Lesson 64 - Beginner accounting course

64. Handling Bad Debts and Allowance for Doubtful Accounts

Managing bad debts is essential for businesses that offer credit sales. Not all customers will pay their invoices on time, and some may never pay at all. To prepare for these potential losses, companies use the Allowance for Doubtful Accounts to estimate and record uncollectible debts.

1. What is Bad Debt?

Bad debt refers to accounts receivable that a business determines will not be collected. These unpaid invoices negatively impact a company’s profits and cash flow.

Examples of Bad Debt:

• A customer files for bankruptcy and cannot pay.

• A client disputes an invoice but never responds.

• A company’s repeated collection attempts fail.

Impact of Bad Debt on Financial Statements:

• Overstates revenue if not accounted for properly.

• Reduces net income when written off.

• Decreases assets because accounts receivable won’t be collected.

2. The Allowance for Doubtful Accounts (ADA)

Since businesses don’t always know which customers will default, they estimate potential losses using the Allowance for Doubtful Accounts (ADA)—a contra-asset account that reduces Accounts Receivable (AR) on the balance sheet.

Key Features of ADA:

✔ Predicts future bad debts based on past trends.
✔ Matches expenses to revenue by recording bad debts in the correct accounting period.
✔ Ensures accurate financial reporting by not overstating receivables.

3. Methods for Estimating the Allowance for Doubtful Accounts

A. Percentage of Sales Method

• Estimates bad debt as a percentage of total sales.

• Commonly used for income statement reporting.

Example:

If a company has €500,000 in credit sales and estimates 2% will be uncollectible, the journal entry is:

B. Aging of Accounts Receivable Method

• Analyzes overdue invoices by time period.

• More accurate because older invoices are more likely to be unpaid.

• Commonly used for balance sheet reporting.

Example Aging Schedule:

Journal Entry to Adjust ADA:

4. Writing Off Bad Debts

If a specific account is confirmed as uncollectible, it is written off. This does not affect the income statement because the expense was already recorded through ADA.

Journal Entry to Write Off an Uncollectible Account (€5,000):

Effect:
✔ No impact on net income (expense already recorded).
✔ Reduces accounts receivable and allowance balance.

5. Recovering a Previously Written-Off Debt

Sometimes, a customer pays after their debt was written off. The business must reverse the write-off and record the payment.

Step 1: Reverse the Write-Off

Step 2: Record the Cash Collection 

Effect:
✔ Restores AR balance before receiving payment.
✔ Increases cash balance without impacting revenue.

6. Direct Write-Off Method (Not GAAP-Compliant)

Some small businesses use the Direct Write-Off Method, which records bad debts only when they become uncollectible.

Example Entry for Direct Write-Off (€3,000 Bad Debt):

Problems with this method:

✖ Violates the Matching Principle (expense recorded in the wrong period).

✖ Overstates assets by not estimating bad debts in advance.

✖ Not allowed under GAAP (Generally Accepted Accounting Principles). 

7. Key Takeaways

✔ Bad debts are an unavoidable risk in businesses that offer credit.
✔ The Allowance for Doubtful Accounts (ADA) helps estimate and prepare for future losses.
✔ Two main estimation methods:

• Percentage of Sales Method (simple, used for income statements).

• Aging of Accounts Receivable (detailed, used for balance sheets).
  ✔ Writing off bad debts removes uncollectible amounts from accounts receivable.
  ✔ Recovering bad debts requires reversing the write-off before recording payment.
  ✔ The direct write-off method is not GAAP-compliant because it fails to match expenses to revenue properly.

8. Why Managing Bad Debt is Crucial

📌 Protects cash flow – Prevents large unexpected losses.
📌 Ensures accurate financial reporting – Keeps financial statements realistic.
📌 Helps assess customer risk – Businesses can adjust credit policies.
📌 Improves business stability – Reduces the risk of cash shortages.

By proactively managing bad debts, businesses can minimize financial risk and maintain strong cash flow while still offering credit to reliable customers.