In most receivables transactions, the amount to be recognized is the exchange price between the two parties. The exchange price is the amount due from a debtor (a customer or a borrower). It is generally evidenced by some type of business document, often an invoice. Receivables are claims held against customers and others for money, goods, or services .

Sales on any basis other than cash make possible the subsequent failure to collect the account. An uncollectible account receivable is a loss of revenue that requires, through proper entry in the accounts a decrease in the asset accounts receivable and a related decrease in income and stockholders’ equity. The loss in revenue and the decrease in income are recognized by recording bad debt expense.

It is very important to understand the concept of the net realizable value of accounts receivable, or NRV. Net realizable value is the amount that an organization expects to convert into cash. For example, if Great Life Inc. has a balance of $1,000,000 in accounts receivable, of which $25,190 are deemed to be uncollectible, then the remaining, $974,810 is the net realizable value, or the amount of cash that will be collected.

The InvestorWords.com defines bad debt as Accounts receivable that will likely remain uncollectible and will be written off. Bad debts appear as an expense on the company’s income statement, thus reducing net income. In general, companies make an estimate of bad debt expenses that might be incurred in the current time period based on past records as part of the process of estimating earnings. Most companies make a bad debt allowance since it is unlikely that all of their debtors will pay them in full.

There are two methods for recording uncollectible: The Direct Write-Off Method and the Allowance Method.

The Direct Write-Off Method is a very weak method because it does not apply the matching principle through which expenses are matched to revenues in the same period. This method records bad debt expense only when a company has given up its collection efforts and declares a specific account as uncollectible. For example, if a company granted credit for $1,000 in year 1 and after failing to collect that amount, in year 3, this account was written off. As a result, the year 3 was affected by an expense that in reality took place in year 1 but no one knew at the time. This method is GAAP only if the amount recorded as bad debt expense is immaterial. Those who disagree with accruals support this method because they consider that it really states facts.
The expense in year 3 is recorded as follows:

Bad debt expense 1,000
Accounts receivable 1,000

The allowance method follows GAAP and each company that has material amounts in accounts receivable should use it. The percentage of receivables that will be uncollectible can be predicted based on historical trends, industry statistics, and market conditions. Companies need to assess the credit worthiness of their customers to prevent a reduction of their profits when accounts have to be written off.

The allowance method follows two approaches: the income statement approach and the balance sheet approach. This method goal is to value an organization’s receivable at their future collectible amounts
The income statement approach is also called percentage-of-sales and it is considered more accurate in applying the matching principle. Let us assume that Life is Great Inc. has determined that 2.52% of its accounts receivable will not be collected by the company. The entry required is:

Bad Debt expense 25,519
Allowance for Bad Debt Expense 25,519

It is worth to note that when this method is used, the balance in the allowance account is not taken into consideration in the calculation of the current year allowance. It is a year in and year out computation.

The balance-sheet approach’s objective is to reflect an accurate estimate of the NRV. Usually, this method is applied based on an aging schedule, applying different percentages based on past experiences to the various age categories. For example, Life is Great Inc. aging summary is as follows:

Age Amount Estimated Uncollectible
0 – 30 days 50,000 5% $2,500
31 – 60 days 4,000 5% 200
61 – 90 days 2,650 - 1,500
Allowance for uncollect. $4,200

Life is Great Inc. had a debit balance of $500 in the allowance account; as a result, the amount to be recorded as bad debt expense would be $4,700 ($4,200 the desired amount + $500 debit balance). The entry would be the same as in the income statement approach, a debit to bad debt expense and a credit to allowance for bad debt expense.

If after an amount has been written off, its total or part of it is recovered, the easiest way to record it is by reversing the original entry by debiting accounts receivable (restating the account) and crediting the allowance for bad debt expense The collection would be then recorded as a normal account receivable by debiting cash and crediting accounts receivable.

Complying with GAAP is a must today more than ever. Be sure you apply these principles when recording bad debt expenses.