The allowance method definition

A bad debt expense is a portion of accounts receivable that your business assumes you won’t ever collect. Also called doubtful debts, bad debt expenses are recorded as a negative transaction on your business’s financial statements. The alternative to the allowance method is the direct write-off method, under which bad debts are only written off when specific receivables cannot be collected. This may not occur until several months after a sale transaction was completed, so the entire profitability of a sale may not be apparent for some time. The direct write-off method is a less theoretically correct approach to dealing with bad debts, since it does not match revenues with all applicable expenses in a single reporting period.

• Now let’s say that a few weeks later, one of your customers tells you that they simply won’t be able to come up with $200 they owe you, and you want to write off their $200 account receivable.
• The seller’s accounting records now show that the account receivable was paid, making it more likely that the seller might do future business with this customer.
• Each category’s overall balance is multiplied by an estimated percentage of uncollectibility for that category, and the total of all such calculations serves as the estimate of bad debts.
• The reason why this contra account is important is that it exerts no effect on the income statement accounts.

Then, in the next accounting period, a lot of their customers could default on their payments (not pay them), thus making the company experience a decline in its net income. Therefore, the direct write-off method can only be appropriate for small immaterial amounts. To estimate bad debts using the allowance method, you can use the bad debt formula. The formula uses historical data from previous bad debts to calculate your percentage of bad debts based on your total credit sales in a given accounting period. In accrual-basis accounting, recording the allowance for doubtful accounts at the same time as the sale improves the accuracy of financial reports. The projected bad debt expense is properly matched against the related sale, thereby providing a more accurate view of revenue and expenses for a specific period of time.

How to Do an Entry for Bad Debt Expenses & Allowances for an Uncollectable Account

Bad debt expenses make sure that your books reflect what’s actually happening in your business and that your business’ net income doesn’t appear higher than it actually is. Accurately recording bad debt expenses is crucial if you want to lower your tax bill and not pay taxes on profits you never earned. Here, we’ll go over exactly what bad debt expenses are, where How To Calculate Bad Debt Expenses With The Allowance Method to find them on your financial statements, how to calculate your bad debts, and how to record bad debt expenses properly in your bookkeeping. If your business allows customers to pay with credit, you’ll likely run into uncollectible accounts at some point. At a basic level, bad debts happen because customers cannot or will not agree to pay an outstanding invoice.

In this post, we’ll further define bad debt expenses, show you how to calculate and record them, and more. Read on for a complete explanation or use the links below to navigate to the section that best applies to your situation. But this isn’t always a reliable method for predicting https://kelleysbookkeeping.com/understanding-current-tax-liabilities-in-balance/ future bad debts, especially if you haven’t been in business very long or if one big bad debt is distorting your percentage of bad debt. Offer your customers payment terms like Net 30 and Net 15—eventually you’ll run into a customer who either can’t or won’t pay you.

How to calculate bad debt expenses using the allowance method

The direct write-off method reports the bad debt on an organization’s income statement when the non-paying customer’s account is actually written off, sometimes months after the credit transaction took place. Company accountants then create an entry debiting bad debts expense and crediting accounts receivable. The journal entry to estimate and record bad debt using either method will result in a debit to bad debt expense and a credit to allowance for doubtful accounts.