Bad Debt Expense Definition and Methods for Estimating

This amount is just sitting there waiting until a specific accounts receivable balance is identified. Once we have a specific account, we debit Allowance for Doubtful Accounts to remove the amount from that account. The net amount of accounts receivable outstanding does not change when this entry is completed.

The amount of the change is the amount of the expense in the journal entry. The final point relates to businesses with very little exposure to the possibility of bad debts, typically, entities that rarely offer credit to its customers. Assuming that credit is not a significant component of its sales, these sellers can also use the direct write-off method. The companies that qualify for this exemption, however, are typically small and not major participants in the credit market. Thus, virtually all of the remaining bad debt expense material discussed here will be based on an allowance method that uses accrual accounting, the matching principle, and the revenue recognition rules under GAAP.

Estimating the Bad Debt Expense

When there is a bad debt, you will credit accounts receivable and debit allowance for doubtful accounts. The adjusting entry to estimate the expected value of bad debts does not reduce accounts receivable directly. Accounts receivable is a control account that must have the same balance as the combined balance of every individual account in the accounts receivable subsidiary ledger. The bad debts account, being an expense, gets debited and the accounts receivable account is credited immediately after an invoice is determined to be uncollectible in the direct write off method. When a specific customer’s account is identified as uncollectible, it is written off against the balance in the allowance for bad debts account. Smith’s uncollectible balance of $225 is removed from the books by debiting allowance for bad debts and crediting accounts receivable.

The percentage of receivables approach (also known as the balance sheet approach) estimates bad debt expenses based on the balance in accounts receivable. This approach looks at the balance of accounts receivable at the end of the period and assumes that a certain amount will not be collected. Accounts receivable is reported on the balance sheet; thus, it is also known as the balance sheet approach. Two methods for the accounting of uncollectible accounts is typically used by the businesses – the direct write off method and the allowance method.

What Is a Bad Debt Expense?

Customers whose accounts have already been written off as uncollectible will sometimes pay their debts. When this happens, two entries are needed to correct the company’s accounting records and show that the customer paid the outstanding balance. The first entry reinstates the customer’s accounts receivable balance by debiting accounts receivable and crediting allowance for bad debts.

On to the calculation, since the company uses the percentage of receivables we will take 6% of the $530,000 balance. This will cause accounts receivable to go down from $861,000 to $860,780 and the allowance for doubtful accounts to be reduced from $17,220 to $17,000; leaving the net realizable accounts receivable the same at $843,780. Units are expected to include accounts receivable write-offs as part of the internal control initiative and include https://simple-accounting.org/ the unit-specific process and materiality threshold. This is because both the asset account and the contra-asset account are decreasing by the same amount, thereby offsetting one another. Consider a roofing business that agrees to replace a customer’s roof for $10,000 on credit. The project is completed; however, during the time between the start of the project and its completion, the customer fails to fulfill their financial obligation.

Why is the Direct Write-Off Method Unacceptable for GAAP? – Introduction to the Direct Write-Off Method for Beginners

On December 31, ABC Inc. recorded a credit of $500 to Accounts Receivable and a debit of $500 to Bad Debt Expenses. In January 2020, the company issued an invoice to one of its customers, David Smith, for $500. The customer failed to pay the invoice by the due date, and the company tried several times to collect the debt but was unsuccessful.

• The amount a company expects to collect from its receivables is known as net realizable value and is an important concept in the presentation of receivables.
• During this tutorial, the account names allowance for doubtful accounts, allowance for bad debt, and allowance for uncollectible accounts will be used interchangeably.
• When using the percentage of sales method, the resulting amount is the amount of bad debt that should be recorded.
• As stated in the previous section, accounts receivable are reported on the balance sheet as an asset.

But, the write off method allows revenue to be expensed whenever a business decides an invoice won’t be paid. This makes a company appear more profitable, at least in the short term, than it really is. July 1 Sold $20,000 of computers to Robertson Company with terms 3/15, n/60.

For example, assume Kenco makes a $5000 credit sale to Bennards on 28th March. On 30th August, Kenco Ltd determines that it will be unable to collect from Bennards. When the account defaults for non-payment on 30th August, Kenco would record the following journal entry to recognise bad debt. The direct write-off method waits until an amount is determined to be uncollectible before identifying it in the books as bad debt. Reporting revenue and expenses in different periods can make it difficult to pair sales and expenses and assets and net income can be overstated.

• This lets companies see how uncertain it is to get paid on their accounts receivable and gives a more accurate picture of their financial situation.
• By receiving the payment, the company is acknowledging that the debt is actually not a bad debt after all.
• The method’s straightforward approach has made it popular among business owners who want an easy and useful way to manage their finances.
• On December 31, ABC Inc. recorded a credit of $500 to Accounts Receivable and a debit of $500 to Bad Debt Expenses.
• For a totally worthless debt, you need to file by either seven years from the original return due date or two years from when you paid the tax, whichever is later.

It also states that the liquidation value of those assets is less than the amount it owes the bank, and as a result Gem will receive nothing toward its $1,400 accounts receivable. After confirming this information, Gem concludes that it should remove, or write off, the customer’s account balance of $1,400. The direct write-off method allows you to write off the exact bad debt, not an estimate, meaning that you don’t have to worry about underestimating or overestimating uncollectible accounts. Beginning bookkeepers in particular will appreciate the ease of the direct write-off method, since it only requires a single journal entry. If an old debt is paid, the journal entry can simply be reversed and the payment posted to the customer’s account.

Business Operations

Thus, the revenue amount remains the same, the remaining receivable is eliminated, and an expense is created in the amount of the bad debt. This expense is called bad debt expenses, and they are generally classified as sales and general administrative expense. Though part of an entry for bad debt expense resides on the balance https://simple-accounting.org/what-is-the-direct-write-off-method-2/ sheet, bad debt expense is posted to the income statement. Recognizing bad debts leads to an offsetting reduction to accounts receivable on the balance sheet—though businesses retain the right to collect funds should the circumstances change. The customer tries avoiding his calls and comes up with different excuses.

• This is because both the asset account and the contra-asset account are decreasing by the same amount, thereby offsetting one another.
• The longer a debt has been outstanding, the less likely it is that the balance will be collected.
• Harold Averkamp (CPA, MBA) has worked as a university accounting instructor, accountant, and consultant for more than 25 years.
• You may notice that all three approaches use the same accounts for the adjusting entry; only the approach changes the financial outcome.

However, the direct write-off method can result in misstating the income between reporting periods if the bad debt journal entry occurred in a different period from the sales entry. For such a reason, it is only permitted when writing off immaterial amounts. The journal entry for the direct write-off method is a debit to bad debt expense and a credit to accounts receivable. The second entry records the customer’s payment by debiting cash and crediting accounts receivable.

The direct write off method violates GAAP, the generally accepted accounting principles. GAAP says that all recorded revenue costs must be expensed in the same accounting period. Under the allowance method, a company needs to review their accounts receivable (unpaid invoices) and estimate what amount they won’t be able to collect. This estimated amount is then debited from the account Bad Debts Expense and credited to a contra account called Allowance for Doubtful Accounts, according to the Houston Chronicle. GAAP mandates that expenses be matched with revenue during the same accounting period. But, under the direct write off method, the loss may be recorded in a different accounting period than when the original invoice was posted.

This throws off the timing of a company’s income and expenses and doesn’t show the real financial picture of how it runs. On June 3, a customer purchases $1,400 of goods on credit from Gem Merchandise Co. On August 24, that same customer informs Gem Merchandise Co. that it has filed for bankruptcy.