5.4 Estimate and Write Off Bad Debt

Estimate Allowance for Doubtful Accounts

There are two ways to estimate the allowance for doubtful accounts:

1. Percentage of credit sales method: also called the income statement approach because bad debt is determined based on the credit sales during the period.
2. Aging-of-receivables method: also called the balance sheet approach because bad debt is determined based on the A/R balance at period-end.

(Harrison et al., 2018, p. 191)

Percentage of Credit Sales Method

Using this method, at each period end, bad debt expense is based on an estimate of percentage of credit sales that will not be collected. 

For example:

Apple reports credit sales for the year of $3,000,000 and estimates bad debts at 1.5% of net credit sales.

Estimated uncollectible accounts (bad debts) expense: $3,000,000 × 1.5% = $45,000

Journal entry to record bad debts expense:

Aging-of-Receivables Method

Under this method, at each period end, the company analyzes customers’ A/R based on how long they have been outstanding (i.e., the aging schedule) to estimate the doubtful accounts. Allowance for doubtful accounts is adjusted to the estimated doubtful accounts amount from the aging schedule. 

Steps to estimate the allowance using the aging-of-receivables method:

1. Classify A/R by age of the receivables (i.e., number of days the A/R has been outstanding) in a matrix.
2. For each age category, estimate the percentage of accounts that will be uncollectible and apply this percentage to determine the allowance amount (as the outstanding days increase, the percentage increases since the company is generally less likely to collect).
3. Sum up the allowance amounts for each age category to obtain the desired balance in the allowance for doubtful accounts at period end.
4. The difference between the desired balance obtained in Step 3 and the current balance in the allowance for doubtful accounts is recorded as a bad debt expense via an adjusting journal entry.

Let’s walk through an example:

Suppose a company has 2 credit customers: Customer A and Customer B. Customers’ account balances are grouped by days outstanding. A percent uncollectible is estimated for each category: the older the account, the less likely that the payment will be received.

(Harrison et al., 2018, p. 190)

Assume A/R and allowance for doubtful accounts had the following balances before the period-end adjustment:

(Harrison et al., 2018, p. 191)

From the aging-of-receivables method computed at period end, the company knows that the allowance for doubtful accounts should have the ending credit balance of $6,156. It already has a credit balance of $346.

Thus, the adjustment needed to bring the credit balance from $346 to $6,150 is $5,810. 

Journal entry to record bad debts expense:

(Harrison et al., 2018, p. 192)

Write Off Uncollectible Accounts

When a specific customer account is deemed uncollectible with a known amount, the specific customer A/R account is reduced (credited) to remove it from the books, and allowance for doubtful accounts is also reduced (debited) for that specific amount.

Journal entry to write-off an uncollectible account:

Notice that writing off uncollectible accounts does not affect total assets, current assets, or net accounts receivable. It also does not affect net income. This is because it does not affect an expense account. Under the allowance method, expenses are recognized in the period in which the related sales took place.

Continuing the previous example: assume the company has determined that $900 of the accounts receivable is uncollectible.

Journal entry to write-off uncollectible account:

The resulting balances:

(Harrison et al., 2018, p. 191)

Recovery of an Uncollectible Account

Although an account has been written off as uncollectible, the customer still owes the money and will sometimes pays off the account in full or in part after the company has deemed it uncollectible.

When such a recovery occurs, the company makes two journal entries: 

1. To reverse the earlier write-off

2. To record the cash collection

Summary of Allowance, Write-Off, and Recovery Journal Entries

Bad debt expense (adjusting journal entry at period end)

Write-off for uncollectible customer accounts

Recovery of a bad debt

For most companies, there is a time lag between earning the income and collecting the cash. Collections from customers are the single most important source of cash for any business. 

You can compute a company’s collections from customers by analyzing its A/R account if you know the opening and ending A/R, the write-offs, and sales on credit. 

Beginning A/R Balance + Sales on Credit – Write-off of Uncollectible Amounts –
Collections from Customers = Ending A/R Balance