Explore here Accounts Receivable accounting topics, including Allowance for Doubtful Accounts, Bad Debt Expense and related matters.
Accounts receivable is a debt from customer, which was resulted by sales made on credit. This means that as business sells goods, but cash for the goods sold will be received after some period of time, which is agreed between the seller and between the customers.
So, seller sells goods to the customer and after some period of time (for example after 30 days) customer pays cash for these goods. When business makes sale following the accrual principle despite cash for the sale will be received later, revenue must be recorded at the moment of sale (check Income Statement Example, as in it the revenue is recorded).
To record sales revenue the following accounting entry is made:
Debit Accounts Receivable – debt from the customer
Credit Sales Revenue
In this way we account for Accounts Receivable to reflect asset (check Balance Sheet Example and explore how it is reflected). This is a right to claim debt from customer and such revenue recording is in line with the accrual principle.
After 30 days when business gets cash from the customer, the following accounting entry will be recorded:
Credit Accounts Receivable
In this way debt from the customer is decreased as cash was received from the customer for the goods sold.
In practice it might happen that customers fail to pay their debts due to financial difficulties, bankruptcy or just refusal to pay. Such non-payment is a loss to the seller. This loss or uncollectible debt must be recorded in the accounting records of the seller in order to be presented in the financial statements.
It is a must to account for such Uncollectible Accounts Receivable and for a loss, which seller incurs due to the failure of the customer to pay the debt. Therefore, if we have a customer with no money, seller incurs loss as accounts receivable become doubtful.
Accounts receivable become doubtful only after the period of time, during which the customer was obliged to pay its debt ends. For example, if the business sells goods on the 1st of July and the payment is due in the 30th of July, debt becomes overdue only after those 30 days passe. Within the period from the sale till payment due date the business still be waiting for the customer to pay the debt and only after that period is over, allowance for doubtful accounts receivable to be considered.
There might be several types uncollectible accounts receivable, i.e. doubtful when there is a chance to recover debts from customers. Usually an allowance is made for these accounts, i.e. they are not written off. This is done since there is still hope to recover those accounts receivable. There are two methods to calculate such allowance:
I. Allowance (or provision for doubtful debts) is made for the debt from a particular customer, if we know that particular customer fails to pay. So this is a doubtful debt and the allowance is made for the specific amount.
The following accounting entry is made:
Debit Operating expenses
Credit Allowance for Uncollectible Accounts Receivable
II. Another method to calculate the allowance for doubtful accounts receivable is the percentage on total accounts receivable balance. Same percentage might be used on the total balance or different percentages might be applied for different groups of accounts receivable depending on their age.
Usually such percentage depends on the historical data and on the general failure of the customers to pay their debts. For the purpose to group accounts receivable their ageing can be used. Separate groups are created based on the age of balances. Accounts receivable are split into several groups based on the age. In the table below we have one group where age of debt is less than 30 days, second group is where the age of debt is from 30 to 60 days and so on. So we have separate groups of the accounts receivable and their age is also indicated.
To calculate the provision for doubtful debts we apply different percentages to different groups of accounts receivable. For example to the first group we apply 2%, to the next group we apply 15% and for the remaining group we apply 60% allowance.
The higher percentage means that this group is older, so these are balances which are all due for 90 and more days, therefore these are less chances to fully recover those accounts receivable.
Allowance for uncollectible accounts receivable is recorded in the separate account, which is contrary account to accounts receivable, i.e. it is on the credit side of the assets part of Balance Sheet.
In this way not just accounts receivable is decreased, but the allowance is recorded separately.
In case accounts receivable is not collectible at all, it has to be written off. The accounting entry depends on how this debt was accounted for before. If allowance was made, write off is settled off with the allowance. If there was no allowance, direct write off method is used, recording bad debt expense.
Accounts Receivable Write Off Via Allowance for Doubtful Accounts
If allowance was made, accounts receivable write off is settled with the allowance, i.e. allowance for doubtful accounts is decreased accounts receivable balance is decreased. In this way specific amount is written off by decreasing the allowance and directly decreasing accounts receivable balance.
Accounts Receivable Direct Write Off
If there was no allowance made, direct write off is done, i.e. accounts receivable balance is directly included into expenses of uncollectible accounts and accounts receivable balance is decreased.
Recovery of Written Off Debt
Sometimes it might happen that customers return their debt and business gets cash even if allowance was made or even if the debt was written off.
If the business has made an allowance, it should be reversed. Cash receipt should be recorded and it is made by the following accounting entry, i.e. allowance is decreased by debiting it, uncollectible accounts receivable expenses are credited. Afterwards cash receipt is recorded and debt from customer is decreased.
In this way we record the recovery of the accounts receivable for which allowance was made. If there was no allowance and the bad debt written off directly, cash receipt is recorded and decrease in expenses is recorded.