Accounting Treatments for Bad Debts Using Allowance for Doubtful Accounts
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Accounting Treatments for Bad Debts Using Allowance for Doubtful Accounts

When a portion of the Accounts Receivable remains uncollected over a specified period of time, Bad Debts should be recognized. Allowance for Doubtful Accounts is determined using the Allowance Method of recognizing bad debts. The generally accepted procedure in the accounting treatment for bad debts should be carefully identified and implemented.

Bad Debts arise when Accounts Receivable remains to be uncollected over time. Most successful business offers sales on credit to customers with good credit standing on agreed terms. However, uncollected Accounts should be managed well in order to minimize bad debts. The declaration of Bad Debts therefore increases the expenses and decreases the net income in the income statement. In order not to prolong the agony of waiting for the possibility of collection; recognition and accounting treatments for bad debts are required. There are two methods of accounting treatments for bad debts:

1. Direct Write-off is an accounting method for bad debts that performs a direct write-off of Accounts Receivable. This is contrary to conservatism and matching principles of accounting; hence, this method is not generally accepted.

Entry:            Debit: Bad Debts Expense            xxx

                        Credit: Accounts Receivable                        xxx

2. Allowance Method is another accounting treatment for bad debts which is most widely used and accepted.

Entry:            Debit: Bad Debts Expense            xxx

                        Credit: Allowance for Doubtful Accounts               xxx

The allowance method of recognizing bad debts is more commonly used as an accounting treatment. The Allowance for Doubtful Accounts is then set up to recognize the probability of the Accounts Receivable to be uncollected. This adjustment is usually made by the end of the fiscal year or depending on the requirements of the business.

The Allowance for Doubtful Accounts is determined using any of the following methods:

  • Percent of Net Sales

Bad Debts and Allowance for Doubtful Accounts are calculated using a predetermined rate of sales. The entry is an addition to the beginning balance of Allowance for Doubtful Accounts.

  • Percent of Receivables

Bad Debts are determined using percent of receivables. The result should be the ending balance of Allowance for Doubtful Accounts. Thus, the beginning balance should be considered in order to come up with the desired ending balance.

When using the Allowance Method in determining the bad debts, the entry at the time of actual write-off will no longer reflect an increase in expense since the provision of bad debts was previously posted. Thus the entry for the actual write-off would be:

                                                Debit: Allowance for Doubtful Accounts   xxx

                                                Credit: Accounts Receivable                        xxx

If collection is made after the write-off, reversal of the two entries for the actual write-off and set-up of bad debts should be done in order to set-up again the Accounts Receivable and subsequently take-up the cash collection as increase in cash and decrease in Accounts Receivable.

Bad Debts can be recognized in the Income Statement as part of Tax Deduction in determining the Net Income before tax for the company. Although, the accounting treatment for Bad Debts provides tax benefit, proper evaluation of the accounting assumptions and entries should be carefully implemented to justify any tax audit.

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Comments (3)

Interesting outlook.

Yes, it is Peter. This can be understood well by those persons with accounting background and I hope others can see the essence of accounting in every business we are in.

Useful accounting. I should learn more. Voted up. Thank you Jeanette for your friendship and support.

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