Importance of Bad Debt Expense
The allowance for doubtful accounts is the preferred method of accounting for doubtful accounts. It is a contra-asset account netted against accounts receivable on the balance sheet. The allowance is increased by the provision for doubtful accounts and recoveries of previously written off receivables and is decreased by the write-off of uncollectible receivables.
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. 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.
The allowance method is used by companies that comply with generally accepted accounting principles, or GAAP. Using this method, management determines that uncollectible debt can be estimated as a percentage of either sales or accounts receivable based on historical percentages. Once bad debt has been estimated, this method results in a debit, or increase, in bad debt expense, and a credit to an allowance for doubtful account — a provision account that is used to offset accounts receivable.
Under the direct write-off method, the journal entry for a bad debt write-off will include a credit to accounts receivable and a debit to bad debt expense. This entry should have support that illustrates how the write-off ties back past due receivables and the company’s write-off policy. The journal entry when using the allowance method for doubtful accounts is different. When using the direct write-off method, an accounts receivable is removed from the balance sheet and expensed on the income statement, as receivables are determined to be uncollectible.
Bad Debts Expense as a Percent of Sales
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. 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.
A company will debit bad debts expense and credit this allowance account. The allowance for doubtful accounts is a contra-asset account that nets against accounts receivable, which means that it reduces the total value of receivables when both balances are listed on the balance sheet. This allowance can accumulate across accounting periods and may be adjusted based on the balance in the account.
There is no allowance for uncollectible accounts listed on the balance sheet. Instead, accounts receivable is always listed at current value, in the current assets section of the balance sheet.
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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. The aggregate balance in the allowance for doubtful accounts after these two periods is $5,400.
- The allowance method is used by companies that comply with generally accepted accounting principles, or GAAP.
- Using this method, management determines that uncollectible debt can be estimated as a percentage of either sales or accounts receivable based on historical percentages.
- Once bad debt has been estimated, this method results in a debit, or increase, in bad debt expense, and a credit to an allowance for doubtful account — a provision account that is used to offset accounts receivable.
Bad Debt Direct Write-Off Method
While this method has advantages, the allowance method for estimating bad debt is popular, because it gives users of financial statements a better idea of financial position. With this method, accounts receivable is organized into categories by length of time outstanding, and an uncollectible percentage is assigned to each category. For example, a category might consist of accounts receivable that is 0–30 days past due and is assigned an uncollectible percentage of 6%. Another category might be 31–60 days past due and is assigned an uncollectible percentage of 15%. All categories of estimated uncollectible amounts are summed to get a total estimated uncollectible balance.
For example, assume that a credit transaction occurs in September 2018 and is determined to be uncollectible in February 2019. This matching issue is the reason accountants will typically use one of the two accrual-based accounting methods introduced to account for bad debt expenses.
GAAP. There are two popular methods for performing the write-off; the allowance method and the direct write-off method. Each technique has advantages and gives users of financial statements insight into a company’s financial position.
Accounts Receivable xxx To record the direct write-off of the uncollectible accounts receivable of XYZ Company. The DRO method is very simple, but permissible under generally accepted accounting standards (GAAP) only when it approximates the allowance method. This method violates two fundamental principles of GAAP, the matching principle and principle of conservatism since net receivables are often overstated. The balance sheet method estimates bad debt based on a percentage of outstanding accounts receivable. ), the direct write-off method is not an acceptable method of recording bad debts, because it violates the matching principle.
Bad Debt Expense Journal Entry
For example, in one accounting period, a company can experience large increases in their receivables account. Then, in the next accounting period, a lot of their customers could default on their payments (not pay them), thus making the company experience a decline in its net income. Therefore, the direct write-off method can only be appropriate for small immaterial amounts. We will demonstrate how to record the journal entries of bad debt using MS Excel. For example, assume Rankin’s allowance account had a $300 credit balance before adjustment.
There are several methods available to assist the company in determining the adequacy of its allowance. Good internal control requires a company to systematically analyze and evaluate the adequacy of the allowance every time a balance sheet is published. Accounts receivable that are determined to be uncollectible are expensed as bad debt. Bad debt shouldn’t be written-off unless the receivables are uncollectible in consistency with a company’s bad debt expense write-off policy and U.S.
That total is reported in Bad Debt Expense and Allowance for Doubtful Accounts, if there is no carryover balance from a prior period. If there is a carryover balance, that must be considered before recording Bad Debt Expense. The balance sheet aging of receivables method is more complicated than the other two methods, but it tends to produce more accurate results. The balance sheet aging of receivables method estimates bad debt based on outstanding accounts receivable, but it considers the time period that an account is past due. Bad Debt Expense increases (debit) and Allowance for Doubtful Accounts increases (credit) for the amount estimated as uncollectible.