A Survey of Different Methods of Accounting for Bad Receivables

During the course of its operations, a company must expect that it will not be able to collect all of its receivables

. There are two general methods companies use to account for these uncollectable receivables ("bad debts"): the "direct write-off" method, and the "allowance" method. While the allowance method is more complex, each method has advantages and disadvantages.

Some companies will account for bad debts as they occur, on an as-needed basis, by debiting an account called the "Bad Debts Expense" and crediting the offending receivable. This method is called the "direct write-off" of receivables. Should the company eventually collect a receivable that they initially deemed uncollectable, they may simply reverse the process. First, they would debit the receivable and credit the "Bad Debts Expense," then they would debit cash and credit the receivable, all for the amount collected. The direct write-off method is advantageous because it is simple and inexpensive to perform. In the case that bad debts represent an immaterial percentage of receivables, the direct-write off method is preferred to the allowance method.

A more complex method of accounting for bad debts involves estimating the loss that will occur due to uncollectable receivables at the end of every accounting period. This method is advantageous because it follows the matching principle - that is, the bad debts are accounted for in the period that the associated sales occur. In order to use the allowance method, a company will implement a contra asset account called "Allowance for Doubtful Accounts." At the end of an accounting period, the company will use an adjusting journal entry to account for potentially uncollectable receivables. To make this adjusting entry, the company debits the "Bad Debts Expense" account, and credits the "Allowance for Doubtful Accounts" based on the estimated percent of receivables that will be uncollectable. In the event that a receivable is deemed uncollectable, the company will debit the "Allowance for Doubtful Accounts," and credit the uncollectable receivable. If a bad debt is collected later, much like in the direct write-off method, the company will first debit the receivable and credit the "Allowance for Doubtful Accounts," then debit Cash and credit the receivable. While the mechanics of the allowance method are similar to the direct write-off method, with the simple addition of the "Allowance for Doubtful Accounts," the complexity arises in the estimation of potential bad debts.

There are three general ways to estimate bad debts. One simple method is to calculate the percentage of revenues that will be uncollectable (based on historical data either from other companies or from past income statements). At the end of every period, that percentage is applied to revenues to calculate the estimated bad debt that will be debited to the "Bad Debts Expense" and credited to "Allowance for Doubtful Accounts." Another method is to calculate the percentage of receivables that will be uncollectable (again using historical data). This method assumes that a certain percentage of all receivables in a given year will be uncollectable; therefore, the balance of the "Allowance for Doubtful Accounts" account will always be adjusted at the end of the year to reflect that percentage of total receivables on the company's balance sheet. The final, most complex method of estimating bad debts involves the aging of accounts receivable. This method is based upon the assumption that, the further overdue a receivable, the less likely the company is to collect on that receivable. Accounts are grouped by their age, and the company will determine what percentage of each group of receivables will be uncollectable. The total values of the receivables for each group are multiplied by the percentage of the group deemed uncollectable, and then all groups' totals are added up to calculate the desired balance of the "Allowance for Doubtful Accounts." At the end of the accounting period, the company makes an adjusting entry (again debiting "Bad Debts Expense" and crediting "Allowance for Doubtful Accounts") in order to make the balance of the Allowance for Doubtful Accounts meet the total expected amount of uncollected receivables.

Uncollectable receivables are a part of doing business that a company must account for. Rather than being caught off guard by the loss of expected revenue due to a bad debt, companies must expect and account for a certain amount of uncollectable debt. The direct write-off method allows a company to record a bad debt when the receivable is deemed uncollectable, and inexpensive method that is useful if bad debts are generally an immaterial part of the company's operations. The allowance method allows a company to estimate in advance the amount of receivables that will be uncollectable, useful because it follows the matching principle. Whichever method a company uses, accounting for bad debt is an important part of keeping the company's financial records representative of the true state of the company.

A Survey of Different Methods of Accounting for Bad Receivables

By: Greg Fiorentino

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