The bad debts allowance is created on the base of credit sales that a firm conducts over the course of a year. A particular percentage of bad debtors are decided from the top management which is to be used to base the bad debt allowance. The consistency is crucial in this regard.
Consider the following example:
Company credit sales = 400000
Uncollectable sales = 28000 (it can be a percentage as discussed in the previous step)
You have to calculate the percentage in the example given above; if you have the percentage move to step 3 instantly. Percentage of bad debts is (28000/400000) 0.07 or 7 percent.
Next year the sales were 500000. Now calculate the bad debts by multiplying the percentage calculated in the previous step. You will multiple 500000 to 7% which equals 35,000. So, you have to see the difference between the last year’s bad debt allowance and this year’s bad debt allowance.
The difference is positive 7000 (35000-28000). So you will credit the bad debt allowance account by 7000. If the amount was negative then you should debit the account. It is easy if you practice it regularly.