How to Account for Bad Debts

Special rules apply for accounting for bad debts.

When businesses sell products, they will often sell using credit. When a business sells on credit, there is a chance that the buyer will not pay his bill. If the buyer does not pay his bill, the business will have a bad debt. Using the generally accepted accounting principles (GAAP), a company must estimate its bad debt expense. The company can estimate the expense using either the percent of sales method, the percent of account receivables method or the aging of receivables method.

Instructions

Percent of Sales Method

1. Estimate what percent of sales you believe will not be collected. Base this estimate on previous results of uncollected sales or a general estimate. For example, Firm A estimates 4 percent of its sales will not be collected.

2. Multiply the estimated sales that will not be collected by the amount of sales. In our example, if Firm A has $500,000 worth of sales, then $500,000 times 4 percent equals $20,000.

3. Debit "Bad Debt Expense" and credit "Allowance for Uncollected Accounts" by the number calculated in Step 2.

Percent of Accounts Receivable Uncollected

1. Estimate what percentage of year-end accounts receivable you believe will not be collected. Base this estimate on previous results of uncollected accounts receivable or a general estimate. For example, Firm A estimates 4 percent of their year-end accounts receivable will not be collected.

2. Multiply the estimated year-end accounts receivable that will not be collected by the amount of year-end accounts receivable. In our example, if Firm A has $200,000 worth of year-end accounts receivable, then $200,000 times 4 percent equals $8,000. This is the required bad debt expense balance.

3. Subtract the existing balance in the allowance for uncollected accounts from the required balance of allowance of uncollected accounts. For example, last year Firm A had $3,000 of allowance for uncollected accounts, so $8,000 minus $3,000 equals a $5,000 required adjustment.

4. Debit "Bad Debt Expense" and credit "Allowance for Uncollected Accounts" by the number calculated in Step 3. Reverse these entries if the number calculated in Step 3 is a negative number.

Aging of Receivables Method

1. Sort out the receivables by their age, then provide an estimate of uncollected for each amount. For example, a company has $50,000 currently due, $20,000 due between 1 day and 30 days from now, and $10,000 due more than 30 days from now. The company estimates 1 percent of the current due, 3 percent from the 1-to-30-day category and 5 percent from the 30-or-more-day category will not be collected.

2. Multiply the uncollected percentage by the amount of accounts receivable in each category. Then add these numbers together. In the example, $50,000 times 1 percent is $500, then $20,000 times 3 percent is $600, then $10,000 times 5 percent is $500. The total for the allowance of uncollected accounts is $1,600.

3. Subtract the existing balance in the allowance for uncollected accounts from the required balance of allowance of uncollected accounts. For example, last year Firm A had $1,000 of allowance for uncollected accounts, so $1,600 minus $1,000 equals a $600 required adjustment.

4. Debit "Bad Debt Expense" and credit "Allowance for Uncollected Accounts" by the number calculated in Step 3. Reverse these entries if the number calculated in Step 3 is a negative number.

References

• Accounting Coach: Accounts Receivable and Bad Debts Expense
• Accounting Coach: Writing Off an Account under the Allowance Method
• Accounting Coach: Credit Risk and Allowance for Loses
• Accounting Coach: Aging of Accounts and Mailing Statements
• JSU: Allowance Method