Companies that provide goods and services often give their customers credit, meaning a certain number of days within which to pay the outstanding balance on their account. Some businesses ask clients to pay cash immediately upon receipt of the good or service. Others send an invoice that must be paid within 15, 30, or even 60 days. Businesses that provide credit know that some clients will never pay their account balances. These accounts are called uncollectible accounts, or bad debt. In order to account for bad debt, companies have two options: the direct write-off or the allowance for doubtful accounts method. The allowance for doubtful accounts method is an estimate of how much of the company's accounts receivable, meaning credit sales, will be uncollectible. This estimate is entered as an adjustment in the books at the end of each accounting period. It allows a company to remain in compliance with financial reporting requirements. The direct write-off method does not. The direct write-off method is simply the writing-off of the bad debt as soon as a company has determined that a certain account is uncollectible.
If a sale becomes uncollectible, then the following entry will be made if the direct write-off method is being used:
Date Account Debit Credit Explanation
Aug 31 Bad Debts Expense $850 Write-off Invoice 3524
Accounts Receivable $850 Write-off Invoice 3524
If the allowance method is being used, the entry will be:
Date Account Debit Credit Explanation
Aug 31 Bad Debts Expense $850 Write-off Invoice 3524
Allowance for Uncollectible Accounts $850 Write-off Invoice 3524
During this tutorial, the account names allowance for doubtful accounts, allowance for bad debt, and allowance for uncollectible accounts will be used interchangeably.