accrual-based accounting statements may not need to worry about Journal Entry 3.) Unfortunately, some of the money you bill customers may be uncollectible.
Let’s say your business brought in $100,000 worth of sales in an accounting period. Based on past trends, you predict that 3% of your sales will be bad debts. You must record $3,000 as a debit in your bad debts expense account and a matching $3,000 as a credit in your allowance for doubtful accounts. For example, assume Rankin’s allowance account had a $300 credit balance before adjustment.
ALLOWANCE METHOD
The sales method applies a flat percentage to the total dollar amount of sales for the period. For example, based on previous experience, a company may expect that 3% of net sales are not collectible. If the total net sales for the period is $100,000, the company establishes an allowance for doubtful accounts for $3,000 while simultaneously reporting $3,000 in bad debt expense. If the following accounting period results in net sales of $80,000, an additional $2,400 is reported in the allowance for doubtful accounts, and $2,400 is recorded in the second period in bad debt expense.
Allowance for doubtful accounts appears on your balance sheet right beneath your accounts receivable balance. It’s a contra-receivable account that reduces the value of your receivables and overall assets. Generally accepted accounting principles require that businesses maintain an allowance for bad debts. That means that estimating uncollectible accounts is a necessary task if you want to produce GAAP financial statements for potential or existing lenders and investors. One way companies derive an estimate for the value of bad debts under the allowance method is to calculate bad debts as a percentage of the accounts receivable balance.
Two primary methods exist for estimating the dollar amount of accounts receivables not expected to be collected. Bad debt expense can be estimated using statistical modeling such as default probability to determine its expected losses to delinquent and bad debt.
In applying the percentage-of-sales method, companies annually review the percentage of uncollectible accounts that resulted from the previous year’s sales. However, if the situation has changed significantly, the company increases or decreases the percentage rate to reflect the changed condition.
As a result, the December 31 balance sheet will be reporting that $97,000 will be turning to cash. During the first 30 days of January the company does not have any other information on bad accounts receivable. However, on January 31 the company learns that an additional $1,000 of its accounts receivable may not be collected. Therefore, on January 31 the company will make an adjusting entry to debit Bad Debts Expense for $1,000 and to credit Allowance for Doubtful Accounts for $1,000.
In short, the percentage of sales method estimates the amount of bad debt expense a company will incur based on the amount of sales it makes on credit. For example, if a business made $100,000 worth of sales revenue on credit and estimates bad debt to be 2% of credit sales, it would add $2,000 to the allowance for doubtful accounts. When the company has to actually write off uncollectible accounts, those are written off against the allowance account.
How to Calculate the Percentage of Bad Debt
When specific accounts are written off, they are charged to the allowance account, which is periodically recomputed. Thus, the expenses are estimated and recorded to match revenues and expenses in a given period – satisfying the matching principle.
The direct write-off method allows for a straightforward calculation and write-off of bad debt. When a business is owed money, and clients fail to pay, there are losses that need to be recognized on the income statement.