Allowance for Bad Debts
Allowance for bad debts are amounts expected to be uncollected, but still with possibilities of being collected. When there is no other possibility for them to be collected, they are considered as uncollectible accounts. For example, if gross receivables are $100,000 and the amount that is expected to remain uncollected is $5,000, the net current asset section of the balance sheet is:
|
Gross accounts receivable |
$100,000 |
|
Less: Allowance for bad debts |
$5,000 |
|
Net receivables |
$95,000 |
In financial accounting and finance, bad debt is the portion of receivables that can no longer be collected, typically from accounts receivable or loans. There are two methods to account for bad debt. Both methods credit the accounts receivable account.
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Direct write off method (Non-GAAP) – A receivable that is not considered collectible, charged directly to the income statement. With this method, the journal entry is a debit to the bad debt expense account.
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Allowance method (GAAP) – An estimate is made at the end of each fiscal year of the amount of bad debt. This estimate is accumulated in a provision, which is then used to reduce specific receivable accounts as and when necessary. With this method, the journal entry is a debit to the allowance for bad or doubtful debts account.
Because of the matching principle of accounting, revenues and expenses should be recorded in the period in which they are incurred. When a sale is made on account, revenue is recorded with account receivable. Because there is an inherent risk that clients might default on payment, accounts receivable have to be recorded at net realizable value. The portion of the account receivable that is estimated to not be collectible is set aside in a contra-asset account, called Allowance for Doubtful Accounts. At the end of each accounting cycle, adjusting entries are made to charge uncollectible receivable as expense. The amount of uncollectible receivable is written off as an expense from Allowance for Doubtful Accounts.