The accounts receivable account is one of the most important asset accounts for companies. It is a very liquid asset as companies expect to receive cash relatively quickly for its sales on account. It also has value in the open market. Each time a company releases its quarterly results, the company has to estimate how much accounts receivables it thinks will be uncollectible. That is done using the allowance for bad debt account on the balance sheet and bad debt expense on the income statement.
Allowance for Bad Debts
The allowance for bad debts is a contra asset account and found on the balance sheet. A contra asset account reduces the value of the associated account. The allowance for bad debts reduces the value of accounts receivable and the total assets for a company. The account is an estimate by the company of how much of its accounts receivables will not be collected. When an account is proven to be uncollectible, the company writes off the amount of the account from the accounts receivable and the allowance accounts. There is no effect on the shareholder's equity or total asset figure or net income.
Bad Debt Expense
The bad debt expense is found on the income statement and adds to the value of the allowance for bad debts. The bad debt expense is the entry that has to be made on the income statement to have the value of the allowance for bad debts as expected. For example, the allowance has a balance of $1,000, but because the company estimates that it will have $2,000 of uncollectible accounts, it enters a bad debt expense of $1,000 on the income statement. The bad debt expense is the adjustable expense that makes sure that the allowance for bad debts is where it is supposed to be.
The allowance method uses the net bad debt expense. The gross bad debt expense would generally be too high because the company already has some reserves if it has a balance in the allowance for bad debt already. The way to calculate the allowance is by finding the beginning year balance minus the write-offs plus the bad debt expense taken during the year.
For example, a company had an allowance for bad debts of $1,000 at the end of last year. During the current year the company had $200 of accounts receivable write-offs and took a bad debt expense of $500. The ending balance on the allowance for bad debt is $1,000 minus $200 plus $500, for a total of $1,300. There are many ways a company can estimate how much of its receivables will be uncollectible, but one is taking it as a percentage of accounts receivable.