Bad Debt Expense Definition and Methods for Estimating

For example, based on experience, a company can expect only 1% of the accounts not yet due (sales made less than 30 days before the end of the accounting period) to be uncollectible. At the other extreme, a company can expect 50% of all accounts over 90 days past due to be uncollectible. For each age category, the firm multiplies the accounts receivable by the percentage estimated as uncollectible to find the estimated amount uncollectible. Then all of thecategory estimates are added together to get one total estimateduncollectible balance for the period. The entry for bad debt wouldbe as follows, if there was no carryover balance from the priorperiod. From this information, anyone studying these financial statements for Year One should understand that an expense estimated at $7,000 was incurred this year because the company made sales that will never be collected.

Bad Debt Expense: Definition and How to Calculate It

When a specific customer has been identified as an uncollectible account, the following journal entry would occur. The first entry reverses the bad debt write-off by increasing Accounts Receivable (debit) and decreasing Bad Debt Expense (credit) for the amount recovered. The second entry records the payment in full with Cash increasing (debit) and Accounts Receivable decreasing (credit) for the amount received of $15,000.

How to Calculate Bad Debt Expense

The income statement method (also known as the percentage of sales method) estimates bad debt expenses based on the assumption that at the end of the period, a certain percentage of sales during the period will not be collected. With this method, accounts receivable is organized into categories by length of time outstanding, and an uncollectible percentage is assigned to each category. For example, a category might consist of accounts receivable that is 0–30 days past due and is assigned an uncollectible percentage of 6%. Another category might be 31–60 days past due and is assigned an uncollectible percentage of 15%. All categories of estimated uncollectible amounts are summed to get a total estimated uncollectible balance.

What Is the Aging Method?

As we have shown, the allowance method is based on the accountant’s ability to estimate future uncollectible accounts that result from current year’s sales. After analyzing the ending balance of $250,000 in Accounts Receivable, management estimated that $12,500 of these accounts would ultimately become uncollectible. Bad Debt Expense increases (debit), and Allowance for DoubtfulAccounts increases (credit) for $48,727.50 ($324,850 × 15%).

• For example, in periods of recession and high unemployment, a firm may increase the percentage rate to reflect the customers’ decreased ability to pay.
• Knowing how to record write-offs as part of financial reporting is necessary at the end of the accounting period, which may run from January to December or any other time period.
• With an income statement approach the bad debt expense is calculated, and the allowance account is the balancing figure.
• Presented below is the current asset section of the Delta Corporation’s balance sheet at December 31, 2019 after the adjusting entry has been made.

To illustrate, let’s continue to use Billie’s WatercraftWarehouse (BWW) as the example. In the previous illustration, the company reports $160,000 as the total of its accounts receivable at the end of Year Two. A separate subsidiary ledger should be in place to monitor the amounts owed by each customer (Mr. A, Ms. B, and so on). The general ledger figure is used whenever financial statements are to be produced.

Using the Allowance Method to Record Uncollectible Accounts Expense

If this does not eventually prove to be true, an adjustment of the overall estimation rates may be indicated. This debit balance will then be eliminated when the new adjusting entry is made. The entry is not to the Uncollectible Accounts Expense account because we are assuming that the $6,000 is included in the $12,500 debit to expense as part of the December 31, 2019 adjusting entry. In preparing a balance sheet, the dollar balance in the Allowance account is netted against the dollar balance of gross accounts receivable.

He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University. how to calculate ending inventory under specific identification Learn how to build, read, and use financial statements for your business so you can make more informed decisions. Bench simplifies your small business accounting by combining intuitive software that automates the busywork with real, professional human support. To demonstrate the application of the aging method, we will use the data from the Porter Company.

The debit part of the adjusting entry is made to the Uncollectible Accounts Expense account. An estimate is required because it is impossible to know with certainty which accounts outstanding at the end of the year will become uncollectible during the next year. Once again, the difference between the expense ($27,000) and the allowance ($24,000) is $3,000 as a result of the estimation being too low in the prior year. When a company sells goods or services on credit, there is always a risk that some customers will not pay their bills. This method aligns with the matching principle of GAAP, ensuring that the expense is recognized in the same period as the related revenue. GAAP is overseen by the Financial Accounting Standards Board (FASB), which regularly updates and issues new standards to address emerging accounting issues and improve the quality of financial reporting.