Bad Debt Allowance is used to account for amounts in Accounts Receivable that are over 90 days past due. It is not to be confused with Bad Debt Expense which is the final step in accounting for debt a business does not expect to collect from its customers. It is a Contra-Asset account which marks down the value of Accounts Receivable. Many businesses face problems collecting payments and should take this allowance. It is provided for businesses so they won’t be left with these amounts in their receivables forever and allows a business to get a more realistic picture of how much money it will be receiving.
Two Methods for Calculating Bad Debt Allowance
The write-off can be taken each month and is calculated by one of two methods. The first is an historical percentage. The business takes the total write-off taken over the past two years and uses the following formula to calculate the current write-off:
Write-Offs ÷ Total Sales = Current write-off Percentage
So for example, if the total amount of write-offs over the last 2 years was $10,000 and the total sales for the last 2 years was $200,000, the calculation would look like this:
$10,000 ÷ $200,000 = 5%
If total sales for the current month are $7,000, then the amount to move to Bad Debt Allowance for the month is $350 ($7,000 x 5%). The entry in the books would be a credit to Accounts Receivable and a debit to Bad Debt Allowance.
If a business does not have two years of history, then it uses the second method. This one uses the total amount of receivables that is over 90 days past due. This amount is found on the Accounts Receivable aging statement in the 90+ column.
If you have $200 past due you can enter $200 into Bad Debt Allowance. Once a business has two years of history it will change to the historical percentage method.
Bad Debt Expense
Keep in mind when making entries into Bad Debt Allowance that the noncollectable amount still remains in the company’s Accounts Receivable. It does not remove the allowance from the books. That is where Bad Debt Expense comes in. If a business has shown that it has made every effort to collect on a debt and 90 days has passed since payment was due, it can be claimed as an expense. That amount is moved from Bad Debt Allowance to Bad Debt Expense which will reduce the income of the business the same as any of its other expenses. This is done by entering a credit to Bad Debt Allowance account and a debit to Bad Debt Expense (which is a debit or decrease to earnings).