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Bad debts occur when people owe a company money and that money is no longer collectible. The Generally Accepted Accounting Principles (GAAP) include allowance methods for companies to account for bad debts. The allowance methods require a company to determine its bad debts and adjust its "bad debt expense" account and its "noncollectables" account.

Determine the beginning balance of the "noncollectables" account. This information is in the company's general ledger of accounts or on its balance sheet in the financial statement. In this example, a company had \$500 in its "noncollectables" account at the beginning of the year.

Next, determine the ending balance in the "noncollectables" account. This is accomplished with either a "percent of sales" method, "percent of accounts receivable" method or an "aging of receivables" method.

With a "percent of sales" method, say, for example, a company estimates that 4 percent of its \$50,000 in sales is noncollectable. The ending balance in its "noncollectables" account would be 4 percent times \$50,000, which equals \$2,000.

In the "percent of accounts receivable" method, say the company estimates that 2 percent of \$40,000 in its accounts receivable is noncollectable. The ending balance in its "noncollectables" account would be 2 percent times \$40,000, which equals \$800.

The "aging receivables" method looks at older debts as having a higher probability of being noncollectable. For example, accounts late zero to 30 days have a 5 percent chance of being noncollectable, accounts 31 to 90 days late have a 50 percent chance of being noncollectable and accounts more than 90 days late have a 90 percent chance of being noncollectable. The accountant would then multiply the amounts outstanding for each time period by the probability of being noncollectable to determine bad debt.

In our "percent of sales" method, adjust the account to \$1,500. This number is derived by subtracting the noncollectable amount calculated in Step 2 from the amount currently in the "noncollectables" account. In our example, this is \$2,000 minus \$500, which equals \$1,500.

In our "percent of accounts receivable" method, adjust the account to \$300. This number is derived by subtracting the noncollectable amount calculated in Step 2 from the amount currently in the "noncollectables" account. In our example, \$800 minus \$500 equals \$300.

Debit the "bad debt expense" account for the amount of the adjustment and credit the the "noncollectables" account for the amount of the adjustment.

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