Question

Describe the two methods of accounting for bad debts under the allowance method (not the direct write off method used on tax returns). Include how we estimate the allowance needed under one of the methods and how we account for write offs and recoveries of write offs.

Answer 1

The allowance method records an estimate of bad debt expense in the same accounting period as the sale. It often takes months for companies to identify specific uncollectible accounts. The allowance method follows the matching principle, which states revenues need to be matched with the expenses incurred in that same accounting period.

Generally, companies will choose between two approaches under the allowance method.

1.Percentage of Sales: Using historical data, a company examines the relationship between sales and uncollectible accounts receivable. If there is a fairly stable relationship between the two, a company will use the historical Uncollectible Accounts / Credit Sales ratio to estimate the bad debts expense in the current period.

For example, a company might find a historical trend indicating 2% of credit sales are never collected from customers. If that company had $100,000 of credit sales in the current period, it would also record the following journal entry:

Date Account Debit Credit

3/31/20XX . Bad Debts Expense $2,000  

Allowance for Doubtful Accounts $2,000

This method is sometimes referred to as the income statement approach.

2.Percentage of Accounts Receivable: Using historical data, a company examines the relationship between accounts receivable and uncollectible accounts. Companies will oftentimes increase the accuracy of these estimates by looking at their aging schedule for patterns, rather than using a composite (or total) of their receivables.

For example, a company might find a historical trend indicating 50% of credit sales over 150 days due are never collected, while 0.5% of credit sales over 30 days are never collected. This approach is illustrated below:

Aging Bad Debts A/R Balance Allowance

Schedule Estimate Bad Debts

Over 30 days 0.5% $300,000 $1,500

31 to 60 days 1.0% $100,000 $1,000

61 to 90 days. 2.0% $ 50,000 $1,000

91 to 120 days 5.0% $7,000 $350

120 to 150 days 15.0% $5,000 $750

Over 150 days. 50% $3,000 $1,500

Total Balance $6,100

This method is sometimes referred to as the balance sheet approach.

Allowance for bad debt, also known as the allowance for doubtful accounts, is a contra asset account and is used as an offset to accounts receivable. This allows the account to be stated in what is known as net realizable value, where:

Net Realizable Value = Accounts Receivable - Allowance for Doubtful Accounts

Recovery Using the Allowance Method
In the case of the customer later paying a written-off debt, we must reverse the journal entry used to write off the debt in section 4 as follows:

(DR.) Accounts Receivable $5,000 (CR.) Allowance for doubtful accounts $5,000

Next, the journal entry to record the cash receipt is as follows:

(DR.) Cash $5,000 (CR.) Accounts Receivable &5,000