You increase your revenue potential when you offer goods on credit, especially if you’re involved in B2B sales. With that said, you also incur losses from unpaid invoices, so it’s important to understand the function of bad debt. Here’s a glossary of key terms.
This balance sheet account represents all of your open accounts from customers who buy on credit. For example, if you sell $1,000 worth of landscaping services, you would bill your customer, debit accounts receivable and credit service revenue. Once the customer pays the invoice, you would reverse the accounts receivable entry and add a debit to cash. Most companies collect on short-term receivables within 30 to 60 days. Non-current receivables remain on the balance sheet for more than one year.
Accrual Based Accounting
Under this method, you record sales revenue during the period it’s incurred, regardless of whether or not you receive cash up front. Likewise, all expenses must be matched with revenues. Unlike the cash method, accrual accounting gives you a better idea of month-to-month profitability.
This is one of two ways to account for bad debts. If you sell products or services on credit, you should expect that some customers will be unable to pay their bills. The allowance method anticipates these bad debts on your books before you actually know who will default. It’s a better alternative to the direct write-off method. Rather than taking an unexpected loss, you maintain a tighter hold on your revenue while keeping all related expenses within the same period. Essentially, you’re budgeting for the portion of receivables that won’t turn into cash.
Allowance for Doubtful Accounts
This is the balance sheet item that reduces your current receivables. As a contra asset account, the doubtful allowance increases with a credit and decreases with a debit. For example, suppose you run a small cleaning company and charge $100 per site and earn $1,000 in credit sales. If you expect that one of your 10 customers will default on the bill, you would credit your allowance account for $500 and debit bad debt expense for the same amount.
Bad Debt Expense
Bad debt is an owed amount that is unlikely to be collected or paid. Like all other expense accounts, bad debt increases with a debit. The allowance account assumes the corresponding credit entry. Bad debts are estimated using one of two methods.
• Percent of Sales: This is the income statement approach. Suppose that after two years in business, you estimate that five percent of invoices will go unpaid. If you earn $10,000 in credit sales, you would debit bad debt expense for $500 and credit your allowance account for the same amount.
• Percent of Receivables: Now assume that you estimate the five percent bad debt based on the $100,000 balance in your receivables account that’s carried over from the previous period. The journal entry would include a $5,000 debit to bad debt and a $5,000 credit to the allowance for doubtful accounts. This is also known as the balance sheet method.
You can also simply remove an unpaid invoice from your receivables and debit bad debt expense. This method violates the accounting principle of matching expenses with revenues, so it should not be used for external reporting. However, this is the required method for income tax purposes.
Assume that you write off a customer invoice, and that customer later ends up paying the bill. Your journal adjustment would include a debit to accounts receivable and a credit to bad debt expense. Then, you can debit cash and credit accounts receivable. You don’t have to be a CPA in order to properly record and analyze bad debts. Just be sure you understand these terms and how each account affects your operation.
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