How to Calculate Bad Debt Under the Allowance Method?

Percentage of Sales Method

Example: The company estimates bad debt based on the percentage of sales method. Sales for the fiscal year ended December 31, 2013 were \$3,400,000, while credit sales were \$2,900,000. The company estimates that 1.5% of credit sales are uncollectible. Allowance for Doubtful Accounts has a credit balance of \$17,000. Record the adjusting journal entry necessary to record bad debt.

First identify the accounts that will be used in the entry. We already know this is a bad debt entry because we are asked to record bad debt. The percentage of sales method is an allowance method. We are also told that the company is estimating bad debt, so this is clearly not a company that uses direct write-off. Therefore, we will be using Allowance for Doubtful Accounts and Bad Debt Expense.

Time to calculate the amount of the transaction. The company estimates that 1.5% of credit sales are uncollectible. Therefore, we will use credit sales.

\$2,900,000 x 1.5% = \$43,500

What is this number? When using the percentage of sales method, we multiply a revenue account by a percentage to calculate the amount that goes on the income statement. That means we are calculating bad debt expense. The amount of expense is proportional to the amount of revenue.

What is the balance in Allowance for Doubtful Accounts? The account had a credit balance of \$17,000 before the adjustment. The entry from December 31 would be added to that balance, making the adjusted balance \$60,500. The percentage of sales method does not factor in the existing balance in Allowance for Doubtful Accounts. Without careful monitoring, the balance in the account could grow indefinitely. It is important for management to monitor the balance to ensure the balance is reasonable.

Percentage of Receivables Method

Example: The company estimates bad debt based on the percentage of receivables method. The balance in Accounts Receivable on December 31, 2013 was \$530,000. The company estimates that 6% of receivables are uncollectible. Allowance for Doubtful Accounts has a credit balance of \$17,000. Record the adjusting journal entry necessary to record bad debt.

As in all journal entries, the first step is to figure out which accounts will be used. Because this is just another version of an allowance method, the accounts are Bad Debt Expense and Allowance for Doubtful Accounts.

On to the calculation, since the company uses the percentage of receivables we will take 6% of the \$530,000 balance.

\$530,000 x 6% = \$31,800

Now to consider what this amount is. We used Accounts Receivable in the calculation, which means that the answer would appear on the same statement as Accounts Receivable. Therefore, we have to consider which of our accounts would appear on the balance sheet with Accounts Receivable. Allowance for Doubtful Accounts is a contra-asset account so that is what we calculated. The adjusted balance in Allowance for Doubtful Accounts should be \$31,800. Since the current balance is \$17,000, we need to increase the balance to \$31,800. We do this by crediting the account \$14,800. The \$14,800 is the amount of Bad Debt Expense that must be recorded.

When using an allowance method, it is critical to know what you are calculating. If using sales in the calculation, you are calculating the amount of bad debt expense. If using accounts receivable, the result would be the adjusted balance in the allowance account.