How to Record Bad Debt: Direct & Allowance Methods

Bad debt represents a financial reality for many businesses extending credit to customers. It refers to accounts receivable that are deemed uncollectible, meaning the business is unlikely to receive payment for goods or services already provided. Accurately accounting for bad debt is important for maintaining precise financial statements and reflecting a business’s actual profitability and asset value. Without proper recording, a company’s assets could be overstated, and its expenses understated, leading to an inaccurate picture of its financial health.

Understanding Uncollectible Accounts

Bad debt is more than just a late payment; it signifies an account receivable that has become definitively uncollectible. While a past-due account still carries an expectation of eventual payment, an uncollectible account has reached a point where recovery is highly improbable or impossible. Businesses establish specific criteria to determine when an account transitions from past-due to uncollectible.

Common indicators that an account is uncollectible include the customer filing for bankruptcy, prolonged non-payment despite diligent collection efforts, or the inability to locate the customer. Legal actions, such as a court ruling confirming the debt’s worthlessness, also serve as definitive signs. A systematic approach ensures consistency and compliance with accounting principles. Businesses often use an aging schedule of receivables to monitor the likelihood of collection as debt ages.

Choosing a Recording Method

Businesses generally choose between two primary methods for recording bad debt: the direct write-off method and the allowance method. The direct write-off method is simpler, recognizing bad debt expense only when a specific account is identified as uncollectible. This method directly reduces accounts receivable and records the expense at that time.

The allowance method involves estimating uncollectible accounts before they are specifically identified. This approach creates an “allowance for doubtful accounts,” a contra-asset account that reduces the reported value of accounts receivable. This method adheres to the matching principle of accounting, which requires expenses to be recognized in the same period as the revenues they helped generate. While the direct write-off method is often used for tax purposes and by smaller businesses with immaterial bad debt amounts, the allowance method is required by Generally Accepted Accounting Principles (GAAP) for businesses with significant amounts of accounts receivable.

Recording Bad Debt Using the Direct Write-Off Method

When using the direct write-off method, a business records the bad debt expense only when it becomes clear that a specific customer’s account will not be collected. This approach is straightforward and directly impacts the financial statements at the point of recognition. The journal entry involves debiting the “Bad Debt Expense” account and crediting the “Accounts Receivable” account for the specific amount deemed uncollectible.

For example, if an account is determined to be uncollectible, the entry would be a debit to Bad Debt Expense and a credit to Accounts Receivable. This entry immediately reduces accounts receivable on the balance sheet and increases bad debt expense on the income statement. This method is generally used for income tax purposes.

Recording Bad Debt Using the Allowance Method

The allowance method is more complex, involving multiple steps to estimate and record uncollectible accounts. The process begins with estimating future uncollectible amounts, typically at the end of an accounting period. Common estimation techniques include the percentage of sales method, which estimates bad debt as a percentage of credit sales, or the aging of receivables method, which categorizes accounts receivable by age and applies different uncollectibility percentages to each age category.

Once the estimate is determined, an adjusting entry is made to record the estimated bad debt expense. This entry involves debiting “Bad Debt Expense” and crediting “Allowance for Doubtful Accounts.” The “Allowance for Doubtful Accounts” reduces gross accounts receivable to its estimated net realizable value on the balance sheet.

When a specific customer account is later identified as uncollectible, a separate entry is made to write off that account. This write-off involves debiting “Allowance for Doubtful Accounts” and crediting “Accounts Receivable.” This write-off does not directly impact Bad Debt Expense or net income, as the expense was already recognized during the estimation step.

Accounting for Recovered Debt

Occasionally, a business may unexpectedly collect a debt that was previously written off as uncollectible. The accounting treatment for these recovered debts depends on the method originally used to write them off. Recording these recoveries ensures accounts are properly reinstated and cash is recognized.

If the debt was originally written off using the direct write-off method, two journal entries are typically required to account for its recovery. First, the original write-off entry is reversed by debiting “Accounts Receivable” and crediting “Bad Debt Expense.” Then, cash collection is recorded by debiting “Cash” and crediting “Accounts Receivable.”

When a debt previously written off under the allowance method is recovered, a similar two-step process is followed. First, the account receivable is reinstated by debiting “Accounts Receivable” and crediting “Allowance for Doubtful Accounts,” which reverses the earlier write-off. Second, cash collection is recorded by debiting “Cash” and crediting “Accounts Receivable,” completing the recovery.