Calculating the bad debt expense for your company requires some analysis of its past rate for collecting receivables. Although you don’t base your bad debt estimate using a percentage of the current accounts receivable balance, the resulting bad debt expense you project will ultimately reduce its balance. Instead, base your estimate on the percentage of past sales the company makes on credit that it’s able to collect on.
Obtain data on uncollectible accounts receivable balances from past years. Calculating a company’s bad debt expense requires you to analyze its history of having to write off accounts as uncollectible. This is because your current bad debt expense estimate should reasonably relate to the percentage of sales the company makes on credit in prior years that customers never pay.
Calculate the percentage of uncollectible credit sales. Most accountants use a multiyear average of prior uncollectible credit sales as a method of estimating the bad debt expense for the current fiscal year. A quick way to do this is by dividing the accounts receivable balances the company never collects by the total sales it makes on credit during the same period. If you’re analyzing multiple fiscal years, perform the calculation for each year and use the average to arrive at your uncollectible percentage for the current year.
Post journal entry to bad debt expense and bad debt reserve account. After multiplying the uncollectible credit sales percentage by the current year sales, you need to post it to the company’s books. This requires a credit entry to the bad debt reserve account, which is also known as the allowance for doubtful accounts. The corresponding debit entry of the same amount is made to the bad debt expense account, which ultimately reduces the net income of the company.
Adjust accounts receivable as you receive accurate data. When you estimate bad debt expense for the year, no entries are made to accounts receivable. However, as the company makes final determinations that specific invoices will never be paid, only then do you reduce the balance of accounts receivable. Do this by making a credit entry to the accounts receivable account by the amount of the bad debt, and a corresponding debit entry to the bad debt reserve account to reduce its balance.
If at the end of the year your write offs of accounts receivable exceeds the balance you estimate in the bad debt reserve account, either your estimate was inaccurate or the current fiscal is atypical in comparison to prior years.
It is possible that a customer may decide to pay an invoice long after the company writes their balance off from the accounts receivable account. When this occurs, it’s imperative that you reverse the write-off by increasing the accounts receivable and bad debt reserve accounts.