Producing financial statements in compliance with GAAP (Generally Accepted Accounting Principles) is a requirement for public companies listed on a US Exchange. The matching principle requires that revenues be matched to their related expense within an accounting period. To approximate this as much as possible, a company must rely on the accrual-basis accounting method to periodically estimate certain revenues and expenses. Accrual-basis accounting is required for a company to be in compliance with GAAP. In the case of uncollectible accounts, there is often a big gap of time between a credit sale and the company realizing that the credit sale cannot be collected.

Let’s say Barry and Sons Boot Makers sold $5 million worth of boots to many customers. Barry and Sons Boot Makers would record revenues of $5 million and accounts receivable of $5 million. If a customer has not paid after three months, the amount may be assigned under “aged” receivables, and if more time passes, the vendor could classify it as a “doubtful” account. At this point, the company believes that receiving all or part of the outstanding amount is doubtful, and will, therefore, debit the bad debt amount and credit allowance for doubtful accounts.

The bad debt expense for the accounting period is recorded with the following percentage of accounts receivable method journal entry. The journal entry for the Bad Debt Expense increases (debit) the expense’s balance, and the Allowance for Doubtful Accounts increases (credit) the balance in the Allowance. The allowance for doubtful accounts is a contra asset account and is subtracted from Accounts Receivable to determine the Net Realizable Value of the Accounts Receivable account on the balance sheet. In the case of the allowance for doubtful accounts, it is a contra account that is used to reduce the Controlling account, Accounts Receivable.

Accounts Receivable and Bad Debts Expense Outline

The company must record an additional expense for this amount to also increase the allowance’s credit balance. On June 3, a customer purchases $1,400 of goods on credit from Gem Merchandise Co. On August 24, that same customer informs Gem Merchandise Co. that it has filed for bankruptcy.

It determines this allowance every month, based on the number of new mortgages it issues to write down the accounts receivable immediately, rather than waiting for those accounts to enter default. This allows the company to provide a more accurate picture of its financial health. The bad debt expense is then the difference between the calculated allowance for doubtful accounts at the end of the account period and the current allowance for doubtful accounts before adjustment. The allowance method is a technique for estimating and recording of uncollectible amounts when a customer fails to pay, and is the preferred alternative to the direct write-off method. Allowance for Doubtful Accounts decreases (debit) and Accounts Receivable for the specific customer also decreases (credit).

Allowance for Doubtful Accounts: Calculation

If, however, a company uses the direct write-off method, it will credit accounts receivable to write off the bad debt. Because the time difference between the sale and the time a company realizes an account is uncollectible is usually long, using the direct write-off method will violate the matching principle. Under the direct write-off method, bad debt expense serves as a direct loss from uncollectibles, which ultimately goes against revenues, lowering your net income. 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.

To account for this possibility, businesses create an allowance for doubtful accounts, which serves as a reserve to cover potential losses. The risk classification method involves assigning a risk score or risk category to each customer based on criteria—such as payment history, credit score, and industry. The company then uses the historical percentage of uncollectible accounts for each risk category to estimate the allowance for doubtful accounts. The aging method groups all outstanding accounts receivable by age, and specific percentages are applied to each group. The aggregate of all groups’ results is the estimated uncollectible amount. For example, a company has $70,000 of accounts receivable less than 30 days outstanding and $30,000 of accounts receivable more than 30 days outstanding.

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Bad debt expense is an income statement account that is used to record client account balances deemed uncollectible by the accounting department. Bad debt expense is reported within the selling, general, and administrative expense section of the income statement. However, the entries to record this bad debt expense may be spread throughout a set of financial statements. The allowance for doubtful accounts resides on the balance sheet as a contra asset. Meanwhile, any bad debts that are directly written off reduce the accounts receivable balance on the balance sheet.

• Let’s use an example to show a journal entry for allowance for doubtful accounts.
• One way to handle uncollectible accounts is to consider them accounts receivable until it becomes evident they will never pay out.
• In particular, your allowance for doubtful accounts includes past-due invoices that your business does not expect to collect before the end of the accounting period.
• Recording the amount here allows the management of a company to immediately see the extent of the expected bad debt, and how much it is offsetting the company’s account receivables.

Continuing our examination of the balance sheet method, assume that BWW’s end-of-year accounts receivable balance totaled $324,850. This entry assumes a zero balance in Allowance for Doubtful Accounts from the prior period. BWW estimates 15% of its overall accounts receivable will result in bad debt. This expense is called bad debt expenses, and they are generally classified as sales and general administrative expense. Though part of an entry for bad debt expense resides on the balance sheet, bad debt expense is posted to the income statement.

Methods for estimating allowance for doubtful accounts

In this context, the contra asset would be deducted from your accounts receivable assets and considered a write-off. Most companies use the allowance method, which is to estimate the amount of doubtful expense it expects. This is done to be in compliance with the matching principle which requires that revenues be matched to their related expenses within an accounting period. When this bad debt is written off, the allowance for doubtful accounts is credited by the write-off amount.

• When companies sell products to customers on credit, the customer receives the product and agrees to pay later.
• It’s eventually determined that Fancy Foot Store had creditors in line that received all assets as priority lenders, therefore, Barry and Sons Boot Makers will not be receiving the $1 million.
• The matching principle states that revenue and expenses must be recorded in the same period in which they occur.
• The companies that qualify for this exemption, however, are typically small and not major participants in the credit market.

This anticipated amount is often termed the net realizable value (receivables). The percentage of credit sales approach focuses on the income statement and the matching principle. Sales revenues of $500,000 are immediately matched with $1,500 of bad debts expense. The balance in the account Allowance for Doubtful Accounts is ignored at the time of fantasy football 2020 positional rankings cheat sheet and top adp values the weekly entries. However, at some later date, the balance in the allowance account must be reviewed and perhaps further adjusted, so that the balance sheet will report the correct net realizable value. If the seller is a new company, it might calculate its bad debts expense by using an industry average until it develops its own experience rate.

The remaining amount from the bad debt expense account (the portion of the $10,000 that is never paid) will show up on a company’s income statement. The first step in accounting for the allowance for doubtful accounts is to establish the allowance. This is done by using one of the estimation methods above to predict what proportion of accounts receivable will go uncollected. For this example, let’s say a company predicts it will incur $500,000 of uncollected accounts receivable. The accounts receivable aging method is a report that lists unpaid customer invoices by date ranges and applies a rate of default to each date range. A mortgage lender, for example, expects a certain percentage of loans to enter default.

Doubtful accounts are considered to be a contra account, meaning an account that reflects a zero or credit balance. In other words, if an amount is added to the “Allowance for Doubtful Accounts” line item, that amount is always a deduction. Whenever a balance sheet is to be produced, these two accounts are netted to arrive at net realizable value, the figure to be reported for this asset.

What Is a Bad Debt Expense?

When companies sell products to customers on credit, the customer receives the product and agrees to pay later. The customer’s obligation to pay later is recorded in accounts receivable on the balance sheet of the selling company. When customers don’t pay their bills, the selling company has to write-off the amount as bad debt or uncollectible accounts.

2Because the focus of the discussion here is on accounts receivable and their collectability, the recognition of cost of goods sold as well as the possible return of any merchandise will be omitted. By a miracle, it turns out the company ended up being rewarded a portion of their outstanding receivable balance they’d written off as part of the bankruptcy proceedings. Of the $50,000 balance that was written off, the company is notified that they will receive $35,000. Rebekiah received her BBA from Georgia Southwestern State University and her MSM from Troy University. She has experience teaching math to middle school students as well as teaching accounting at the college level. She has a combined total of twelve years of experience working in the accounting and finance fields.