Selling goods or services on credit means that the seller takes an unsecured credit risk. In other words, there is always a possibility that a client will not be able to pay an amount owed to a supplier. Moreover, the supplier is an unsecured creditor because his or her claim against client assets is not backed by any lien.
Assuming that some portion of accounts receivable will probably not be collected, the amount of accounts receivable reported in a balance sheet can be overstated. Applying the bad debts allowance method reduces the effect of overstating. It involves using a contra asset Allowance for Doubtful Accounts in the balance sheet and Bad Debt Expense (also referred to as Uncollectible Accounts Expense) in the income statement.
Using the bad debts allowance method requires an estimation of bad debts that may arise in the accounting period, which is usually a percentage of total sales on credit.
The bad debts allowance method requires several entries to be made in the general journal.
The adjusting entry should be made at the end of accounting period to recognize the amount of bad debts expense. It is recorded by debiting the Bad Debts Expense account and crediting Allowance for Doubtful Accounts by the estimated amount of receivables that will likely be uncollected.
The Bad Debts Expense is a temporary account and is closed at the end of the accounting period. The balance of Allowance for Doubtful Accounts is deducted from Accounts Receivable in the balance sheet. In other words, the net value of receivables is reported in the balance sheet to prevent overstating.
If some specific account is recognized as uncollectible, it should be written off under the bad debt allowance method. This requires a single entry to be recorded in the general journal by debiting Allowance for Doubtful Accounts and crediting Accounts Receivable for the amount of uncollectible debt.
This entry only affects the balance sheet accounts and is not reported on the income statement because this loss was already counted as bad debts expense.
Sometimes a customer will pay part or the whole amount of a debt that was previously written off. Under the allowance method, recovery of bad debts requires two entries to be made in the general journal.
The first one is recorded by debiting Accounts Receivable and crediting Allowance for Doubtful Accounts for the amount of cash collected.
The second entry debits the Cash account and credits Accounts Receivable by the same amount.
To illustrate the bad debts allowance method, assume that RetailX LTD has made following transactions in the 3rd financial quarter:
These transactions should be recorded in the general journal as follows:
The entry made on July 25 records bad debts written off in the amount of $900. On September 12, RetailX LTD recovers the bad debt of $600 by two entries. Finally, at the end of the accounting period on September 30, RetailX LTD reported credit losses of $1,500 in the income statement.
Let’s transform the entries in the example above to a T-account.
As far as Allowance for Doubtful Accounts is a contra asset account, it increases by crediting and reduces by debiting.
In turn, Bad Debts Expense has the credit balance. Like any other temporary account, its beginning balance always equals to zero, and this account is closed at the end of the accounting period.