Allowance MethodThe Allowance Method of Accounting for Bad Debts

A. Estimating Bad Debts Based on Sales

Estimating bad debts as a percentage of sales is consistent with the matching
concept in that the bad debt expense is recorded in the same time period as the
associated revenue.
Net credit sales
x Bad debt percentage
----------------------
= Bad debt expense
Note: When using the estimate based on sales, the entry for bad debt
expense is made for the amount of the calculation.
Examples:
Jones Company has net credit sales of $75,000 and estimates that bad
debts are approximately 3% of net credit sales. The year end balance in
accounts receivable is $200,000.
> Record the entry assuming that the allowance account currently has a
credit balance of $300. The journal entry to record the bad debts
would be as follows:
Debit Credit
------- -------
Bad debt expense (75,000 x 3%) 2,250
Allowance for doubtful accounts 2,250
After the above entry, the allowance account would have a balance of
$2,550 (i.e., $2,250 + $300). The net realizable value of accounts
receivable after adjustment would be $197,450 (i.e., $200,000 - $2,550).
> Record the entry assuming that the allowance account currently has a
debit balance of $300. The journal entry to record the bad debts
would be as follows:
Debit Credit
------- -------
Bad debt expense (75,000 x 3%) 2,250
Allowance for doubtful accounts 2,250
After the above entry, the allowance account would have a balance of
$1,950 (i.e., $2,250 - 300). The net realizable value of accounts
receivable after adjustment would be $198,050 (i.e., $200,000 - $1,950).
B. Estimating Bad Debts Based on Receivables
The estimate based on receivable could be one that uses an aging or a single
calculation based on total receviables as shown below:
Accounts receivable balance
x Estimated percent uncollectible
--------------------------------
= Desired ending balance of Allowance
for Doubtful Accounts (credit balance)
Note: When using the estimate based on receivables, the entry for bad debt
expense must consider the current balance in the allowance
account. The amount of the bad debt expense for the entry is the
amount that is needed to bring the balance in the allowance account
to the amount of the desired ending balance The ending balance
must be a credit balance.
 Examples:
O'Reilly Company has an accounts receivable balance of $200,000 and
estimates that bad are approximately 1.5% of accounts receivable.
> Record the entry assuming that the allowance account currently has a
credit balance of $300. The journal entry to record the bad debts
would be as follows:
Debit Credit
------- -------
Bad debt expense ((200,000 x 1.5%) - 300) 2,700
Allowance for doubtful accounts 2,700
After the above entry, the allowance account would have a balance of
$3,000 (i.e., $200,000 x 1.5%). The net realizable value of accounts
receivable after adjustment would be $197,000 (i.e., $200,000 - $3,000).
> Record the entry assuming that the allowance account currently has a
debit balance of $300. The journal entry to record the bad debts
would be as follows:
Debit Credit
------- -------
Bad debt expense ((200,000 x 1.5%) + 300) 3,300
Allowance for doubtful accounts 3,300
After the above entry, the allowance account would have a balance of
$3,000 (i.e., $200,000 x 1.5%). The net realizable value of accounts
receivable after adjustment would be $197,000 (i.e., $200,000 - $3,000).
C. Write-off of Accounts Receivable
A write-off of accounts receivable has no effect on income because the allowance
approach bases any bad debt expense on an estimate using either net sales or
accounts receivable as shown above. The write-off is simply a removal of the
receivable and a reduction of the allowance account.
Example:
Prepare the entry to record the write-off of a $1,500 account receivable.
Debits Credits
-------- --------
Allowance for doubtful accounts 1,500
Accounts receivable 1,500
Note that the write-off does not change net realizable accounts
receivable. For example, if accounts receivable and the allowance
account were $200,000 and $20,000 before the write-off, respectively;
net realizable accounts receivable would be $180,000 before the
write-off (i.e., $200,000 - $20,000). After the write-off, net
realizable receivables would still be
$180,000 (i.e., $198,500 - 18,500).
D. Recovery of an Accounts Receivable Write-off
A recovery of a write-off of accounts receivable involves two basic parts.
First, there is a reversal of the write-off entry. Secondly, there is a
collection of the receivable just as if it had never been written off.
Example:
The customer was able to repay $1,000 of the $1,500 written off
in the prior write-off.
Debits Credits
-------- --------
Accounts Receivable 1,000
Allowance for Doubtful Accounts 1,000
Cash 1,000
Accounts Receivable 1,000