For the income statement, using the allowance method helps the company to have better matching of the period which the revenue earns and the period which bad debt expense incurs. Hence, making journal entry of bad debt expense this way conforms with the matching principle of accounting. Properly making journal entry for bad debt expense can help the company to have a more realistic view of its net profit as well as making total assets reflect its actual economic value better. This is due to the value of accounts receivable in the balance sheet should state at the cash realizable value and the period that expense incurs should match with the time that revenue earns. If the account has an existing credit balance of $400, the adjusting entry includes a $4,600 debit to bad debts expense and a $4,600 credit to allowance for bad debts. Another way sellers apply the allowance method of recording bad debts expense is by using the percentage of credit sales approach.
- If the corporation prepares weekly financial statements, it might focus on the bad debts expense for its weekly financial statements, but at the end of each quarter focus on the allowance account.
- For instance, the company may have a policy to (Based on past trends) provide 30% on balance overdue from days and 50% on balance due 90 plus days.
- Under the direct write-off method, the company records the journal entry for bad debt expense by debiting bad debt expense and crediting accounts receivable.
- Further, providing an allowance is in line with the prudence concept of accounting, which suggests early recording of an expense and delay in recording the income.
- Next, let’s assume that the corporation focuses on the bad debts expense.
The bad debt expense is then the difference between the calculated allowance for doubtful accounts at the end of the account period and the current allowance for doubtful accounts before adjustment. It’s important to note that the creation of allowance in the balance sheet requires recording expenses in the income statement. However, once allowance exists in the balance sheet, it can be used to remove receivables without affecting the income statement. The historical bad debt experience of a company has been 3% of sales, and the current month’s sales are $1,000,000. Based on this information, the bad debt reserve to be set aside is $30,000 (calculated as $1,000,000 x 3%). In the following month, $20,000 of the accounts receivable are written off, leaving $10,000 of the reserve still available for additional write-offs.
Since we had $2,000 in the opening and the required estimate for the allowance was $12,000. Further, providing an allowance is in line with the prudence concept of accounting, which suggests early recording of an expense and delay in recording the income. Let’s assume that a corporation begins operations on November 1 in an industry where it the real estate proforma is common to give credit terms of net 30 days. In this industry approximately 0.3% of credit sales will not be collected. Compared to the direct write-off method, the allowance method is preferred because of its usefulness and applicability. Furthermore, this is called an income statement or statement of the comprehensive income approach.
Percentage of Receivables Method
Based on past experiences and its credit policy, the company estimates that 1% of credit sales which is USD 18,500 will be uncollectible. Besides, when it comes to creating an allowance, the organization creates a reserve account, and the amount for the bad debts nets off against that reserve. An allowance account is a contra account for the assets; the amount is recorded in this contra account to offset overstated debtors that the business cannot collect. Moreover, the following treatment is made to record the bad debt expense under the direct method. Over time since an invoice was written off, a customer may unexpectedly pay an invoice. In such a case, the process is reversed, and accounts receivable are reinstated to be treated like a normal debtor collection.
The amount used will be the ESTIMATED amount calculated using sales or accounts receivable. In order to use the allowance method, it is first necessary to estimate the allowance needed using a suitable method. The entry has reinstated the customer balance, and now we need to record the cash receipt. It’s important to note that we have assumed the opening allowance for the bad debt as zero in the above entry. U.S GAAP leaves it up to the company to determine how they want to implement the allowance method. On the other hand, writing off through the allowance method helps to locate the creation of provision, use of the provision, reversal, etc.
Recovery of Account under Allowance Method
Later entries for the write-off just make adjustments in the balance sheet, and the net impact of the presentation remains the same. The accounts receivable method for the allowance calculation is more sophisticated and uses the aging report to assess the amount for the allowance. For instance, the company may have a policy to (Based on past trends) provide 30% on balance overdue from days and 50% on balance due 90 plus days. If the corporation prepares weekly financial statements, it might focus on the bad debts expense for its weekly financial statements, but at the end of each quarter focus on the allowance account. When the organization’s financial statements are finalized, these expenses are reviewed by the higher management to understand the financial reporting process better and control the business’s credit aspects. The process is also encouraged by the prudence concept of accounting, as bad debt expense is recorded before the actual write-off.
