If a Company Fails to Record Estimated Bad Debt Expense

Writing Off an Account under the Allowance Method

Under the allowance method, if a specific client’s accounts receivable is identified equally uncollectible, it is written off by removing the amount from Accounts Receivable. The entry to write off a bad account affects only
balance sheet
accounts: a debit to Allowance for Doubtful Accounts and a credit to Accounts Receivable. No expense or loss is reported on the
income argument
because this write-off is “covered” nether the earlier adjusting entries for estimated bad debts expense.

Permit’s illustrate the write-off with the following example. On June 3, a customer purchases $i,400 of goods on credit from Gem Merchandise Co. On August 24, that same customer informs Gem Merchandise Co. that it has filed for bankruptcy. The client states that its depository financial institution has a lien on all of its assets. It likewise states that the liquidation value of those assets is less than the amount it owes the bank, and every bit a effect Gem volition receive nil toward its $1,400 accounts receivable. Afterwards confirming this data, Gem concludes that it should remove, or
write off, the customer’s business relationship balance of $i,400.

Under the allowance method of recording credit losses, Jewel’south entry to write off the customer’s business relationship balance is as follows:

The two accounts affected past this entry incorporate this data:

Note that prior to the August 24 entry of $1,400 to write off the uncollectible amount, the net realizable value of the accounts receivables was $230,000 ($240,000 debit balance in Accounts Receivable and $10,000 credit balance in Allowance for Doubtful Accounts). After writing off the bad account on Baronial 24, the net realizable value of the accounts receivable is still $230,000 ($238,600 debit balance in Accounts Receivable and $8,600 credit residue in Assart for Doubtful Accounts).

The Bad Debts Expense remains at $ten,000; it is not directly affected by the periodical entry write-off. The bad debts expense recorded on June xxx and July 31 had
anticipated
a credit loss such every bit this. It would exist double counting for Precious stone to record both an predictable estimate of a credit loss
and
the actual credit loss.

Recovery of Account under Allowance Method

After a seller has written off an accounts receivable, it is possible that the seller is paid part or all of the business relationship balance that was written off. Under the allowance method, if such a payment is received (whether directly from the client or equally a result of a court action) the seller will take the following 2 steps:

1. Reinstate the account that was written off by reversing the write-off entry. If we assume that the $1,400 written off on Aug 24 is collected on October 10, the reinstatement of the business relationship looks similar this:

   

2. Process the $one,400 received on October 10:

   

The seller’s accounting records now bear witness that the account receivable was paid, making it more than likely that the seller might do future business concern with this customer.

Bad Debts Expense equally a Percent of Sales

Another style sellers apply the assart method of recording bad debts expense is by using the
percentage of credit
sales approach. This approach automatically expenses a per centum of its credit sales based on past history.

For example, let’s assume that a company prepares weekly financial statements. Past experience indicates that 0.three% of its sales on credit will never exist collected. Using the per centum of credit sales approach, this company automatically debits Bad Debts Expense and credits Allowance for Doubtful Accounts for 0.3% of each week’due south credit sales. Let’s assume that in the current calendar week this company sells $500,000 of goods on credit. It estimates its bad debts expense to be $1,500 (0.003 x $500,000) and records the post-obit journal entry:

The percentage of credit sales approach focuses on the income statement and the matching principle. Sales revenues of $500,000 are immediately matched with $1,500 of bad debts expense. The residuum in the account Allowance for Doubtful Accounts is ignored at the time of the weekly entries. However, at some later appointment, the balance in the allowance account must be reviewed and perchance further adjusted, so that the balance sail will report the correct net realizable value. If the seller is a new company, information technology might summate its bad debts expense by using an industry average until information technology develops its own experience rate.