Journal entry for accounts receivable bad debts
Accounts receivable refers to the amounts owed to a business by its customers for goods or services provided on credit. Bad debt, on the other hand, refers to receivables that are unlikely to be collected because the customer is unable or unwilling to pay. When a customer fails to fulfill their payment obligation, the business may consider the outstanding amount as bad debt.
Accounting for bad debt is important for financial reporting accuracy. There are two primary methods for accounting for bad debt:
- Direct Write-Off Method:
- Under this method, a company recognizes bad debt expense only when a specific account receivable is deemed uncollectible.
- The specific account is then directly written off, meaning it is removed from the accounts receivable on the balance sheet and charged as an expense on the income statement.
The direct write-off method is straightforward but may not adhere to the matching principle, which requires expenses to be recognized in the same period as the related revenue.
- Allowance Method (or Provision for Doubtful Debts):
- The allowance method is more conservative and aligns with the matching principle. Instead of waiting for a specific account to be identified as uncollectible, a business estimates and sets aside a certain amount for potential bad debts.
- This estimated amount is recorded as a contra-asset account called “Allowance for Doubtful Accounts” on the balance sheet. The corresponding bad debt expense is recognized on the income statement.
When a specific account is deemed uncollectible, the business reduces the accounts receivable and simultaneously decreases the allowance for doubtful accounts.
The allowance method provides a more accurate representation of the true financial position of a company, anticipating that not all accounts receivable will be collected.
In summary, bad debt in accounts receivable is managed through accounting methods like the direct write-off method or the allowance method, depending on a company’s preference and the accounting standards it follows. The goal is to accurately reflect the financial impact of uncollectible receivables in the financial statements.
Journal entry for accounts receivable bad debts
Let’s consider a scenario where a business sells goods on credit to a customer, and the customer later fails to pay. We’ll create journal entries for both the Direct Write-Off Method and the Allowance Method.
Direct Write-Off Method:
Assume the business sold goods for $1,000 on credit to a customer but later determines that the customer cannot pay. The journal entry under the Direct Write-Off Method would be:
- At the time of the sale:
| Account | Debit | Credit |
|---|---|---|
| AR | 1,000 | |
| Sale | 1,000 |
This entry recognizes the revenue from the sale.
- When the bad debt is identified:
| Account | Debit | Credit |
|---|---|---|
| Bad Debt Exp | 1,000 | |
| AR | 1,000 |
This entry directly writes off the specific accounts receivable that is deemed uncollectible and recognizes bad debt expense.
Allowance Method:
Assuming the business estimates a 2% allowance for doubtful debts on credit sales of $1,000, the journal entries would be as follows:
- At the time of the sale:
Account Debit Credit AR 1,000 Sale 1,000 This entry recognizes the revenue from the sale.
- To establish the allowance for doubtful debts:
Account Debit Credit Bad Debt Exp 20 Allowance for Doubtful Acc 20 This entry estimates and records the bad debt expense based on the percentage of credit sales.
- When the bad debt is identified:
Account Debit Credit Allowance for Doubtful Acc 100 AR 100
This entry reduces the specific accounts receivable and the allowance for doubtful accounts, reflecting the actual uncollectible amount.
These entries reflect the different approaches to accounting for bad debt under the Direct Write-Off Method and the Allowance Method. The Allowance Method, with its provision for doubtful debts, aims to recognize potential bad debts before they are specifically identified, providing a more accurate representation of the company’s financial position.
