Reference no: EM131329340

Bad Debt Expense Calculations

One of my classes a few terms ago asked for an example or a bit better explanation regarding calculating Bad Debt Expenses. The following is what I have come up with.

There are three basic methods for handling the calculation of Bad Debt Expense:

· Direct Write Off Method: Accounts Receivable are written off directly when it becomes obvious that the account holder will not pay. (This is not an accrual accounting method so there is no Allowance for Doubtful Accounts.)

· Percent of Net Sales Method: This is an accrual accounting method. The Bad Debt Expense is calculated by multiplying the Net Sales (credit sales) by a specific percentage. The results is the Bad Debt Expense and is accrued directly into the Allowance for Doubtful Accounts. NOTE: very important, there is no (that is NO) adjustment made to the calculated Bad Debt Expense using this method. One more time, biggest error students make is to try to alter the calculated Bad Debt Expense by some balance that is left over from the prior accounting period. Do not make that mistake.

Accounts Receivable Method: (Also similar methods are called Percent of Accounts Receivable Method or Ageing of Accounts Receivable): This is an accrual accounting method. The amount of expected un-collectable accounts is determined based on an analysis of the Accounts Receivable. (Ie., a percentage or an aging table of the year end balances in Accounts Receivable.) NOTE: very important, we MUST take into consideration any current balance left over from the prior accounting period in the Allowance for Doubtful Accounts. The objective is to make an adjusting entry to record the Bad Debt Expense that will result in the Allowance for Doubtful Accounts becoming the exact amount that was calculated as un-collectable.

Make sure that you read the question or exam problem carefully to determine exactly which method you are required to use.

Now for some examples:

Direct Write Off Method: Lloyd Products learned the Joe Smuck has just skipped town and traveled to a country without an extradition treaty with the US. Joe owes Lloyd $500. Prepare the appropriated adjusting entry, Lloyd uses the Direct Write Off Method to account for bad debts.

Bad Debt Expense   500
Accounts Receivable, Joe Smuck  500

Percent of Net Sales and Ageing of Accounts Receivable Methods:

Case: Lloyd Products is undecided about which base to use in estimating un-collectible accounts. On December 31, 2005, the balance in Accounts Receivable was $680,000 and net credit sales amounted to $3,900,000 during 2005. An aging analysis of the accounts receivable indicated that $38,000 in accounts are expected to be un-collectible. Past experience has shown that about 1% of net credit sales eventually are un-collectible. The Allowance for Doubtful Accounts has an unadjusted debit balance on December 31, 2005 of $700.

Percent of Net Sales Method: $3,900,000 * 1% = $39,000 bad debt expense.

Dec 31  Bad Debt Expense  39,000
Allowance for Doubtful Accounts  39,000

Note: I do not care what the current balance is in the Allowance for Doubtful Accounts when using the Percent of Net Sales Method. Make sure you remember this it is critical.

Accounts Receivable Method (Aging or Percent): Now it is critical to remember that you were already told the desired adjusted balance for the Allowance for Doubtful Accounts. The aging analysis tells us the we current expect that $38,000 of our current Accounts Receivable to be un-collectable. Use a T-account to figure the needed adjusting entry.

Allowance for Doubtful Accounts

Un adj bal Dec 31 700        Adj entry 38,700
                                       Ending Balance 38,000
Bad Debt Expense
Adj entry 38,700

Note we are making ending balance in the Allowance for Doubtful Accounts to be equal to the amount of the expected (calculated) un-collectable accounts based on some factor related to the Accounts Receivable.