Allowance of Doubtful Accounts Journal Entry

Instructor: Mark Koscinski

Mark has a doctorate from Drew University and teaches accounting classes. He is a writer, editor and has experience in public and private accounting.

In this lesson you will learn how to account for business bad debt using an allowance for doubtful accounts. You will learn the journal entries used to record transactions and tools to calculate its adequacy.

The Allowance for Doubtful Accounts

Bad News

You are the credit manager of a small toy company. The day seemed promising until you picked up the Wall Street Journal at breakfast. On page one, you see your largest customer filed for bankruptcy protection. It owes your company a substantial amount of money and you wonder how the anticipated bad debt will affect your company's financial statements.

Direct Write-Off Method

There are two methods for recording bad debts. The first is called the direct write-off method or DRO method of accounting. When you have determined a receivable will not be collected, you make the following journal entry:

Dr. Bad Debt Expense xxx
Cr. Accounts Receivable xxx
To record the direct write-off of the uncollectible accounts receivable of XYZ Company.

The DRO method is very simple, but permissible under generally accepted accounting standards (GAAP) only when it approximates the allowance method. This method violates two fundamental principles of GAAP, the matching principle and principle of conservatism since net receivables are often overstated. Very few large companies use the DRO method because of this reason.

Allowance Method

The allowance method of recording bad debts is required under GAAP. A company estimates future bad debt and accounts for the anticipated loss in the current year. It is consistent with GAAP because the bad debt expense is recorded in the year the corresponding revenue has been recognized. In other words, when you record the sale, you know some of the receivables will not be collected. The matching principle requires you to record the anticipated loss at that time.

The allowance for doubtful accounts is established by the following journal entry:

Dr. Provision for doubtful accounts xxx
Cr. Allowance for doubtful accounts xxx
To establish an adequate allowance for doubtful accounts.

Provision for Doubtful Accounts

In accounting, the word provision is used to emphasize the bad debt expense is an estimate. To say you are recording a provision for doubtful accounts means you are estimating the amount of bad debt expense necessary for proper accounting. Good internal control requires a systematic approach to determine adequacy of the allowance. This must be done each time a balance sheet is published.

Determining Allowance Adequacy

Percentage of Sales

There are three common methods management may use when determining the adequacy of the allowance. The first uses a percentage of sales to determine the provision for doubtful accounts. A company in business for a number of years will have a history of uncollectible accounts, and knows what percentage of its receivables are historically not collected. Suppose that is 5%. If sales for the year are $100 million, the entry to record the provision will be:

Dr. Provision for doubtful accounts 5,000,000
Cr. Allowance for doubtful accounts 5,000,000
To record the provision for doubtful accounts.

Percentage of Outstanding Receivables

The second method uses a percentage of outstanding receivables to determine the allowance for doubtful accounts. Let's assume you have $20 million of outstanding accounts receivable and historically 10% of the outstanding receivables will become uncollectible. In this case, the required allowance is $2,000,000. If the allowance has a current balance of $1 million, you will need to make the following journal entry:

Dr. Provision for doubtful accounts 1,000,000
Cr. Allowance for doubtful accounts 1,000,000
To increase the allowance to its required balance of $2 million.

Aging Method

A third method of estimating doubtful accounts uses a receivables aging report. The older a receivable becomes, the less likely it will be collected. A higher and higher allowance percentage will be assessed as the receivables age past their due date. Many companies will assume a receivable over ninety days past due should be assumed completely uncollectible.

The Allowance as a Contra-Account

Accounts receivable need to be presented on the balance sheet at its collectible balance. The allowance is a contra-account to accounts receivable, reducing the gross accounts receivable to its collectible balance. Using our previous example, a typical disclosure of accounts receivable on the balance sheet would be:

Accounts receivable, net of the allowance for doubtful accounts of $2 million 18,000,000

Write-offs and Recoveries

Let's continue our previous example. Suppose an accounts receivable with an outstanding balance of $500,000 has been deemed uncollectible. The entry to write-off the receivable is as follows:

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