This method violates the GAAP matching principle of revenues and expenses recorded in the same period. And the estimates being made by these organizations are based on the number of sales being made for the reporting year. Creating reserves for credit sales in the same accounting period is a more logical approach that satisfies the matching concept of accounting.
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. 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. To illustrate, let’s continue to use Billie’s Watercraft Warehouse (BWW) as the example.
Double Entry Bookkeeping
Assuming that credit is not a significant component of its sales, these sellers can also use the direct write-off method. The companies that qualify for this exemption, however, are typically small and not major participants in the credit market. Thus, virtually all of the remaining bad debt expense material discussed here will be based on an allowance method that uses accrual accounting, the matching principle, and the revenue recognition rules under GAAP. The aging of accounts receivable method is another balance sheet approach and is a refinement of the percentage of accounts receivable method discussed above. The allowance method for accounting uses mechanics that consist of debiting bad debt expenses and crediting the allowance for doubtful accounts at the beginning of the process.
- Thus, virtually all of the remaining bad debt expense material discussed here will be based on an allowance method that uses accrual accounting, the matching principle, and the revenue recognition rules under GAAP.
- In this example, the $85,200 total is the net realizable value, or the amount of accounts anticipated to be collected.
- The allowance for doubtful accounts on the balance sheet is increased by credit journal entry.
- However, if the management has decided to write off some specific balance, there is a specific process of journal entries to be followed.
- However, GAAP and IFRS have issued guidance, and the management needs to assess expected loss to be recorded in the balance sheet.
The first entry reverses the bad debt write-off by increasing Accounts Receivable (debit) and decreasing Bad Debt Expense (credit) for the amount recovered. The second entry records the payment in full with Cash increasing (debit) and Accounts Receivable decreasing (credit) for the amount received of $15,000. The understanding is that the couple will make payments each month toward the principal borrowed, plus interest.
After writing off the bad account on August 24, the net realizable value of the accounts receivable is still $230,000 ($238,600 debit balance in Accounts Receivable and $8,600 credit balance in Allowance for Doubtful Accounts). 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.
Let’s consider that BWW had a $23,000 credit balance from the previous period. Since it may not be easy for the business to identify which parties will not pay their money back, they set up some general reserve in proportion to the credit sales during the period. The debit impact of the journal entry is the removal of the allowance from the accounting book. The credit side leads to eliminating the account balance not expected to be collected from customers.
Accounts Receivable and Bad Debts Expense Outline
However, if the management has decided to write off some specific balance, there is a specific process of journal entries to be followed. The outstanding balance of $2,000 that Craft did not repay will remain as bad debt. There is one more point about the use of the contra account, Allowance for Doubtful Accounts.
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. 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.
AccountingTools
However, excess allowance creation can significantly reduce the accounting profit, which can also be questioned. Completing the challenge below proves you are a human and gives you temporary access. All content on this website, including dictionary, thesaurus, literature, geography, and other reference data is for informational markets in financial instruments directive mifid ii purposes only. This information should not be considered complete, up to date, and is not intended to be used in place of a visit, consultation, or advice of a legal, medical, or any other professional. Textbook content produced by OpenStax is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike License .
The Bad Debts Expense remains at $10,000; it is not directly affected by the journal entry write-off. The bad debts expense recorded on June 30 and July 31 had anticipated a credit loss such as this. It would be double counting for Gem to record both an anticipated estimate of a credit loss and the actual credit loss.
Writing-off An Account Under Allowance Method (Guidance)
As mentioned earlier in our article, the amount of receivables that is uncollectible is usually estimated. This is because it is hard, almost impossible, to estimate a specific value of bad debt expense. Sometimes people encounter hardships and are unable to meet their payment obligations, in which case they default. Therefore, there is no guaranteed way to find a specific value of bad debt expense, which is why we estimate it within reasonable parameters. Bad Debt Expense increases (debit), and Allowance for Doubtful Accounts increases (credit) for $48,727.50 ($324,850 × 15%).
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. The financial statements are viewed by investors and potential investors, and they need to be reliable and must possess integrity. Bad Debt Expense increases (debit), and Allowance for Doubtful Accounts increases (credit) for $22,911.50 ($458,230 × 5%). Let’s say that on April 8, it was determined that Customer Robert Craft’s account was uncollectible in the amount of $5,000.
Balance Sheet Method for Calculating Bad Debt Expenses
This variance in treatment addresses taxpayers’ potential to manipulate when a bad debt is recognized. 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.
What is Bad Debt?
When we decide a customer will not pay the amount owed, we use the Allowance for Doubtful accounts to offset this loss instead of Bad Debt Expense. 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. An alternate way is to provide an allowance based on the debtor’s balance. It’s equally important to note that only a direct method of write-off is acceptable under the income tax reporting statute of the United States. It’s important to note that both methods aim to eliminate uncollectible debtors and present a true and fair view of the business.
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. 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. For the sake of this example, assume that there was no interest charged to the buyer because of the short-term nature or life of the loan. When the account defaults for nonpayment on December 1, the company would record the following journal entry to recognize bad debt.