No matter how careful any business is in extending credit, there will always be some customers that will not pay their bills. This bad debt must be written off by the business as a loss and a reduction in its accounts receivables and as an added expense since the debt will not be collected. The Generally Accepted Accounting Principles (GAAP) allowance method allows companies to estimate and write off their bad debts. According to Michael C. Dennis, MBA, CBF, “Under the allowance method bad debts are estimated and recorded to match revenues and expenses in a given period – satisfying the matching principle.”
Use the GAAP allowance method based on a percentage of sales to estimate the amount of bad debt that will be uncollectible during the current fiscal year. This income statement approach is very easy to calculate. Take the company's current year’s sales and multiply this figure by the firm's historical rate of uncollectible debt. For example, assume that the company’s sales during the current year equal $2,500,000 and its historical average for uncollectible accounts for bad debt is 3 percent of total sales per year. You would then multiply the current year’s sales by the estimated amount of uncollectible debt: $2,500,000 x 3% = $75,000.
Estimate the amount of bad debt for the current fiscal year by using a percentage of total receivables. This is the balance sheet approach. Some companies assume that a certain historical or industry percentage of outstanding receivables will be uncollectible. If a company realizes that historically it has not been able to collect 6 percent of its outstanding receivables, it will use this percentage for the current year estimate as well. For example, if a company’s current receivables equal $425,000 and its historical average of uncollectible bad debt is 6 percent, then the firm would multiply the current receivables by the historical average of uncollectible bad debt: 6% x $425,000 = $25,000.
Use the aging analysis of accounts receivable method (also known as the balance sheet approach) to estimate how much bad debt will be uncollectible during the current fiscal year. This GAAP accounting method is considered more sophisticated and accurate than the percentage of receivables approach. Under this allowance method, a company applies different percentages based on past experience for various aging categories. For example, a company assumes the following: 0-30 days past due current accounts receivables = $50,000 and the historical average for uncollectible debt for this period is 5 percent. Then the amount of uncollectible debt for this period would be $2,500: $50,000 x 5% = $2,500. For accounts that are 31-60 days past due with current accounts receivables = $40,000 and the historical average for uncollectible debt for this period is 5 percent, then the amount of uncollectible debt for this period would be $2,000: $40,000 x 5% = $2,000. For accounts that are 61-90 days past due (current accounts receivables = $2,650 and the historical average for uncollectible debt for this period is 10 percent, then the amount of uncollectible debt for this period would be $265: $2,650 x 10% = $265. The total estimated amount for uncollectible bad debt for the current year would be $4,765: $2,500 + $2,000 + $265 = $4,765.
Record the estimated uncollectible accounts expense. This is the estimated uncollectible bad debts for the current year. The company would establish the related allowance for uncollectible accounts (this asset account will offset the accounts receivable balance) in a ledger. Once the company has estimated the amount of bad debt that it will be unable to collect for the current year, by using either the percentage of sales, percentage of accounts receivables or aging analysis of accounts receivable method, the company must log this information into a journal. The company would simply take the estimated bad debt and debit the amount to the uncollectible accounts expense and credit the allowance for uncollectible accounts. For example, assume that the company estimated that it would not be able to collect $10,000 owed for the current year; the journal entry would look like this:
Uncollectible Accounts Expense -- $10,000 (Debit)
Allowance for Uncollectible Accounts -- $10,000 (Credit).
Write off an individual account that has been deemed uncollectible. Once a company has proven that it will definitely not be able to collect the money owed by an individual debtor, it will have to write off the amount owed in a journal. In this case the amount to be written off is not an estimate but has been proven to be uncollectible. The company would credit the allowance for uncollectible accounts and debit the accounts receivable. For example, if a particular debtor owed $1,500 and could not pay it back during the current fiscal year, the journal entry would look like this:
Allowance for Uncollectible Accounts --$1,500 (Debit)
Accounts Receivables -- $1,500 (Credit).
This write-off entry reduces both the allowance for uncollectible accounts and the related accounts receivables and has no impact on the income statement. It also has no impact on the net realized value (NRV) of receivables -- the amount of money deemed collectible after a company has estimated how much money will be uncollectible: accounts receivables = estimated uncollectible bad debts. For example, if accounts receivables = $200,000 and the allowance for uncollectible accounts = $20,000 before the write-off, then the NRV would be $180,000: $200,000 - $20,000 = $180,000. If $1,500 was then written off as uncollectible, then the NRV would still be $180,000 because the company would reduce both accounts receivables by $1,500 ($200,000 - $1,500 = $198,500) and the allowance for uncollectible accounts by $1,500 ($20,000 - $1,500 = $18,500; $198,500 - $18,500 = $180,000).
Reverse the write-off entry if a total or part of the debt that was written off was recovered and record the cash that was collected. Sometimes a company is able to collect on an account that was previously written off. In this case an entry must be recorded to show the recovery. This process involves two steps: (1) Reverse the write-off entry and (2) record the cash collection on the account. For example, if $1,000 was collected on a previous write-off, then the company would reverse the entry recorded at the time of the write-off. In this case accounts receivables would be credited, and the allowance for uncollectible accounts would be debited:
Account Receivables -- $1,000 (Debit)
Allowance for Uncollectible Accounts -- $1,000 (Credit).
The company would then record the cash it had collected by debiting cash and crediting accounts receivables.
Cash -- $1,000 (Debit) Account Receivables -- $1,000 (Credit)
In these entries it may seem that the allowance for uncollectible accounts is being increased, but it is assumed that another account may prove to be uncollectible in the future so the overall estimate for uncollectible bad debts will stay the same.
In order to minimize losses a company should extend credit only after proper references and credit scores have been obtained and analyzed.
The longer a receivable is past due, the less likely the chances of collection.