Bad Debts & the Allowance Method

Not every customer who buys on credit ends up paying — bad debts must be estimated and expensed in the SAME period as the related sale, using either a percentage of sales or a percentage of receivables.

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Key things to remember

1Bad Debts Expense must be ESTIMATED and matched to the period of the related sale, not the period the loss is discovered.
2Income statement method: Bad Debts Expense = Net Sales × estimated %.
3Balance sheet method: Bad Debts Expense = (Accounts Receivable × estimated %) − existing Allowance balance.
4An age analysis assigns a higher uncollectible % to older, longer-overdue balances.
5Net Realizable Accounts Receivable = Accounts Receivable − Allowance for Uncollectible Accounts.
6Writing off a specific account never touches Bad Debts Expense and never changes Net Realizable Accounts Receivable.

Bad Debts are uncollectible amounts owed by customers — money a business extended as credit that it will, realistically, never collect. Bad Debts Expense is the loss due to uncollectible accounts. Because of the matching principle, a business cannot wait until a customer's account is officially declared uncollectible (which could be a year or more later) to record the expense — the expense has to be ESTIMATED and recorded in the same period as the related credit sales. This is the allowance method: instead of guessing which specific customer will not pay, the business estimates a total dollar amount and sets up an Allowance for Uncollectible Accounts (a contra-asset to Accounts Receivable).

AThe Income Statement Method

Uses a percentage of net sales as a basis for estimated bad debts expense
Focuses on matching the expense to the revenue that caused it
Bad Debts Expense = Net Sales × estimated %
Simple to apply; ignores any existing Allowance balance

BThe Balance Sheet Method

Uses a percentage of accounts receivable as a basis for estimating bad debts expense
Focuses on getting the Allowance account balance exactly right at period end
Required Allowance balance = Accounts Receivable × estimated %
Bad Debts Expense = required balance − existing Allowance balance

A more precise version of the balance sheet method is an Accounts Receivable Age Analysis — a list of balances owed by each customer and how long the balance has been owed, with older balances assigned a much higher estimated uncollectible percentage than fresh ones, since the longer a debt sits unpaid, the less likely it is ever to be collected.

Fig 1Estimating and writing off bad debts under the allowance method

Net Realizable Accounts Receivable is accounts receivable less estimated bad debts — the honest, realistic value of what a business actually expects to collect, shown on the balance sheet instead of the raw (overstated) total owed by customers.

Writing off an account

When a specific customer's account is finally confirmed uncollectible (bankruptcy, for example), it is written off: Dr Allowance for Uncollectible Accounts / Cr Accounts Receivable—[Customer]. Notice this entry does NOT touch Bad Debts Expense at all — the expense was already recorded back when the allowance was originally estimated. A write-off also does not change Net Realizable Accounts Receivable, because both Accounts Receivable and the Allowance shrink by the exact same amount.

Worked examples

Reveal one step at a time and try to beat it to the next line.

Example 1

A business had Net Sales of $500,000 this year and estimates that 1% of net sales will eventually prove uncollectible. Journalize the year-end adjustment using the income statement method.

Example 2

The same business has Accounts Receivable of $80,000 at year end and estimates 5% will prove uncollectible. Before adjusting, the Allowance for Uncollectible Accounts already has a $900 credit balance left over from last year. Journalize the year-end adjustment using the balance sheet method, and calculate Net Realizable Accounts Receivable.

Where marks get lost

Forgetting to subtract an existing Allowance balance when using the balance sheet method — only the SHORTFALL to the required balance is expensed.
Debiting Bad Debts Expense when writing off a specific customer's account — the write-off debits the Allowance account, not the expense, since the expense was already recorded earlier.
Believing that writing off an account changes Net Realizable Accounts Receivable — it does not, because both Accounts Receivable and the Allowance drop by the same amount.
Using the income statement method's percentage against total Accounts Receivable instead of Net Sales (or vice versa for the balance sheet method).
Assuming an age analysis uses one flat percentage for every customer, when its entire purpose is to apply DIFFERENT percentages to different age brackets.

Flashcards 7

Bad Debts

Bad Debts Expense

The Income Statement Method

The Balance Sheet Method

+ 3 more

Practice

Net Sales $360,000; estimated bad debts rate 1.5% (income statement method). Find Bad Debts Expense.

Accounts Receivable $95,000; estimated uncollectible rate 4% (balance sheet method); existing Allowance credit balance $600 before adjusting. Find the Bad Debts Expense needed.

Writing off a specific customer's account under the allowance method:

The balance sheet method for estimating bad debts is designed mainly to get which number correct?

What tool lists how long each customer's balance has been outstanding, to apply different bad-debt percentages by age?

Accounts Receivable $60,000; Allowance for Uncollectible Accounts $4,000. Find Net Realizable Accounts Receivable.

Which two accounts are affected when a specific customer's account is written off?

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