To account for bad debts, a company has two approaches at its disposal. One is commonly referred to as the sales approach which will use a percentage of the total sales to compute the bad debts amount. The other refers to the accounts receivable approach which calculates the final amount by taking a percentage of accounts receivable.
For accounting purposes, a journal entry is recorded in the two general ledger accounts, which will be referred to as a bad debt expense account, and allowance for doubtful account. Irrespective of the method applied, the former will have a debit entry, while the latter will have a credit entry. Allowance for doubtful account is known as a contra-asset account, which is used to subtract a related amount from an asset account, which in this case is accounts receivable.
In the first approach, a company will look at the historical data and determine a percentage of its sales which they feel will not be collected. So for instance, if a company has reported sales of $1000, and has set 2% for sale uncollectible, then by multiplying the two values, it will know that $20 of the sales revue will go unpaid. By establish that in the books, it will debit the bad expense account $20, and credit the same amount in the Allowance for Doubtful Accounts. Here any outstanding balance in the Allowance account will not be considered.
Now look at the other approach. Assume that the company has decided that 2% of the accounts receivable will go uncollected. If the A/R’s balance is 2000, the journal entry to record this expense will be to report the Bad debt Expense as $40 (2000 x 0.02) and credit the Allowance account $40. As opposed to the sales approach, any previous amount in the allowance account will be carry forward and the entries will be adjusted accordingly.