If an adjusting entry of $3,000 is made during year 2, Bad Debts Expense will report a $3,000 debit balance, while Allowance for Doubtful Accounts might report a credit balance of $17,000. The Allowance for Doubtful Accounts reports on the balance sheet the estimated amount of uncollectible accounts that are included in Accounts Receivable. Balance sheet accounts are almost always permanent accounts, meaning their balances carry forward to the next accounting period. In other words, they are not closed and their balances are not reset to zero. The allowance method is the more widely used method because it satisfies the matching principle. The allowance method estimates bad debt during a period, based on certain computational approaches.

The aging method is often referred to as the balance sheet approach because the accountant attempts to measure, as accurately as possible, the net realizable value of Accounts Receivable, which is a balance sheet figure. It is reported along with other selling, general, and administrative costs. In either case, bad debt represents a reduction in net income, so in many ways, bad debt has characteristics of both an expense and a loss account. Bad debt expense is the way businesses account for a receivable account that will not be paid. Bad debt arises when a customer either cannot pay because of financial difficulties or chooses not to pay due to a disagreement over the product or service they were sold.

The second entry records the payment in full with Cash increasing (debit) and Accounts Receivable decreasing (credit) for the amount received of $15,000. For the taxpayer, this means that if a company sells an item on credit in October 2018 and determines that it is uncollectible in June 2019, it must show the effects of the bad debt when it files its 2019 after-tax income definition tax return. This application probably violates the matching principle, but if the IRS did not have this policy, there would typically be a significant amount of manipulation on company tax returns. For example, if the company wanted the deduction for the write-off in 2018, it might claim that it was actually uncollectible in 2018, instead of in 2019.

Aging Method vs. Percentage of Sales Method

For example,
a category might consist of accounts receivable that is 0–30 days
past due and is assigned an uncollectible percentage of 6%. Another
category might be 31–60 days past due and is assigned an
uncollectible percentage of 15%. All categories of estimated
uncollectible amounts are summed to get a total estimated
uncollectible balance. That total is reported in Bad Debt Expense
and Allowance for Doubtful Accounts, if there is no carryover
balance from a prior period. If there is a carryover balance, that
must be considered before recording Bad Debt Expense. The balance
sheet aging of receivables method is more complicated than the
other two methods, but it tends to produce more accurate results.

  • Therefore, the direct write-off method can only be appropriate for small immaterial amounts.
  • The general ledger account Accounts Receivable usually contains only summary amounts and is referred to as a control account.
  • The next step is to calculate the probability of default for each of the above category, which is then multiplied by the sum of the accounts receivable from each category.

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. Basically, it gives you valuable insight into your relationship with credit.

Example of Bad Debt Expense

The direct write-off method involves writing off a bad debt expense directly against the corresponding receivable account. Therefore, under the direct write-off method, a specific dollar amount from a customer account will be written off as a bad debt expense. It’s like you said, those two methods, it can be really great if you know you’re the logical person or you know you’re the person who needs a quick reward that can help you choose between them. When that debt is paid off, you roll the amount you’re paying toward the next smallest debt, much like a snowball accumulating momentum rolling down the hill. So the best thing to do is just make a plan for managing it going forward and that can take some of the stress out of it.

Aging Used in Calculating the Allowance

Because a small portion of customers will likely end up not being able to pay their bills, a portion of sales or accounts receivable must be ear-marked as bad debt. This small balance is most often estimated and accrued using an allowance account that reduces accounts receivable, though a direct write-off method (which is not allowed under GAAP) may also be used. For example, when companies account for bad debt expenses in
their financial statements, they will use an accrual-based method;
however, they are required to use the direct write-off method on
their income tax returns. This variance in treatment addresses
taxpayers’ potential to manipulate when a bad debt is recognized.

Bad Debt Expense Definition and Methods for Estimating

Bad debts expense is calculated as provided in percentage of receivables method of bad debts estimation. The aging method usually refers to the technique for estimating the amount of a company’s accounts receivable that will not be collected. The estimated amount that will not be collected should be the credit balance in the contra asset account Allowance for Doubtful Accounts.

The aging method groups all outstanding accounts receivable by age, and specific percentages are applied to each group. The aggregate of all groups’ results is the estimated uncollectible amount. For example, a company has $70,000 of accounts receivable less than 30 days outstanding and $30,000 of accounts receivable more than 30 days outstanding. The allowance method is an accounting technique that enables companies to take anticipated losses into consideration in its financial statements to limit overstatement of potential income. To avoid an account overstatement, a company will estimate how much of its receivables from current period sales that it expects will be delinquent. However, while the direct write-off method records the exact amount of uncollectible accounts, it fails to uphold the matching principle used in accrual accounting and generally accepted accounting principles (GAAP).

How to calculate the bad debt expense

And if there are no additions or write-offs, the balance in the account is zero. At the end of 2019, the balance in Accounts Receivable was $200,000, and an aging schedule of the accounts is presented below. The aging method involves determining the desired balance in the Allowance for Uncollectible Accounts. This method considers historical data and assigns higher percentages to older balances, which are considered more risky.

How to Estimate Bad Debt Expense

Let’s consider a situation where BWW had a $20,000 debit balance
from the previous period. Allowance for Doubtful Accounts decreases (debit) and Accounts
Receivable for the specific customer also decreases (credit). Allowance for doubtful accounts decreases because the bad debt
amount is no longer unclear.

Accounts receivable aging is useful in determining the allowance for doubtful accounts. When estimating the amount of bad debt to report on a company’s financial statements, the accounts receivable aging report is used to estimate the total amount to be written off. Two primary methods exist for estimating the dollar amount of accounts receivables not expected to be collected. Bad debt expense can be estimated using statistical modeling such as default probability to determine its expected losses to delinquent and bad debt. The statistical calculations can utilize historical data from the business as well as from the industry as a whole. The specific percentage will typically increase as the age of the receivable increases, to reflect increasing default risk and decreasing collectibility.