It's an inevitable reality that not all customers will pay down their account balances. To account for this lost income, businesses record bad debt expense on a periodic basis. The balance-sheet approach to bad debts expresses uncollectible accounts as a percentage of accounts receivable. The difference between the current balance of allowance for doubtful accounts and the amount calculated using the balance sheet approach is the amount of bad debt expense for the period.
There are two primary methods for estimating bad-debt expense. The first is an income-statement approach that measures bad debt as a percentage of sales. The second is a balance-sheet approach that measures uncollectibles as a percentage of ending accounts receivable. Under the balance-sheet approach, the company looks at historical data and estimates what percentage of receivables ends up being uncollectible. For example, if the company writes off an average of $5,000 in a year and ending receivables average $1 million, the company estimates uncollectible accounts at 5 percent of receivables.
If you don't want to simply measure debt as a percentage of ending accounts receivable, you can make a more nuanced calculation through the aging of receivables method. This is still a balance-sheet approach to bad debt expense, but the receivables are first refined by age and then percentages are assigned. The logic is that a customer with an old debt is more likely to default than a customer with a new debt. To account for this, the business places a higher probability of noncollection on older debts. For example, a business may assign a 5 percent probability of default on debts that are under 90 days old and 10 percent on debts older than 90 days.
When booking bad-debt expense, the second half of the journal entry is a contra-equity account called allowance for doubtful accounts. This balance of this account reduces the net value of the accounts receivable. For example, if a business has $500,000 in accounts receivable and an allowance for doubtful accounts of $20,000, it has $480,000 in net accounts receivable.
The allowance for doubtful accounts is significant when using the balance-sheet approach for calculating bad debt. That's because the balance sheet-approach calculates what the allowance for doubtful accounts should be, not necessarily bad debt expense itself. For example, if a company calculates that uncollectible accounts should be $20,000 under the balance-sheet approach and the allowance for doubtful accounts is currently $8,000, $12,000 is added to the account and booked as bad debt expense.
The journal entry to record bad debts is a debit to bad debt expense and a credit allowance for doubtful accounts. Say that a company estimates bad debt at 5 percent of receivables. The accounts receivable balance is $1 million, so the allowance for doubtful accounts should be $50,000. The allowance for doubtful accounts still has $9,000 left over from it last year, so the company debits bad debt expense for $41,000 and credits allowance for uncollectible accounts for $41,000. This brings the total balance of the uncollectibles account to $50,000.