3.2 Bad Debt & Allowance for Doubtful Accounts
Key Takeaways
- U.S. GAAP uses the allowance method so bad-debt expense is estimated and matched to related credit sales; tax reporting often deducts a bad debt only when a specific account becomes worthless.
- Percent-of-sales computes this period's expense: $80,000 of credit sales × 1.5% = a $1,200 debit to Bad Debt Expense and credit to Allowance for Doubtful Accounts.
- Aging computes the target credit balance in Allowance; if aging requires $3,230 and Allowance already has an $800 credit, expense is $2,430.
- Writing off $450 under the allowance method debits Allowance for Doubtful Accounts and credits Accounts Receivable with no new expense on the write-off date.
- A recovery first restores the customer by debiting Accounts Receivable and crediting Allowance, then records the cash collection.
Not every dollar of Accounts Receivable will be collected. End-of-period adjusting work therefore includes an estimate of uncollectible customer balances. AIPB's adjusting-entries skill set treats this estimate as part of converting the books to accrual statements: you compute the period's bad-debt cost, post the adjusting entry, and carry a valuation allowance so receivables appear at the amount expected to be collected. This independent OpenExamPrep section walks through the allowance method used in U.S. generally accepted accounting principles (GAAP), contrasts it with direct write-off, and shows the later write-off and recovery entries that do not redo the original estimate.
Why an estimate instead of waiting for a default
If Harbor Lane records $80,000 of credit sales in December and waits until a customer actually defaults in March to recognize any loss, December profit is overstated and March profit is punished for a December sale. The allowance method estimates uncollectible amounts in the same period as the related credit sales (or against the receivables that exist on the statement date). The estimate is not a guess pulled from thin air: it is based on history, current aging, and knowledge of specific customers, then recorded as an adjusting entry.
Net realizable value of receivables = Accounts Receivable − Allowance for Doubtful Accounts. Allowance is a contra-asset. It has a credit balance and sits next to Accounts Receivable on the balance sheet. You do not credit Accounts Receivable itself when you record the estimate, because you do not yet know which customers will fail to pay.
Allowance method versus direct write-off
| Feature | Allowance method | Direct write-off method |
|---|---|---|
| When expense is recorded | Period of related credit sales (estimate) | Period a specific account is deemed worthless |
| Adjusting entry | Debit Bad Debt Expense, credit Allowance | None for an estimate |
| Write-off of a known account | Debit Allowance, credit Accounts Receivable | Debit Bad Debt Expense, credit Accounts Receivable |
| Receivables on the balance sheet | Reported at net realizable value | Reported at gross AR until a write-off |
| Typical use | U.S. GAAP for material receivables | Tax reporting when a specific debt is worthless; also used on the books only when uncollectibles are immaterial |
GAAP uses the allowance method so expense is matched and assets are not overstated. Direct write-off is simple — when Harbor Lane decides a $450 invoice will never be collected, it debits Bad Debt Expense $450 and credits Accounts Receivable $450 — but it can leave overstated receivables until that day arrives. For tax reporting, a deduction for a business bad debt commonly waits until a specific receivable is worthless; this chapter does not invent tax-form or dollar-threshold rules. Keep the books on the allowance method for GAAP statements, and treat tax as a separate measurement that often follows actual worthlessness rather than an allowance estimate. If a problem asks which method GAAP requires for material AR, the answer is the allowance method.
Percent of sales (income-statement approach)
Harbor Lane's December credit sales are $80,000. Past experience suggests 1.5% of credit sales will not be collected.
Estimated bad-debt expense = $80,000 × 0.015 = $1,200.
December 31 adjusting entry:
- Debit Bad Debt Expense $1,200
- Credit Allowance for Doubtful Accounts $1,200
Under percent of sales, the computed amount is the expense. You do not first inspect the existing allowance balance to decide the expense (unless a problem specifically tells you to). If Allowance already had a $300 credit, it becomes $1,500 after this entry. If it had a $200 debit balance (write-offs ran hotter than last period's estimate), it becomes a $1,000 credit after posting $1,200. The income statement still shows $1,200 of bad-debt expense because that is the rate applied to this period's credit sales.
