Question

how do companies account for bad debt? Why would they use an allowance account instead of directly crediting A/R? What are the various methods of accounting for bad debt? Describe the differences in how the expense is calculated.

Answer 1

Bad debt expense is a loss that is incurred by company due to nonpayment on the part of accounts receivable. There are two methods for computing the amount of bad debts expense.

1. Direct write – off method
2. Allowance method

In case of allowance method, Bad debts expense account is debited and Allowance for doubtful accounts is credited. The allowance method provides in advance for uncollectible accounts to set aside money in a reserve account. Most of companies follow conservative principle and they booked bad debts expenses in advance on the basis of their past experience. They set aside a particular amount in a reserve account called Allowance for doubtful accounts and whenever any bad debts occurred in future then it is set off against this reserve account.

Journal entry under allowance method for writing off bad debts expense is as follows:

Bad debts expense Dr

Allowance for doubtful accounts Cr

The direct write-off method recognizes bad debts as an expense at the point when it is actually incurred. As the name suggest, in this particular method, bad debts expense is directly written off against accounts receivable accounts and no reserve is created. This method is required for US income taxes.

Journal entry under allowance method for writing off bad debts expense directly is as follows:

Bad debts expense Dr

Accounts receivable Cr