Allowance for Doubtful Accounts and Bad Debt Expense

The allowance for doubtful accounts estimates the portion of receivables that may not be collectible.

This approach complies with the matching principle, recognizing potential credit losses in the same period as related revenues.

Proper calculation and adjustment of the allowance ensure that accounts receivable are presented at their net realizable value.

Failing to estimate bad debts accurately can lead to overstated assets and misstated net income.

Overview / Definition

The allowance for doubtful accounts is a contra-asset account used to offset accounts receivable, reflecting the estimated amount that may not be collected.

This method recognizes that some customers may default on their payment obligations, requiring companies to account for potential credit losses.

The related expense, known as bad debt expense, is recorded in the income statement under operating expenses.

This treatment aligns with US GAAP (ASC 326 - CECL Model) and IFRS 9, which both emphasize timely recognition of credit losses.

Recognition and Measurement

There are two primary methods for estimating bad debts:

✦ Percentage of Sales Method: Estimates bad debts as a fixed percentage of credit sales.

✦ Aging of Accounts Receivable Method: Estimates uncollectible amounts based on the age of outstanding receivables.

Example – Percentage of Sales Method:

• Credit Sales for the year: $500,000

• Estimated Bad Debt Rate: 2%

Bad Debt Expense = $500,000 x 2% = $10,000

Journal Entry:

debit Bad Debt Expense – 10,000

credit Allowance for Doubtful Accounts – 10,000

Example – Aging of Receivables Method:

Age of Receivable	Balance	Estimated Uncollectible %	Allowance
0–30 Days	100,000	1%	1,000
31–60 Days	50,000	3%	1,500
61–90 Days	20,000	10%	2,000
Over 90 Days	10,000	25%	2,500

Total Allowance Needed = $7,000

If the current balance in the allowance account is $2,000, an additional $5,000 must be recorded.

Journal Entry:

debit Bad Debt Expense – 5,000

credit Allowance for Doubtful Accounts – 5,000

Journal Entry Examples

1. Writing Off an Uncollectible Account (Customer Defaulted on $3,000):

debit Allowance for Doubtful Accounts – 3,000

credit Accounts Receivable – Customer Name – 3,000

2. Recovering a Previously Written-Off Account ($1,500):

First, Reverse the Write-Off:

debit Accounts Receivable – Customer Name – 1,500

credit Allowance for Doubtful Accounts – 1,500

Then, Record the Cash Collection:

debit Cash – 1,500

credit Accounts Receivable – Customer Name – 1,500

Disclosure Requirements

Companies must disclose:

✦ The method used to estimate uncollectible accounts.

✦ The opening and closing balances of the allowance for doubtful accounts.

✦ Bad debt expense recognized during the period.

✦ Significant changes in credit policies or collection procedures.

Disclosures typically appear in the notes to the financial statements under the Accounts Receivable section.

IFRS Comparison

Criteria	US GAAP (ASC 326 – CECL)	IFRS (IFRS 9)
Model Used	Current Expected Credit Loss (CECL)	Expected Credit Loss (ECL)
Estimation Approach	Lifetime Losses for All Receivables	12-Month or Lifetime Losses
Allowance Required	Yes	Yes
Reversal of Impairment	Not Common	Permitted

IFRS requires companies to assess whether to apply a 12-month expected loss or lifetime expected loss based on credit risk deterioration.

Common Errors

✦ Underestimating Bad Debts: Leads to overstated accounts receivable and net income.

✦ Incorrect Use of Aging Method: Applying inappropriate percentages to different aging categories.

✦ Failure to Adjust for Prior Allowance Balance: Not considering existing balances when calculating the necessary adjustment.

✦ Not Recognizing Recoveries Properly: Failing to reverse write-offs before recording cash collections.

✦ Inadequate Disclosures: Not clearly explaining the estimation methods and assumptions used for the allowance.