Bad debts are uncollectible customer invoices that have already been recorded as revenue. Since the revenue recorded when the invoice was issued will never be collected, the company must record an expense to offset it. Businesses can account for bad debt using either the direct write-off or allowance method.
For United States tax purposes, the direct write-off method of bad debt accounting is required, whereby bad debt is recorded only when a particular customer invoice is determined to be uncollectible. Contrary to income tax reporting, US generally accepted accounting principles (GAAP) require businesses to use the allowance method and record estimated bad debts as income is recorded from issuing invoices. Under the method, companies may choose any of the three estimation methods: the percentage of sales method, percentage of ending receivables method, and aging of receivables, or only aging, method.
- For tax purposes, the IRS only allows the direct write-off method for bad debt deductions, which requires the taxpayer to identify precisely which debt is uncollectible rather than estimating bad debt.
- Cash-basis taxpayers cannot have bad debt expense since they don’t recognize income until the cash is received.
- US GAAP requires estimating bad debts as invoices are issued.
- The easiest way to estimate bad debts is the percentage of sales method, while the most sophisticated way is the aging of receivables method. Although sophisticated, it provides the most approximate bad debt estimates.
- Companies with an “allowance for bad debts” account use the allowance method for bad debts. Those using the direct method don’t need to have an allowance account.
Writing Off Bad Debt: Direct Write-off & Allowance Methods
Writing off is the process of removing worthless accounts in the books. The method of writing off depends on the method you use: the direct write-off method is used for tax purposes, while the allowance method is the method of writing off bad debts based on estimates.
Since the allowance method uses estimates, it is not allowed for tax because bad debt deductions must be based on receivables that are already deemed worthless. However, GAAP uses it for financial reporting.
Cash-basis businesses don’t need to recognize bad debts since they don’t record receivables and credit sales.
1. Direct Write-off Method
Once you’re sure that the amount due cannot be collected anymore, you have to write them off the books. The amount written off should be the whole uncollectible amount.
For example, Customer A’s invoice for $500 has been overdue for 120 days. After a series of collection attempts, the company determines that Customer A’s receivable is worthless. The journal entry to write off Customer A’s account is:
Bad debts expense
Accounts receivable - Customer A
2. Allowance Method
Under the allowance method, write-offs are based on estimates—unless there’s conclusive evidence that certain customer accounts are uncollectible. This method uses estimations since the company is still unsure which customer accounts will be worthless. Companies that follow GAAP should use it to recognize bad debts.
All bad debt estimates are recorded in ADA (also called allowance for bad debts account). It is a contra-asset account, which means it is shown as a reduction to accounts receivable on the balance sheet. It reduces accounts receivable (A/R) to net realizable value or the amount that the company can reasonably expect to collect from customers.
Methods of Estimating Bad Debts Under the Allowance Method
For US GAAP, A/R must be stated at its net realizable value, which means companies must estimate the amount of new sales that will eventually become bad debt and never be collected. Hence, accountants use estimations to approximate the portion of current accounts receivable that will never be collected.
Below are the three methods of estimating bad debts under the allowance method.
Let’s look at a sample scenario where the company uses the percentage of receivables method in determining bad debts. Based on the ending A/R balance and the uncollectibility rate, the company estimates that $1,000 of the currently outstanding customer debt will eventually become uncollectible. This means that the ADA required balance should be $1,000 at the end of the period.
However, since the allowance is a balance sheet account, it likely already has a balance left over from last year’s estimate. The bad debt journal entry for the year isn’t $1,000, but rather whatever amount is necessary to adjust the allowance for bad debt balance to the required balance of $1,000. Assuming the company has a $200 balance in ADA, the required bad debts adjustment is $800.
The journal entry to adjust the allowance account is:
Bad debts expense
Allowance for bad debts
To further illustrate, let’s say that after several collection attempts, the company determined that Customer A’s outstanding balance of $500 is worthless and needs to be written off. The journal entry to write off bad debts under the allowance method is:
Allowance for bad debts
Accounts receivable - Customer A
Instead of using the bad debts expense account, we debited the allowance account instead. If you see an account title “allowance for bad debts” in the chart of accounts, it means that the business is using the allowance method. Otherwise, the business is using the direct write-off method.
While bad debts are unavoidable in the normal course of business, you can reduce their occurrence by properly managing A/R. Our article about A/R best practices provides some tips that can help you manage A/R.
Bad Debts Expense vs Bad Debts Allowance
Bad debt expense is an income statement account while bad debt allowance is a balance sheet account. Exactly how to interpret these accounts depends on whether you use the direct write-off or allowance method of accounting for bad debt:
- If you are using the direct write-off method, bad debt expense is the amount of invoices that have been deemed uncollectible in the current period. There will be no bad debt allowance account in the balance sheet since all uncollectible accounts are charged directly to expense when they become uncollectible.
- If you are using the allowance method, bad debt expense represents the amount of current period sales that you estimate will eventually become uncollectible. The bad debt allowance account offsets accounts receivable on the balance sheet to reduce them to their net realizable value, or the amount you estimate will be collectible.
Frequently Asked Questions (FAQs)
No, recognizing bad debts is not required—unless you are required to follow GAAP. However, businesses with significant A/R should recognize bad debts for financial reporting purposes to avoid overstating your revenue and A/R. Otherwise, you may opt to write off bad debts individually as they become worthless.
Bad debts are considered as expenses since they occur in the normal course of business. By definition, losses are deductions arising from events that are not normally occurring, such as loss due to fire or inventory theft.
Bad debt estimation occurs because it’s necessary for GAAP to recognize bad debt expense in the same period as the revenue that generated it. Recognizing bad debts promotes conservatism in the financial statements because it reports A/R at its net realizable value. Meanwhile, the IRS only allows bad debt deductions under the direct write-off method once it is certain that a particular debt will not be collected.