Allowance for Doubtful Debts
Introduction
A business may sell goods or services on credit to customers.
![dd2](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd2.jpg)
This means, the business allows customers time to pay.
![dd3](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd3.jpg)
The business needs to keep a record of each sale transaction.
![dd4.1](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd4.1.jpg)
You need to show that a value of goods or services came from sales and the value of those goods or services went to accounts receivable.
![dd5.1](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd5.1.jpg)
Accounts receivable is the collective name for all customer accounts.
![dd6.2](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd6.2.jpg)
To record each sales transaction, you credit the sales account.
![dd7.1](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd7.1.jpg)
This shows a value of goods or services came from sales.
![dd8.1](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd8.1.jpg)
Next, you debit the individual customer’s account.
![dd9.1](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd9.1.jpg)
This shows the value of goods or services went to that particular customer.
![dd10.1](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd10.1.jpg)
The debit entry also shows that the customer owes this money to the business.
![dd10.0.1](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd10.0.1.jpg)
In time, most customers will pay what they owe.
![dd11](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd11.jpg)
However, some won’t, and the debt will be deemed un-collectible.
![dd12](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd12.jpg)
These debts are known as bad debts and need to be written off.
![dd13](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd13.jpg)
Direct Write Off
One way to deal with bad debts is to wait for customers to default.
![dd14](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd14.jpg)
Then write the debt off to bad debts expense.
![dd15](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd15.jpg)
To do this, you credit the customer’s account.
![dd16](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd16.jpg)
This shows you have taken value from the account
![dd17](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd17.jpg)
Offsetting the customer’s account this way brings the account’s balance to zero and writes off the debt
![dd18](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd18.jpg)
After this, you debit the bad debts expense account
![dd19](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd19.jpg)
This shows you have assigned the value to bad debts expense
![dd20](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd20.jpg)
And the debt has now become one of the expenses involved in making sales.
![dd21.1](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd21.1.jpg)
Allowance for Doubtful Debts
Another way to deal with bad debts is to make an allowance for them, when sales are made.
![dd22.2](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd22.2.jpg)
In other words, you anticipate likely bad debts ahead of time.
![dd23.0.1](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd23.0.1.jpg)
The reason you do this is to satisfy the matching principle.
![dd25](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd25.jpg)
Sales may be made in one accounting period.
![dd26](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd26.jpg)
But bad debts resulting from these sales may not occur to a later period
![dd27](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd27.jpg)
In accordance with the matching period, expenses incurred should be recorded in the period revenue was earned.
![dd28](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd28.jpg)
To do this, you need to estimate likely bad debts
![dd29](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd29.jpg)
This estimation may be a percentage of sales.
![dd30](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd30.jpg)
Alternatively, it can be a percentage of accounts receivable.
![dd31](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd31.jpg)
To record likely bad debts, you use an allowance for doubtful debts account.
![dd32](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd32.jpg)
The account is attached to accounts receivable.
![dd33](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd33.jpg)
It’s an asset account, but its balance isn’t shown on the diagram.
![dd34.2](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd34.2.jpg)
Only accounts receivable is shown.
![dd35](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd35.jpg)
This is because the doubtful debts account is a contra account.
![dd36](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd36.jpg)
Most asset accounts, including accounts receivable, balance on the debit side.
![dd37](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd37.jpg)
To the contrary, doubtful debts balances on the credit side.
![dd38](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd38.jpg)
The account is also classified as a valuation account.
![dd39.2](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd39.2.jpg)
This is because any debit entries in doubtful debts will reduce the value of accounts receivable.
![dd40](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd40.jpg)
To record doubtful debts, record the estimate in doubtful debts with a credit entry.
![dd41](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd41.jpg)
This shows you have effectively taken value from accounts receivable.
![dd42](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd42.jpg)
Then you debit bad debts expense
![dd43](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd43.jpg)
This shows you have assigned the value as an expense.
![dd44](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd44.jpg)
Once complete, the transaction will show you have effectively taken value from accounts receivable and allocated it to as bad debts
![dd45](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd45.jpg)
Later, some customers will default on their debt obligation.
![dd46](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd46.jpg)
When a customer defaults, you credit the customer account.
![dd47.1](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd47.1.jpg)
This shows you are taking value from their account.
![dd48.1](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd48.1.jpg)
It also offsets the debit entry—thereby bringing the account’s balance to zero and writing off the debt.
![dd49.1](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd49.1.jpg)
Ordinarily, you would debit bad debts expense at this point.
![dd50.1](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd50.1-1.jpg)
But you recorded bad debts earlier—when recording doubtful debts.
![dd51.1](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd51.1-1.jpg)
And the bad debts will have been recognized already—in a previous period.
![dd52.1](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd52.1.jpg)
So here, all you need to do is show that the customer’s debt is no longer doubtful—because it has been written off.
![dd53.1](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd53.1.jpg)
To do this, you debit the allowance for doubtful debts account.
![dd54.1](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd54.1.jpg)
This shows you have transferred the customer’s debt to doubtful debts.
![dd55.1](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd55.1.jpg)
Once updated, the doubtful debts balance will show how much debt is still doubtful.
![dd56.1](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd56.1.jpg)
Over time, the balance of your doubtful debts account may steadily rise or fall.
![dd57](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd57.jpg)
This will happen if your estimate for bad debts is too high or too low.
![dd58](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd58.jpg)
To bring things into line, you will need to adjust your estimate.
![dd59](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd59.jpg)
Doing this will result in a more accurate reflection of bad debts expense.
![dd60](https://seeaccountingnow.online/wp-content/uploads/2021/12/dd60.jpg)
© R.J. Hickman 2021