The bad debt expense account is the account that shows the amount of uncollectible accounts receivable that have occurred in a given accounting period. Because funds that are expected to be collected but end up as uncollectible become expenses to the company. Next, let’s assume that the corporation focuses on the bad debts expense. As a result, https://www.quick-bookkeeping.net/how-to-record-a-loan-to-your-business-in/ its November income statement will be matching $2,400 of bad debts expense with the credit sales of $800,000. If the balance in Accounts Receivable is $800,000 as of November 30, the corporation will report Accounts Receivable (net) of $797,600. Let’s look at how the first example we talked about earlier is recorded in your accounting records.

All categories of estimated uncollectible amounts are summed to get a total estimated uncollectible balance. That total is reported in Bad Debt Expense and Allowance for Doubtful Accounts, if there is no carryover balance from a prior period. If there is a carryover balance, that must be considered before recording Bad Debt Expense. The balance sheet aging of receivables method is more complicated than the other two methods, but it tends to produce more accurate results. This is because it considers the amount of time that accounts receivable has been owed, and it assumes that the longer the time owed, the greater the possibility that individual accounts receivable will prove to be uncollectible. The bad debt expense account is debited for the amount of the allowance, and the allowance for doubtful accounts is credited in the same amount.

The aggregate of all group results is the estimated uncollectible amount. If your answer is to debit the bad debt expense account in the amount of $125.74 and credit the allowance for doubtful accounts account in the same amount, then you’re exactly correct. Each time that a credit sale is made, the balance in the account receivable account increases. The balance represents the amount of money that the company expects to receive from its credit customers. So, when a customer doesn’t pay, then obviously, the balance in that customer account won’t be collected. As of January 1, 2018, GAAP requires a change in how health-care entities record bad debt expense.

What Is an Allowance for Doubtful Accounts?

When a company sells on credit, it is essentially lending the client the funds to purchase the goods. If the customer does not pay, then the company has a bad debt on its books. Let’s consider a situation where BWW had a $20,000 debit balance from the previous period. For example, a customer takes out a $15,000 car loan on August 1, 2018 and is expected to pay the amount in full before December 1, 2018.

Bad debt expense is an income statement account that is used to record client account balances deemed uncollectible by the accounting department. 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 the weekly entries.

The entry for bad debt would be as follows, if there was no carryover balance from the prior period. Because customers do not always keep their promises to pay, companies must provide for these uncollectible accounts in their records. The direct write-off method recognizes bad accounts as an expense at the point when judged to be uncollectible and is the required method for federal income tax purposes. The allowance method provides in advance for uncollectible accounts think of as setting aside money in a reserve account. The allowance method represents the accrual basis of accounting and is the accepted method to record uncollectible accounts for financial accounting purposes.

The direct write-off method is used only when we decide a customer will not pay. We do not record any estimates or use the Allowance for Doubtful Accounts under the direct write-off method. This method violates the GAAP matching principle of revenues and expenses recorded in the same period. 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. On March 31, 2017, Corporate Finance Institute reported net credit sales of $1,000,000.

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The first example is calculated using a percentage that is based on industry average. In that example, we calculated the expected amount of uncollectible accounts in the second quarter of year one of operation, based on the allowance method, to be $168. To record this, you debit the bad debt expense in the amount of $168 and credit the allowance for doubtful accounts in the same amount. The direct write-off method works by directly writing-off bad debt expenses from accounts receivable into the expense account.

When the firm makes the bad debts adjusting entry, it does not know which specific accounts will become uncollectible. Thus, the company cannot enter credits in either the Accounts Receivable control account or the customers’ accounts receivable subsidiary ledger accounts. If only one or the other were credited, freelance invoice template the Accounts Receivable control account balance would not agree with the total of the balances in the accounts receivable subsidiary ledger. Without crediting the Accounts Receivable control account, the allowance account lets the company show that some of its accounts receivable are probably uncollectible.

1. 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.
2. When a specific customer has been identified as an uncollectible account, the following journal entry would occur.
3. You record the allowance for doubtful accounts by debiting the Bad Debt Expense account and crediting the Allowance for Doubtful Accounts account.
4. This will cause accounts receivable to go down from $861,000 to $860,780 and the allowance for doubtful accounts to be reduced from $17,220 to $17,000; leaving the net realizable accounts receivable the same at $843,780.
5. However, the company is owed $90,000 and will still try to collect the entire $90,000 and not just the $85,200.
6. We use this estimate to record Bad Debt Expense and to setup a reserve account called Allowance for Doubtful Accounts (also called Allowance for Uncollectible Accounts) based on previous experience with past due accounts.

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. For example, a start-up customer may be considered a high risk, while an established, long-tenured customer may be a low risk.

How to Estimate the Allowance for Doubtful Accounts

For the past 52 years, Harold Averkamp (CPA, MBA) has worked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online.

Advantages of the Allowance Method

Since the business owner doesn’t know who will or will not pay, then they must estimate a reasonable dollar amount that won’t be collected in order to keep their accounting records as accurate as possible. If the company has been in operation for a little while, then they can reasonably decide the percentage of past accounts that were uncollectible. If not, then the rule of thumb is to use the industry average to calculate what dollar amount of uncollectible accounts can be reasonably estimated for each accounting period. Keep in mind, however, that the dollar amount calculated is simply an estimate of a future bad debt. Most companies use the allowance method, which is to estimate the amount of doubtful expense it expects.

During this tutorial, the account names allowance for doubtful accounts, allowance for bad debt, and allowance for uncollectible accounts will be used interchangeably. Allowance for Doubtful Accounts decreases (debit) and Accounts Receivable for the specific customer also decreases (credit). Allowance for doubtful accounts decreases because the bad debt amount is no longer unclear. Accounts receivable decreases because there is an assumption that no debt will be collected on the identified customer’s account. The two methods used in estimating bad debt expense are 1) Percentage of sales and 2) Percentage of receivables.