Writing Off an Account Under the Allowance Method

The underlying principle for bad debt provisions is that it is practically impossible to ascertain what amount of receivables the business will be able to recover during a year. As such, companies build some provisions based on historical trends and continuously re-adjust the net realizable value of the current accounts receivable. These adjustments are made to cushion the blow of irrecoverable receivables on the lending companies’ financials.

For this reason, it will not be appropriate to credit the personal account of any particular debtor at the end of a financial year for expected bad debts. Firstly, the loss of $9,200, which was already written off and appears as a debit balance in the bad debts acocunt. The most prevalent approach — called the “percent of sales method” — uses a pre-determined percentage of total sales assumption to forecast the uncollectible credit sales. Bad debt recovery occurs when you receive payment for a debt previously written off as uncollectible.

Percentage of Receivables

Bad debt is a loss for the business, and it is transferred to the income statement to adjust against the current period’s income. Every fiscal year or quarter, companies prepare financial statements. The financial statements are viewed by investors and potential investors, and they need to be reliable and must possess integrity. A collection agency or lawyer might be able to get a customer to pay you.

Now, at the end of the current year, a fresh provision will need to be created to bring the provisions account back to the desired level of the given percentage. At the end of 2014, it is not known as to which specific debtor will fail to pay his debts in 2015, though it is known, out of past experience, that some debtors will certainly fail to pay. During 2014, Mr. David wrote off $9,200 as bad debt, specifically as amounts due from various debtors who either died or declared bankruptcy. The allowance reserve is set in the period in which the revenue was “earned,” but the estimation occurs before the actual transactions and customers can be identified. Credit sales all come with some degree of risk that the customer might not hold up their end of the transaction (i.e. when cash payments left unmet). In either case, when a specific invoice is actually written off, this is done by creating a credit memo in the accounting software that specifically offsets the targeted invoice.

Allowance Method: Journal Entries (Debit and Credit)

Giving Sales access to customer payment history and cash flow data also helps them make more informed credit decisions. A collaborative accounts receivable solution—such as Versapay—uses automation and cloud-based collaboration 20+ professionally crafted freelance invoice templates technology to get customers, sales, and AR on the same page. Let’s say a company has $70,000 of accounts receivable less than 30 days outstanding and $30,000 of accounts receivable more than 30 days outstanding.

Reverse the write-off entry by increasing the accounts receivable account with a debit and decreasing the bad debt expense account with a credit. Record the payment by increasing the cash account with a debit and decreasing the accounts receivable account with a credit. The percentage of credit sales approach focuses on the income statement and the matching principle. Sales revenues of $500,000 are immediately matched with $1,500 of bad debts expense. The balance in the account Allowance for Doubtful Accounts is ignored at the time of the weekly entries. However, at some later date, the balance in the allowance account must be reviewed and perhaps further adjusted, so that the balance sheet will report the correct net realizable value.

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The journal entry is a debit to the bad debt expense account and a credit to the accounts receivable account. It may also be necessary to reverse any related sales tax that was charged on the original invoice, which requires a debit to the sales taxes payable account. Using the direct write-off method, write off debt the second you decide the account is uncollectable.

• In accrual accounting, companies recognize revenue before cash arrives in their accounts and must record expenses in the same accounting period the revenue originated.
• Finance Strategists is a leading financial literacy non-profit organization priding itself on providing accurate and reliable financial information to millions of readers each year.
• To estimate the amount a report called Accounts Receivable Aging Report, which breaks up the Accounts Receivable by the amount of time they have been sitting in the books, is used.
• Once this account is identified as uncollectible, the company will record a reduction to the customer’s accounts receivable and an increase to bad debt expense for the exact amount uncollectible.
• For this reason, companies that are required to adhere to GAAP do not use this method to report bad debt.

The Allowance for Doubtful Accounts amount is then deducted from the total Accounts Receivable to produce Net Realizable Accounts Receivable. Although Pareto Analysis has been mentioned as a way to estimate the allowance for doubtful accounts, it is, in fact, a good way to determine which doubtful accounts to focus on for collection efforts. It is not as effective as a method for estimating how much of an allowance for doubtful accounts you should make. The most effective and commonly used methods for determining an adequate amount to provision are discussed below.

Matching Principle: Bad Debt and Revenue

The two most common methods you can use to write off bad debt are the direct write-off method and the allowance method. Both methods move money out of the asset account accounts receivable when you decide an account is uncollectable. An allowance for doubtful accounts is considered a “contra asset,” because it reduces the amount of an asset, in this case the accounts receivable.

In the U.S., the direct write-off method is required for income tax purposes, but is not the method to be used for a company’s financial statements. However, David still wants to maintain a provision for bad debts at 2% of debtors. Mr. David wishes to maintain a provision for bad debts at 2% of trade debtors.

How Does a Bad-Debt Write-off Show on the Books?

If you wait several months to write off a bad debt, as is common with the direct write off method, the bad debt expense recognition is delayed past the month in which the original sale was recorded. Thus, there is a mismatch between the recordation of revenue and the related bad debt expense. You don’t need to create a bad debts recovered account to record bad debt recovery. Debit your Accounts Receivable account and credit your Allowance for Doubtful Accounts account. Bad debt expense, or BDE is an accounting entry that lists the dollar amount of receivables your company does not expect to collect. Accountants record bad debt as an expense under Sales, General, and Administrative expenses (SG&A) on the income statement.

The specific percentage typically increases as the age of the receivable increases to reflect rising default risk and decreasing collectibility. Debtors should be written off when it can be reasonably assured that the debtor will not pay the sum owed. The provision for bad debts should include an allowance for uncollectable debts and any net credit balances in these allowance accounts at year-end should be charged to bad debts expense. When an account is written off, the debit balance in the allowance account for uncollectable debts should be debited and a corresponding credit entry made to bad debts expense. A bad debt can be written off using either the direct write off method or the provision method. The first approach tends to delay recognition of the bad debt expense.