When writing off an uncollectible account under the allowance method is credited and is debited?

The direct write-off and allowance methods of recording bad debt expense

Table of Contents Show

• Bad Debt Direct Write-Off Method
• Bad Debt Allowance Method
• How to Estimate Accounts Receivables
• Importance of Bad Debt Expense

First, let’s determine what the term bad debt means. Sometimes, at the end of the fiscal period, when a company goes to prepare its financial statements, it needs to determine what portion of its receivables is collectible. The portion that a company believes is uncollectible is what is called “bad debt expense.” The two methods of recording bad debt are 1) direct write-off method and 2) allowance method.

Bad Debt Direct Write-Off Method

The method involves a direct write-off to the receivables account. 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. We will demonstrate how to record the journal entries of bad debt using MS Excel.

Bad Debt Allowance Method

When it comes to large material amounts, the allowance method is preferred compared to the direct write-off method. However, many companies still use the direct write-off for small amounts. The reason for the preference is because the method involves a contra asset account that goes against accounts receivables. A contra asset account is basically an account with an opposite balance to accounts receivables and is recorded on the balance sheet as such:

The reason why this contra account is important is that it exerts no effect on the income statement accounts. It means, under this method, bad debt expense does not necessarily serve as a direct loss that goes against revenues.

The three primary components of the allowance method are as follows:

1. Estimate uncollectible receivables.
2. Record the journal entry by debiting bad debt expense and crediting allowance for doubtful accounts.
3. When you decide to write off an account, debit allowance for doubtful accounts and credit the corresponding receivables account.

Sometimes, people or businesses pay back the amount but at a later date, which means that you need to reverse the write off you made and record the collection of the receivables. It would involve the following entry:

How to Estimate Accounts Receivables

As mentioned earlier in our article, the amount of receivables that is uncollectible is usually estimated. Why? This is because it is hard, almost impossible, to estimate a specific value of bad debt expense. Companies cannot control how or when people pay. Sometimes people encounter hardships and are unable to meet their payment obligations, in which case they default. The same thing happens to companies as well. Therefore, there is no guaranteed way to find a specific value of bad debt expense, which is why we estimate it within reasonable parameters.

The two methods used in estimating bad debt expense are 1) Percentage of sales and 2) Percentage of receivables.

1. Percentage of Sales

Percentage of sales involves determining what percentage of net credit sales or total credit sales is uncollectible. It is usually determined by past experience and anticipated credit policy. Once management calculates the percentage, they multiply it by their net credit sales or total credit sales to determine bad debt expense. Here’s an example:

On March 31, 2017, Corporate Finance Institute reported net credit sales of $1,000,000. Using the percentage of sales method, they estimated that 1% of their credit sales would be uncollectible.

As you can see, $10,000 ($1,000,000 * 0.01) is determined to be the bad debt expense that management estimates to incur.

2. Percentage of Receivables

Under the percentage of receivables method of estimating bad debt expense, companies prepare an aging schedule, as shown below:

Again, the percentages are determined by past experience and past data. The most important part of the aging schedule is the number highlighted in yellow. It represents the amount that is required to be in the allowance of doubtful accounts. However, if there is already a credit balance existing in the allowance of doubtful accounts, then we only need to adjust it. For example, let’s assume that there was a $100 credit already existing in the allowance account. In order to record the adjustment, we simply take the $372 and subtract the $100, giving us $272 and we record it as follows:

What if, instead of a credit balance in the allowance account, we posted a debit balance prior to the adjustment? Well, in this case, we would simply add. For example, let’s say there was a $175 debit existing in the allowance account. In order to record the adjustment, we simply take the $372 and add the $175 to get $547 and we record it as follows:

Importance of Bad Debt Expense

Every fiscal year or quarter, companies prepare financial statements. The financial statements are viewed by investors and potential investors, and they need to be reliable and must possess integrity. Investors are putting their hard-earned money into the company and if companies are not providing truthful financial statements, it means that they are cheating investors into placing money into their company based on false information.

Bad debt expense is something that must be recorded and accounted for every time a company prepares its financial statements. When a company decides to leave it out, they overstate their assets and they could even overstate their net income.

Bad debt expense also helps companies identify which customers default on payments more often than others. If a company does decide to use a loyalty system or a credibility system, they can use the information from the bad debt accounts to identify which customers are creditworthy and offer them discounts for their timely payments.

Learn More

If you think you have mastered bad debt expense and how to record it, make sure to check out these related articles to get a deeper understanding of other accounting concepts:

The term bad debt refers to an amount of money that a creditor must write off as a result of a default on the part of the debtor. If a creditor has a bad debt on the books, it becomes uncollectible and is recorded as a charge-off. Bad debt is a contingency that must be accounted for by all businesses that extend credit to customers, as there is always a risk that payment won't be collected. These entities can estimate how much of their receivables may become uncollectible by using either the accounts receivable (AR) aging method or the percentage of sales method.

