Bad debt expense occurs when a company experiences a loss due to products sold or services provided that they ultimately do not receive payment for. The bad debt expense only relates to transactions that involve a company’s accounts receivable account.
There are two methods that a company may use to account for bad debt expense: the direct write-off method and the allowance method.
The direct write-off method requires that a company determines the exact amount that a customer will not be paying for products received or services rendered. The company then would take this amount and remove it from the accounts receivable account. When it comes to U.S. income taxes the “direct write-off method” is the required method. Bad debt expense is charged for the amount and accounts receivable is written off for the same amount. The journal entry looks like this:
Debit: Bad Debt Expense $XXX
Credit: Accounts Receivable $XXX
The allowance method requires that a company estimates the amount of bad debt expense that they will occur over a certain period of time. The company takes this amount that they estimate (based on a combination of historical records, equations, formulas, etc.) and they then use an account known as “allowance for doubtful accounts” and they credit this account. This account is a contra asset account which means it is not a liability but still reduces an asset account, in this case the accounts receivable account. The journal entry for this method looks like this:
Debit: Bad Debt Expense $XXX
Credit: Allowance for Doubtful Accounts $XXX
There is widespread belief that the “allowance method” is a better method for a company to use to account for bad debt expense. One of the reasons is that a company’s balance sheet will display a more representative amount that will be collected from their accounts receivable account. Another reason is that a company’s bad debt expense that will be reported on the income statement will be closer to the time of the related credit sales.
