Allowance for credit losses: Journal Entries
The topic of the allowance for credit losses is included in subsequent measurement of accounts receivable.
The below concept map is a continuation from the last page detailing the concepts that you need to learn related to the allowance for credit losses.
Before working through the allowance method, it’s worth contrasting it with the simpler alternative: the direct write-off method, which expenses a specific account only once it’s identified as uncollectible, with no estimate and no contra-asset account involved. GAAP permits the direct write-off method only when bad debts are immaterial, because it recognizes the expense whenever the account happens to be written off rather than matching it to the period of the related sale. The allowance method covered below is the GAAP-preferred approach because it satisfies the matching principle.
Journal entries
The accounting for credit losses for accounts receivable are best learned by understanding the journal entries and T-accounts of all the relevant accounts affected. It is also important to know what are the relationships among these accounts to be able to analyze exam problems properly. Three accounts are generally used for this process:
We find that getting familiar with their normal balances and the nature of the accounts help with better understanding of the journal entries. Get familiar with the following journal entries (JEs) and then we will use them to discuss the estimation process in the next section.
JE 2: Record estimated credit losses
A discussion on how this journal entry is prepared is in the next section about the estimation process. When we book bad debts expense, the accounts receivable is not directly affected because this is only an estimate of future credit losses. Instead companies should include this estimate in a contra-asset account called “allowance for credit losses” which effectively decreases the amount of accounts receivable in the balance sheet.
| Account | Debit | Credit | Financial statement element |
| Bad debts expense | $500 | Expense | |
| Allowance for credit losses | $500 | Asset (contra) | |
| To record estimated bad debts for the period | |||
The balance of the “allowance for credit losses” account at the end of the period, represents the total amount of accounts receivable that the company does not expect to collect in the future.
JE 3: Record write-off of receivables
When a company determines with certainty that an accounts receivables is uncollectible, the company needs to record a write-off using the following journal entry:
| Account | Debit | Credit | Financial statement element |
| Allowance for credit losses | $300 | Asset (contra) | |
| Accounts receivable | $300 | Asset | |
| To record write-off of accounts receivable | |||
Notice that the journal entry above does not have an impact on the bad debts expense. This is because the impact on the income statement (i.e., expense) has already been previously recorded through the estimation process in JE 2 above.
In effect, a write-off of an accounts receivable does not impact the net accounts receivable since we are just removing the uncollectible balance from both the allowance account and the accounts receivable account. Write-offs during the year can exceed the allowance’s balance, which leaves a temporary debit balance in the allowance; the year-end adjusting entry (JE 2) then credits the allowance enough to reach the required ending balance.
JE 4: Record recovery of previously written-off receivables
It is also common that companies recover previously written off accounts receivables. When this happens, we first re-establish the receivable that was previously written off by reversing JE 3 - debiting accounts receivable and crediting allowance for credit losses - and then record the normal collection of that cash. Because accounts receivable is debited and credited by the same amount across those two steps, they net out, so companies typically record the recovery directly as a single compound entry:
| Account | Debit | Credit | Financial statement element |
| Cash | $100 | Asset | |
| Allowance for credit losses | $100 | Asset (contra) | |
| To record recovery of previously written-off accounts receivable | |||
Note that collections of previously written-off accounts receivable are not recorded as income but are reflected as an adjustment to the allowance for credit losses. The only time when the income statement is affected is during the estimation of bad debts (JE 2).
T-accounts related to allowance
A lot of the problems in the exam related to the allowance can be solved by an in-depth understanding of the T-accounts. Below is an example which references the journal entries from the previous section.
Allowance for credit losses T-account
Accounts receivable T-account
Quick trace: beginning balance $200 + estimate (JE 2) $500 − write-off (JE 3) $300 + recovery (JE 4) $100 = ending balance $500. In general, beginning allowance + estimate − write-offs + recoveries = ending allowance. Exam questions on the allowance account typically give you a beginning balance plus some combination of estimates, write-offs, and recoveries, and ask you to solve for the missing piece.
The image below previews the aging-of-receivables method used to estimate the allowance balance - a technique covered in full on the next page, Allowance for credit losses: Estimation process.