Under the allowance method, the company’s management needs to assess the percentage of the uncollectible amount. However, GAAP and IFRS have issued guidance, and the management needs to assess expected loss to be recorded in the balance sheet. So, when it’s time to make a write-off, we can use allowance without affecting the business’s income statement, and the entry will only impact the balance sheet. The alternative to the allowance method is the direct write-off method, under which bad debts are only written off when specific receivables cannot be collected. This may not occur until several months after a sale transaction was completed, so the entire profitability of a sale may not be apparent for some time. The direct write-off method is a less theoretically correct approach to dealing with bad debts, since it does not match revenues with all applicable expenses in a single reporting period.
Accounting aspects for write off
On August 24, that same customer informs Gem Merchandise Co. that it has filed for bankruptcy. It also states that the liquidation value of those assets is less than the amount it owes the bank, and as a result Gem will receive nothing toward its $1,400 accounts receivable. After confirming this information, Gem concludes that it should remove, or write off, the customer’s account balance of $1,400. 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.
However, there is a difference between allowance creation and a direct write-off. From a control perspective, the use of the direct method can be a little risky, it’s because if there are no sound controls manager might write off balances in a personal capacity. Similarly, an account receivable is credited when writing off a specific balance. Sometimes, the direct write-off for the account balance does not seem logical as the business may be unable to locate which debtor should be written off. Let’s try and make accounts receivable more relevant or understandable using an actual company.
Bad Debt Expense Journal Entry
Later, when a specific account receivable is actually written off as uncollectible, the company debits Allowance for Doubtful Accounts and credits Accounts Receivable. Companies that use the percentage of credit sales method base the adjusting entry solely on total credit sales and ignore any existing balance in the allowance for bad debts account. If estimates fail to match actual bad debts, the percentage rate used to estimate bad debts is adjusted on future estimates. The mechanics of the allowance method are that the initial entry is a debit to bad debt expense and a credit to the allowance for doubtful accounts (which increases the reserve). The allowance is a contra account, which means that it is paired with and offsets the accounts receivable account. When a specific bad debt is identified, the allowance for doubtful accounts is debited (which reduces the reserve) and the accounts receivable account is credited (which reduces the receivable asset).
However, if an unexpected collection is made, the account balance is reinstated by the recreation of the consumed allowance. Under the direct write-off method, the company records the journal entry for bad debt expense by debiting bad debt expense and crediting accounts receivable. If the allowance for bad debts account had a $300 credit balance instead of a $200 debit balance, a $4,700 adjusting entry would be needed to give the account a credit balance of $5,000. So, management needs to analyze the individual party balances with the help of an aging statement. This helps decide if a specific balance should be presented as a net debtor in the balance sheet for the accounting period or if an allowance should be created against it. Although, the number of days passed since invoice overdue is an essential factor in determining if a specific balance should be written down.
What is the Allowance Method?
The seller’s accounting records now show that the account receivable was paid, making it more likely that the seller might do future business with this customer. And with this, the total amount of uncollectable accounts appears in the reserve account for financial reporting purposes. When it comes to the direct write-off method, all the bad debts of the organizations are charged to the expense account. An alternate way is to provide an allowance based on the debtor’s balance.
The reserve is created opposite to the assets to record the amount required for doubtful debtors. Later, the allowance for doubtful accounts is used instead of bad debt expense to offset losses resulting from nonpayment from customers. Frequently the allowance is estimated as a percentage of the outstanding receivables. Management establishes a percentage relationship between the amount of receivables and expected losses from uncollectible accounts. Companies often prepare a schedule in which customer balances are classified by the length of time they have been unpaid.
This approach automatically expenses a percentage of its credit sales based on past history. The bad debt expense for the accounting period is recorded with the following percentage of accounts receivable method journal entry. The previous allowance method directly estimated the bad debt expense based on the credit sales recorded on the income statement of the business.
Under the allowance method, every bad debt write-off is debited to the allowance account (not to Bad Debt Expense) and credited to the appropriate Account Receivable. Unlike the allowance method, the company only records bad debt expense when they determine a particular account to be uncollectible. And as the name suggested, bad debt expense will only show up when the company decides to write off any particular accounts. With the allowance method, allowance for doubtful accounts is recognized in the balance sheet as the contra account to receivables. This would ensure that the company states its accounts receivable on the balance sheet at their cash realizable value. The company usually uses the allowance method to account for bad debt expense as it excludes the accounts receivable that are unlikely to be recoverable in the report.
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. However, at some later date, the balance in the allowance account must be reviewed and perhaps further adjusted, so that the balance sheet will report the correct net realizable value. If the seller is a new company, it might calculate its bad debts expense by using an industry average until it develops its own experience rate. Net realizable value is the amount the company expects to collect from accounts receivable.