direct write-off method
Loaning money contains risk. Every time a business extends payment terms to a customer, that business is taking on risk. Not every customer will pay on time, some may not pay at all. When a customer defaults on an amount due, this is called bad debt.
When an account is deemed to be uncollectible, the business must remove the receivable from the books and record an expense. This is considered an expense because bad debt is a cost of doing business. Part of the cost of allowing customers to borrow money, which is essentially what a customer is doing when the business allows the customer time to pay, is the expense related to uncollectible receivables. This expense is called Bad Debt Expense.
There are two ways a company can account for bad debt expense: the direct write-off method and the allowance method.
The Direct Write-off Method for Bad Debt
The direct write-off method allows a business to record Bad Debt Expense only when a specific account has been deemed uncollectible. The account is removed from the Accounts Receivable balance and Bad Debt Expense is increased.
Example #1: On March 2, Dependable Car Repair, Inc. has deemed that a $1,400 in Accounts Receivable, due from Joe Smith, is uncollectible and should be recorded as a bad debt.
Dependable must reduce Accounts Receivable by $1,400 and record the Bad Debt Expense.
What happens if the customer later sends payment? This happens fairly regularly in business. If the customer’s balance is written off as uncollectible, there is nothing to apply the payment against. If the company applies the balance against the customer’s account, the entry would cause a negative balance or an amount due to the customer. In order to accept the payment, the company must first restore the balance to the customer’s account. The company would debit Accounts Receivable. What would the credit be? It’s not revenue because the company has not done any work or sold anything. By receiving the payment, the company is acknowledging that the debt is actually not a bad debt after all. Therefore, the company should reduce Bad Debt Expense.
Example #2: On June 23, Dependable Car Repair received a check for $1,400 from Joe Smith, whose balance was written off as uncollectible on March 2.
This transaction requires two entries. The first entry will restore the balance in accounts receivable. The second entry will show the receipt of the payment. It seems counterintuitive to restore the balance to pay it off, but for recordkeeping purposes, it is necessary to restore the account balance and show the customer properly paid his debt. We must make sure to show that Joe Smith paid the amount he owed, not just the fact that the company received some cash.
The direct write-off method is an easy way to manage bad debt when nonpayment is rare. However, this method violates the matching principle which states that expenses must be matched with revenue. When companies extend credit to customers, it is fairly common that some percentage of those customers will not pay. It may take a long time before the company has exhausted all efforts to collect the debt. Typically, the write off occurs in a different fiscal year than the revenue was recorded. This is why direct write-off violates the matching principle. How can we match the bad debt expense to the revenue associated with it?
The Allowance Method for Bad Debt
The allowance method creates bad debt expense before the company knows specifically which customers will not pay. Based on prior history, the company knows the approximate percentage or sales or outstanding receivables that will not be collected. Using those percentages, the company can estimate the amount of bad debt that will occur. That allows us to record the bad debt but since accounts receivable is simply the total of many small balances, each belonging to a customer, we cannot credit Accounts Receivable when this entry is recorded.
We must create a holding account to hold the allowance so that when a customer is deemed uncollectible, we can use up part of that allowance to reduce accounts receivable. This holding account is called Allowance for Doubtful Accounts. Allowance for Doubtful Accounts is a contra-asset linked to Accounts Receivable. The allowance is used the reduce the net amount of receivables that are due while leaving all the customer balances intact.
To record the bad debt, which is an adjusting entry, debit Bad Debt Expense and credit Allowance for Doubtful Accounts. When a customer is identified as uncollectible, we would credit Accounts Receivable. We cannot debit bad debt because we have already recorded bad debt to cover the percentage of sales that would go bad, including this sale. Remember that allowance for doubtful accounts is the holding account in which we placed the amount we estimated would go bad. 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.
