If you sell to customers on credit terms, you will eventually have some customers not pay their invoices, and you have to absorb a loss. These uncollectible receivables are recorded as bad debt on the income statement of the company. A company has two ways to report credit losses: the direct write-off method and the allowance method.
As an example, you can see how recording bad debt affects a financial statement by examining the statements of the Hasty Hare Corporation, a manufacturer of sneakers for rabbits.
TL;DR (Too Long; Didn't Read)
Bad debts get recorded on a company's income statement.
The Direct Write-off Method
Under the direct write-off method, you charge an unpaid invoice directly to the bad debt expense account on the profit and loss statement when it becomes obvious that a specific customer will not pay.
For instance, suppose Hasty Hare had a customer, Ace Retail Shoes, who owed $1,800. After the account had gone 180 days past due, the lawyers for Ace notified Hasty Hare that Ace had declared bankruptcy, and the debt was uncollectible. Hasty Hare would record that $1,800 as a bad debt expense in its current monthly profit and loss statement.
The problem with this method is that it violates the accounting principle that requires that expenses be matched with the related revenues in the same accounting period. The sale to Ace Retail Shoes would have been recorded almost a year before the bad debt was charged to the income statement, distinctly different accounting periods.
The Allowance Method
With the allowance method, an estimated amount of bad debt expense is recorded in the same period as sales are made. The idea is that a certain amount of bad debt can be expected for a given amount of sales based on historical data.
This amount of projected bad debt is recorded to an expense account on the profit and loss statement and added to "allowance for doubtful accounts" on the balance sheet.
How to Estimate an Allowance for Bad Debts
The two ways to estimate an allowance for bad debts are the percentage of sales method and the accounts receivable aging method.
Percentage of sales method: Suppose Hasty Hare had sales of $150,000 in a month. Historically, the company's accountants project that 2% of the credit sales will not be collected. Accordingly, they enter a bad debt expense of $3,000 on the company's monthly financial statement and add the same amount to the “allowance for doubtful accounts” on the balance sheet.
Accounts receivable aging method: This method is based on an evaluation of the collectibility of accounts receivable. Assume Hasty Hare has current receivables of $140,000 of which $120,000 is due within 30 days and $20,000 is outstanding for more than 30 days. An estimate of projected bad debt loss might be 1% of the current amount, $1,200, and 3% of the amount over 30 days, $600, for a total of $1,800.
How to Record Bad Debt Expense and Allowance for Doubtful Accounts
Under the allowance for doubtful accounts method, bad debt expense is recorded based on monthly sales. The monthly bad debt expense is added to the allowance for doubtful accounts as a contra account to accounts receivable.
Suppose Hasty Hare had current accounts receivable of $160,000 and an allowance for doubtful accounts balance of $12,000. This results in net receivables of $148,000.
The bad debt expense formula to record the $1,800 loss from Ace Retail Shoes under the allowance method requires two journal entries. You make a journal entry to reduce accounts receivable to $158,200 and another entry to reduce the allowance for doubtful accounts to $10,200. Notice that after these journal entries, the net accounts receivable remains at $148,000. The profit and loss statement is unaffected by these entries.
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