When a company extends credit to customers, inevitability some portion of those receivables will turn into bad debt. As a result, an entry must be prepared to adjust the balance sheet and income statement. Preparing and posting a bad debt journal entry is typically done during month-end close.
What is Bad Debt?
Accounts receivable 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. 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.
Definition of the Allowance for Doubtful Accounts
Under the allowance method for bad debt write-offs, a contra-asset account is created 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.
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 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. The journal entry when using the allowance method for doubtful accounts is different.
The credit is posted to the allowance for doubtful accounts, and the debit is posted to bad debt expense. 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 should be reviewed and adjusted, to meet changes in payment activity and trends in the marketplace.
When expensing bad debt 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.