Let’s say that the balance in Accounts Receivable is $10,000 (debit) and the balance in Allowance for Doubtful Accounts is $500 (credit). Net accounts receivable is $9,500. This is how it would be presented on the balance sheet:
If a customer who owed $100 was deemed uncollectible on April 7, we would credit Accounts Receivable to remove the customer’s balance and debit Allowance for doubtful Accounts to cover the loss.
What effect does this have on the balances in each account and the net amount of accounts receivable? The balance in Accounts Receivable drops to $9,900 and the balance in Allowance for Doubtful Accounts falls to $400. The net amount is still the same.
How is that possible? Allowance for Doubtful Accounts is where we store the nameless, faceless uncollectible amount. We know some accounts will go bad, but we do not have a name or face to attach to them. Once an uncollectible account has a name, we can reduce the nameless amount and decrease Accounts Receivable for the specific customer who is not going to pay.
What if the customer later pays the bill? We would need to restore the balance in accounts receivable. Because we identified the wrong account as uncollectible, we would also need to restore the balance in the allowance account. If the customer paid the bill on September 17, we would reverse the entry from April 7 and then record the payment of the receivable.
Calculating Bad Debt Under the Allowance Method
As stated previously, the amount of bad debt under the allowance method is based on either a percentage of sales or a percentage of accounts receivable. When doing the calculations, it is important to understand what the resulting number actually represents. Because one method relates to the income statement (sales) and the other relates to the balance sheet (accounts receivable), the calculated amount is related to the same statement. When using the percentage of sales method, the resulting amount is the amount of bad debt that should be recorded. When using the percentage of accounts receivable method, the amount calculated is the new balance in allowance for doubtful accounts.
Percentage of Sales Method
The percentage of sales method is based on the premise that the amount of bad debt is based on some measure of sales, either total sales or credit sales. Based on prior years, a company can reasonably estimate what percentage of the sales measure will not be collected. If a company takes a percentage of sales (revenue), the calculated amount is the amount of the related bad debt expense.
Example: The company estimates bad debt based on the percentage of sales method. Sales for the fiscal year ended December 31, 2013 were $3,400,000, while credit sales were $2,900,000. The company estimates that 1.5% of credit sales are uncollectible. Allowance for Doubtful Accounts has a credit balance of $17,000. Record the adjusting journal entry necessary to record bad debt.
First identify the accounts that will be used in the entry. We already know this is a bad debt entry because we are asked to record bad debt. The percentage of sales method is an allowance method. We are also told that the company is estimating bad debt, so this is clearly not a company that uses direct write-off. Therefore, we will be using Allowance for Doubtful Accounts and Bad Debt Expense.
Time to calculate the amount of the transaction. The company estimates that 1.5% of credit sales are uncollectible. Therefore, we will use credit sales.
$2,900,000 x 1.5% = $43,500
What is this number? When using the percentage of sales method, we multiply a revenue account by a percentage to calculate the amount that goes on the income statement. That means we are calculating bad debt expense. The amount of expense is proportional to the amount of revenue.
What is the balance in Allowance for Doubtful Accounts? The account had a credit balance of $17,000 before the adjustment. The entry from December 31 would be added to that balance, making the adjusted balance $60,500. The percentage of sales method does not factor in the existing balance in Allowance for Doubtful Accounts. Without careful monitoring, the balance in the account could grow indefinitely. It is important for management to monitor the balance to ensure the balance is reasonable.
Percentage of Receivables Method
The percentage of receivables method automatically monitors the balance in Allowance for Doubtful Accounts because each year the calculation gives us the amount that should be in the account based on the amount of receivables outstanding. The contra-asset, Allowance for Doubtful Accounts, is proportional to the balance in the corresponding asset, Accounts Receivable.
When using the percentage of receivables method, it is usually helpful to use T-accounts to calculate the amount of bad debt that must be recorded in order to update the balance in Allowance for Doubtful Accounts. This is very similar to the adjusting entries involving shop supplies or prepaid expenses. If the transaction tells you what the new balance in the account should be, we must calculate the amount of the change. The amount of the change is the amount of the expense in the journal entry.
