Bad Debt Expense Definition, Reporting Methods

Bad Debt Expense increases (debit), and Allowance for Doubtful Accounts increases (credit) for $22,911.50 ($458,230 × 5%). This means that BWW believes $22,911.50 will be uncollectible debt. 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 receivable line item in the balance sheet tends to be lower under the allowance method, since a reserve is being netted against the receivable amount.

If the customer paid the bill on September 17, we would reverse the entry from April 7 and then record the payment of the receivable. If the customer’s balance is written off as uncollectible, there is nothing to apply the payment against. If the company applies the balance against the customer’s account, the entry would cause a negative balance or an amount due to the customer. In order to accept the payment, the company must first restore the balance to the customer’s account. It’s not revenue because the company has not done any work or sold anything.

2 Account for Uncollectible Accounts Using the Balance Sheet and Income Statement Approaches

Because this is just another version of an allowance method, the accounts are Bad Debt Expense and Allowance for Doubtful Accounts. What effect does this have on the balances in each account and the net amount of accounts receivable? The balance in Accounts Receivable drops to $9,900 and the balance in Allowance for Doubtful Accounts falls to $400.

• The direct write off method offers a way to deal with this for accounting purposes, but it comes with some pros and cons.
• The company then debits $ 5,000 from Bad Debts Expenses and credits $ 5,000 from Accounts Receivables.
• In this example, the $85,200 total is the net realizable value, or the amount of accounts anticipated to be collected.
• Therefore, the business would credit accounts receivable of $10,000 and debit bad debt expense of $10,000.
• In order to accept the payment, the company must first restore the balance to the customer’s account.
• Conversely, provision for doubtful debt is booked as a bad debt expense under the allowance method.

As per the prudence concept of accounting which is also referred to as the conservatism principle, revenue shall only be recognized when certain, and expense shall be booked when probable. On to the calculation, since the company uses the percentage of receivables we will take 6% of the $530,000 balance. Bad debt expense recognition is delayed under the direct write-off method, while the recognition is immediate under the allowance method.

Direct write off method vs. the allowance method

When using the percentage of accounts receivable method, the amount calculated is the new balance in allowance for doubtful accounts. Continuing our examination of the balance sheet direct write-off method 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.

Instead, the allowance method is to be used for the financial statements. The alternative to the direct write off method is to create a provision for bad debts in the same period that you recognize revenue, which is based upon an estimate of what bad debts will be. This approach matches revenues with expenses, so that all aspects of a sale are included within a single reporting period. Conversely, the direct write-off method might involve a delay of several months between the initial sale and a charge to bad debt expense, which does not provide a complete view of a transaction within one reporting period. Therefore, the allowance method is considered the more acceptable accounting method. For example, a company may recognize $1 million in sales in one period, and then wait three or four months to collect all of the related accounts receivable, before finally charging some bad debts off to expense.

Resources for Your Growing Business

If an old debt is paid, the journal entry can simply be reversed and the payment posted to the customer’s account. Therefore, always consult with accounting and tax professionals for assistance with your specific circumstances. The most important thing to remember when working with the allowance methods for bad debt is to know what you have calculated! Once you figure a dollar amount, ask yourself if that amount is the bad debt expense or the allowance. If it is the allowance, you must then figure out how much bad debt to record in order to get to that balance. The calculation here is a few more steps but uses the same methodology used in all the other methods.

Bad debt is the money that a customer or customers owe that you don’t believe you will be able to collect. If you’re a small business owner who doesn’t regularly deal with bad debt, the direct write-off method might be simpler. But the allowance method is more commonly preferred and often used by larger companies and businesses frequently handling receivables. If you’re wondering which method is best for your small business, speak with a professional for insights into your specific situation. Bad debts in business commonly come from credit sales to customers or products sold and services performed that have yet to be paid for.

To compensate for this problem, accountants have developed “allowance methods” to account for uncollectible accounts. Importantly, an allowance method must be used except in those cases where bad debts are not material (and for tax purposes where tax rules often stipulate that a direct write-off approach is to be used). Allowance methods will result in the recording of an estimated bad debts expense in the same period as the related credit sales, and generally result in a fairer balance sheet valuation for outstanding receivables. As will soon be shown, the actual write-off in a subsequent period will generally not impact income.