Allowance for credit losses: Journal Entries

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 1: Record the sale

This has already been covered in previous sections but only included here to show the full picture of the estimation process.

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.

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:

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. (Note that JE 1 through JE 4 on this page are independent, illustrative entries rather than a single continuous period - that’s why the write-off here is larger than the single estimate in JE 2. In practice, a write-off can never exceed the allowance’s accumulated credit 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:

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