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Accounting for Bad Debts

The two methods for accounting for bad debts are the Direct Write-off method and the Allowance method.

Direct write-off does not properly match, nor does it conform to conservatism, hence the method is not GAAP. It is, however, the method that must be used for income tax reporting.

The Allowance method (is GAAP) does properly match expenses with revenues and is in conformity with conservatism and can be applied in two different, yet similar ways: Income statement method—relies on an estimate based on a percentage of net credit sales. The balance in the allowance account at the end of the period is not taken into consideration. The percentage of net credit sales is debited to Bad debt expense and credited to the Allowance for bad debts accounts, no matter the balance in the allowance account. (The Kimmel, et al. text does not present this method)

Balance sheet method—relies on an estimate of uncollectible accounts made during an analysis of the Accounts receivable account. The balance in the Allowance account is taken into consideration and the adjusting entry brings the Allowance account up to the desired amount. If the allowance account has a debit balance, it is “overdrawn”. In other words, there have been more write-offs than planned. If the allowance account has a credit balance, it has a positive balance and has not been utilized as fully as was expected.

Accounting for bad debts expense is done only at the end of the accounting period and is done as an adjusting entry. The Bad debt expense account is not used at the time individual accounts are written off. The adjusting entry looks identical under either the Income Statement method or the Balance Sheet method (since Direct Write-off is not GAAP, we won’t do the journal entries related to the method). The adjusting journal entry replenishes the allowance

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