The bad debt expense is entered as a debit to increase the expense, whereas the allowance for doubtful accounts is a credit to increase the contra-asset balance. The company now has a better idea of which account receivables will be collected and which will be lost. For example, say the company now thinks that a total of $600,000 of receivables will be lost. The company must record an additional expense for this amount to also increase the allowance’s credit balance. Because the allowance for doubtful accounts is established in the same accounting period as the original sale, an entity does not know for certain which exact receivables will be paid and which will default. Therefore, generally accepted accounting principles (GAAP) dictate that the allowance must be established in the same accounting period as the sale, but can be based on an anticipated or estimated figure.

• The provision for doubtful money owed is the estimated amount of unhealthy debt that will arise from accounts receivable that have been issued but not yet collected.
• Let’s say that on April 8, it was determined that Customer Robert
  Craft’s account was uncollectible in the amount of $5,000.
• The financial statements are viewed by investors and potential investors, and they need to be reliable and must possess integrity.
• Analysts carefully monitor the days outstanding numbers for signs of weakening business conditions.

With an allowance for uncollectible accounts, the company determines the average number of accounts that enter default and records it on the balance sheet as a “contra asset” to offset the accounts receivable. This allows companies to anticipate write-downs of bad debt by accounting for them as early as possible. In accrual-basis accounting, recording the allowance for doubtful accounts at the same time as the sale improves the accuracy of financial reports. 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. For example, when companies account for bad debt expenses in their financial statements, they will use an accrual-based method; however, they are required to use the direct write-off method on their income tax returns.

3: Direct Write-Off and Allowance Methods

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 balance in the account Allowance for Doubtful Accounts is ignored at the time of the weekly entries. However, pulse surveys at some later date, the stability in the allowance account have to be reviewed and perhaps further adjusted, so that the stability sheet will report the right internet realizable value. If the seller is a new company, it might calculate its bad money owed expense through the use of an business average until it develops its own expertise rate.

• This is done by using one of the estimation methods above to predict what proportion of accounts receivable will go uncollected.
• Based on previous experience, 1% of accounts receivable less than 30 days old will be uncollectible, and 4% of those accounts receivable at least 30 days old will be uncollectible.
• Suppose that Ito Company has total accounts receivable of $425,000 at the end of the year, and is in the process or preparing a balance sheet.
• Therefore, the direct write-off method can only be appropriate for small immaterial amounts.
• 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.
• You may notice that all three methods use the same accounts for the adjusting entry; only the method changes the financial outcome.

Hopefully, your accounting software has a process in place to accomplish this transaction, but it’s rare enough that you may have to figure out the result you want and then make it happen using the built-in systems. Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own.

It means, under this method, bad debt expense does not necessarily serve as a direct loss that goes against revenues. 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 entire amount is written off as bad debt expense on the income statement and the allowance for doubtful accounts is also reduced by $1 million. The percentage-of-receivables method estimates uncollectible accounts by determining the estimated net realizable value of accounts receivable, so many accountants refer to this as the balance-sheet method. To illustrate, let’s continue to use Billie’s Watercraft
Warehouse (BWW) as the example. The allowance method is the more widely used method because it
satisfies the matching principle.

Why Do Accountants Use Allowance for Doubtful Accounts?

Businesses that use cash accounting principles never recorded the amount as incoming revenue to begin with, so you wouldn’t need to undo expected revenue when an outstanding payment becomes bad debt. In other words, there is nothing to undo or balance as bad debt if your business uses cash-based accounting. Calculating your bad debts is an important part of business accounting principles. Not only does it parse out which invoices are collectible and uncollectible, but it also helps you generate accurate financial statements.

Risk Classification Method

Notice that bad debt expense in this case is simply the other half of the entry to get the balance sheet account adjusted. The focus in this case is on the net realizable value of the receivables, and the income statement (bad debt expense) is relegated to second place. Using this allowance method, the estimated balance required for the allowance for doubtful accounts at the end of the accounting period is 7,100. Based on this review, ABC increases the allowance for doubtful accounts by $500 by debiting the allowance for doubtful accounts account and crediting the bad debt expense account.

Module 6: Receivables and Revenue

Management may disclose its method of estimating the allowance for doubtful accounts in its notes to the financial statements. Though the Pareto Analysis can not be used on its own, it can be used to weigh accounts receivable estimates differently. For example, a company may assign a heavier weight to the clients that make up a larger balance of accounts receivable due to conservatism. Some companies may classify different types of debt or different types of vendors using risk classifications.

Fundamentals of Bad Debt Expenses and Allowances for Doubtful Accounts

Note that allowance for doubtful accounts reduces the
overall accounts receivable account, not a specific accounts
receivable assigned to a customer. Because it is an estimation, it
means the exact account that is (or will become) uncollectible is
not yet known. The final point relates to companies with very little exposure
to the possibility of bad debts, typically, entities that rarely
offer credit to its customers. Assuming that credit is not a
significant component of its sales, these sellers can also use the
direct write-off method.

Free Financial Modeling Lessons

Bad Debt Expense increases (debit) as does Allowance for Doubtful Accounts (credit) for $58,097. The net effect is a reduction in total assets and a reduction in the allowance for doubtful accounts. When a company sells goods or services on credit, there is always a risk that some customers will not pay their bills. The allowance reserve is set in the period in which the revenue was “earned,” but the estimation occurs before the actual transactions and customers can be identified. Accounts uncollectible are receivables, loans, or other debts that have virtually no chance of being paid. An account may become uncollectible for many reasons, including the debtor’s bankruptcy, an inability to find the debtor, fraud on the part of the debtor, or lack of proper documentation to prove that debt exists.