Accounts receivable is the result of a company selling goods and services on account. Customers have a specific period in which to pay off open balances. Two activities that relate to accounts receivable are allowance for doubtful accounts and bad debts expense. The first reports potentially uncollectable accounts and the other is the formal recognition of lost income.
Allowance for Doubtful Accounts
Companies often track open accounts receivable balances through an aging report. This report lists all unpaid balances according to the age of each account. Common aging reports list accounts under 30, 60, 90 and 120 days old. Companies make dollar allowances for a certain percentage they deem uncollectable. Historical trends dictate what percentage of current open accounts receivable will be uncollectable.
Accountants review their company's past uncollected accounts receivable. They determine that 10 percent of all accounts aged 120 days or older will be uncollectable. Upon review of the current accounts receivable aging report, accountants find $12,500 in accounts receivable 120 days or older. An accountant books an entry to debit allowance for doubtful accounts by $1,250 and a credit to accounts receivable for $1,250 to balance the entry.
Bad Debts Expense
Bad debts expense formally recognizes that a company cannot recover an accounts receivable balance. Accountants also call this process writing off old accounts receivable amounts. An accountant will transfer the dollar amount written off by moving the balance from the allowance for doubtful accounts to the bad debts expense account. This results in balances moving from the balance sheet to the income statement for a specific accounting period.
Upon review of the accounts receivable aging report, accountants determine that $950 is no longer collectable. The business owing the money is now defunct and unable to pay its bill. An accountant will debit bad debts expense and credit allowance for doubtful accounts. This recognizes the bad debt and allows the company to remove the open accounts receivable from its books.