Businesses tend to sell their goods and services on credit to increase their sales. If businesses do not offer credit sales, they will be losing some sales income to other competitors who are offering credit sales.
Offering credit sales means that businesses are willing to assume some credit risk to increase their sales. We do not live in a perfect world and there will be some defaults. However, the companies still sell the goods or services on credit as they believe that the benefits of increased sales outweigh the credit risks involved.
As a result of credit sales, a current asset known as accounts receivable is recorded on the balance sheet. As per prudence principle, this asset needs to be looked at carefully as it may be overstated if some of the balances of accounts receivable are not recoverable or collectible.
Creating allowance for bad or doubtful debts is a commonly used approach to ensure that accounts receivable are not overstated. (Direct write-off method, a rather less prudent approach can also used to account for bad debts which is explained separately).
Allowance for doubtful debts
Allowance for doubtful debts approach requires that an entity should predict the future and recognize an allowance for the estimated credit losses, instead of waiting for the default to happen. Numerous factors can be used to estimate the expected credit losses. An entity can use the historical trends of bad debts along with specific information available about the debtors to estimate the expected credit losses i.e., the amounts that are considered uncollectible or whose recoverability is doubtful. A contra account is used to record the allowance for doubtful debts and net amount of accounts receivable is presented on the balance sheet (Accounts receivable balance – Allowance for doubtful debts balance).
Following journal entry is made to record the allowance for doubtful debts.
Bad debts expense (P/L) – Debit
Allowance for doubtful debts (Contra account) – Credit
* Allowance for doubtful debts is also called provision for doubtful debts.
Subsequently, when the debtor defaults, only the balance sheet accounts have an impact as the bad debt expense was already recorded in the income statement at the time of creation of allowance for doubtful debts. Following journal entry is made to record the actual bad debt.
Allowance for doubtful debts (Contra account) – Debit
Accounts receivable – Credit
Let’s take a look at the following example to understand the accounting of bad debts under allowance method.
On 31 January, Fast Courier Co. has accounts receivable balance of $50,000. Credit revenue during the month was $60,000 whereas $10,000 was collected from customers. At the time of monthly reporting, the management of the company estimates the amounts whose recoverability is doubtful. It is estimated that $5,000 is not likely to be recovered.
On 15th February, a customer having a balance due of $3,000 defaults and confirms that he will not be able to pay the amount due. In February, Fast Courier Co. earns credit revenue of $60,000 and collects $30,000 cash from its debtors. On 28 February, balance of accounts receivable account is $77,000. It is estimated that $12,000 is not likely to be recovered.
Following journal entries will be made to record the allowance for doubtful debts.
In the financial statements for the month of January,
- Net balance of $45,000 will be presented as accounts receivable on the balance sheet.
- Bad debts expense of $5,000 will be reported in the income statement.
In the financial statements for the month of February,
- Net balance of $65,000 will be presented as accounts receivable on the balance sheet.
- Bad debts expense of $10,000 will be reported in the income statement.