Businesses estimate the amount of receivables that may not be collected in the future using an "allowance for bad debt" (also known as an allowance for doubtful accounts) to take this risk into account.
What is an Allowance for Bad Debt?
An allowance for bad debt is a "counter asset account" that lowers the total reported receivables to reflect only the amounts anticipated to be paid. A contra-asset account has a credit balance, which cancels out the linked asset account's debit amount. In this instance, the amount of sales made on credit is recorded in the accounts receivable account, which is offset by the allowance for bad debt.
The amount of receivables that are anticipated to be impossible to collect is the basis for the allowance for bad debt. The estimate may be based on a number of variables, including previous collection rates, sector averages, customer creditworthiness, and receivables age. The estimate is evaluated and modified from time to time to account for adjustments to conditions or expectations.
The allowance for bad debt is recorded in the income statement as a "expense," typically under selling, general, and administrative expenditures (SG&A). The expense lowers net income, which has a knock-on effect on shareholders'
equity and retained earnings. Also, the expense is a non-cash item that the cash flow statement adds back to net income.
How to Calculate an Allowance for Bad Debt?
The "percentage of sales method" and "percentage of receivables method" are the two main approaches used to determine an allowance for bad debt.
Using a fixed percentage of all credit sales performed over a given time period, the percentage of sales method determines the tolerance for bad debt. The tolerance for bad debt, for instance, is $20,000 (2% x $1,000,000) if a corporation forecasts that 2% of credit sales will not be collected. The journal entry to record this is:
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The percentage of sales approach adheres to the "matching principle" of accounting by matching expenses to revenues generated during the same period. It does not, however, take into consideration the age of the receivables or the current level in the allowance account.
The allowance for bad debt is determined using the proportion of receivables method as a percentage of the ending accounts receivable total or a percentage of various kinds of receivables according to the length of time they have been unpaid (also known as "aging of receivables"). For instance, if a business expects that 5% of its accounts receivable ($500,000) won't be collected, the allowance for bad debt would be $25,000 ($5% x $500,000). Alternatively, if the company uses an aging schedule and estimates different percentages for different age groups, then the allowance for bad debt is calculated as follows:
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The journal entry to record this is:
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Based on their age and risk profile, the proportion of receivables method indicates the actual collectability of the receivables. It does not, however, immediately connect the cost to the income made over the same time frame.
How to Write Off an Account Receivable?
The allowance for bad debt is debited and accounts receivable is credited when a specific account receivable is determined to be uncollectible. For instance, if a client owes $1,000 and files for
bankruptcy, the journal entry to write off their account would be as follows:
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This entry has no impact on net income or cash flow, but it reduces accounts receivable and the allowance for bad debt by $1,000. The write-off does not constitute a new expense; it is merely an adjustment to the accounting. When the allowance for bad debt was assessed and recorded, the expense was already recognized.
How to Recover a Written-Off Account Receivable?
An account receivable that was previously written off may occasionally be paid by a client. The business must now reverse the write-off and report the cash received. For instance, the journal entry to reflect a client payment of $1,000 that was written off would be:
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In the first entry, the write-off is undone, and the amounts of accounts receivable and allowance for bad debt are reinstated. The second entry documents the cash receipts and lowers the amount of accounts receivable. The net result is an increase in cash and a $1,000 reduction in the allowance for bad debt. Net income and other accounts are unaffected.
