In running a business, bad debt is an unfortunate reality that one may have to deal with. This is the money owed to a business that has been decided to be not collectible. In accounting, there are two common methods that companies use to write off bad debt which are the direct write-off method and the allowance method. These two methods move money out of the accounts receivable account (an asset account) when it has been decided that an account is uncollectable. In this article, we will discuss the adjusting entry for bad debt expense under both methods.
Bad debt expense explained
When a company records credit sales, it makes a credit entry to a revenue account and a debit entry to an account receivable. The issue with the accounts receivable balance is that there is no guarantee that the company will collect the money owed from credit sales. In as much as the company may be entitled to receive payment from the credit sales to customers, there are still chances that the company may never actually receive those funds.
Therefore, since there is a possibility that the company may not actually receive all accounts receivable amounts, accounting rules requires that a company estimate the amount it may not be able to collect and record it as a deduction against net income. This is because, despite the fact that revenue had been recorded, it never materialized into cash.
This estimated amount is called bad debt expense and can be defined as the amount recognized when a receivable is no longer collectible because a customer is not able to fulfill their obligation to settle an outstanding debt. A customer’s failure to pay their debt could be due to bankruptcy or other financial problems. Hence, the majority of companies and businesses that extend credit to their customers report bad debts as an allowance for doubtful accounts (also known as a provision for credit losses) on the balance sheet.
On the income statement, bad debt expenses are generally classified as sales and general administrative expenses. Recognizing bad debts requires an offsetting reduction to accounts receivable on the balance sheet. However, should the circumstances change, businesses retain the right to collect funds and make a bad debt expense adjusting entry to reverse the initial journal entry.
See also: Accrued revenue adjusting entry
Adjusting entry for bad debt expense
Bad debts are uncollectible amounts from customer accounts that negatively affect accounts receivable. Recognizing these bad debts is required when the future collection of receivables cannot be reasonably assumed. As earlier said, there are two methods a company may use to recognize bad debt such as the direct write-off method and the allowance method. However, should the circumstances change, an adjusting entry for bad debt expense should be made.
Direct write-off method and the bad debts expense adjusting entry
When using the direct write-off method, companies write off the debt the second they decide the account is uncollectable. Based on how long past due an invoice is and after failed collection efforts, the majority of bookkeepers decide a customer will not pay an invoice. As soon as this account is identified as uncollectible, the company records an increase in bad debt expense and a reduction to the customer’s accounts receivable for the exact amount uncollectible.
That is, you increase the bad debt expense account with a debit entry and decrease the accounts receivable account with a credit entry. For instance, if a customer, Mr. Peter has a 91-day late $1,500 invoice, the company’s bad debt expense journal entry would look like this:
|Bad debt expense||$1,500|
However, in as much as the direct write-off method records the exact amount of uncollectible accounts, it is not an acceptable method of recording bad debts under generally accepted accounting principles (GAAP). This is because it violates the matching principle used in accrual accounting which requires that expenses should be matched to the related revenues in the same accounting period in which they occur.
As a matter of fact, the direct write-off method delays the recognition of bad debt until the specific customer accounts receivable are identified. Hence, the main problem with this method is the unpredictability of when the expense may occur. As a result, the allowance method is used for publicly traded company reporting instead of this method.
Adjusting entry for bad debt expense (direct write-off method)
When a company receives the money it wrote off as uncollectable, it must reverse the write-off entry and record the payment. This means making an adjusting entry for bad debt expense which means reversing the write-off entry by increasing the accounts receivable account with a debit and decreasing the bad debt expense account with a credit. Then, the company has to record the payment by increasing the cash account with a debit entry and decreasing the accounts receivable account with a credit entry.
For instance, if Mr. Peter paid the invoice 75 days after the company wrote it off. The bookkeeper would reverse the write-off journal entry by making a bad debt adjusting entry:
|Bad debt expense||$1,500|
Then, the received payment would be recorded as follows:
Allowance method and the adjusting entry for bad debt expense
Compared to the direct write-off method, the allowance method is more widely used. This is because it satisfies the GAAP matching principle. Based on certain computational approaches, this method estimates bad debt during a period, and the calculation matches bad debt with related sales. When using the allowance method, the bookkeeper creates an allowance account for potential bad debt.
That is, you make a debit entry to the bad debt expense account to increase the account and make a credit entry to the allowances for doubtful accounts (contra-asset account) to increase the account. For example, assume you decide you will have $2,000 in bad debt for the accounting period. To set up the allowance account, you have to debit $2,000 to the Bad Debts Expense, and credit $2,000 to the Allowances for Doubtful Accounts. That is:
|Bad debt expenses||$2,000|
|Allowance for doubtful accounts||$2,000|
Then, when you decide an account is uncollectable, you write it off by decreasing the allowances for doubtful accounts account with a debit entry and decreasing the accounts receivable account with a credit entry. For instance, if Mrs. Mary has a 121-day late $1,500 invoice. Here is the write-off journal entry:
|Allowances for Doubtful Accounts||$1,500|
Adjusting entry for bad debt expense (Allowance method)
If in the future, the company receives the money it wrote off as uncollectable, it must reverse the write-off entry and record the payment. It makes an adjustment for bad debt expense by reversing the write-off entry. This is an increase to the accounts receivable account by debit and a decrease to the allowances for doubtful accounts account by credit. If for instance, Mrs. Mary paid the invoice 75 days after the company wrote it off. The adjusting entry for bad debts would be:
|Allowances for Doubtful Accounts||$1,500|
Then, the company would record the payment of the debt by increasing the cash account with a debit entry and decreasing the accounts receivable account with a credit entry:
Read also: When are adjusting entries recorded?
Example on bad debt expense adjusting entry
In order to understand the adjusting entry for bad debt expense better, let us look at another example. Assume a customer takes out a $25,000 car loan on August 1, 2022, and is expected to pay the amount in full before December 1, 2022. For the sake of this example, let’s say there was no interest charged to the customer because of the short-term nature of the loan.
On December 1, the customer fails to make payment and the company has to record this nonpayment and recognize it as bad debt. The journal entry for this would be:
|December 1, 2022||Bad debt expense||$25,000|
Let’s say in the future, this customer unexpectedly pays the debt in full on May 1, 2023, the company would have to reverse the previously written-off bad debt by making an adjusting entry for bad debts. That is:
|May 1, 2023||Accounts receivable||$25,000|
|Bad debt expense||$25,000|
Then, the journal entry to record the payment of the debt in full would be:
|May 1, 2023||Cash||$25,000|