Bad Debt Expense Journal Entry and Example

Every fiscal year or quarter, companies prepare financial statements. The financial statements are viewed by investors and potential investors, and they need to be reliable and possess integrity. As mentioned earlier in our article, the amount of receivables that is uncollectible is usually estimated. This is because it is hard, almost impossible, to estimate a specific value of bad debt expense. The two methods of recording bad debt are free paycheck calculator 1) direct write-off method and 2) allowance method.

Double Entry Bookkeeping

Upgrading to a paid membership gives you access to our extensive collection of plug-and-play Templates designed to power your performance—as well as CFI’s full course catalog and accredited Certification Programs. Sometimes, people encounter hardships and are unable to meet their payment obligations, in which case they default. When it comes to large material amounts, the allowance method is preferred compared to the direct write-off method.

Now that you know how to calculate bad debts using the write-off and allowance methods, let’s take a look at how to record bad debts. The accounting for writing off bad debts depends on the method companies use to record them. Unlike the allowance method, the company only records bad debt expense when they determine a particular account to be uncollectible.

Journal Entry for the Bad Debt Write Off

This method doesn’t attempt to match bad debt expense to sales revenue in the income statement. Likewise, the direct write-off method does not conform to the matching principle of accounting at all. As a result, a bookkeeping entry must be prepared to adjust the balance sheet and income statement.

How to record the bad debt expense journal entry

However, this balance also decreases when customers cannot repay their balance. These instances are common for companies that provide credit terms to customers for their sales. Contrary to customers that default on receivables, debt tends to be a more serious matter, where the loss to the creditor is substantially greater in comparison.

1. The allowance is determined using an estimate derived from historical bad debt and trends in the marketplace.
2. Establishing an allowance for bad debts is a way to plan ahead for uncollectible accounts.
3. Bad debt expenses are usually categorized as operational costs and are found on a company’s income statement.
4. The journal entries for writing off bad debts depend on the method used to account for them.
5. This account holds all the receivable balances which may come from various customers.
6. To allow for such doubtful and bad debts, it is important to create a reserve (as an estimate).

For example, company XYZ Ltd. decides to write off one of its customers, Mr. Z as uncollectible with a balance of USD 350. Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts.

What are the journal entries for Written Off Bad Debts?

Situation 1 – No adjustment is made when bad debts are included in the trial balance. Without such adjustments being made during the preparation of financial statements, the numbers shown in the firm’s final accounts will not be accurate. When you write off bad debt, you simply acknowledge that you have suffered a loss. Written-off bad debt is not directly affected the statement of change in equity directly. However, a statement of change in equity, taking into account net profit or losses during the year, is taken from the income statement.

There are two popular methods for performing the write-off; the allowance method and the direct write-off method. Each technique has advantages and gives users of financial statements insight into a company’s financial position. Recording bad debts is assets meaning in accounting an important step in business bookkeeping and accounting. It’ll help keep your books balanced and give you realistic insight into your company’s accounts, allowing you to make better financial decisions. However, bad debt expenses only need to be recorded if you use accrual-based accounting.

For example, in one accounting period, a company can experience large increases in their receivables account. Then, in the next accounting period, a lot of their customers could default on their payments (not pay them), thus making the company experience a decline in its net income. When expensing bad debt from a customers account or cost of goods sold, the journal entry should be prepared using a method consistent with U.S. Remaining consistent will enable investors, owners and management to accurately monitor bad debt and its impact on the bottom-line. In accounting, the bad debt expense emerges from customers that purchased a product or service using credit as the form of payment, rather than cash, yet are unable to fulfill their obligations to eventually pay in cash. Establishing an allowance for bad debts is a way to plan ahead for uncollectible accounts.

The bad debt account attempts to capture the estimated amount that the creditor (i.e. the seller) must write off from the “default” of the debtor (i.e. the buyer) in the current period. The reason the expense is an “estimate” is due to the fact that a company cannot predict the specific receivables that will default in the future. Recording uncollectible debts will help keep your books balanced and give you a more accurate view of your accounts receivable balance, net income, and cash flow. The company has a total accounts receivable balance of $110,000 at the year-end, including several customer balances.

However, if the calculated provision is lower, the journal entries will include the following. It may happen for several reasons, for example, the customer going through liquidation or bankruptcy. Double Entry Bookkeeping is here to provide you with free online information to help you learn and understand bookkeeping and introductory accounting. In addition, the creditor could have a lien on an asset belonging to the debtor, i.e. the debt was collateralized as part of the financing arrangement. In order words, the approximated figures must be backward-looking and forward-looking, with management remaining conservative per the prudence principle with regard to how effective their operating adjustments will be.

Bad Debt Direct Write-Off Method

Also called doubtful debts, bad debt expenses are recorded as a negative transaction on your business’s financial statements. A bad debt can be written off using either the direct write off method or the provision method. The first approach tends to delay recognition of the bad debt expense.

However, many companies still use the direct write-off for small amounts. For most companies, the better route is to improve their collection processes internally and implement the right procedures to reduce such occurrences. In the latter scenario, the customer might never have had the intent to pay the seller in cash. While some might view it as overly conservative, it reduces the chance of steep losses that were unexpected.