Estimating Bad Debt Expense

The requirement that a company estimate its bad debt expense follows the matching principle: revenues generated from credit sales are matched with the bad debt estimates from those credit sales.

The bad debt expense reduces net income for the same period the credit sales were reported on the income statement. Because it cannot be known which accounts will be written off until the period after credit sales are made, estimates are required.

Estimates for bad debt are also subtracted from the accounts receivable balance by creating the allowance for doubtful accounts contra account. This account reduces the accounts receivable balance to arrive at the reportable amount of receivables on the balance sheet. This reportable amount is called the net realizable value, or the amount of cash the company expects to receive from accounts receivable.

The estimate for bad debt reduces both the net earnings on the income statement for the period, and the accounts receivable asset on the balance sheet.

Two Purposes for Bad Debt Expense

The estimate for bad debts reduces both net earnings on the income statement, and the accounts receivable
asset on the balance sheet.

Estimating bad debts therefore serves two main purposes:

It matches the revenue generated from credit sales with the expense incurred from them by recording a bad debt expense on the income statement.
It reduces the accounts receivable balance on the balance sheet using the contra account allowance for doubtful accounts.

Estimates for bad debt are either based on

1. A percentage of credit sales, or

2. A percentage of the ending accounts receivable balance.

Both methods are acceptable under GAAP. The first method emphasizes the matching principle, while the second
method emphasizes reporting account receivable at the net realizable value.

Since Sunny Sunglasses is new in the business, Sunny estimated that roughly 1% of credit sales will be uncollectible based on industry averages, and recorded the following entry at year-end: