How to Close a Loss Allowance for Bad Debts

Estimating credit losses before they occur is a conservative approach to managing your accounts receivable.

The allowance method for reporting credit losses permits a company to make an estimation of how much of its accounts receivable turns into a credit loss rather than converting to cash. A company does not need to have specific information on which customer invoices it believes will not be paid. The company creates an account called the "allowance for doubtful accounts," which it carries forward on it balance sheet. An increase in the allowance for doubtful accounts results in a bad debt expense on the company's income statement.

Instructions

1. Establish an allowance for doubtful accounts. You may estimate what portion of your accounts receivable is uncollectible. If every year 1 percent of your accounts receivables is uncollectible, multiply 1 percent by your accounts receivable balance to estimate your allowance for doubtful accounts. For example, the allowance for doubtful accounts balance is $10,000 -- 1 percent times $1,000,000 in accounts receivable.

2. Use your general ledger account to debit allowance for doubtful accounts -- balance sheet item -- for $10,000. Credit "bad debt expense" -- income statement item -- for $10,000.

3. Adjust your allowance for doubtful accounts as needed based on actual accounts receivable you had to write off during the year. For instance if at year-end you discover a credit balance of $9,000 for the allowance for doubtful accounts, this means you recorded an actual loss of $1,000. Write off losses by debiting allowance for doubtful accounts and crediting accounts receivable. To write off a $1,000 credit loss, debit allowance for doubtful accounts $1,000 and credit accounts receivable $1,000.

4. Close out the bad debt expense at year end by reversing the previous journal. In this case, debit bad debt expense and credit the allowance for doubtful accounts. Continuing with the previous example, debit bad debt expense for $1,000 and credit allowance for doubtful accounts by $1,000. This zeroes out the bad debt expense account for next year to record and tally the credit losses for the next accounting year.

Tips & Warnings

• One way of doing this is aging your accounts receivable by classifying invoices according to how many days past due and assigning a probability of how likely you are to receive payment. For example, assign a 99 percent probability of receiving payment on all outstanding invoices, 97 percent probability of receiving payment on invoices one to 30 days past due, 92 percent probability on invoices 31 to 60 days past due, 70 percent to invoices 61-90 days past due and so forth. Multiply the probability of not receiving payment by the receivable balances in each past due category. For example, your credit loss estimate is $4,950 for invoices one through 30 days past due -- 3 percent times $165,000 account receivable balance.

References

• The American Institute of Professional Bookkeepers: Recording Bad Debt Expense for Tax v. Book Purposes
• Accounting Coach: Accounts Receivable and Bad Debts Expense
• Jacksonville State University: The Allowance Method of Accounting for Bad Debts