What is the method of estimating bad debt expense that involves a detailed examination of outstanding accounts and their length of time past due? | Homework.Study.com (2024)
A bad debt is one that was once collectible but is now impossible to get back from the person who was supposed to pay it. This indicates that as debt goes unpaid, it gets worse. The cause of this non-payment may be because the debtors file for bankruptcy or have financial difficulties, which makes it difficult for the creditors to collect their debts.
To calculate bad debt expenses, divide your historical average for total bad credit by your historical average for total credit sales. This formula gives you the percentage of bad debt, which represents the estimated portion of sales deemed uncollectible.
The direct write-off method records the exact amount of uncollectible accounts as they are specifically identified. In order to comply with the matching principle, bad debt expense must be estimated using the allowance method in the same period in which the sale occurs.
A bad debt expense can be estimated by taking a percentage of net sales based on the company's historical experience with bad debt. This method applies a flat percentage to the total dollar amount of sales for the period.
The allowance method of accounting for bad debts has the following advantages over the direct write-off method including: Records estimated bad debts expense in the period when the related sales are recorded. Reports account receivable on the balance sheet at the estimated amount of cash to be collected.
The allowance method is an estimate of the amount the company expects will be uncollectible made by debiting bad debt expense and crediting allowance for uncollectible accounts. If a specific account becomes uncollectible, it will debit allowance for doubtful accounts and credit accounts receivable.
A method of estimating bad debts that focuses on the balance sheet rather than the income statement is the allowance method based on: Direct write-off.
In accrual accounting, companies recognize revenue before cash arrives in their accounts and must record expenses in the same accounting period the revenue originated. This makes things difficult if months after making a sale on credit, a customer doesn't pay their invoice. This is where the bad debt expense comes in.
The first method—percentage-of-sales method—focuses on the income statement and the relationship of uncollectible accounts to sales. The second method—percentage-of-receivables method—focuses on the balance sheet and the relationship of the allowance for uncollectible accounts to accounts receivable.
The other option for calculating a bad debt expense formula is the ageing of accounts receivable formula. This involves taking the total amount of outstanding invoices and dividing it by your average monthly sales, from which you can calculate an estimated bad debt expense.
- since a company will not know which customers will not pay their accounts, so they must make an estimation of the amount of accounts receivable that will prove uncollectible. this estimation becomes the basis for matching bad debts expense with current sales revenue.
Once you have the ending amount for the ABD account, you can carry on to calculate the bad debt expense as we have already learned. The balance sheet method therefore has two variations. One uses the ending accounts receivable amount and the other breaks down the accounts receivable account by age.
The method that requires estimating the amount of bad debt expense and then determining the balance of the allowance for doubtful accounts that will differ from the expense if there is an unadjusted balance is the Allowance method.
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