Accounting for Bad Debts
The two methods for accounting for bad debts are the Direct Write-off method and theAllowance method.
does not properly match, nor does it conform to conservatism, hence themethod
GAAP. It is, however, the method that must be used for income taxreporting.
The Allowance method
(is GAAP) does properly match expenses with revenues and isin conformity with conservatism and can be applied in two different, yet similar ways:
Income statement method
—relies on an estimate based on a percentage of netcredit sales. The balance in the allowance account at the end of the period
takeninto consideration. The percentage of net credit sales is debited to Bad debt expense andcredited to the Allowance for bad debts accounts, no matter the balance in the allowanceaccount.
(The Kimmel, et al. text does not present this method)
Balance sheet method
—relies on an estimate of uncollectible accounts madeduring an analysis of the Accounts receivable account. The balance in the Allowanceaccount
taken into consideration and the adjusting entry brings the Allowance accountup to the desired amount. If the allowance account has a debit balance, it is “overdrawn”.In other words, there have been more write-offs than planned. If the allowance accounthas a credit balance, it has a positive balance and has not been utilized as fully as wasexpected.Accounting for bad debts expense is done
at the end of the accounting period and isdone as an adjusting entry. The Bad debt expense account is not used at the timeindividual accounts are written off. The adjusting entry looks identical under either theIncome Statement method or the Balance Sheet method (since Direct Write-off is notGAAP, we won’t do the journal entries related to the method). The adjusting journalentry replenishes the allowance account, which is a contra-asset account and is in effect areserve for uncollectible accounts, in order to provide for the write-offs that will surelyoccur as a result of past credit sales. The only difference between the income statementmethod and the balance sheet method would be the amount in question:12/31Bad debt expenseX,XXXAllowance for bad debtsX,XXX
Net realizable value:
Since we know that we probably won’t be able to collect the entire amount of our receivables, we must present the amount that we reasonably believe that we
collecton the balance sheet (remember that conservatism tells us to avoid overstating our assets).This net amount is often referred to as the net realizable value (NRV) of accounts