• Bad debt refers to loans or outstanding balances owed that are no longer deemed recoverable and must be written off.
• Incurring bad debt is part of the cost of doing business with customers, as there is always some default risk that is associated with extending credit.
• To comply with the matching principle, bad debt expense must be estimated using the allowance method in the same period in which the sale occurs.
• There are two main ways to estimate an allowance for bad debts: the percentage sales method and the accounts receivable aging method.
• Bad debts can be written off on both business and individual tax returns.

Bad debt is any credit advanced by any lender to a debtor that shows no promise of ever being collected, either partially or in full. Any lender can have bad debt on their books, whether that's a bank or other financial institution, a supplier, or a vendor.

Bad debts end up as such because the debtor can't or refuses to pay because of bankruptcy, financial difficulty, or negligence. These entities may exhaust every possible avenue to collect on bad debts before deeming them uncollectible, including collection activity and legal action.

Businesses must account for bad debt expenses using one of two methods. The first is the direct write-off method, which involves writing off accounts when they are identified as uncollectible. While this method records the precise figure for accounts determined to be uncollectible, it fails to adhere to the matching principle used in accrual accounting and generally accepted accounting principles (GAAP).

The second is the matching principle, which requires that expenses be matched to related revenues in the same accounting period they are generated. Bad debt expense must be estimated using the allowance method in the same period and appears on the income statement under the sales and general administrative expense section. Since a company can't predict which accounts will end up in default, it establishes an amount based on an anticipated figure. In this case, historical experience helps estimate the percentage of money expected to become bad debt.

The direct write-off method is used in the United States for income tax purposes.

The Internal Revenue Service (IRS) allows businesses to write off bad debt on Schedule C of tax Form 1040 if they previously reported it as income. Bad debt may include loans to clients and suppliers, credit sales to customers, and business-loan guarantees. However, deductible bad debt does not typically include unpaid rents, salaries, or fees.

For example, a food distributor that delivers a shipment to a restaurant on credit in December will record the sale as income on its tax return for that year. But if the restaurant goes out of business in January and does not pay the invoice, the food distributor can write off the unpaid bill as a bad debt on its tax return in the following year.

Individuals are also able to deduct a bad debt from their taxable income if they previously included the amount in their income or loaned out cash and can prove that they intended to make a loan at the time of the transaction and not a gift. The IRS classifies non-business bad debt as short-term capital losses.

The term bad debt can also be used to describe debts that are taken to pay for goods that don't appreciate. In other words, bad debt is a form of borrowing that doesn't help your bottom line. In this sense, bad debt is in contrast to good debt, which an individual or company takes out to help generate income or increase their overall net worth.

Recording bad debt involves a debit and a credit entry. Here's how it's done:

The allowance for doubtful accounts nets against the total AR presented on the balance sheet to reflect only the amount estimated to be collectible. This allowance accumulates across accounting periods and may be adjusted based on the balance in the account.

Payments received later for bad debts that have already been written off are booked as bad debt recovery.

We've established that bad debts must be recorded. But what amounts are listed on corporate financial statements? This involves estimating uncollectible balances using one of two methods. This can be done through statistical modeling or an AR aging method, or through a percentage of net sales. We've highlighted the basics of each below.

The AR 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. This method determines the expected losses to delinquent and bad debt by using a company's historical data and data from the industry as a whole. The specific percentage typically increases as the age of the receivable increases, to reflect increasing default risk and decreasing collectibility.

Let's say a company has $70,000 of accounts receivable less than 30 days outstanding and $30,000 of accounts receivable more than 30 days outstanding. Based on previous experience, 1% of AR less than 30 days old will not be collectible and 4% of AR at least 30 days old will be uncollectible.

This means the company must report an allowance and bad debt expense of $1,900. This is calculated as:

($70,000 x 1%) + ($30,000 x 4%)

If the next accounting period results in an estimated allowance of $2,500 based on outstanding accounts receivable, only $600 ($2,500 - $1,900) will be the bad debt expense in the second period.

A bad debt expense can be estimated by taking a percentage of net sales, based on the company’s historical experience with bad debt. This method applies a flat percentage to the total dollar amount of sales for the period. Companies regularly make changes to the allowance for doubtful accounts, so that they correspond with the current statistical modeling allowances.

Using the example above, let's say a company expects 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. The aggregate balance in the allowance for doubtful accounts after these two periods is $5,400.