Pursuant to Generally Accepted Accounting Principles (GAAP), companies can estimate their bad debt expense using the allowance method. A common way of applying the allowance method is to estimate the bad debt expense is to analyze an aging Accounts Receivable (AR) report. An aging AR report provides accountants with a comprehensive view of the outstanding receivable balances and the number days they are past due.
Estimate the percent of the AR balance that is uncollectible. To estimate the percent of your company’s current AR balance that is uncollectible, you must analyze the aging AR report. For example, if the AR balance is $1 million, of which $20,000 is more than four months past due, it’s reasonable to estimate that 2 percent of the AR balance will never be collected.
Create the journal entry for your bad debt estimate. Your journal entry must increase the allowance for doubtful accounts, which is a contra-asset account to AR on the balance sheet, and the bad debt expense account, which reduces the company’s net income on the profit and loss statement. Prepare a credit entry to the allowance account to increase the balance and a debit entry to the bad debt expense account.
Reduce the AR balance when debts become worthless. A journal entry is necessary to reduce the balance of the AR account once the company decides to permanently write off an invoice. For example, after eight months of unsuccessful attempts to collect on a $10,000 invoice, the company may decide that it’s time to just write it off. You do this by recording a credit entry to the AR account for $10,000, and a corresponding debit entry to the allowance account.
Increase the AR balance for future collections. If the company eventually recovers all, or part, of the $10,000 invoice, you must make a debit entry to AR for the amount the company collects. You must also make a credit entry of the same amount to the allowance account. The balance in the allowance account reflects the amount of bad debts the company estimates it will write off before the end of the fiscal year. And since the customer ultimately pays the invoice, it’s unnecessary to use up the balance of the allowance account for the invoice.
Companies often report a net accounts receivable balance that reports the balance of the AR account, minus the balance of the allowance for doubtful accounts account.
Accountants use allowance for doubtful accounts to record estimates only. However, you never make an entry to the AR account until the company makes a final determination that a specific debt is uncollectible.