Bad Debt Expense vs Allowance for Doubtful Accounts

Use the percentage of bad debts you had in the previous accounting period to help determine your bad debt reserve. At the time revenue is recorded, a company does not yet know which accounts will prove to be uncollectible. We don’t want to record any reduction in the Accounts Receivable account so we use a related contra account called Allowance for Doubtful Accounts or Allowance for Uncollectible Accounts to track the estimate. By using the contra account, we can preserve the true Accounts Receivable balance while also recognizing that some portion of that balance is overvalued because of potential bad debt. For the percentage of receivables method, we use the balance of the accounts receivable at the end of the period to determine the estimated amount of the ending balance of the allowance for doubtful accounts. This method is usually referred to as the balance sheet approach as we use the balance sheet item (e.g. accounts receivable) as the base of our calculation.

• Note that some authors and companies may refer to the allowance account as Allowance for Uncollectible Expense, Allowance for Bad Debts or Provision for Bad Debts.
• For example, if last year your accounts receivable balance was $40,000, and you had $4,000 in bad debt, you could use this information to predict bad debt totals for the current year.
• Bad debts expense refers to the portion of credit sales that the company estimates as non-collectible.

Assume a company has $230,000 of accounts receivable at the end of its accounting year. Its Allowance for Doubtful Accounts (before any further adjustment) has a credit balance of $10,000. At this point, the company’s balance sheet will report that the company will collect the net amount of $220,000. However, the credit manager’s recent review indicates that the company will not be collecting a total of $25,000 of the accounts receivable. Doubtful accounts represent the amount of money deemed to be uncollectible by a vendor. Adding an allowance for doubtful accounts to a company’s balance sheet is particularly important because it allows a company’s management to get a more accurate picture of its total assets.

Example of Writing off an Account

Allowance for bad debts (or allowance for doubtful accounts) is a contra-asset account presented as a deduction from accounts receivable. The allowance for doubtful accounts is paired with and offsets accounts receivable. It represents management’s best estimate of the amount of accounts receivable wave payroll review 2021 that will not be paid by customers. When the allowance is subtracted from accounts receivable, the remainder is the total amount of receivables that a business actually expects to collect. Actual results may vary from management’s expectations for accounts receivable collections.

The above journal entry signifies an increase in the company’s cash and a decrease in its account receivable since the customer has fulfil their obligation by paying off their debt. This entry directly reduces the accounts receivable balance while recognizing an expense for the uncollected amount. Tracking bad debt vs. doubtful debt allows businesses to directly write-off confirmed losses from non-payments while reserving funds through the allowance for probable future write-offs from existing receivables. Understanding the nuances between bad debt expense and allowance for doubtful accounts is a common accounting challenge. The Pareto analysis method is a statistical method where those customers are identified who contributes to the majority of debts and helps to focus the collection efforts on those customers to reduce the bad debt expenses.

• If you’re using the accrual method of accounting, you should be using the allowance for doubtful accounts in your business.
• Doubtful accounts are considered to be a contra account, meaning an account that reflects a zero or credit balance.
• For example, a category might consist of accounts receivable that is 0–30 days past due and is assigned an uncollectible percentage of 6%.
• Then, it aggregates all receivables in each grouping, calculates each group by the percentage, and records an allowance equal to the aggregate of all products.
• If he is expected to pay for the purchase before April 21, 2023, then CalvinKlien will make the following journal entry at the time of the purchase.

Similarly, the income statement should report all revenues that have been earned—not just the revenues that have been billed. After further review, it is learned that $3,000 of work has been performed (and therefore has been earned) as of December 31 but won’t be billed until January 10. Because this $3,000 was earned in December, it must be entered and reported on the financial statements for December. An adjusting entry dated December 31 is prepared in order to get this information onto the December financial statements. We can use the accounts receivable aging report to determine the allowance for doubtful accounts by applying different percentages on each balance of accounts receivable classified by the number of days overdue. The applied percentages are usually based on our experiences in business as well as the available industry data (e.g. industry average of customer default) that is publicly obtainable.

Doubtful Accounts – Journal Entry

The income statement account Supplies Expense has been increased by the $375 adjusting entry. It is assumed that the decrease in the supplies on hand means that the supplies have been used during the current accounting period. The balance in Supplies Expense will increase during the year as the account is debited. The balance in the asset Supplies at the end of the accounting year will carry over to the next accounting year.

Methods for estimating allowance for doubtful accounts

As a small business owner, you take a giant leap of faith every time you extend credit to your customers. Even with the most stringent analysis of a customer’s ability to pay, there’s going to be a time when a customer (or two) doesn’t pay what they owe. These percentages are multiplied by total sales in each customer category, then the resulting three separate dollar amounts are added up and converted to a percentage based on the total sales amount. Companies use a double-entry accounting system to record the allowance for doubtful accounts. When the age of accounts varies significantly or inconsistent payment histories are present, using the age-based estimation method to manage accounts may not be effective. Companies typically use historical data, industry trends, and their experience with individual customers to make this estimate.

Companies create an allowance for doubtful accounts to recognize the possibility of uncollectible debts and to comply with the matching principle of accounting. After figuring out which method you’ll use, you can create the account in the chart of accounts. As a result, the estimated allowance for doubtful accounts for the high-risk group is $25,000 ($500,000 x 5%), while it’s $15,000 ($1,500,000 x 1%) for the low-risk group. Thus, the total allowance for doubtful accounts is $40,000 ($25,000 + $15,000).

Why is the Direct Write-off Method Unacceptable Under GAAP?

The company would then record a journal entry at the end of the accounting period that includes a debit to the bad debt expense account for $3,000 and a credit to the allowance for doubtful accounts for $3,000. 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.

The revenue of $10,000 and the expense of $5,000 should be reported in June, the month when the revenue is reported as earned. Companies use either the Direct Write-off Method or the Allowance Method for managing bad debts. This infographic shows how to determine the journal entries needed based on the method chosen. Careful monitoring of the allowance account enables businesses to fine-tune their bad debt policies and evaluate the realizable value of receivables. Integrating these analyses into financial reporting and projections can improve accuracy. The allowance for doubtful accounts is a contra-asset account that nets against total accounts receivable to estimate the amount that will ultimately be uncollectible.

Let’s assume that a review of the accounts receivables indicates that approximately $600 of the receivables will not be collectible. This means that the balance in Allowance for Doubtful Accounts should be reported as a $600 credit balance instead of the preliminary balance of $0. The two accounts involved will be the balance sheet account Allowance for Doubtful Accounts and the income statement account Bad Debts Expense.

Later, if a customer fails to pay their account balance and the company deems the account uncollectible, they would record another journal entry to write off the bad debt. The customer owes $500, and the company writes off the debt as uncollectible. Contra assets are accounts used to reduce the value of a related asset account on the balance sheet. They are recorded with a credit balance, opposite to asset accounts’ normal debit balance. The allowance method is the more widely used method because it satisfies the matching principle.