How to Record Doubtful Accounts

Recognizing that some customers won't pay their invoices is a fundamental part of accrual accounting. Properly recording these doubtful accounts is key to presenting an accurate financial picture of your business's health. This article will walk you through the correct methods for estimating and booking bad debt expense, writing off uncollectible invoices, and handling subsequent recoveries.

What Are Doubtful Accounts?

Doubtful accounts, also known as bad debts, are accounts receivable that are unlikely to be collected. When you sell goods or services on credit, you create an account receivable—an asset representing money owed to you. However, reality dictates that not all of these receivables will be converted to cash. The process of accounting for doubtful accounts involves estimating this future loss and recognizing it as an expense in the same period as the related revenue.

This practice adheres to two cornerstone principles of Generally Accepted Accounting Principles (GAAP):

• The Matching Principle: This principle directs businesses to report an expense on their income statement in the same period as the related revenue. Since the revenue from the credit sale is recognized at the time of sale, the potential expense of that sale not being collected should also be recognized.
• The Conservatism Principle: This principle guides accountants to anticipate potential losses but not potential gains. It encourages a degree of caution, ensuring that assets (like accounts receivable) are not overstated on the balance sheet.

There are two primary methods for handling bad debt: the allowance method and the direct write-off method. Let's explore each one.

The Allowance Method: The GAAP-Approved Approach

The allowance method is the preferred and GAAP-compliant way to account for bad debt. It involves creating a contra-asset account called the "Allowance for Doubtful Accounts" (or sometimes "Allowance for Bad Debts"). A contra-asset account is an asset account with a natural credit balance, meaning it reduces the balance of another asset account. In this case, it reduces the gross accounts receivable to its net realizable value—the amount you realistically expect to collect.

The key here is that you estimate and record bad debt expense before you know which specific invoices will go bad. This happens via a period-end adjusting journal entry. There are two common techniques for estimating the amount for this entry.

Estimating Bad Debt with the Percentage of Sales Method

The percentage of sales method (or income statement approach) is straightforward. It estimates bad debt expense based on a flat percentage of the period's credit sales. This percentage is typically derived from the company's historical data on uncollectible accounts.

The Formula:
Total Credit Sales for the Period x Historical Bad Debt Percentage = Bad Debt Expense

Let's walk through an example:

Imagine your company, "Quality Widgets Inc.," had credit sales of $500,000 for the year. Based on historical trends, you know that about 2% of credit sales eventually become uncollectible.

1. Calculate the Bad Debt Expense:
   $500,000 (Credit Sales) x 2% (Historical Rate) = $10,000 (Bad Debt Expense for the period)
2. Record the Adjusting Journal Entry:
   At the end of the year, you'll make this journal entry to record the expense and fund the allowance account:

Debit: Bad Debt Expense for $10,000
Credit: Allowance for Doubtful Accounts for $10,000

This entry correctly places the $10,000 expense on the income statement for the year when the $500,000 in sales occurred, perfectly following the matching principle. The Allowance for Doubtful Accounts balance on the balance sheet now increases by $10,000.

Estimating Bad Debt with the Percentage of Receivables Method

The percentage of receivables method (or balance sheet approach) focuses on estimating the appropriate final balance for the Allowance for Doubtful Accounts. The most common sub-method here is the "Aging of Accounts Receivable" method, which is more precise.

This technique involves categorizing all open invoices by their age (how long they have been outstanding) and applying a different percentage of expected uncollectability to each category. The logic is simple: the older an invoice is, the less likely it is to be collected.

Let's walk through an aging example:

At year-end, Quality Widgets Inc. has a total Accounts Receivable balance of $120,000. Before the year-end adjustment, its Allowance for Doubtful Accounts has a credit balance of $500.

1. Create an Aging Schedule: You first group the outstanding receivables by age. You then apply a historical default percentage to each group.

   • Current (0-30 days): $70,000 (1% estimated uncollectible) = $700
   • 31-60 days past due: $30,000 (5% estimated uncollectible) = $1,500
   • 61-90 days past due: $15,000 (20% estimated uncollectible) = $3,000
   • Over 90 days past due: $5,000 (50% estimated uncollectible) = $2,500

2. Calculate the Target Allowance Balance: You add up the estimated uncollectible amounts from each category.
   $700 + $1,500 + $3,000 + $2,500 = $7,700

   This is the required ending balance in your Allowance for Doubtful Accounts account.

