If a company makes a sale on credit, basically what happens, because of the matching principle, is that the company must estimate its expense while also making a bad debt expense and a warranty expense estimate? or it must await until we see that the client will may not pay or will not pay and recognize the bad debt expense on the income statement?
Could anyone please go step by step on the procedures a company goes through when they make a sale on credit: what I think is like this:
-
Sale on credit, recognize revenue, recognize expense (because of the matching principle), make an entry for accounts receivable, make an entry to allowance for doubtful accounts.
-
If the customer does not pay, or increase probability of not paying, update allowance for doubtful accounts, go and recognize a bad debt expense en the SG&A expense.
Bad debt expense: actual loss on not recovering the cash
Allowance doubtful account: estimation amount not recovering form acc. receivables, RIGHT?
OR should bad debt expense be recognized also on the step number 1?. Thank you!!!
You don’t recognize any bad debt when you make the sale on credit because that would hit the company’s books. You reserve for bad debt when you believe there is a chance of the customer not paying. You expense the bad debt only when you know the customer isn’t going to pay (bankruptcy or if it’s not worth pursuing the payment anymore).
There are three common approaches to estimating bad debts:
- As a (fixed) percentage of total sales
- As a (fixed) percentage of credit sales
- Via an aging schedule on Accounts Receivable
Suppose that you use method 2, using 5% of credit sales as your estimate of uncollectable debts. I’ll show you some transactions.
(I apologize that the columns don’t line up correctly; I hope that it’s clear enough.)
Sell $20,000 of merchandise on credit.
Debit Credit
Accounts Receivable $20,000
Bad Debt Expense 1,000
Sales $20,000
Allowance for Doubtful Accounts 1,000
Customer pays in full.
Debit Credit
Cash $20,000
Accounts Receivable $20,000
Sell $10,000 of merchandise for cash.
Debit Credit
Cash $10,000
Sales $10,000
Sell $5,000 of merchandise on credit.
Debit Credit
Accounts Receivable $5,000
Bad Debt Expense 250
Sales $5,000
Allowance for Doubtful Accounts 250
Customer never pays, and you finally write off the account.
Debit Credit
Allowance for Doubtful Accounts $5,000
Accounts Receivable $5,000