Use credit sales, not cash sales and not total revenue, unless the facts give a rate on total sales. Cash sales have no collection risk.
Aging of receivables (balance-sheet approach)
Aging asks a different question: what credit balance should Allowance show so that AR minus Allowance equals what we still expect to collect? Each age bucket gets a higher uncollectible percentage as invoices get older.
Harbor Lane's December 31 aging:
| Age bucket | Receivable balance | Uncollectible rate | Required allowance |
|---|---|---|---|
| Current (not yet due) | $40,000 | 1% | $400 |
| 1–30 days past due | $12,000 | 4% | $480 |
| 31–60 days past due | $6,000 | 10% | $600 |
| 61–90 days past due | $3,000 | 25% | $750 |
| Over 90 days past due | $2,000 | 50% | $1,000 |
| Total | $63,000 | $3,230 |
The target credit balance in Allowance is $3,230. The adjusting entry fills the gap between that target and the unadjusted allowance balance.
If Allowance currently has an $800 credit:
Required expense = $3,230 − $800 = $2,430.
- Debit Bad Debt Expense $2,430
- Credit Allowance $2,430
If Allowance currently has a $200 debit (prior write-offs exceeded the old estimate):
Required expense = $3,230 + $200 = $3,430.
You must restore the debit and then reach the $3,230 credit target. Skipping the existing balance is the number-one aging error.
Percent of sales and aging can be used together in a real close: sales-based estimates during the year, aging as a reasonableness check at year-end. On an exam item, use the method the facts specify and do not blend them unless asked.
Writing off a specific account
In February, Harbor Lane confirms that customer Dana Ruiz will not pay a $450 invoice. Under the allowance method the loss was already estimated. The write-off removes the receivable and uses up part of the allowance:
- Debit Allowance for Doubtful Accounts $450
- Credit Accounts Receivable $450
No Bad Debt Expense appears on the write-off date. Expense was recorded when the estimate was adjusted. Net realizable value is also unchanged by the write-off: AR falls $450 and Allowance falls $450, so AR minus Allowance is the same. That is a useful check if a question asks whether a write-off changes net receivables.
Direct write-off would have debited Bad Debt Expense $450 and credited AR $450 in February instead — which is why GAAP rejects that timing for material amounts.
Recoveries after a write-off
In May, Ruiz unexpectedly pays the $450. Two entries restore the history and then record cash. First reverse the write-off:
- Debit Accounts Receivable $450
- Credit Allowance for Doubtful Accounts $450
Then record the collection:
- Debit Cash $450
- Credit Accounts Receivable $450
Reinstating AR documents that this customer did pay, which matters for credit files. Crediting Allowance (not Bad Debt Expense) keeps the recovery inside the valuation account. Some firms credit a recovery income account instead of Allowance; unless a problem names that policy, restore Allowance. Never debit Cash and credit AR without the reinstatement if the invoice was already removed from the subledger — the customer would not be in AR to credit.
Putting the year in order
A clean sequence for the year is: record credit sales; post collections; post write-offs against Allowance as specific accounts fail; then, at period-end, adjust Bad Debt Expense so Allowance equals the aging target (or so expense equals the sales percentage). Confusing that order produces two common wrong entries: debiting Bad Debt Expense when writing off under the allowance method, and treating the aging total as expense without looking at the existing allowance balance. Both errors misstate net income and the net receivables line on the balance sheet.
Which statement correctly contrasts the allowance method with direct write-off for a bookkeeper preparing accrual financial statements?
December credit sales are $80,000. Management estimates 1.5% will prove uncollectible and uses the percent-of-sales approach. Which adjusting entry records the estimate?
Using the allowance method, Harbor Lane writes off a $450 customer balance that is confirmed uncollectible. Which entry is correct?