Bad Debts Allowance Method

The allowance method is one of the two common techniques of accounting for bad debts, the other being the direct write-off method. Allowance method is a better alternative to the direct write-off method because it is according to the matching principle of accounting. In allowance method, the doubtful debts are estimated and bad debts expense is recognized before the debts actually become uncollectible.

Bad debts expense is recognized early because bad debts are probable and they can be estimated to a fairly accurate extent therefore they fulfill the criteria required for recognition of contingent losses and it is necessary to recognize bad debts expense.

Recognition Entry

The first step in the allowance method is to pass an adjusting entry at the end of an accounting period to recognize estimated bad debts expense. Unlike direct write-off method, we do not credit accounts receivable at this stage because it is actually a control account of many individual debtor accounts and we do not yet not know which particular debtor will make a default. We only know the estimated amount of receivables which are likely to end up uncollected. Therefore a provision account called allowance for doubtful accounts is credited in the adjusting entry. Thus:

Bad Debts Expense600
Allowance for Doubtful Accounts600

The bad debts expense account, just like any other expense account, is closed to income summary account of the period. The allowance for doubtful debts is contra-asset account. It is presented on balance sheet by subtracting it from accounts receivable as shown below:

Accounts Receivable$15,000
Less: Allowance for Doubtful Accounts− 600
Accounts Receivable, net$14,400

Write-off Entry

In the next period, when a debt is actually determined as uncollectible, the following journal entry is passed to write it off.

Allowance for Doubtful Debts70
Accounts Receivable70

As more and more debts are written off, the balance in the allowance account decreases.

Recovered Bad Debts

When any bad debt is recovered, two journal entries are passed. The first one reverses the write-off entry and the second one is a routine journal entry to record collection. Thus:

Accounts Receivable70
Allowance for Doubtful Debts70
Cash70
Accounts Receivable70

At the end of next accounting period, bad debts are estimated again and the balance in the allowance account is adjusted. There are two commonly used methods to estimate and adjust the balance of allowance account:

  1. Percentage of Sales Method
  2. Percentage of Receivables Method
    (usually done via Aging of Receivables Technique)

Written by Irfanullah Jan