Companies may encounter bad debts as a part of their credit policy toward customers. These bad debts result in an expense that can lead to losses. Over the years, companies accumulate experience that helps them forecast future balances that may go bad. Companies can also create an allowance for bad debts, which does not reflect the actual amount.
What is the Allowance for Bad Debts?
Allowance for bad debts (or also allowance for doubtful debt) is an expense recorded in the income statement similar to bad debt. It includes an estimate of the value of accounts receivable a company expects to go “bad” in the future. As stated above, companies use their historical records to predict how much bad debts they may expect in a specific period.
Allowance for bad debts allows companies to create a provision for possible future expenses. However, it does not represent the actual value of bad debt. Although recorded as a bad debt expense, allowance for bad debts does not decrease the accounts receivable balance. Instead, it becomes a liability on the balance sheet. After each financial period, companies adjust this amount to reflect the estimated allowance for bad debts.
Why do companies need Allowance for Bad Debts?
Allowance for bad debts doesn’t represent an actual irrecoverable balance. Instead, it shows an estimate of possible future bad debts. Companies still record their bad debts aside from this process. Therefore, some may wonder why the allowance for bad debts is necessary. One of the primary reasons for doing so is to conform to accounting principles and practices.
Estimating and recording allowance for bad debts falls under the conservatism principle in accounting. This principle requires companies to account for losses at the earliest possible. On the other hand, companies must only record profits once sufficient evidence is available. It is also known as the prudence concept. Under this concept, recording allowance or bad debts becomes mandatory.
What is the accounting for Allowance for Bad Debts?
The accounting for the allowance for bad debts defers from bad debts. While it does raise an expense in the income statement, the balance sheet impact is not similar. Usually, bad debts decrease the accounts receivable balance. However, the same does not apply to the allowance for doubtful debts. In this case, the accounting treatment differs.
With allowance for bad debts, companies recognize an expense in the income statement. On the other hand, companies must also create a provision. At the end of each year, they must evaluate their allowance for bad debts provision. If it is higher than the previous year, the company must increase its expense by that amount. If it is lower, the company must recognize an income.
What is the journal entry for Allowance for Bad Debts?
When a company initially recognizes an allowance for bad debts, it must use the following journal entry.
| Dr | Bad debt expense |
| Cr | Allowance for bad debts |
At the end of each financial period, it must reevaluate this amount. If the amount is higher than previously recorded, the company must use the same journal entry to increase it by that amount. If it is lower, the company uses the following journal entry.
| Dr | Allowance for bad debts |
| Cr | Other income |
Conclusion
Allowance for bad debts estimates the accounts receivable balances a company expects to be irrecoverable. Usually, companies calculate this amount by using historical data. Other factors may also play a role in this amount. The accounting treatment of allowance for bad debts includes the initial recognition and year-end evaluations.
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