Target the ending allowance; the existing balance — credit or debit — matters

◈ 9 cards

Build an aging schedule to the required allowance, and compute bad debts expense as the difference from the existing balance — subtracting a credit, adding a debit.

The other question

The income-statement approach asked how much of this year's sales will go bad? The balance-sheet approach asks how much of what customers owe us right now will never arrive? — and the answer is not the expense. It is the balance the allowance must hold at year end. The expense is whatever entry gets the allowance from where it is to where it must be.

$Bad debts expense = Required allowance - existing credit balance or + existing debit balance$

Worked example — aging Bramble Lane's receivables

Suppose Bramble Lane used this approach instead. At 31 December customers owe 148,000. The older a debt, the likelier it is lost, so the receivables are sorted into age buckets and each bucket gets its own loss rate from experience:

Age	Balance	Estimated uncollectible	Required allowance
current	100,000	1 %	1,000
1–30 days past due	28,000	4 %	1,120
31–60 days past due	12,000	10 %	1,200
61–90 days past due	5,000	25 %	1,250
over 90 days	3,000	60 %	1,800
	148,000		6,370

The allowance must show a 6,370 credit at 31 December. That is the target; now look at what is there.

Case A — the allowance holds a 1,300 credit (last year's estimate outlasted last year's write-offs). It needs 6,370; it has 1,300; the entry supplies the difference:

$6, 370 - 1, 300 = 5, 070$

Dec 31  Bad Debts Expense                  5,070
            Allowance for Doubtful Accounts          5,070

Case B — the allowance holds a 900 debit. During the year more accounts were written off than last year's allowance held, so the allowance was overdrawn: it is 900 on the wrong side. To reach a 6,370 credit it must first be brought back to zero (900) and then up to the target (6,370):

$6, 370 + 900 = 7, 270$

Dr Bad Debts Expense 7,270 / Cr Allowance for Doubtful Accounts 7,270. Drawing the T-account settles the direction every time: a credit balance is part of the way to the target, so it is subtracted; a debit balance is the wrong way from the target, so it is added.

Either way the balance sheet reads the same, because the target is the same:

Accounts receivable                      148,000
Less allowance for doubtful accounts      (6,370)
Accounts receivable, net                 141,630

A single rate

A smaller case gives one rate for the whole balance rather than an aging. Harrowgate: receivables 62,000, 3 % estimated uncollectible, the allowance holding a 400 credit. Target $62, 000 \times 3% = 1, 860$ ; expense $1, 860 - 400 = 1, 460$ . The mechanics are the aging schedule's with one bucket.

The mark that is lost most often

Booking the target as the expense — 6,370 — is the single commonest error on this family. It is right only when the allowance happens to be empty. Under the income-statement approach the computed figure is the expense and the balance is ignored; under the balance-sheet approach the computed figure is the ending balance and the existing balance is everything. Say which approach the case uses before writing a number. In Excel the target is =SUMPRODUCT(balances, rates); the expense is that cell minus (or plus) the existing balance.

Older debts get higher rates. The total, 6,370, is the balance the allowance must hold — the target, not the expense.