3. Determine the Current Period's Expense: Your goal is to get the Allowance account to $7,700. It currently has a $500 credit balance. Therefore, you need to add to it.
   $7,700 (Target Balance) - $500 (Existing Balance) = $7,200 (Bad Debt Expense for the period)

4. Record the Adjusting Journal Entry:
   Now you book the entry for the amount calculated in the previous step.

Debit: Bad Debt Expense for $7,200
Credit: Allowance for Doubtful Accounts for $7,200

After posting this entry, the balance in the Allowance for Doubtful Accounts will be $500 + $7,200 = $7,700, precisely where you want it to be. This method provides a more accurate Net Realizable Value for your accounts receivable on the Balance Sheet.

Writing Off a Specific, Uncollectible Account

So, you've been recording your bad debt expense estimate periodically. What happens when you decide a specific invoice from a specific customer is truly uncollectible? Now you write it off. Let's say a customer, "Bad Payers LLC," owes you $800, and they've gone out of business. It's time to remove their receivable from your books.

The journal entry uses the allowance account you've built up:

Debit: Allowance for Doubtful Accounts for $800
Credit: Accounts Receivable (for Bad Payers LLC) for $800

Notice a very important detail: Bad Debt Expense is NOT part of this entry. You already expensed this potential loss when you made your periodic adjusting entry. The write-off simply cleans up the Accounts Receivable ledger and draws down the allowance you previously created. This transaction has no effect on the income statement or the total assets on your balance sheet; it just reduces both Gross AR and the Allowance, leaving the Net Realizable Value unchanged.

Handling a Recovery of a Written-Off Account

Sometimes, miracles happen. Six months after writing off the $800 invoice from Bad Payers LLC, you receive a check from them in the mail for the full amount. Now you need to record the recovery.

This requires a two-step process:

1. Step 1: Reverse the Write-Off. First, re-establish the customer's account receivable by reversing the entry you used to write it off.

   Debit: Accounts Receivable (for Bad Payers LLC) for $800
   Credit: Allowance for Doubtful Accounts for $800

2. Step 2: Record the Cash Payment. Now that the receivable is back on the books, you can record the customer's payment just as you would for any other invoice.

   Debit: Cash for $800
   Credit: Accounts Receivable (for Bad Payers LLC) for $800

Following both steps is important for maintaining a clean and accurate transaction history for that customer account.

What About the Direct Write-Off Method?

The direct write-off method is much simpler, but it is not compliant with GAAP. Under this method, you do nothing until a specific invoice is deemed uncollectible. Only then do you record an expense.

Using the previous example, if Bad Payers LLC's $800 invoice from last year becomes uncollectible this year, you would simply make this entry:

Debit: Bad Debt Expense for $800
Credit: Accounts Receivable (for Bad Payers LLC) for $800

The problem is clear: the revenue from this sale was recognized last year, but the expense is being recognized this year. This violates the matching principle. This method also overstates your accounts receivable, as there is no allowance to account for expected losses. For these reasons, it is only acceptable for businesses that have very few, immaterial incidences of bad debt, or for tax purposes where a direct write-off is often required.

Putting It Into Practice with Accounting Software

Modern accounting tools make recording doubtful accounts more manageable. In a program like QuickBooks Online or Xero, the workflow generally looks like this:

• Initial Setup: Ensure you have the necessary accounts in your Chart of Accounts: a "Bad Debt Expense" account (expense type) and an "Allowance for Doubtful Accounts" account (asset type, specifically an "Other Current Asset" often set to counteract Accounts Receivable).
• Recording the Estimate: At the end of each period, you will use the general journal entry feature to record the debit to Bad Debt Expense and credit to the Allowance for Doubtful Accounts based on your calculations (either from the percentage of sales or aging method).
• Writing Off an Invoice: When a specific invoice is uncollectible, you can use a credit memo. You would create a credit memo for the customer, apply it to the unpaid invoice, and code the credit to the Allowance for Doubtful Accounts account. This correctly cleans up the receivable without hitting your expense account a second time.

Final Thoughts

Mastering the accounting for doubtful accounts using the allowance method is fundamental to accurate financial reporting. By estimating and recording bad debt expense in the same period as revenue, you provide a more reliable and GAAP-compliant view of your company's performance and financial position.

Determining the right bad debt estimate or handling the complex tax implications of bad debt and recoveries can involve a lot of research. Rather than spending valuable hours confirming IRC sections or state guidance, Feather AI gives us instant, citation-backed answers. You can ask complex tax questions in plain English and get audit-ready responses in seconds, freeing you to focus on the strategic judgment that builds lasting client trust and better business outcomes.