When a small business extends credit to customers, inevitability some portion of those transactions will turn into bad debt since the recovery of bad debts in most cases is unlikely, even when threatening to report to a collection agency. As a result, a bookkeeping entry must be prepared to adjust the balance sheet and income statement. Preparing and posting a bad debt adjusting entry is typically done during month-end close or sometimes at the end of the year.
What Is Bad Debt?
Accounts receivable or invoices that are determined to be uncollectible are expensed as bad debt. Bad debt shouldn’t be written-off unless the receivables are uncollectible in consistency with a company’s bad debt expense write-off policy and U.S. GAAP which is a guide for standard accounting principles. There are two popular methods for performing the write-off; the allowance method and the direct write-off method. Each technique has advantages and gives users of financial statements insight into a company’s financial position.
See how to calculate an uncollectable bad debt expense account.
Definition Of The Allowance For Doubtful Accounts
Under the allowance method for bad debt write-offs, a contra-asset account is created in your accounting books or in your software on the balance sheet that carries a credit balance. When the allowance is netted against accounts receivable, it provides financial statement users with an estimate of receivables that are still collectible. The allowance is determined using an estimate derived from historical bad debt and trends in the marketplace. An amortization table is typically used to track the allowance and the frequency at which it’s recognized on the income statement. The allowance method is based on the matching principle.
What is the Direct Write-Off Method?
When using the direct write-off method, an accounts receivable is removed from the balance sheet and expensed on the income statement, as receivables are determined to be uncollectible. There is no allowance for uncollectible accounts listed on the balance sheet. Instead, accounts receivable is always listed at current value, in the current assets section of the balance sheet. While this method has advantages, the allowance method for estimating bad debt is popular, because it gives users of financial statements a better idea of their net income and financial position.
Bad Debt Journal Entry Example
Under the direct write-off method, the journal entry for a bad debt write-off will include a credit to accounts receivable and a debit to bad debt expense. This entry should have support that illustrates how the write-off ties back past due receivables and the company’s write-off policy for the current period. The journal entry when using the allowance method for doubtful accounts is different.
The credit is posted to the allowance for the doubtful accounts account, and the debit balance is posted to bad debt expense. Bad debt expenses can be found in the general ledger. The amortization table that tracks the bad debt allowance should be used as support for the entry. At year-end, the allowance for doubtful accounts needs adjustment, so that the subsequent year’s allowance can be booked at the new estimated amount. Each year the allowance for doubtful accounts or bad debt reserve should be reviewed and adjusted, to meet changes in payment activity and trends in the marketplace. This, along with past experience, will give you some kind of foundation for the next accounting period.
When expensing bad debt from a customers account or cost of goods sold, the journal entry should be prepared using a method consistent with U.S. GAAP or another set of accredited accounting standards. Remaining consistent will enable investors, owners and management to accurately monitor bad debt and its impact on the bottom-line.
Resources:
What Is Bad Debt?
Accounts receivable or invoices that are determined to be uncollectible are expensed as bad debt. Bad debt shouldn’t be written-off unless the receivables are uncollectible in consistency with a company’s bad debt expense write-off policy and U.S. GAAP which is a guide for standard accounting principles. There are two popular methods for performing the write-off; the allowance method and the direct write-off method. Each technique has advantages and gives users of financial statements insight into a company’s financial position.
See how to calculate an uncollectable bad debt expense account.
Definition Of The Allowance For Doubtful Accounts
Under the allowance method for bad debt write-offs, a contra-asset account is created in your accounting books or your software on the balance sheet that carries a credit balance. When the allowance is netted against accounts receivable, it provides financial statement users with an estimate of receivables that are still collectible. The allowance is determined using an estimate derived from historical bad debt and trends in the marketplace. An amortization table is typically used to track the allowance and the frequency at which it’s recognized on the income statement. The allowance method is based on the matching principle.
What is the Direct Write-Off Method?
When using the direct write-off method, an accounts receivable is removed from the balance sheet and expensed on the income statement, as receivables are determined to be uncollectible. There is no allowance for uncollectible accounts listed on the balance sheet. Instead, accounts receivable is always listed at current value, in the current assets section of the balance sheet. While this method has advantages, the allowance method for estimating bad debt is popular, because it gives users of financial statements a better idea of their net income and financial position.
Bad Debt Journal Entry Example
Under the direct write-off method, the journal entry for a bad debt write-off will include a credit to accounts receivable and a debit to bad debt expense. This entry should have support that illustrates how the write-off ties back past due receivables and the company’s write-off policy for the current period. The journal entry when using the allowance method for doubtful accounts is different.
The credit is posted to the allowance for the doubtful accounts account, and the debit balance is posted to bad debt expense. Bad debt expenses can be found in the general ledger. The amortization table that tracks the bad debt allowance should be used as support for the entry. At year-end, the allowance for doubtful accounts needs adjustment, so that the subsequent year’s allowance can be booked at the new estimated amount. Each year the allowance for doubtful accounts or bad debt reserve should be reviewed and adjusted, to meet changes in payment activity and trends in the marketplace. This, along with past experience, will give you some kind of foundation for the next accounting period.
When expensing bad debt from a customers account or cost of goods sold, the journal entry should be prepared using a method consistent with U.S. GAAP or another set of accredited accounting standards. Remaining consistent will enable investors, owners and management to accurately monitor bad debt and its impact on the bottom-line.
Resources:
https://www.hud.gov/sites/documents/BADDEBTEXPFINDATA.PDF
https://fmx.cpa.texas.gov/fm/pubs/aps/27/c001_all.php