Example: The company estimates bad debt based on the percentage of receivables method. The balance in Accounts Receivable on December 31, 2013 was $530,000. The company estimates that 6% of receivables are uncollectible. Allowance for Doubtful Accounts has a credit balance of $17,000. Record the adjusting journal entry necessary to record bad debt.
As in all journal entries, the first step is to figure out which accounts will be used. Because this is just another version of an allowance method, the accounts are Bad Debt Expense and Allowance for Doubtful Accounts.
On to the calculation, since the company uses the percentage of receivables we will take 6% of the $530,000 balance.
$530,000 x 6% = $31,800
Now to consider what this amount is. We used Accounts Receivable in the calculation, which means that the answer would appear on the same statement as Accounts Receivable. Therefore, we have to consider which of our accounts would appear on the balance sheet with Accounts Receivable. Allowance for Doubtful Accounts is a contra-asset account so that is what we calculated. The adjusted balance in Allowance for Doubtful Accounts should be $31,800. Since the current balance is $17,000, we need to increase the balance to $31,800. We do this by crediting the account $14,800. The $14,800 is the amount of Bad Debt Expense that must be recorded.
When using an allowance method, it is critical to know what you are calculating. If using sales in the calculation, you are calculating the amount of bad debt expense. If using accounts receivable, the result would be the adjusted balance in the allowance account.
Aging of Accounts Receivable Method
The aging method is a modified percentage of receivables method that looks at the age of the receivables. The longer a debt has been outstanding, the less likely it is that the balance will be collected. The aging method breaks down receivables based on the length of time each has been outstanding and applies a higher percentage to older debts.
Notice how the estimated percentage uncollectible increases quickly the longer the debt is outstanding. Judging the amount that is uncollectible based off an aging schedule is the most accurate way to calculate bad debt because history tells us that the longer a debt is outstanding, the less likely the company is to collect it.
Example: The company uses the Aging Method to calculate bad debts. The company produced the following aging schedule on December 31, 2013:
Allowance for Doubtful Accounts had a credit balance of $9,000 on December 31. Record the adjusting journal entry for bad debt.
As with every other entry we have completed, the first step is to identify the accounts. This is another variation of an allowance method so we will use Bad Debt Expense and Allowance for Doubtful Accounts.
The calculation here is a few more steps but uses the same methodology used in all the other methods. Multiply the percentage by the balance outstanding. In this case, we have a percentage for each outstanding period. Once you know how much from each time period, add them to get the total allowance balance.
The adjusted balance in Allowance for Doubtful Accounts is $14,360. Since the unadjusted balance is $9,000, we need to record bad debt of $5,360.
Can Allowance for Doubtful Accounts have a debit balance? How would that happen? Allowance for Doubtful Accounts is a holding account for potential bad debt. When an account is written off, the allowance is debited. If the company underestimates the amount of bad debt, the allowance can have a debit balance. If the company uses a percentage of sales method, it must ensure that there will be enough in Allowance for Doubtful Accounts to handle the amount of receivables that go bad during the year. One of the benefits of using a receivables method is that we are calculating the new balance in the allowance account or bring the allowance account up to the level needed for the percentage of receivables that are outstanding. This is not the case with the sales method.
Example: Record the adjusting entry assuming the same facts as above, except the Allowance for Doubtful Accounts has a debit balance of $2,000.
Since Allowance for Doubtful Accounts has a normal credit balance, a debit balance in the account is like overdrawing the account. We need to bring the account even, then add enough to get the balance to $14,360. Therefore, we want to add the amounts. You could also look at it like this:
New balance – old balance = amount of adjustment
$14,360 – $(-2,000) = $16,360
When you subtract a negative, you add the number. The amount of the entry will be $16,360.
The most important thing to remember when working with the allowance methods for bad debt is to know what you have calculated! Once you figure a dollar amount, ask yourself if that amount is the bad debt expense or the allowance. If it is the allowance, you must then figure out how much bad debt to record in order to get to that balance.