Companies provide services or sell goods for cash or on credit. Allowing credit tends to encourage more sales. However, businesses that allow credit are faced with the risk that their receivables may not be collected.
Accounts receivable is presented in the balance sheet at net realizable value, i.e. the amount that the company expects it will be able to collect.
Net realizable value (NRV) for accounts receivable is computed like this:
| Accounts Receivable - Gross Amount | $100,000 |
| Less: Allowance for Bad Debts | 3,000 |
| Accounts Receivable - NRV | $ 97,000 |
Allowance for Bad Debts (also often called Allowance for Doubtful Accounts) represents the estimated portion of the Accounts Receivable that the company will not be able to collect.
Take note that this amount is an estimate. There are several methods in estimating doubtful accounts. These estimates are often based on the company's past experiences.
To recognize doubtful accounts or bad debts, an adjusting entry must be made at the end of the period. The adjusting entry for bad debts looks like this:
| Dec | 31 | Bad Debts Expense | xxx.xx |
|---|---|---|---|
| Allowance for Bad Debts | xxx.xx |
Bad Debts Expense a.k.a. Doubtful Accounts Expense: An expense account; hence, it is presented in the income statement. It represents the estimated uncollectible amount for credit sales/revenues made during the period.
Allowance for Bad Debts a.k.a. Allowance for Doubtful Accounts: A balance sheet account that represents the total estimated amount that the company will not be able to collect out of its total Accounts Receivable.
Bad Debts Expense is an income statement account while the latter is a balance sheet account. Bad Debts Expense represents the uncollectible amount for credit sales made during the period. Allowance for Bad Debts, on the other hand, is the uncollectible portion of the entire Accounts Receivable.
You can also use Doubtful Accounts Expense and Allowance for Doubtful Accounts in lieu of Bad Debts Expense and Allowance for Bad Debts. However, it is a good practice to use a uniform pair. Some say that Bad Debts have a higher degree of uncollectibility that Doubtful Accounts. In actual practice, however, the distinction is not really significant.
Gray Electronic Repair Services estimates that $100.00 of its credit revenue for the period will not be collected. The entry at the end of the period would be:
| Dec | 31 | Bad Debts Expense | 100.00 |
|---|---|---|---|
| Allowance for Bad Debts | 100.00 |
Again, you may use Doubtful Accounts. Just be sure to use a logical (and uniform) pair every time. For example:
| Dec | 31 | Doubtful Accounts Expense | 100.00 |
|---|---|---|---|
| Allowance for Doubtful Accounts | 100.00 |
If the company's Accounts Receivable amounts to $3,400 and its Allowance for Bad Debts is $100, then the Accounts Receivable shall be presented in the balance sheet at $3,300 – the net realizable value.
| Accounts Receivable - Gross | $ 3,400 |
| Less: Allowance for Bad Debts | 100 |
| Accounts Receivable - NRV | $ 3,300 |
Bad debts expense refers to the portion of credit sales that the company estimates as non-collectible.
The journal entry to record bad debts is:
Dr Bad Debts Expense
Cr Allowance for Bad Debts
Another common term used for bad debts is "doubtful accounts".
Allowance for bad debts (or allowance for doubtful accounts) is a contra-asset account presented as a deduction from accounts receivable.