Many businesses try to accommodate their customers by extending them credit. Occasionally, a customer may abuse the privilege by failing to pay his bill. The way a company accounts for bad debts depends on whether it uses cash-basis or accrual-basis accounting.

Direct Method

If you use the cash accounting method, you don’t recognize expenses until you pay them. Cash-based businesses use the direct method to write off bad debts. When you decide that an account is uncollectable, debit bad debt expense and credit accounts receivable for the amount written off. The problem with the direct method is that it doesn’t match an expense to the period in which you incur it. This gives a distorted picture of the net profits for a period. To observe the matching principle, you must perform accrual accounting and use bad debt allowance accounts.

Allowance Method

An allowance for bad debt is your estimate for debt you’ll have to write off in the upcoming period. The allowance is a contra-asset account linked to accounts receivable. At the beginning of the period, you credit your bad debt estimate to the allowance account and debit an equal amount to bad debt expense. In this way, you recognize the loss up front, during the period in which you expect the loss to occur. Your estimate of the period’s debt may differ from your actual experience, but you can make an adjustment at any time.

Write-Offs

When you write off a debt, debit the bad debt allowance account and credit accounts receivable for the loss. This simply shifts the loss from anticipated to real. The write-off doesn’t create a new expense, since you already recognized the expense at the beginning of the period. If your write-off exceeds the amount posted in the allowance account, you’ll wind up with a negative allowance -- that is, a debit balance. To remedy this, you can enter an additional transaction to further debit bad debt expense and credit bad debt allowance. If you find you consistently need to do this, you might want to increase your initial bad debt estimate at the beginning of the period.

Example

Neptune Hats, a retail store selling waterproof headgear, has projected quarterly credit sales of $100,000. The store’s policy is to set aside 2 percent of sales as an allowance for bad debts. On July 1, it debits bad debt expense and credits bad debt allowance for $2,000. On August 15, a customer with a $2,500 balance due declares bankruptcy, and the store decides to write off the debt. It posts a $2,500 debit to bad debt allowance and credits the same amount to accounts receivable. This leaves a $500 debit balance in the allowance account, which the store remedies on August 16 by debiting bad debt expense and crediting bad debt allowance for $1,000, giving a $500 credit balance to the allowance account.