How to Calculate Bad Debt Reserve
For purposes of financial reporting, a bad debt reserve, also known as the allowance for doubtful accounts, provides an estimate of the percentage of receivables a company doesn't expect to collect. Whenever accountants increase the bad debt reserve, they also book a bad debt expense that immediately reduces the net income the company will report. However, there are a number of journal entries that are necessary to make simultaneously with the bad debt reserve.
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Instructions
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Estimate the percentage of credit sales that are ultimately noncollectable. Setting up a bad debt reserve is an art rather than a science. Estimating the percentage of credit sales that customers will ultimately default on requires a thorough analysis of the company's historical data. More often than not, accountants estimate the bad debt reserve as a percentage of overall sales rather than analyzing each customer's credit or invoice.
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Prepare the journal entry for bad debt reserve. Once you calculate a reasonable bad debt estimate, you must prepare a journal entry to post it to the company's financial records. This requires a credit entry equal to the estimate to the bad debt reserve account, which is a contra-asset account on the balance sheet. The corresponding debit entry for the same amount is made to the bad debt expense, which is an income statement account. The result is that the company immediately writes off a percentage of its credit sales based solely on estimates.
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Reduce accounts receivable for customer defaults. At the time you set up the bad debt reserve, it's unnecessary to reduce the accounts receivable account balance. However, once the company determines a debt is worthless, only then does it reduce the accounts receivable to eliminate the credit sale. This is done by making a credit entry to accounts receivable and a debit entry by the same amount to the bad debt reserve. By debiting the reserve account, the company is essentially using some of the bad debts it estimated earlier.
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Make adjustments if customers eventually pay their debt. In some cases, a company may determine a debt as noncollectable due solely to the passage of time without receipt of payment. However, if you write off a debt from the accounts receivable account but later collect on it, adjusting entries are necessary. For example, suppose one month after reducing the balances in the accounts receivable and bad debt reserve accounts for a customer's $10,000 unpaid invoice, the company finally receives payment. This requires you to credit the bad debt reserve account and debit accounts receivable by $10,000.
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Tips & Warnings
It's important to remember that the bad debt reserve account balance reflects an estimate and that you should never adjust the accounts receivable balance until you have a reasonable basis for writing a specific debt off as noncollectable.
