Bad Debts Allowance Method

Allowance method of bad debts recognition is an accounting technique in which bad debts for the next accounting period are estimated and an expense for bad debts is recognized in the current period based on the estimate, before the debts actually become irrecoverable.

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 follows the matching principle of accounting by recognizing the bad debts in the same period as the related sales to which the receivables relate.

Bad debts expense is recognized early because bad debts are probable and they can be estimated to a fairly accurate extent. Apart from the matching principle stated above, bad debts expenses also fulfill the criteria required for recognition of contingent losses and it is necessary to recognize such expenses.

Journal Entries

The following example illustrates the journal entries related to allowance for bad debts expense at various stages.

Recognition

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 that relates to closing receivables balance. 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 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. The accounts receivable are presented on the balance sheet net of the allowance for doubtful debts, as shown below:

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

Write-off

In the next period, when a debt is actually determined as irrecoverable, 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.

Recovery of 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 in the allowance account:

  1. Percentage of Sales Method
  2. Percentage of Receivables Method
    (This is usually done using aging of receivables.)

by Irfanullah Jan, ACCA and last modified on

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