Businesses must expect to sustain some losses from uncollectible accounts and should therefore show on the balance sheet the net amount of accounts receivable, the amount expected to be collected, rather than the gross amount. The difference between the gross and net amounts represents the estimated uncollectible accounts, or bad debts“. These expenses are attributed to the year in which the sale is made, though they may be realized at a later date. Through this post, we are going to discuss: how to record uncollectible account [Bad Debt], how to compute (calculate) it and what to do if later on it’s become collectible.

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There are two methods of recording uncollectible accounts; the “direct write-off method” and the “allowance method“.

 

Direct Write-Off Method

In small businesses, losses that arise from uncollectible accounts are recognized in the accounts in the period in which they become uncollectible. Under this method, when an account is deemed uncollectible, it is written off the books by a debit to the expense account, Bad Debt Expense, and a credit to the individual customer’s account and to the controlling account.

EXAMPLE: If Lie Dharma Inc.’s $300 account receivable, dated May 15, 200X, was deemed uncollectible in January of 20XX, the entry in 20XX would be:

[Debit]. Bad Debt Expense = $300
[Credit]. Accounts Receivable, Lie Dharma Inc. = $300

 

Allowance Method

As it is often discussed, one of the fundamentals of accounting is that revenue be matched with expenses in the same year [known as the “matching principle“]. Under the direct write-off method, the loss was not recorded until a year after the revenue had been recognized. The allowance method does not permit this!. The income statement for each period must include all losses and expenses related to the income earned in that period. Therefore, losses from uncollectible accounts should be deducted in the year in which the sale is made. Since it is impossible to predict which particular accounts will not be collected, an adjusting entry is made, usually at the end of the year.

EXAMPLE: assume that in the first year of operation, a firm has estimated that $2,000 of accounts receivable will be uncollectible. The adjusting entry would be:

[Debit]. Bad Debt Expense = $2,000
[Credit]. Allowance for Bad Debt = $2,000

 

The credit balance of “Allowance for Bad Debt (contra asset)” appears on the balance sheet as a deduction from the total amount of Accounts Receivable:

Accounts Receivable $30,000
Less: Allowance for Bad Debt 2,000
______________________________

Balance $28,000

The $28,000 will become the estimated realizable value of the accounts receivable at that date. The bad debt expense will appear as an operating expense in the income statement.

 

Computing Uncollectible Accounts

There are two generally accepted methods of calculating the amount of uncollectible accounts. One method is to use a flat percentage of the net sales for the year. The other method takes into consideration the ages of the individual accounts at the end of the fiscal year. Let’s go further to the details. Read on…

 

Percentage of Sales Method

Under the percentage of sales method, a fixed percentage of the total sales on account is taken.

EXAMPLE: If charge sales were $200,000 and experience has shown that approximately 1 percent of such sales will become uncollectible at a future date, the adjusting entry for the bad debt account would be:

[Debit]. Bad Debt Expense = $2,000
[Credit]. Allowance for Bad Debt = $2,000

 

The same amount is used whether or not there is a balance in the “Allowance for Bad Debt account“. However, if any substantial balance should accumulate in the allowance account, a change in the percentage figure would become appropriate.

 

Balance Sheet Method

Under the balance sheet method, every account is aged; that is, each item in the balance is related to the sale date. The further past due the account, the more probable it is that the customer is unwilling or unable to pay. A typical analysis is shown below:

Uncollectible Account Analysis

NOTE: The calculated allowance for uncollectible accounts ($1,800 above) is reconciled at the end of the year with the actual balance in the allowance account, and an adjusting entry is made. The amount of the adjusting entry must take into consideration the balance of the “Allowance for Bad Debt” account. The percentage of sales method does not follow this procedure.

 

Recovery of Uncollectible Accounts

If a written-off account is later collected in full or part (a recovery of bad debts), the write-off will be reversed for the amount received.

EXAMPLE: After his account has been written off, Mr. Lie Dharma Putra pays his account in full. The reversing entry to restore his account will be:

[Debit]. Accounts Receivable, Lie Dharma Putra = $600
[Credit]. Allowance for Bad Debt = $600

 

A separate entry will then be made in the cash receipts journal to record the collection, debiting Cash $600 and crediting Accounts Receivable, Lie Dharma Putra. If a partial collection was made, the reversing entry should be made for the amount recovered.