In the business world, cash does not always change hands immediately upon the transfer of the accompanying goods or services. Most businesses must often sell their products to customers on credit - the product is sold, an invoice is sent to the customer, and the customer pays the purchase price within a set time period. Using this model, there is an inherent risk of customer default. These defaults must be appropriately recognized as expenses by the seller, and an allowance must be maintained for the default of these so-called "doubtful" accounts. Learning how to account for doubtful debts is a matter of recording this allowance properly.
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- 1Record the journal entry to recognize a sale on credit. Accounting for doubtful debts presupposes credit sales, so begin by recording the sale in the general journal. For example, consider a company that renders $2000 of services to a customer on credit. To record the journal entry, the company debits Accounts Receivable for $2000 and credits Service Revenue for $2000.
- 2Estimate the portion of accounts receivable that will be uncollectible. When selling goods or services on credit, it is not likely that a company will be able to collect all of the money owed - some customers will default (fail to pay). To account for this, an allowance account needs to be set up to deal with the uncollectible amounts.
- One method of estimating the uncollectible amount is to use a percentage of total sales. For example, a company might look at historical data and determine that 2 percent of its sales on credit will go uncollected.
- Another method involves creating a receivables aging schedule. This is a more complex process that uses historical data to determine the likelihood of payment based on how many days past due an invoice is.
- 3Record the journal entry to create the doubtful account allowance. In the example above, assume the company decides to estimate uncollectible accounts as 2 percent of total service revenue. The allowance needed is therefore (0.02 * 2000), or $40. To record the journal entry and establish the allowance account, the company debits Bad Debts Expense for $40 and credits Allowance for Doubtful Accounts for $40.
- Allowance for Doubtful Accounts is a contra-asset account. Its balance is subtracted from Accounts Receivable to arrive at what is called "net realizable receivables."
- The expense is recorded immediately in accordance with the matching principle. Even though this customer may very well pay in full, the expense is recognized to match it with its corresponding revenue.
- 4Adjust the balance of the allowance account as necessary. If the company above records another $10,000 in service revenue, another journal entry is needed to increase the allowance account. The company debits Bad Debts Expense for $200 and credits Allowance for Doubtful Accounts for $200. The allowance account's balance is now $240.
- 5Record the journal entry to recognize an uncollectible account. When an individual account is identified as uncollectible (for example, if the buyer went bankrupt and lost all their assets), a journal entry is needed. In the example above, imagine that a customer's account balance of $100 has been deemed uncollectible. To write off the account, the seller debits Allowance for Doubtful Accounts for $100 and credits Accounts Receivable for $100. In this way, the allowance account balance is used to essentially cover the drop in receivables.
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Last edited:
March 27, 2012 by Xaid..
Categories:
Finance and Business
Recent edits by: Genius_knight, Maluniu, Veracious (see all)
