What are Bad Debts?
Credits are given to customers to encourage sales. However, not all receivables are collectible, there are some accounts which are considered as doubtful accounts also known as bad debt or uncollectible accounts. That’s why an allowance for doubtful accounts should be provided to write down the receivables to their recoverable values or Net Realizable Values. An allowance for doubtful accounts are estimated amounts of receivables which are doubtful of collection. These are contra-asset accounts, which is a deduction to accounts receivable.
What are the Two Methods of Bad Debts Accounting?
There are two methods in accounting for doubtful accounts, namely:
- Allowance method; and
- Direct write-off method.
Allowance method recognizes bad debt expense when they become probable, in order to avoid overstatement of receivables. The entry to record bad debts expense when collectability of accounts become doubtful is debit Bad debt expense or doubtful account expense and credit allowance for doubtful accounts. When doubtful accounts become certain or worthless, the entry to record the write-off is debit Allowance for doubtful accounts and credit accounts receivables. However, there are some instances that the doubtful accounts are recovered. When previous accounts which are written- off are recovered, the previous entry to record the write-off should be reversed and the collection should be recorded. The entry to record the reverse of write-off is debit Accounts Receivables and credit Allowance for doubtful accounts and the entry to record collection is debit Cash on Hand and credit Accounts receivables. These are the entries used to record the allowance for doubtful accounts using the Allowance method.
Direct Writeoff Method
Another method of accounting for doubtful accounts is the Direct write-off method. Unlike in the allowance method the direct write-off method recognizes bad debts expense and directly writes it off from the balance of accounts receivables when uncollectibility of accounts becomes certain and not when loss becomes probable. In effect receivables maybe overstated prior to the write-off. This method is usually unacceptable for Financial Reporting purposes except for micro entities. This method is used for taxation purposes because tax is deductible only when Accounts Receivables are deemed worthless. The entry to record write-off of accounts deemed worthless under the Direct Method is debit Bad debts expense and credit Accounts Receivables. When the accounts previously written-off are recovered, the entry to record the recovery is debit Cash on Hand and credit Gain on Recovery of Accounts Receivables. In the Direct write-off method there is no need to reverse the entry to record the write-off prior to the recording the recovery.
3 Ways of Estimating Doubtful Accounts
In order to record these entries under the Allowance Method, the estimated amounts of doubtful accounts must be obtained. There are three methods on how to estimate the doubtful accounts, namely: