Journal entry for allowance for doubtful accounts

Introduction

In business, losses due to uncollectible accounts tend to occur when we extend credit to increase sales resulting in many credit sales taking place during each accounting period. In this case, we need to make the journal entry for allowance for doubtful accounts at the end of each accounting period in order to account for the expected loss.

At the end of each accounting period, we need to record the expected losses due to uncollectible accounts into the allowance for doubtful accounts on the balance sheet. At the same time, we need to recognize it as an expense during the accounting period by recording the same amount of the expected losses into the bad debt expense on the income statement. This is to comply with the matching principle of accounting.

The losses that occur due to uncollectible accounts are the losses that come from the credit sales. Likewise, under the matching principle of accounting, these losses should be recognized and recorded at the same accounting period that the credit sales are made. This way, the losses or expenses will match with the revenues that the credit sales generate for the business.

Of course, we do not know which customers are going to default on their payment or how much amount will we lose exactly. Likewise, we need to estimate the amount of allowance for doubtful accounts. The estimation of the expected losses is usually made based on our past experiences and industry average data.

Journal entry for allowance for doubtful accounts

We can make the journal entry for allowance for doubtful accounts by debiting the expected losses for the period into the bad debt expense account and crediting the same amount into the allowance for doubtful accounts at the period end of the adjusting entry.

In this journal entry, allowance for doubtful accounts is a contra account to accounts receivable on the balance sheet. Likewise, its normal balance is on the credit side as the allowance for doubtful accounts will deduct the balance of the accounts receivable when we determine the total assets on the balance sheet.

On the other hand, the bad debt expense is an expense item on the income statement. Likewise, this journal entry decreases total assets on one side and increases total expenses on another side.

Allowance for doubtful accounts example

For example, we have made a total of $10,000 credit sales during the accounting period. Based on our past experiences and the industry average data, we expect that 3% of total credit sales during the period will become uncollectible accounts.

Hence, we can make an estimation that $300 ($10,000 x 3%) of the total credit sales will become bad debt. In this case, we need to make allowance for doubtful accounts with this amount and record this $300 into the bad debt expense during the period to comply with the matching principle of accounting.

Likewise, at the period-end adjusting entry, we need to make the journal entry for allowance for doubtful accounts by debiting the $300 amount into the bad debt expense account and crediting the same amount into the allowance for doubtful accounts as below:

In this journal entry, total assets on the balance sheet decrease by $300 while total expenses on the income statement increase by the same amount.

Determine allowance for doubtful accounts

In accounting, we can determine the allowance for doubtful accounts by using the percentage of sales method or percentage of receivables method. While the percentage of sales method seems to be simpler, the percentage of receivables method can provide more detailed information if we use the accounts receivable aging report for this purpose.

Percentage of sales

As in the example above, we may determine the estimated amount of allowance for doubtful accounts by using the total amount of the credit sales during the period to multiply with the estimated percentage of the default (e.g. 3%). This is usually referred to as an income statement approach in which we use the income statement item (e.g. credit sales) as the base of the estimation.

Also, in the example above, we make the journal entry for allowance for doubtful accounts by directly recording the amount (e.g. $300) that we get from the estimation to be the allowance for doubtful accounts. For the percentage of receivables method, this will be a bit different.

Percentage of receivables

For the percentage of receivables method, we use the balance of the accounts receivable at the end of the period to determine the estimated amount of the ending balance of the allowance for doubtful accounts. This method is usually referred to as the balance sheet approach as we use the balance sheet item (e.g. accounts receivable) as the base of our calculation.

Unlike the percentage of sales method, we do not make the journal entry for allowance for doubtful accounts immediately. We need to determine the increase (or decrease) of allowance for doubtful accounts first as this amount will represent the expense that should be recorded in the income statement during the period.

Under the percentage of receivables method, we should use the accounts receivable aging report to determine the allowance for doubtful accounts. This is due to it providing more detailed information about the receivables and making our estimation of allowance for doubtful accounts to be more accurate.

The accounts receivable aging report is the report that shows the balance of accounts receivable that is classified by the number of days overdue, as the format of presentation. This report usually shows all the customers’ accounts as its main role is to help us manage the accounts receivable in the business.

We can use the accounts receivable aging report to determine the allowance for doubtful accounts by applying different percentages on each balance of accounts receivable classified by the number of days overdue. The applied percentages are usually based on our experiences in business as well as the available industry data (e.g. industry average of customer default) that is publicly obtainable.

For example, the balance of the allowance for doubtful accounts at the beginning of the period on our balance sheet is $500. And we have the accounts receivable aging report at the end of the period which is December 31 below:

Accounts receivable aging report

As of December 31

Based on our past experiences and the industry average, we can estimate that the accounts receivable in each day overdue category has a certain percentage of becoming the bad debt as below:

• Overdue from 1 to 30 days: 3% of accounts receivable
• Overdue from 31 to 60 days: 10% of accounts receivable
• Overdue from 61 to 90 days: 20% of accounts receivable
• Overdue more than 90 days: 50% of accounts receivable

In this case, we can determine the allowance for doubtful accounts with the calculation as below:

Allowance for doubtful accounts on December 31 = (1,500 x 3%) + (800 x 10%) + (1,200 x 20%) + (1,050 x 50%) = $890

Hence, the allowance for doubtful accounts increase by $390 ($890 – $500) during the accounting period.

In this case, we can make the journal entry for allowance for doubtful accounts by debiting the increase of $390 into the bad debt expense and crediting the same amount into the allowance for doubtful accounts as below: