What is the effect on the balance sheet when a company writes off a customers accounts receivable?

How businesses account for a receivable account that will not be paid

What is Bad Debt Expense?

Bad debt expense is the way businesses account for a receivable account that will not be paid. Bad debt arises when a customer either cannot pay because of financial difficulties or chooses not to pay due to a disagreement over the product or service they were sold.

Summary

Bad debt expense is used to reflect receivables that a company will be unable to collect.
Bad debt can be reported on financial statements using the direct write-off method or the allowance method.
The amount of bad debt expense can be estimated using the accounts receivable aging method or the percentage sales method.

Reporting Bad Debts

Bad debt can be reported on the financial statements using the direct write-off method or the allowance method.

1. Direct write-off method

The direct write-off method involves writing off a bad debt expense directly against the corresponding receivable account. Therefore, under the direct write-off method, a specific dollar amount from a customer account will be written off as a bad debt expense.

However, the direct write-off method can result in misstating the income between reporting periods if the bad debt journal entry occurred in a different period from the sales entry. For such a reason, it is only permitted when writing off immaterial amounts. The journal entry for the direct write-off method is a debit to bad debt expense and a credit to accounts receivable.

2. Allowance method

The allowance method estimates bad debt expense at the end of the fiscal year, setting up a reserve account called allowance for doubtful accounts. Similar to its name, the allowance for doubtful accounts reports a prediction of receivables that are “doubtful” to be paid.

In contrast to the direct write-off method, the allowance method is only an estimation of money that won’t be collected and is based on the entire accounts receivable account. The amount of money written off with the allowance method is estimated through the accounts receivable aging method or the percentage of sales method. An example of an allowance method journal entry can be found below.

Entry 1: The amount of bad debt is estimated using the accounts receivable aging method or percentage of sales method and is recorded as follows:

Entry 2: When a specific receivables account is deemed to be uncollectible, allowance for doubtful accounts is debited and accounts receivable is credited.

Estimating the Bad Debt Expense

The amount of bad debt expense can be estimated using the accounts receivable aging method or the percentage sales method.

1. Accounts receivable aging method

The accounts receivable aging method groups receivable accounts based on age and assigns a percentage based on the likelihood to collect. The percentages will be estimates based on a company’s previous history of collection.

The estimated percentages are then multiplied by the total amount of receivables in that date range and added together to determine the amount of bad debt expense. The table below shows how a company would use the accounts receivable aging method to estimate bad debts.

2. Percentage of sales method

The percentage of sales method simply takes the total sales for the period and multiplies that number by a percentage. Once again, the percentage is an estimate based on the company’s previous ability to collect receivables.

For example, if a company with sales of $2,000,000 estimates that 2% of sales will be uncollectible, their bad debt expense would be $40,000 [$2,000,000 * 0.02].

Example

Consider a roofing business that agrees to replace a customer’s roof for $10,000 on credit. The project is completed; however, during the time between the start of the project and its completion, the customer fails to fulfill their financial obligation.

The original journal entry for the transaction would involve a debit to accounts receivable, and a credit to sales revenue. Once the company becomes aware that the customer will be unable to pay any of the $10,000, the change needs to be reflected in the financial statements.

Therefore, the business would credit accounts receivable of $10,000 and debit bad debt expense of $10,000. If the customer is able to pay a partial amount of the balance [say $5,000], it will debit cash of $5,000, debit bad debt expense of $5,000, and credit accounts receivable of $10,000.

Significance of Bad Debt Expense

Fundamentally, like all accounting principles, bad debt expense allows companies to accurately and completely report their financial position. At some point in time, almost every company will deal with a customer who is unable to pay, and they will need to record a bad debt expense. A significant amount of bad debt expenses can change the way potential investors and company executives view the health of a company.

For the above-mentioned reasons, it is critical that bad debts are recorded timely and accurately. In addition, they help companies recognize customers who defaulted on payments to avoid similar situations in the future.

Additionally, bad debt expense does comes with tax implications. Reporting a bad debt expense will increase the total expenses and decrease net income. Therefore, the amount of bad debt expenses a company reports will ultimately change how much taxes they pay during a given fiscal period.

What happens to receivables on the balance sheet?

The receivable remains on the balance sheet until it is paid, at which time the amount received joins your cash on the asset side. Any outstanding amounts your customers owe you remain as receivables, but only for a limited time. For example, a business may create a mailing list of clients or establish a patent.

Is the ending balance on the trial balance sheet for accounts receivable?

The ending balance on the trial balance sheet for accounts receivable is usually a debit. Accounts receivables represent the value of a company’s outstanding invoices owed by customers for products and/or services delivered. Accounts receivables should ideally be collected within 90 days or less with a 90% collection rate.

What is the nature of a firm's accounts receivable?

The nature of a firm's accounts receivable balance depends on the sector in which it does business, as well as the credit policies the corporate management has in place. A company keeps track of its A/R as a current asset on what's called a " balance sheet ."

How does a bad debt write off affect the balance sheet?

Some companies just write off a bad debt as an expense on the income statement. But my question is how does it affect the balance sheet? A debt such as an accounts receivable is shown as an asset on the balance sheet. So if we remove an asset from the sheet, won't this mean that the balance sheet no longer balances out? balance-sheet

How does a write

When debts are written off, they are removed as assets from the balance sheet because the company does not expect to recover payment. In contrast, when a bad debt is written down, some of the bad debt value remains as an asset because the company expects to recover it.

What happens when you write

Definition of the Write-off of a Bad Account The write-off of a bad account usually refers to eliminating an account receivable due to the customer's inability to pay the amount owed. The entry to write off a bad account depends on whether the company is using the direct write-off method or the allowance method.

Does a write

Under the allowance method, a write‐off does not change the net realizable value of accounts receivable. It simply reduces accounts receivable and allowance for bad debts by equivalent amounts.

How does accounts receivable affect balance sheet?

How would cash collected on accounts receivable affect the balance sheet? When it collects cash against its A/R balance, a company is converting the balance from one current asset to another. Its A/R balance decreases, while its cash balance increases. Liabilities and equity remain unchanged.