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.
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 $30,000Less: 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:
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.
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