If a Company Fails to Record Estimated Bad Debts Expense

Writing Off an Account under the Allowance Method

Under the allowance method, if a specific customer’s accounts receivable is identified as uncollectible, it is written off past removing the amount from Accounts Receivable. The entry to write off a bad account affects merely
residuum sheet
accounts: a debit to Assart for Hundred-to-one Accounts and a credit to Accounts Receivable. No expense or loss is reported on the
income argument
because this write-off is “covered” under the earlier adjusting entries for estimated bad debts expense.

Let’s illustrate the write-off with the following example. On June iii, a customer purchases $1,400 of goods on credit from Gem Merchandise Co. On August 24, that same client informs Gem Trade Co. that it has filed for bankruptcy. The customer states that its depository financial institution has a lien on all of its assets. It besides states that the liquidation value of those avails is less than the amount information technology owes the banking company, and as a consequence Gem will receive cypher toward its $one,400 accounts receivable. After confirming this information, Gem concludes that information technology should remove, or
write off, the customer’s account balance of $1,400.

Nether the allowance method of recording credit losses, Gem’south entry to write off the customer’s account residuum is as follows:

The two accounts affected by this entry comprise this data:

Note that prior to the Baronial 24 entry of $ane,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). Afterward writing off the bad account on Baronial 24, the net realizable value of the accounts receivable is still $230,000 ($238,600 debit residue in Accounts Receivable and $8,600 credit balance in Allowance for Doubtful Accounts).

The Bad Debts Expense remains at $x,000; information technology is not directly affected by the journal entry write-off. The bad debts expense recorded on June 30 and July 31 had
anticipated
a credit loss such as this. Information technology would be double counting for Gem to tape both an anticipated approximate of a credit loss
and
the actual credit loss.

Recovery of Business relationship under Allowance Method

Afterward a seller has written off an accounts receivable, it is possible that the seller is paid part or all of the account balance that was written off. Under the allowance method, if such a payment is received (whether directly from the customer or as a result of a court activeness) the seller will have the following ii steps:

1. Reinstate the account that was written off past 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 account looks like this:

   

2. Process the $1,400 received on October 10:

   

The seller’s bookkeeping records at present prove that the business relationship receivable was paid, making it more probable that the seller might exercise future business with this client.

Bad Debts Expense as a Percent of Sales

Some other way sellers apply the allowance method of recording bad debts expense is past using the
percentage of credit
sales approach. This approach automatically expenses a percentage 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 be collected. Using the percentage of credit sales approach, this company automatically debits Bad Debts Expense and credits Assart for Doubtful Accounts for 0.3% of each week’s credit sales. Permit’southward assume that in the current week this company sells $500,000 of goods on credit. It estimates its bad debts expense to be $1,500 (0.003 10 $500,000) and records the following 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 remainder in the account Allowance for Doubtful Accounts is ignored at the time of the weekly entries. Notwithstanding, at some later appointment, the remainder in the assart account must exist reviewed and perhaps further adjusted, so that the residual sheet will written report the correct net realizable value. If the seller is a new company, it might summate its bad debts expense by using an industry average until information technology develops its own experience rate.