The account receivable section of the balance sheet is an important element showing the amount of sales made via credit by customers of an entity. It gives an insight into how a company manages liquidity.
In the real world, not all customers will pay their dues, that’s just the reality of going into business. Accounting standards are established to give a true picture of a company’s financial position and performance so what happens to any potential bad debt?
There’s a special account generally called allowance for bad debt that is used for this exact purpose. A little deep dive into this account will help enlighten its purpose.
Allowance for Bad Debt: Definition
The majority of businesses allow their customers to pay for goods or services via credit. While a good portion of customers will end up paying their invoices, there’s always the possibility that some of them don’t end up paying their dues.
A company needs to take that into consideration when preparing for its financial statements since the goal is to present its financial information as accurately as possible.
The account “Allowance for Bad Debt” or “Allowance for Doubtful Accounts” or any other iteration of names with a similar meaning is where accountants record amounts that are most likely uncollectible.
This is a contra-asset account, meaning it’s part of the assets on the balance sheet but unlike other asset accounts that are natural debit accounts, this is a natural credit account.
This is due to the fact that an allowance for bad debt will always be grouped with the accounts receivable and ultimately be netted together to arrive at net receivables.
Balances in this account are estimated with management’s best knowledge of the historical collection rate and actual numbers might differ. This is why we call this a valuation account and the balances in the account can always be updated to reflect the true situation of the amounts expected to be unrecoverable from customers.
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How to Estimate Allowance for Bad Debt?
For a newly formed company with no historical information, a good indication of how to value the allowance for bad debt account is to look at other companies in the same industry.
As such, a startup can average the data from multiple companies in the same operating industry to get an idea of how much of its receivables will be unrecoverable.
With time, every company will be able to build its own historical data and rely on that to estimate future allowance for bad debts. There are two main methods to estimate the allowance for bad debt once historical data is accessible; the accounts receivable method and the sales method.
Accounts receivable method:
This is a popular method since it usually gives a better valuation. This concept is based on using the data from accounts receivable. An entity is able to classify its accounts receivable by age.
To clarify, this means the entire balance in the accounts receivable can be split into different categories based on how long a specific receivable exists. For example, popular categories are less than 30 days, 31 to 60 days, 61 to 180 days and more than 181 days.
Naturally, the longer a receivable exists, the higher are the chances that the client will default on payment. A company can therefore estimate how much of receivables in each aging category ends up not settling their dues using historical data and apply the rules on current year data.
Sales method:
The sales method is a little less popular since it tends to be less accurate. As the name mentions, this method relies on the sales of a company.
Using historical data, a company can look back and see how much of sales made via credit end up being bad debt with customers not paying their dues.
Journal Entry Examples
Let’s break it down and look at Carl’s Construction Company (“CCC”). CCC has accounts receivable of $100,000 at year-end and made sales of $500,000 via credit for the year. The $100,000 in receivables is split in the following aging categories:
| Less than 30 days | 31-60 days | 61-180 days | Over 181 days | Total receivables |
| $60,000 | $25,000 | $10,000 | $5,000 | $100,000 |
CCC notes that looking at prior years, clients generally pay their balances on all receivables of less than 30 days.
About 10% of clients end up not paying for receivables that are in 31-60 days, 25% of clients don’t pay for receivables that are in 61-180 days and 90% of clients don’t pay receivables that are over 181 days.
If looking at the sales side, CCC notes they usually have 2% of sales made via credit that are unrecoverable.
Calculating the allowance for bad debt using the accounts receivable method will end up with a value of $9,500. This is the result of multiplying the probability of clients not paying in each aging category with the balances of receivables in each category.
Sales Method
Using the sales method, the allowance for bad debt would result in a value of $10,000. This is calculated by multiplying the historical percentage of sales via credit that is unrecoverable with current-year sales made via credit.
The journal entries for the accounts receivable and sales method will look like the following:
Accounts receivable method | Debit | Credit |
| Bad debt expense (expense) | $9,500 | |
| Allowance for bad debt (asset) | $9,500 |
Sales method | Debit | Credit |
| Bad debt expense (expense) | $10,000 | |
| Allowance for bad debt (asset) | $10,000 |
Notice how the above entries do not touch the accounts receivable? This is the whole purpose of the contra-asset allowance for bad debt accounts.
When we net the allowance for bad debt accounts with accounts receivable, we get a true picture of receivables without ever touching the accounts receivable.
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| Accounts receivable method | |
| Accounts receivable | $100,000 |
| Less: allowance for bad debt | ($9,500) |
| Total accounts receivable | $90,500 |
| Sales method | |
| Accounts receivable | $100,000 |
| Less: allowance for bad debt | ($10,000) |
| Total accounts receivable | $90,000 |
What happens if we get confirmation that clients will not pay their invoices? Let’s say CCC got news that one of his clients went bankrupt and will not be paying CCC any amount due. That client had an invoice of $5,000 and CCC had recorded an allowance for bad debt for this already.
We simply write off the account receivable along with the allowance for bad debt. The journal entry would look like this:
Debit | Credit | |
| Allowance for bad debt (asset) | $5,000 | |
| Account receivable (asset) | $5,000 |
Allowance for Bad Debt: Recap and Final Thoughts
Estimating the amount of receivables that will likely be uncollected is essential for a company to paint an accurate picture of their financial situation.
Management’s estimated value will be recorded in the account called allowance for bad debt which can be updated based on new information over time.
There are two methods for companies to estimate this amount, with the most popular method being the accounts receivable method, mainly relying on historical data from aging accounts receivable.
The other method is the sales method which relies on historical data of credit sales that are ultimately unsettled. Regardless of the method used, this is an important account for accountants to understand in all industries.
