The Allowance Method of Accounting for Bad Debts

A. Estimating Bad Debts Based on Sales

Estimating bad debts as a percentage of sales is consistent with the matching concept in that the bad debt expense is recorded in the same time period as the associated revenue.


       Net credit sales
     x Bad debt percentage
       ----------------------
     = Bad debt expense

     Note:  When using the estimate based on sales, the entry for bad debt
            expense is made for the amount of the calculation.

     Examples:
     Jones Company has net credit sales of $75,000 and estimates that bad
     debts are approximately 3% of net credit sales.  The year end balance in
     accounts receivable is $200,000.

     > Record the entry assuming that the allowance account currently has a
       credit balance of $300.  The journal entry to record the bad debts
       would be as follows:

                                                  Debit       Credit
                                                 -------     -------
       Bad debt expense (75,000 x 3%)             2,250
            Allowance for doubtful accounts                   2,250

       After the above entry, the allowance account would have a balance of
       $2,550 (i.e., $2,250 + $300).  The net realizable value of accounts
       receivable after adjustment would be $197,450 (i.e., $200,000 - $2,550).

     > Record the entry assuming that the allowance account currently has a
       debit balance of $300.  The journal entry to record the bad debts
       would be as follows:

                                                  Debit       Credit
                                                 -------     -------
       Bad debt expense (75,000 x 3%)             2,250
            Allowance for doubtful accounts                   2,250

       After the above entry, the allowance account would have a balance of
       $1,950 (i.e., $2,250 - 300).  The net realizable value of accounts
       receivable after adjustment would be $198,050 (i.e., $200,000 - $1,950).

B. Estimating Bad Debts Based on Receivables

The estimate based on receivable could be one that uses an aging or a single calculation based on total receviables as shown below:


       Accounts receivable balance
     x Estimated percent uncollectible
       --------------------------------
     = Desired ending balance of Allowance
         for Doubtful Accounts (credit balance)

     Note:  When using the estimate based on receivables, the entry for bad debt
            expense must consider the current balance in the allowance
            account.  The amount of the bad debt expense for the entry is the
            amount that is needed to bring the balance in the allowance account
            to the amount of the desired ending balance  The ending balance
            must be a credit balance.

     Examples:
     O'Reilly Company has an accounts receivable balance of $200,000 and
     estimates that bad are approximately 1.5% of accounts receivable.

     > Record the entry assuming that the allowance account currently has a
       credit balance of $300.  The journal entry to record the bad debts
       would be as follows:

                                                  Debit       Credit
                                                 -------     -------
       Bad debt expense ((200,000 x 1.5%) - 300)   2,700
            Allowance for doubtful accounts                   2,700

       After the above entry, the allowance account would have a balance of
       $3,000 (i.e., $200,000 x 1.5%).  The net realizable value of accounts
       receivable after adjustment would be $197,000 (i.e., $200,000 - $3,000).

     > Record the entry assuming that the allowance account currently has a
       debit balance of $300.  The journal entry to record the bad debts
       would be as follows:

                                                  Debit       Credit
                                                 -------     -------
       Bad debt expense ((200,000 x 1.5%) + 300)  3,300
            Allowance for doubtful accounts                   3,300

       After the above entry, the allowance account would have a balance of
       $3,000 (i.e., $200,000 x 1.5%).  The net realizable value of accounts
       receivable after adjustment would be $197,000 (i.e., $200,000 - $3,000).

C. Write-off of Accounts Receivable

A write-off of accounts receivable has no effect on income because the allowance approach bases any bad debt expense on an estimate using either net sales or accounts receivable as shown above. The write-off is simply a removal of the receivable and a reduction of the allowance account.


    Example:
    Prepare the entry to record the write-off of a $1,500 account receivable.

                                               Debits         Credits
                                              --------       --------
    Allowance for doubtful accounts             1,500
       Accounts receivable                                     1,500

    Note that the write-off does not change net realizable accounts
    receivable.  For example, if accounts receivable and the allowance
    account were $200,000 and $20,000 before the write-off, respectively;
    net realizable accounts receivable would be $180,000 before the
    write-off (i.e., $200,000 - $20,000).  After the write-off, net
    realizable receivables would still be
    $180,000 (i.e., $198,500 - 18,500).

D. Recovery of an Accounts Receivable Write-off

A recovery of a write-off of accounts receivable involves two basic parts. First, there is a reversal of the write-off entry. Secondly, there is a collection of the receivable just as if it had never been written off.


    Example:
    The customer was able to repay $1,000 of the $1,500 written off
    in the prior write-off.

                                               Debits         Credits
                                              --------       --------
    Accounts Receivable                         1,000
       Allowance for Doubtful Accounts                         1,000

    Cash                                        1,000
       Accounts Receivable                                     1,000