How to Calculate an Allowance for Bad Debt

How to Calculate an Allowance for Bad Debt
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An allowance for bad debt allows a small business to calculate how much of its credit sales may be uncollectible and turn into bad debt expense. The allowance for bad debt is a contra asset used to improve the accuracy of a business’s financial reports, help identify accounts in default and assist a company in clearly seeing its cash flow.

How Do You Calculate Allowance for Uncollected Accounts Receivable?

Under Generally Accepted Accounting Principles (GAAP), the allowance method follows the matching principle, recording bad debt expenses in the same period the respective sales occurred, explains the Cornell Law School Legal Information Institute. The Corporate Finance Institute (CFI) notes that this differs from the direct write-off method, in which the debt might be written off in a different period from the sales entry.

Common ways of determining the allowance using the allowance method include the following:

  • The accounts receivable (AR) or balance sheet method
  • The aging AR report method
  • Estimating from a percentage of credit sales.

Calculating the Allowance for Bad Debt From Accounts Receivable

To estimate the amount of uncollectible debt, you can use your company’s current balance sheet and historical data to determine the amount of accounts receivable that may never be collected. This is called the balance sheet method or percentage of accounts receivable method.

  • Calculate the historical percentage of bad debts in accounts receivable using previous years’ data.
  • Locate the total accounts receivable on the current balance sheet.
  • Multiply total accounts receivable by the historical percentage to estimate the allowance for uncollectible accounts in the current year.

For example, if the AR balance is $1 million and historical data shows that the company typically has five percent bad debts each year, it is reasonable to estimate that the uncollectible debt this year will be $50,000.

Using historical data is most accurate when debts are also broken down into buckets, as in the aging method.

Estimating the Allowance for Bad Debt With an Aging AR Report

A common way of applying the allowance method to estimate the bad debt expense is to analyze an aging accounts receivable (AR) report. This is also called the balance sheet aging method.

An aging AR report provides a comprehensive view of the outstanding receivable balances and the number of days overdue. Tracking the age of receivables helps gauge how likely a debt will be paid and, according to CFI, identify irregularities in a company's financial records. Generally, the greater the age of the debt, the more likely it will become an uncollectible account.

In this method, you create different buckets for the age of accounts expected to be uncollectible. Then, multiply the total dollar amount in each bucket by a certain percentage to calculate the estimated total value of uncollectible accounts receivable. The percentage used to multiply each bucket is based on historical data, which usually increases with each age bucket.

Using the Percentage of Sales Method to Calculate Uncollectible Accounts

The percentage of sales approach is also called the income statement approach. The idea behind this method is that at year end, a certain percentage of all credit sales will be uncollectible. To estimate your allowance for doubtful accounts using this method, multiply the total amount of credit sales from your year-end income statement by the historical percentage of unpaid debts.

For instance, if your total credit sales this year are $50,000 and in previous years your uncollectible accounts receivable was four percent, the valuation of allowance for doubtful accounts this year will be $2,000.

How to Create a Journal Entry for Bad Debt Estimates

Your journal entry in the general ledger must increase the allowance for doubtful accounts, which CFI says 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 write off an invoice permanently. For example, after eight months of unsuccessful attempts to collect a $10,000 invoice, the company may decide that it’s time to write it off.

Following the GAAP matching principle, you record a credit entry to the AR account for $10,000 and a corresponding debit entry to the allowance account.

Increase the AR Balance if the Debt Is Collected

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. Accounts receivable are considered a current asset, and since the customer ultimately pays the invoice, it’s unnecessary to use up the balance of the allowance account for the invoice.

Is Allowance for Bad Debts Deducted From Accounts Receivable?

Allowance for bad debts is deducted from accounts receivable because it is a contra asset or debit against the company’s account balance. Because bad debt and doubtful accounts reduce the total accounts receivable that a company can expect to collect, the allowance for them is entered as a deduction from accounts receivable.