3 3 Bad Debt Expense and the Allowance for Doubtful Accounts Financial and Managerial Accounting

This method is usually referred to as the balance sheet approach as we use the balance sheet item (e.g. accounts receivable) as the base of our calculation. This is Suspense Account usually referred to as an income statement approach in which we use the income statement item (e.g. credit sales) as the base of the estimation. On the other hand, the bad debt expense is an expense item on the income statement. Likewise, this journal entry decreases total assets on one side and increases total expenses on another side.

SaaS companies (monthly vs. annual contracts)

• To deeply understand the risk profile of your customer base and proactively address aging receivables.
• Companies with a long operating history may rely on their long-term average of uncollectible accounts.
• Bad debt expense is the loss that incurs from the uncollectible accounts where the customers did not pay the amount owed.
• The Direct Write-off Method only captures an expense when a company determines a debt to be uncollectible.
• In the financial statements the asset a/c would be offset against the contra asset a/c to show the net balance.
• For companies having minimal bad debt activity, a quarterly update may be sufficient.

When simplicity is paramount, bad debt is infrequent and immaterial, or you’re not subject to GAAP (e.g., very small businesses). Even after an account is deemed uncollectible and potentially written off, there’s often an opportunity for recovery, especially for suspended accounts (e.g., accounts temporarily put on hold due to non-payment). More importantly, it will outline the strategic actions you can take, armed with this critical financial insight. When a customer pays an invoice that was previously written-off under the Direct Write-off Method, the debt must first be re-instated in the accounting records. Once re-instated, a payment can be applied to the re-instated invoice amount. Since the purpose of the contra account is to be offset against the balance on another account, it follows that the normal balance on the contra account will be the opposite of the original account.

• For reference, the chart below sets out the type, side of the accounting equation (AE), and the normal balance of some typical accounts found within a small business bookkeeping system.
• The allowance for doubtful accounts resides within your balance sheet’s “contra assets” division.
• The allowance method, considered more accurate and generally accepted under Generally Accepted Accounting Principles (GAAP), estimates bad debt expense before specific accounts become uncollectible.
• If you use double-entry accounting, you also record the amount of money customers owe you.
• This entry assumes a zero balance in Allowance for Doubtful Accounts from the prior period.

Direct Write-Off Method

The allowance for doubtful accounts might seem too subjective or imprecise for accounting, but it’s more accurate than pretending every invoice will be paid in full. Watch for dramatic changes in a company’s allowance for doubtful accounts in economic downturns. GAAP since the expense is recognized in a different period as when the revenue was earned. Your accountant’s busy estimating how much of that is just expensive toilet allowance for doubtful accounts normal balance paper. Sure, they take the first punch if a customer ghosts, but if the BNPL provider collapses or chargebacks spike, you—the merchant—could still get burned.

Contra Accounts

Their payments have been overdue for more than 40 days and ABC’s management was not sure if the payment will ever be made. Therefore, they create an allowance for doubtful accounts in their balance sheet if this client does not make the payment. If you use the accrual basis of accounting, you will record doubtful accounts in the same accounting period as the original credit sale. This presents a more realistic picture of the accounts receivable amounts you expect to collect versus what goes under the allowance for doubtful accounts. You credit the allowance to record your estimate for bad debts and debit it to write off a specific invoice.

How to Estimate Accounts Receivables

The entry for bad debt would be as follows, if there was no carryover balance from the prior period. The direct write-off method delays recognition of bad debt until the specific customer accounts receivable is identified. Once this account is identified as uncollectible, the company will record a reduction to the customer’s accounts receivable and an increase to bad debt expense for the exact amount uncollectible. For example, https://www.bookstime.com/ if a company with $100,000 in credit sales for the year estimates based on historical data that 2% of credit sales will be uncollectible, the estimated allowance for doubtful accounts would be $2,000.

The allowance can be calculated using different methodologies, and a straightforward way is to use historical context. If a certain percentage of accounts receivable is typically written off, it’s reasonable to use that percentage as an estimate. Upon review of your Allowance for Doubtful Accounts the balance may be significantly higher or lower than the actual amount of uncollectible invoices. In this case, adjustments must be made to the allowance account so a fair representation of uncollectible receivables is shown. Adjustments can be made manually to increase the allowance if there are specific situations that individuals are aware that may cause collection issues.

Master accounting topics that pose a particular challenge to finance professionals. Services businesses, particularly those with project-based work, often use milestone billing. Double Entry Bookkeeping is here to provide you with free online information to help you learn and understand bookkeeping and introductory accounting. Vivek Shankar specializes in content for fintech and financial services companies. He has a Bachelor’s degree in Mechanical Engineering from Ohio State University and previously worked in the financial services sector for JP Morgan Chase, Royal Bank of Scotland, and Freddie Mac. Vivek also covers the institutional FX markets for trade publications eForex and FX Algo News.