Nowadays cash is not transferred immediately with the transfer of goods or services. Most of the businesses deal the products on the credit basis. The commodity is sold, and an invoice is sent to the customer and fixed future date for payment. The customer makes payment on due date. In this case, there is a higher chance of customer default (fail to pay). This default must be treated as an expense of the seller, and a part of money is set aside for this default, known as” Doubtful” accounts. If you want to learn how to account for doubtful debts, just follow the below-given step by step guide.
1. Record the journal entry to identify a sale on credit.
Accounting for doubtful debts assumes credit sale, start by recording the sale in a general journal. For example, suppose a company that provides $2000 of services to a customer on credit and to record this journal entry, the company will debit Account Receivable for $2000 and credit services revenue $2000.
2. Calculate the portion of accounts receivable that will be noncollectable.
When goods or services are sold on the credit basis, it is not possible that a company will be able to get the whole amount owing. Some customers will fail to pay the money. For recovering this payment, an allowance is set aside to deal the bad debts.
- Using a percentage of total sales is one method to estimate the noncollectable. For example, a company may look at past data and conclude that 2% of its sales on credit will be uncollected.
- Creating a receivable old schedule is another method.It is a more complex method. It uses past data to determine the possibility of payment founded on how many days past due receipt is.
3. Record the journal entry to generate the doubtful account allowance.
In the example above, let suppose the company decides to estimate bad debts accounts as 2 percent of total services revenue. Therefore, the allowance needed is (2/100 * 2000) = $40. The company debits Bad Debts Expense for $40 and credit Allowance for doubtful accounts for $40.
- Allowance for Doubtful Accounts is contra-asset account. To know net realizable “receivables” allowance for doubtful account is subtracted from account receivable.
- The expense is entered quickly by Using the matching principle. Even though this consumer may very well pay in full, the expense is acknowledged to match it with its respective revenue.
4. Arrange the balance of the allowance account as necessary.
Suppose if the company records another $10,000 in service revenue, then another journal entry is needed to increase the allowance account. The company debits Bed Debts Expense by $200 and credits Allowance for doubtful Account by $200. The allowance accounts balance is now equal to $240.
5. Record the journal entry to identify a noncollectable account.
When an individual account is recognized as bad debt (for example if the buyer become bankrupt and lost all asset), a journal entry is needed.In the above example, suppose that a customer’s account balance of $100 has been considered bad debts. To write off accounts, the company debits Allowance for Doubtful Accounts for $100 and credits Account Receivable for $100. Through this, the balance of allowance account is used to cover the drop in receivable essentially