Bad debts are accounts receivable that a small or large business can't collect. The allowance method is used to estimate bad debt reserves, which companies incur because customers sometimes cannot pay their bills on time, or at all. Bad debt reserves are recorded as an expense on the profit and loss statement and as allowance for doubtful accounts, which is a contra account that reduces accounts receivable on the balance sheet.
Reserve Based on Sales
Companies can estimate bad debt reserves based on a percentage of net credit sales, which are credit sales minus returns and allowances. This percentage can be based on a company's historical experience with bad debts or an industry average. The journal entries to record the bad debt reserve estimate on the books are to debit bad debt expense and credit allowance for doubtful accounts. For example, if a company has $100,000 in net credit sales during an accounting period and its bad debts are on average 2 percent of credit sales, the bad debt reserve is $2,000. Therefore, the profit and loss impact is a $2,000 reduction in net income for the accounting period.
Reserve Based on Receivables
Companies can also estimate bad debt reserves from their accounts receivable balance. The first step is to find a target ending balance for the allowance for doubtful accounts, which is a suitable percentage of the accounts receivable balance. The journal entries to record the bad debt reserve estimate on the books are to debit bad debt expense and credit allowance for doubtful accounts, after adjusting for the existing balance in allowance for doubtful accounts. For example, if allowance for doubtful accounts has a credit balance of $500 and its target ending balance is $3,000, the bad debt expense is $3,000 minus $500, or $2,500, which is the net reduction in net income. Companies can also use the aging of receivables to estimate the probabilities of not collecting on debts that have been outstanding for different periods. Companies may also assign risk factors to individual accounts to estimate the bad debt reserves.
Bad Debt Write-Off
In the allowance method, writing off bad debt has no effect on the profit and loss statement. The journal entries to remove the bad debt from the books are to debit the allowance for doubtful accounts category, then credit accounts receivable, which are both balance sheet accounts. If a company collects on a previously written-off account, there is also no effect on the profit and loss statement. Reverse the write-off with journal entries that debit accounts receivable and credit allowance for doubtful accounts, then record the cash recovery by debiting the cash account and crediting accounts receivable.
Generally accepted accounting principles require companies to use the allowance method for financial reporting purposes. However, companies must use the direct method for tax reporting purposes. In the direct method, companies debit their bad debt expense accounts and credit accounts receivable only after they're certain that they cannot collect on particular accounts. There is no reserve for bad debts in the direct method.